Third Circuit Highlights Limits on Royalty and Other Payment-Stream Collateral in Bankruptcy

City of Chester v. PHCC and its potential implications for royalty monetizations, royalty bonds, and other financings secured by contractual rights to payment

Introduction: Cutting Off Payment Streams in Bankruptcy

    A recent Third Circuit decision offers important drafting and structuring lessons for participants in financings secured by contractual rights to payment. Although the decision, In re City of Chester, Pennsylvania, 182 F.4th 264 (3d Cir. 2026), arose from a chapter 9 bankruptcy case involving pledged municipal revenues, the court’s discussion of the post-bankruptcy termination of liens on contractual payment streams is not limited to chapter 9 cases or municipal financings. The court’s reasoning could extend to any financing involving a security interest in a stream of payments.

            Because patent licenses often generate critical value for life sciences companies, the issues addressed in City of Chester come into play in capital-raising life sciences transactions involving those licenses, including royalty monetizations, royalty-backed bonds, and loans secured by related royalty and milestone payments. As discussed below, however, the risks highlighted in City of Chester do not affect each of these structures equally.

            Overview: Two Risks Related to Postpetition Payment Streams

            The Third Circuit’s decision primarily addresses two issues concerning a lender’s continued security interest in a payment stream after a bankruptcy filing:

• Scope of the Grant. City of Chester illustrates the important distinction between a security interest in future payments versus a security interest in a prepetition contractual right that generates the payments as “proceeds” for purposes of Article 9 of the Uniform Commercial Code (“UCC”). That distinction is material in bankruptcy because section 552(a) of the Bankruptcy Code generally cuts off pre-bankruptcy (“prepetition”) liens from extending to post-bankruptcy (“postpetition”) property, but section 552(b) preserves a lien in postpetition property that constitutes the proceeds of prepetition collateral. 
• Indeterminate Proceeds. City of Chester also highlights that even if the prepetition collateral includes a payment right, bankruptcy may cut off the lien if postpetition payments arise only as a result of the postpetition actions of the debtor or a third party. If the payments are “too indeterminate” as of the bankruptcy filing, they may constitute postpetition property free of the prepetition lien.

            The first risk (scope of the grant) is largely a drafting point. Lenders should ensure the granting clause captures both the prepetition payment right and postpetition proceeds. This point is well understood by practitioners, and most royalty purchase agreements and royalty-backed financings are already drafted to address it. Still, City of Chester is a reminder that drafting gaps can have dire consequences in bankruptcy.

            The second risk (indeterminate proceeds) is potentially more significant and less susceptible to mitigation through a simple drafting improvement like a more detailed collateral description.[1] As discussed below, the section 552 risk can largely be mitigated by structural deal changes, such as a grant of a security interest in the patents underlying a royalty stream or the use of a true-sale or SPV structure to separate the payment stream from licensor bankruptcy risk.

The Underlying Issue: Lien Cutoffs in Bankruptcy under Section 552(a)

            Outside of bankruptcy, a lender can perfect a security interest in property of the debtor that does not yet exist when the security agreement is executed. Section 9-204 of the UCC authorizes “after-acquired property” clauses in security agreements, and Section 9-502 permits perfection in after-acquired property by filing a financing statement that properly describes the applicable collateral.[2] As the debtor acquires additional property after entering into the security agreement, that property becomes the lender’s collateral without the need for additional action by the parties or additional public filings. The UCC also generally provides for the continuation of a lender’s security interest in the “proceeds” of its collateral, which are defined in part as “[w]hatever is collected on, or distributed on account of, collateral.” UCC §§ 9-102, 9-203(f), 9-315. Together, these provisions allow for the continued acquisition and disposition of collateral during the life of the financing.

            A bankruptcy filing interrupts the smooth operation of this common financing mechanism. Section 552(a) of the Bankruptcy Code generally provides that property acquired by a debtor after the commencement of the bankruptcy (postpetition property) is not subject to a lien resulting from a prepetition security agreement. Section 552(b)(1), however, creates an exception to this general rule that preserves a lien in “proceeds, products, offspring, or profits” of prepetition collateral if the security agreement extends to those items by its terms and is enforceable under applicable nonbankruptcy law (e.g., the UCC).

