United States: No Surcharge For You: Third Circuit Rules That Section 506(c) Surcharge Is "Sharply Limited"

The ability to "surcharge" a secured creditor's collateral in bankruptcy is an important resource available to a bankruptcy trustee or chapter 11 debtor in possession ("DIP"), particularly in cases where there is little or no equity in the estate to pay administrative costs, such as the fees and expenses of estate-retained professionals. However, as demonstrated by a ruling handed down by the Third Circuit Court of Appeals, the circumstances under which collateral may be surcharged are narrow. In In re Towne, Inc., 2013 BL 232068 (3d Cir. Aug. 29, 2013), the court of appeals affirmed an order denying a motion by special counsel to direct payment of its fees and expenses by surcharging the proceeds of a secured creditor's collateral because the law firm's services did not directly benefit—and in some cases sought to disadvantage—the secured creditor.

Surcharge of Collateral

Section 506(c) of the Bankruptcy Code provides an exception to the general rule that the payment of expenses associated with administering a bankruptcy estate, including the administration of assets pledged as collateral, must derive from unencumbered assets. Under section 506(c), a trustee or DIP "may recover from property securing an allowed 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." The purpose of the provision is to prevent secured creditors from obtaining a financial windfall at the expense of the estate and unsecured creditors by ensuring that the secured creditors are responsible for the same collateral disposition costs within a bankruptcy case that normally would arise in a foreclosure or similar state law proceeding outside bankruptcy. See Loudoun Leasing Development Co. v. Ford Motor Credit Co. (In re K & L Lakeland, Inc.), 128 F.3d 203 (4th Cir. 1997); In re TIC Memphis RI 13, LLC, 498 B.R. 831 (Bankr. W.D. Tenn. 2013).

Three elements must be satisfied in order to surcharge collateral under the terms of section 506(c): (i) the expenditure must be necessary; (ii) the amounts expended must be reasonable; and (iii) the secured creditor must benefit from the expense. The inquiry into what costs are reasonable and necessary, and the extent to which they benefit the party being surcharged, is factual, and the party seeking recovery has the burden of establishing those elements. See 4 COLLIER ON BANKRUPTCY ¶ 506.05[9] (16th ed. 2014). If an expense satisfies the requirements of section 506(c), the proceeds from the sale or other disposition of the collateral must be used first to pay the surcharged expense, with any excess applied to payment of the claim(s) secured by the property. In Towne, the Third Circuit considered whether the sale proceeds of collateral in a chapter 7 case could be surcharged to pay the fees and expenses of special counsel retained by the DIP before the case was converted from chapter 11 to chapter 7.

Towne

Towne, Inc., and its affiliate, DMD Towne, LLC (collectively, the "Debtors"), owned and operated a franchised BMW car dealership in Oyster Bay, New York. The Debtors' assets, which consisted of the franchise agreement, the real property on which the dealership was located, and various inventory, were fully encumbered by liens securing approximately $9 million owed to BMW Financial Services, NA, LLC ("BMW").

The Debtors filed for chapter 11 protection in New Jersey in April 2009. The bankruptcy court later authorized the Debtors to retain The Margolis Law Firm ("Margolis") as special counsel for the purpose of finding prospective purchasers.

Shortly after the petition date, BMW sought relief from the automatic stay to foreclose on its collateral. In opposing the motion, Margolis represented that it had received an offer to purchase the Debtors' assets for $6 million. The bankruptcy court granted relief from the stay, but BMW agreed to forbear from foreclosing immediately to allow the Debtors to pursue the proposed sale transaction.

On the Debtors' behalf, Margolis commenced litigation against BMW, seeking, among other things, to reduce the amount of BMW's secured claim to $6 million, which relief would have allowed the proposed $6 million sale of the assets to proceed free and clear of BMW's liens under section 363(f)(3) of the Bankruptcy Code. Margolis also conducted an investigation that led to the commencement of a state court administrative proceeding against BMW regarding its lending and franchise relationship with the Debtors.

Due to the ongoing litigation, BMW, which could have blocked the proposed sale because it was significantly undersecured, refused to consent to the transaction unless the Debtors, as a quid pro quo, released BMW from the claims that had been asserted against it. The Debtors refused to do so, and the sale fell through.

In August 2009, the bankruptcy court converted the Debtors' cases to chapter 7 and appointed a trustee to liquidate the estate. Shortly afterward, BMW contacted prospective purchasers of the Debtors' assets, and the trustee and BMW selected a buyer willing to pay $5.5 million from several bidders. As part of the proposed transaction, the trustee agreed to execute releases in favor of BMW on behalf of the estate. The bankruptcy court approved the sale in early 2010. The court's order included a consensual carve-out from the sale proceeds in the amount of $177,000 for the benefit of the trustee, as well as a 10 percent distribution to general unsecured creditors.

Margolis subsequently filed a motion under section 506(c) seeking payment from the sale proceeds of approximately $90,000 in fees and expenses for services provided as special counsel to the Debtors prior to conversion of the cases. The bankruptcy court denied the request, concluding that Margolis's services benefited primarily the Debtors and their principals and that any benefit to BMW was "purely incidental and thus outside the scope of section 506(c)." The district court affirmed on appeal.

The Third Circuit's Ruling

Margolis fared no better with the Third Circuit. In its unpublished ruling, the court of appeals acknowledged its prior decisions holding that, ordinarily, an attorney's fees and expenses "may be charged only against the surplus of the debtor's estate." Section 506(c), the Third Circuit explained, "provides a limited exception to this rule" that permits a claimant to recover expenses from secured collateral "only under 'sharply limited' circumstances" (quoting In re Visual Indus., Inc., 57 F.3d 321, 325 (3d Cir. 1995)).

The Third Circuit concluded that Margolis failed to meet the requirements of section 506(c) because it did not prove that its legal services and related expenses were necessary to preserve or dispose of the collateral or that such services provided a direct benefit to BMW. Although Margolis detailed its efforts to market the Debtors' assets to potential purchasers and to consummate purchase agreements for the sale of the collateral, the Third Circuit explained, such "efforts did not result in an actual sale."

Moreover, the court added, Margolis was not responsible for, or involved in any way in, the sale transaction that was later consummated. The Third Circuit agreed with the bankruptcy court's "purely speculative" characterization of Margolis's contention that it "prevented termination of the Franchise" and thereby benefited BMW by preserving the value of the collateral. In fact, the court of appeals emphasized, Margolis's legal services benefited primarily the Debtors rather than BMW and were "actually contrary to [BMW's] interests" in many respects.

The Third Circuit rejected Margolis's remaining arguments, including the contention that BMW consented to a surcharge of its collateral to pay the law firm's fees and expenses. According to the court, Margolis demonstrated nothing more than BMW's "limited cooperation with [Margolis's] initial efforts to effectuate a sale of the Collateral," which would not support a finding that BMW consented to be surcharged for Margolis's fees and expenses.

Outlook

Towne reinforces the Third Circuit's prior decisions that surcharging collateral under section 506(c) is possible only under "sharply limited" circumstances. Unless a secured creditor explicitly consents to a carve-out, a trustee or DIP attempting to surcharge collateral must be prepared to demonstrate that the costs of preserving or disposing of collateral are necessary and reasonable and provide a direct benefit to the secured creditor.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Mark G. Douglas
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions