SRZ's reorganization group recently helped a lender avoid a surcharge against its collateral for legal fees. U.S. Bankruptcy Judge Arthur N. Votolato of the District of Rhode Island handed the lender the important victory on July 5, 2007, after an earlier trial. In re California Webbing Industries, Inc., 2007 WL 1953018 (Bankr. D. R. I., 7/5/07). In a detailed 22-page opinion, Judge Votolato held that the lender never consented to the use of its collateral to pay the fees of counsel for a Chapter 11 debtor and the creditors' committee in its failed reorganization case. Moreover, the court found that, based on the facts adduced at trial, the professionals had waived any right to surcharge the lender's collateral.
The court reviewed the prior case record, including cash collateral orders and stipulations drafted by SRZ for the lender. The relevant orders and stipulations required the debtor to use the lender's cash collateral to pay only for necessary business operating expenses and to make monthly payments to the lender. The court found that the lender had never agreed to any alleged "carve-out" of its collateral for professional fees. To the contrary, it found that the lender had, at every opportunity, stressed that it was not consenting to the surcharge of its collateral for the payment of professional fees. As the court put it, "a clearer statement of the secured creditor's intention would be hard to find, and for this Court to conclude, on this record, that [the lender] consented to a carve-out would last about as long on appeal as it would take the reviewing court to write-REVERSED." Id. at *4, n.8.
Courts Cannot Order Professional Fee Carve-Outs
The court also rejected the professionals' argument that it had previously ordered a carve-out for professional fees from the lender's collateral. A "carve-out," it reasoned, is "an agreement between a secured lender, on the one hand, and the trustee or debtor-in-possession, on the other, providing that a portion of the secured creditor's collateral may be used to pay administrative expenses." Id. at *2, quoting Richard B. Levin, "Almost All You Ever Wanted to Know About Carve Out," 76 Am. Bankr. L. S. 445 (2002) (emphasis added). There was no agreement by the lender here, and the estate's professionals had not asked the court to order a carve-out during the pendency of the case. Rather, they raised the issue more than two years after the Chapter 11 case had been converted to a Chapter 7 liquidation. Moreover, reasoned the court, it had no power to surcharge the lender's collateral on the facts before it, and had never done so. Finally, the court suggested that the lender could seek the recovery of all fees previously paid to the lawyers from its collateral, noting its prior warning on the record that the interim fee payments were subject to "disgorgement." Id.
Significance of Ruling
Secured lenders have long had reason to fear possible surcharging of their collateral by a trustee, debtor and creditors' committee in a reorganization case. Since the Bankruptcy Code first became effective on October 1, 1979, §506(c) has allowed the "trustee [to] recover from [collateral] the reasonable, necessary costs and expenses of preserving, or disposing of, such property to the extent of any benefit to the [secured creditor]."
11 U.S.C. §506(c). Despite some early troubling lower court rulings, the appellate courts have consistently limited the surcharge remedy in recent years by overturning attempts to override the Code's "plain language" at the expense of secured creditors. See e.g., In re Grimland, Inc., 243 F.3d 228 (5th Cir. 2001) (overturning surcharge on lender's collateral imposed by district and bankruptcy courts).
Established Obstacles to Surcharge
The cost of maintaining a lender's collateral must ordinarily be borne by the unencumbered assets of the debtor's estate. Thus, the typical administrative expenses of the debtor's estate (e.g., professional fees) cannot be recovered from the secured lender's collateral because the trustee acts for the benefit of unsecured creditors, not the secured creditor. In re Flagstaff Foodservice Corp., 739 F.2d 73, 76 (2d Cir. 1984) ("Flagstaff I"). Code §506(c) provides an exception to the general rule, however, when the trustee incurs "properly identified" preservation expenses "primarily for the benefit of" the secured lender if the lender has either "caused" or consented to the accrual of these expenses. In re Flagstaff Foodservice Corp., 762 F.2d 10, 12 (2d Cir. 1984) ("Flagstaff II"). Thus, the trustee's legal fees may be surchargeable against the lender's collateral under §506(c) to the extent of the benefit provided, so long as (a) the services were necessary for the preservation and disposal of the collateral; (b) the expenses are reasonable in amount; and (c) the expenses have been incurred for the primary benefit of the secured creditor. Flagstaff I, 739 F.2d at 75-76 (held, claims of professionals for debtor-in-possession and creditors' committee subordinate to postbankruptcy lender's priority claim and first lien in financing order); In re Blackwood Assocs. L.P., 153 F. 3d 61, 68 (2d Cir. 1998); In re Grimland, Inc., 243 F.3d 228, 232 (5th Cir. 2001) ("We have interpreted this language to require a quantifiable and direct benefit to the secured creditor; indirect or speculative benefits may not be surcharged, nor may expenses that benefit the debtor or other creditors").
These legal hurdles are meaningful. In re Debbie Reynolds Hotel & Casino, Inc., 255 F.3d 1061, 1067-68 (9th Cir. 2001) ("This is not an easy standard to meet"; because of "onerous burden of proof, it is unlikely that creditors will use this provision when any other provision of the Code is available.").
Lender's Consent to Being Surcharged Not to be Lightly Inferred
The secured lender in Flagstaff I, supra, obtained a super-priority interest in all of the debtor's assets in exchange for entering into a post-petition financing arrangement. Reversing the bankruptcy and district courts, which had authorized the surcharge of the lender's collateral for the estate's professional fees, the Second Circuit stressed the lender's lack of consent to being surcharged plus the existence of the lender's super-priority claim:
Although a secured creditor may consent to bearing the costs of professional fees,…, 'such consent is not to be lightly inferred … merely because a secured creditor cooperates with the debtor ….' [T]he existence of consent is negatived [here] by the [super-priority] provisions of the Financing Order …. The Financing Order granting [the lender] a superpriority position was intended to give [the lender] protection against the very [professional fee] awards made herein. The lack of sufficient unencumbered assets to pay [attorney's] fees is not an adequate basis for denying [the creditor] its super-priority status. Flagstaff I, 739 F. 2d at 77 (citations omitted).
More recently, in In re Cooper Commons, LLC, 424 F.3d 963 (9th Cir. 2005), amended at 430 F.3d 1215 (9th Cir. 2005), the Ninth Circuit rejected a law firm's challenge to a post-bankruptcy financing agreement sought by a Chapter 11 trustee. The law firm had assisted the debtor in obtaining post-bankruptcy financing from its pre-bankruptcy lender to complete construction of a condominium project. The bankruptcy court approved three separate stipulations authorizing such financing, each of which contained a $50,000 carve-out in favor of the debtor's professionals. A Chapter 11 trustee later moved for court approval of additional financing from the same lender, including payment of professionals' fees which excluded those of the debtor's law firm. The bankruptcy court granted the trustee's motion at an interim hearing. Subsequently, at the final financing hearing, the debtor's law firm objected, arguing that the court should set aside funds to pay its legal fees. The trustee responded, and the court agreed, that the law firm's claim was moot, because the lender had acted in good faith when making advances to the trustee after the interim hearing, and any relief granted to the debtor's law firm would affect "the validity of any debt … incurred" and violate §364(e). Id. at 967-68.
On appeal, the Bankruptcy Appellate Panel upheld the order of the bankruptcy court, but held that its finding of good faith was clearly erroneous. The debtor's law firm appealed to the Ninth Circuit. The Ninth Circuit also upheld the bankruptcy court's order, declining to invalidate, adjust, or redistribute the financing agreement, and held that because the debtor's counsel had failed to obtain a stay pending appeal, the lender's good faith post-bankruptcy extension of credit to the trustee was protected by § 364(e). Id. at 969-70. Only the Trustee or Debtor-in-Possession Has Standing to Surcharge a Lender's Collateral
In Hartford Underwriters Ins. Co. v. Union Planters Bank, N.A., 530 U.S. 1 (2000), the Supreme Court unanimously held that an administrative expense claimant (a post-bankruptcy insurance provider) lacked standing under §506(c) to surcharge the lender's collateral. Adopting a "plain language" approach, the court reasoned "that the trustee is the only party empowered to evoke" a §506(c) surcharge." Id. at 6. See also In re Conveyor Technology Group, Inc., 2004 WL 2044092 at *3 (Bankr. D. Kan. 2004) (held, Chapter 11 debtor-in-possession, exercising trustee's powers under §1107(a), had standing to move under §506(c) to surcharge collateral, despite intervening conversion of case to Chapter 7 prior to hearing on surcharge motion). The bankruptcy court's financing order in Hartford had authorized the payment of insurance premiums and other budgeted post-bankruptcy expenses from the lender's post-bankruptcy loan proceeds and from the lender's cash collateral. The unpaid insurance company claimant, however, had never asked the trustee to pursue its administrative expense claim, and had never sought permission from the bankruptcy court to do so. Id. at 13 n.5. Rather, it "asserted an independent right to use §506(c)," which is what the court rejected. Id.