Facts of City of Chester

            The City of Chester, Pennsylvania, pledged several revenue streams (the “Pledged Revenues”) to debtholders in connection with two municipal bond financings aimed at rescuing the city from financial decline: an issuance of $19 million in guaranteed revenue bonds (the “Revenue Bonds”); and a transaction in which the city agreed to pay a portion of Delaware County’s obligations under $28.6 million of general obligation bonds issued in connection with the construction of a professional soccer facility (the “Contribution Obligation”). The Pledged Revenues consisted of (i) payments by the operator of an incineration facility, calculated based on the amount of trash processed at the facility (the “Host Community Revenues”), and (ii) payments by a casino operator, calculated based on gambling revenues, which were required under state law and the operator’s contract with the city (the “Casino Revenues”). The Revenue Bonds were secured by both the Host Community Revenues and the Casino Revenues, while the Contribution Obligation was secured only by the Casino Revenues.

The Bankruptcy Court Decision: No Liens on Postpetition Pledged Revenues

            In its chapter 9 case, the city sought to avoid the liens of the bondholders and the county (the “Finance Parties”) in the Pledged Revenues and the turnover of cash generated postpetition by the Pledged Revenues, which was being held by the indenture trustee of the Revenue Bonds. In a summary judgment decision, the bankruptcy court first found the Finance Parties had properly perfected their security interests in the Pledged Revenues by filing financing statements because the Pledged Revenues constituted either “a payment intangible or account” under the UCC, rather than “money,” as argued by the city.[3]

            The bankruptcy court held, however, that the security interests were nonetheless cut off under section 552(a) with respect to any Pledged Revenues paid or payable to the city after the petition date.[4] The court reasoned that the UCC defines proceeds as “whatever is collected on or distributed on account of collateral,” and that separate collateral must exist for proceeds to arise.[5] In the court’s view, the Pledged Revenues could not constitute proceeds of prepetition collateral under section 552(b) because “the collateral quite simply is the Pledged Revenues themselves, which are not capable of producing identifiable proceeds to be collected on account of those revenues.”[6] The court contrasted a debtor granting a prepetition lien on patents, where the licensed patents generate royalties the debtor receives postpetition, stating the royalty payments would be exempt from cutoff under section 552(b) as proceeds of prepetition collateral.[7]

            Setting the stage for the Third Circuit’s treatment of indeterminate proceeds, the bankruptcy court made an alternative holding in a footnote: the Pledged Revenues were not subject to the Finance Parties’ liens because any payments by the facility operator and the casino depended on the amount of waste collected at the facility and the volume of gambling activity, respectively—postpetition actions of third parties. Citing a decision arising from Puerto Rico’s PROMESA proceeding (“Puerto Rico”), the court explained that any right to payment with respect to the Pledged Revenues “was contingent upon and only arises from the postpetition acts of others, and any proceeds from that right would constitute proceeds of postpetition property.”[8]

Scope of the Grant: Third Circuit Remands with Focus on the Granting Language

            On appeal, the Third Circuit differentiated the granting clauses of the two financings, concluding that the bankruptcy court had not fully considered material differences between them. Specifically, the agreement governing the Contribution Obligation granted an interest “in and to” the Pledged Revenues,[9] while the trust indenture governing the Revenue Bonds granted a security interest in “all of the right, title and interest of the City in and to” the Pledged Revenues.[10] The court suggested the broader language in the indenture might reach a prepetition right to payment distinct from the future stream of cash itself,[11] such that postpetition revenue payments could constitute proceeds.[12] The court remanded and instructed the bankruptcy court to determine the scope of collateral under each financing and whether the postpetition revenues qualified as proceeds under the UCC.

Does a Prepetition Lien Continue in “Indeterminate” Proceeds?

