As a general rule, absent an express agreement to the contrary, expenses associated with administering the bankruptcy estate, including pledged assets, are not chargeable to a secured creditor’s collateral or claim but must be paid out of the estate’s unencumbered assets. Recognizing, however, that the bankruptcy estate may be called upon to bear significant expense in connection with preserving or disposing of encumbered assets as part of an overall reorganization (or liquidation) strategy, U.S. bankruptcy law has long recognized an exception to this general principle in cases where reasonable and necessary expenses directly benefit the secured creditor. Thus, section 506(c) provides that a debtor-in-possession ("DIP") or trustee “may recover from property securing an allowed secured claim the reasonable, necessary costs and expenses of preserving, or disposing of, such property to the extent of any benefit to the holder of such claim, including the payment of all ad valorem property taxes with respect to the property.”

Costs must be both necessary to preserve or dispose of collateral and reasonable to qualify for the section 506(c) surcharge. Consistent with the statute’s underlying purpose in preventing a secured creditor from realizing a windfall when the estate shoulders expenses that would otherwise be borne by the creditor if it had foreclosed on collateral, such costs and expenses must also directly (rather than incidentally) benefit the secured creditor. Direct benefit to the secured creditor generally means that the expense in question preserves or increases the value of the collateral. If an expense satisfies the requirements of section 506(c), proceeds from the sale or other disposition of the collateral must be used first to pay the surcharged expense, with the excess applied to payment of the claim(s) secured by the property.

Secured creditors may also expressly consent to payment of certain costs and expenses of administering a bankruptcy estate from their collateral. Such administrative "carve-outs" are common in chapter 11 cases involving a debtor with assets that are fully or substantially encumbered by the liens of pre-bankruptcy lenders. As part of a post-petition financing or cash collateral agreement, a pre-bankruptcy lender may agree that a specified portion of its collateral can be used to pay administrative claims, such as professional fees and expenses incurred by a DIP, trustee, or official committee; statutory fees; or "burial" costs that may be incurred if a chapter 11 case is later converted to a chapter 7 liquidation.

The quid pro quo for an administrative carve-out in a post-petition financing or cash collateral agreement, however, is commonly waiver of the ability to surcharge under section 506(c). Because the total amount of administrative costs incurred in connection with a chapter 11 case is difficult to predict at the outset of the bankruptcy, a carve-out accompanied by a surcharge waiver must be negotiated carefully to ensure as nearly as possible that there will be adequate funds available to meet anticipated administrative expenses. A ruling recently handed down by the Ninth Circuit Court of Appeals illustrates what can happen when a carve-out later proves to be inadequate to satisfy costs in a chapter 11 case bordering on administrative insolvency. In a matter of apparent first impression in the Ninth Circuit, the court of appeals held in Weinstein, Eisen & Weiss v. Gill (In re Cooper Commons LLC) that professional fees and expenses incurred by a chapter 11 DIP could not be paid from the DIP lender’s collateral because the DIP waived its right to seek a section 506(c) surcharge and failed to negotiate an adequate carve-out in connection with the financing.

Cooper Commons

Real estate developer Cooper Commons LLC ("Cooper") filed for chapter 11 protection in 2002 during the construction and sale of a 62-unit condominium development in West Hollywood, California. Prior to filing for bankruptcy, Cooper had received approximately $16 million in financing from Comerica Bank ("Comerica") to fund development of the project. In order to salvage its investment, Comerica agreed to provide an additional $7 million to Cooper in three separate court-approved post-petition financing transactions that would allow Cooper to complete the condominium-construction project. The law firm Weinstein, Eisen & Weiss ("Weinstein") served as Cooper’s chapter 11 counsel and negotiated each of the DIP financing agreements. The agreements included a $50,000 carve-out for administrative and professional fees. Each of the agreements also contained a waiver of Cooper’s right to surcharge Comerica’s collateral under section 506(c).

The bankruptcy court ordered the appointment of a chapter 11 trustee for Cooper in 2003. Estimating that it would cost several million dollars to complete the condominium project, the trustee negotiated yet another financing agreement with Comerica. The agreement, which was later approved by the court, included a carve-out in the amount of approximately $890,000 for “the actual and necessary fees and costs of the Trustee and his professionals . . . approved by an order of the Court after notice and an opportunity for hearing.” Weinstein, realizing that Cooper’s bankruptcy estate was administratively insolvent and could not pay the full amount of the legal fees and expenses incurred by Cooper when it was a DIP, appealed the financing order to a bankruptcy appellate panel for the Ninth Circuit, which affirmed the ruling below. Weinstein then appealed to the Ninth Circuit Court of Appeals, which dismissed the appeal as being moot because Weinstein failed to obtain a stay of the financing order pending its appeal.

Two years afterward, the trustee’s carve-out proved to be inadequate, and Comerica agreed to an additional $250,000 carve-out from its cash collateral. Weinstein objected to the trustee’s motion seeking bankruptcy-court approval of the augmented carve-out, arguing that the augmentation would result in unfair treatment to other administrative claimants. The court overruled the objection. After the district court affirmed the ruling on appeal, Weinstein appealed to the Ninth Circuit.

The Ninth Circuit’s Ruling

Weinstein fared no better in the court of appeals, which addressed the issue as a matter of apparent first impression. The Ninth Circuit rejected Weinstein's assertion that “the future of bankruptcy law is at stake in this case . . . [because it] will have opened the door to side deals” allowing secured lenders and trustees to rearrange statutory payment priorities for their benefit. Characterizing the situation before it as decidedly “less momentous,” the court explained that the section 506(c) waiver negotiated by Weinstein on Cooper’s behalf was unambiguous and expressly provided that any carve-out payable to Weinstein and other professionals retained by Cooper was limited to $50,000. By contrast, the subsequent financing agreement between the trustee and Comerica was expressly limited to fees up to the specified amount incurred by the trustee. As a consequence, the Ninth Circuit concluded, Weinstein had no claim against Comerica’s collateral.

According to the court of appeals, Comerica acted properly when limiting the use of its cash collateral to “the services necessary for the ongoing management by the Trustee of the estate.” Because the funds were already subject to Comerica’s lien, the Ninth Circuit emphasized, Comerica was free to specify the particular expenses it was willing to carve out from its collateral. Weinstein, the court explained, had “no direct, pecuniary interest in the encumbered assets of the estate.”

Outlook

Cooper Commons is a cautionary tale. Administrative insolvency is a risk in almost every chapter 11 case, even if the DIP’s financial outlook at the inception of the case is rosy. Weinstein obviously believed that a $50,000 carve-out was sufficient when it negotiated the DIP financing agreements. That judgment later proved to be flawed, as Cooper’s chapter 11 case dragged on for another two years and costs mounted to the point where it was impossible for Cooper’s estate to pay the full amount of its post-trustee and pre-trustee administrative claims. A secured creditor’s collateral can be surcharged pursuant to section 506(c) only if an expense incurred by the estate to preserve or dispose of the collateral directly benefits the secured creditor, unless the secured creditor agrees otherwise. Cooper Commons demonstrates that courts will strictly enforce any carve-out/waiver agreement negotiated at arm’s length, even if it means that administrative claims cannot be paid in full and confirmation of a chapter 11 plan for the debtor is impossible.

Even if the law firm could have overcome the formidable obstacle erected by the unambiguous terms of loan documentation it negotiated in connection with Cooper's DIP financing, Weinstein would have assumed the additional burden of demonstrating that professional fees incurred by Cooper conferred a direct benefit upon Comerica. The likelihood of prevailing on such an argument is limited at best.