The Chapter 11 debtors in In re Inteliquest Media Corp., 326 B.R. 825 (BAP 10th Cir. 2005), entered into a post-bankruptcy financing stipulation with lenders, waiving "any and all claims which might now or hereafter exist against Secured Parties pursuant to Section 506(c)." Inteliquest, 326 B.R. at 827. The stipulation was approved by a final order of the bankruptcy court on November 8, 2002. Thereafter, the case was converted to a Chapter 7 liquidation, and the court appointed a trustee. Id. at 827.
The Chapter 7 trustee and lenders filed stipulations authorizing collateral to be surcharged for the trustee's expenses. The court approved the stipulations and also granted fee applications submitted by the debtor's attorneys. A court order stated that the “obligation of [lenders] set forth herein shall be in full and complete satisfaction of any and all Section 506(c) claims or charges that the Trustee, his professionals or any successor trustee shall have against [lenders] or [their] collateral.” The debtors did not appeal. Id. at 827. The debtors later moved to compel the trustee "to prosecute a claim pursuant to 11 U.S.C. § 506(c) for an order allowing attorney[']s fees and costs of debtors … to be assessed against [the lenders'] collateral …[.]" The trustee and the lenders objected, and the court denied the debtor's motion based on the res judicata effect of its earlier orders. In affirming the bankruptcy court’s order, the Bankruptcy Appellate Panel reiterated that only a trustee has standing to pursue a surcharge claim. Id. at 830.
Junior Secured Creditors Lack Standing to Surcharge
The Ninth Circuit, in In re Debbie Reynolds Hotel & Casino, Inc., 225 F.3d 1061 (9th Cir. 2001), applied the Supreme Court's Hartford ruling to prevent a junior lender from trying to surcharge a senior lender's collateral. The senior secured lender had entered into a settlement agreement providing for a $50,000 payment from its collateral to counsel for the debtor-in-possession. In return, the debtor-in-possession agreed that the senior lender's claims would be "irrevocably allowed and that no debtor, administrative claimant or party in interest may … seek to surcharge any of [the senior lender's] collateral pursuant to [Code] §506(c)." 255 F.3d at 1064. As the Ninth Circuit put it, "[in] effect, [the senior lender] attempted to buy 'closure' by agreeing to a $50,000 surcharge in exchange for assurance that there would be no further challenges to collection of its secured debt." Id.
The junior lender in Debbie Reynolds had previously made a post-bankruptcy loan to the debtor on a superpriority basis subject only to the rights of the senior secured lender, consistent with §364(c) ("the right to payment ahead of all administrative and unsecured claims"). Id. at 1064. The junior secured lender later objected to the debtor's proposed settlement with the senior lender, sought to surcharge the senior lender's collateral for repayment of its bankruptcy loan, and argued that the language of the settlement agreement between the senior lender and the debtor-in-possession improperly precluded it from seeking a surcharge under Code §506(c). Id. According to the junior lender, its super-priority claim enabled it to "collect ahead" of debtor's counsel." Id.
The bankruptcy court approved this settlement agreement over the objection of the junior lender, but the Bankruptcy Appellate Panel reversed, holding that the bankruptcy court should have determined whether the senior lender had benefited from the actions of the junior lender and that the debtor's professionals could not be paid ahead of the junior lender. The Ninth Circuit reversed again, holding that the junior lender lacked standing to object to the settlement, citing Hartford. Id. at 1065.
Direct Payment to DIP's Counsel
The court in Debbie Reynolds also held that, in view of the senior lender's express consent, counsel for the debtor could be reimbursed directly from the lender's collateral. Id. According to the court, the party "that provided the benefit to the secured creditor [may] directly receive the reimbursement from the secured collateral…. [A] §506(c) surcharge is not an administrative claim, but an assessment against a secured party's collateral…. [I]t does not come out of the debtor's estate, but rather comes directly from the secured party's recovery. Consequently, "§506(c) expenses do not fall within the priority scheme of the … Code at all. These expenses 'are paid first out of the proceeds of the sale, before a secured creditor is paid.'" Id. at 1067.
The recent California Webbing decision confirms that unpaid professionals still try to collect from lenders despite protective language in court orders and a consistent line of appellate rulings since 1984. They usually fail, but the lenders have to litigate the issue, usually at their own expense. Congress, courts and lenders should shift the expense of this kind of litigation to the unsuccessful claimant.