            The Third Circuit also invited the bankruptcy court to revisit its alternative holding that postpetition payments based on Host Community Revenues and Casino Revenues were unencumbered under section 552. Without reaching a conclusion on the issue, the court noted that it “may be” the debtholders were not entitled to postpetition revenue payments “because those proceeds were indeterminate at the time of the bankruptcy filing.”[13] In support, the court quoted the holding in Puerto Rico that “[u]ntil the postpetition computations [were] performed based upon postpetition facts, the receivable . . . did not exist.”[14] In so doing, it framed the issue on remand as one that the bankruptcy court could consider to avoid a more strenuous analysis of the granting clauses, but left unanswered the more interesting question: the scope of any “indeterminate proceeds” rule (if there is one) as applied to postpetition payment streams. For now, City of Chester means that financings involving security interests in future payment streams face potential risk and uncertainty in bankruptcy scenarios.

            While a comprehensive assessment of the “indeterminate proceeds” approach is beyond the scope of this article, it is worth highlighting that neither the bankruptcy court nor the Third Circuit examined the Puerto Rico decisions for relevant distinctions in the type of transactions and postpetition acts at issue there. Indeed, the special circumstances of Puerto Rico may not support a broad interpretation of the indeterminate proceeds analysis that City of Chester may suggest. In a 2020 decision in Puerto Rico, the First Circuit upheld the lower court’s indeterminate proceeds holding, but also clarified that the contingent revenues at issue (employer retirement fund contributions) were indeterminate because payment of such amounts was “contingent on Puerto Rico’s future fiscal status and the decisions of future Puerto Rico legislatures” to apportion the retirement fund payments to the bonds or other fiscal needs.[15] As the First Circuit later characterized the ruling on those unique facts, the bondholders had a “mere expectancy” of receiving the future revenues, not “a conveyable right of receipt that could support a section 552(b)(1) claim on post-petition proceeds[.]”[16]

In a further 2024 decision in Puerto Rico, the First Circuit emphasized that the need for additional government action was the deciding factor in its prior decision, concluding the employer contributions were not proceeds because “their receipt depended on intervening appropriation by the Puerto Rico legislature.”[17] That is, the First Circuit focused on whether the prepetition payment right was fixed, not on the postpetition actions of third parties. That situation seems distinguishable from the facts in City of Chester, where the city’s right to payment was established prepetition by existing statute and contract, and the postpetition payment is merely calculated based on revenues of facilities and casinos. Likewise, Puerto Rico can be distinguished from a licensee selling products, calculating amounts and making royalty payments postpetition as required under a prepetition license agreement.

            Two other issues not directly addressed in City of Chester – but implicit in the indeterminate proceeds analysis – may impact bankruptcy risk in connection with payment streams. First, City of Chester focused on the acts of third parties (the operators and customers of the waste facility and the casino). Existing caselaw already recognizes that proceeds generated by significant postpetition acts of the debtor requiring estate resources may be freed from a prepetition lien.[18] Patent license agreements often include continuing performance obligations of the debtor-licensor related to the ongoing commercialization of the IP. Those ongoing obligations create postpetition actions by the debtor that could put royalty payments at risk under the indeterminate proceeds analysis. 

            Second, section 552(b) supplies a tool for addressing value that the estate adds to collateral property after the petition date. Under the so-called “equities of the case exception,” the court may limit an otherwise valid lien on postpetition proceeds to the extent necessary to compensate the debtor for the provision of goods and services that benefit the collateral.[19] That exception to section 552(b)’s proceeds rule accounts for postpetition contributions by the debtor when allocating the value of collateral subject to a prepetition lien on proceeds.[20] In other words, assessing the extent of a lien on postpetition payments is not an all or nothing proposition.

Implications for Royalty Monetizations and Patent License-Backed Financings

            Royalty monetizations and patent license-backed financings can be sorted into four categories for purposes of assessing the relative impact of City of Chester.

• True sales of an entire royalty stream. If the seller sells its entire interest in a royalty stream in a transaction structured as a true sale, the royalties are not property of the seller’s estate, and section 552 does not come into play. The principal bankruptcy risk in those transactions is rejection of the license agreement, which we discussed in our earlier article.[21]
• Capped and partial sales. In many royalty monetization transactions, the buyer receives royalties only until it has received a specified multiple of the purchase price, after which the royalties revert to the seller. Because the seller retains residual ownership and the buyer’s return is limited, these transactions carry a risk of recharacterization as secured loans in the seller’s bankruptcy. Purchase agreements typically include a backup security interest in the purchased royalty rights to ensure that any recharacterized loan is properly perfected. If the transaction is recharacterized, that backup security interest consists of payment-stream collateral like the collateral at issue in City of Chester, and the risks in that case come into play.
• Royalty bonds and loans secured only by payment rights. Royalty-backed notes and loans secured solely by the borrower’s rights to payment under one or more license agreements (and not structured through a bankruptcy-remote SPV) face the City of Chester issue directly, without the threshold recharacterization question.
• Loans secured by the licensed intellectual property. Life sciences loans under which license agreements and the corresponding royalties are part of a broader collateral package generally do not face the City of Chester risks, because the lender typically also holds a security interest in the licensed patents and related intellectual property. Under the UCC, proceeds include “whatever is acquired upon the sale, lease, license, exchange, or other disposition of collateral.”[22] Royalties paid under a license of encumbered intellectual property are therefore proceeds of that intellectual property, whether or not the amount of the payment was sufficiently crystallized on the petition date. A loan secured by license agreements and royalty payments, but not by the underlying intellectual property, is exposed to the same risk as a royalty bond.

It is worth noting that no court has applied the indeterminate proceeds analysis to a royalty stream under an IP license. In Puerto Rico, the First Circuit framed the indeterminacy question as whether the creditor held “a conveyable right of receipt” on the petition date. In the context of an IP license, a licensor can sell its right to future royalties outright, and if the transaction is treated as a true sale, postpetition royalties are property of the buyer whether their amount was determinable on the petition date or not, because the right is not property of the estate. Thus, it would seem that a right that can be, and routinely is, conveyed prior to bankruptcy would necessarily meet the “conveyability” test in Puerto Rico. But until the questions about indeterminate proceeds raised by City of Chester, including the proper interpretation of the line of Puerto Rico decisions, are resolved, the risk of lien cutoff on indeterminacy grounds should be treated as a live issue.[23]

Takeaways: Drafting and Structuring Considerations

1. Grant a security interest in the specific rights to payment under the license agreement

City of Chester makes clear that the grant should cover the debtor’s right to payment, not merely the payment stream. The grant should include all of the seller’s or borrower’s right, title and interest in and to its rights to receive royalty and other payments under specified sections of the license agreement, identified as accounts, payment intangibles and general intangibles, together with all proceeds. Most royalty purchase agreements and royalty-backed financings are already drafted this way. Forms should nonetheless be checked, and collateral descriptions limited to “royalties” or “royalty payments” should be corrected.

2. Take a security interest in the licensed intellectual property where possible

A lien on the licensed patents and related intellectual property renders any royalties the proceeds of that intellectual property for UCC and section 552 purposes and largely sidesteps both the granting-clause question and the indeterminacy question. As discussed in our earlier article, it also protects the buyer if the debtor attempts to transfer the intellectual property free of the buyer’s interest after rejecting the license.

3. Structure as a true sale to a bankruptcy-remote special purpose vehicle

For capped and partial monetizations, moving the license agreement and the entire royalty stream into a bankruptcy-remote SPV, which then sells the capped interest to the buyer, reduces both recharacterization risk and rejection risk. Although this structure raises its own issues, including potential substantive consolidation and licensee consent issues that must be analyzed and addressed on the specific facts of the transaction, it is often a viable option.

4. Diligence the licensor’s ongoing obligations

The more the royalty stream depends on postpetition performance by the licensor, such as supply, manufacturing, development or regulatory obligations, the stronger the argument may be that postpetition royalties are not proceeds of prepetition collateral, and the more room the court may have to limit the lien under the indeterminate proceeds or equities-of-the-case exceptions. Those obligations should be identified in diligence and addressed appropriately in the transaction documentation.

If you have any questions concerning the material discussed in this client alert, please contact the members of our Restructuring and Bankruptcy and Finance practices.