Professionals in the business of marketing and selling assets of distressed companies play a vital role in bankruptcy cases. Based upon the often financially precarious positions of their debtor clients, these professionals aim to secure every assurance that they will receive full compensation for their services in the context of a bankruptcy case. In scenarios where no unencumbered assets remain in a bankruptcy estate to satisfy the fees of a professional retained to dispose of a secured creditor's collateral, a bankruptcy trustee or chapter 11 debtor in possession ("DIP") may attempt to pay such fees by surcharging the collateral in accordance with section 506(c) of the Bankruptcy Code. Under a ruling handed down in 2009 by the Fifth Circuit Court of Appeals in the case of In re Skuna River Lumber, LLC, however, surcharge under section 506(c) may not be a viable option in cases where the bankruptcy court enters an order approving a sale and the collateral is no longer part of the bankruptcy estate.
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 costs, including professional fees, incurred in connection with the disposition of collateral where the costs were both reasonable and necessary to preserve or dispose of the collateral. The general purpose of section 506(c) is to prevent secured creditors from obtaining a financial windfall at the expense of the estate and unsecured creditors by ensuring that 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.
Three elements must be satisfied to surcharge collateral under 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 the extent to which they benefit the party being surcharged is factual, and the party seeking recovery has the burden of demonstrating those elements. 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.
Skuna River Lumber
Skuna River Lumber, LLC ("Skuna"), operated a lumber mill in Mississippi. Skuna borrowed approximately $2.4 million on a secured basis to fund its operations. Inadequate cash flow forced Skuna to file for chapter 11 protection in early 2006 in Mississippi. Skuna decided to seek court authority to sell substantially all of its assets under section 363(b) after it was unable to secure DIP financing or additional capital. The company obtained authorization from the bankruptcy court to retain Equity Partners, Inc. ("EPI"), to assist in the sale process. The retention order expressly reserved EPI's right to seek payment for its services by surcharging the collateral of Skuna's prepetition lenders in accordance with section 506(c). Although EPI's marketing efforts attracted several third-party bidders, Skuna's lenders ultimately prevailed as the successful bidders at the auction by credit-bidding a portion of their secured claims. The amount of the lenders' prevailing credit bid was $705,000, well below the $2.4 million face amount of the debt.
Because the prevailing credit bid yielded no sale "proceeds" in the traditional sense, and there were no other unsecured assets from which Skuna could satisfy EPI's fees and expenses, EPI tried by means of surcharge under section 506(c) to impose a judicial lien on the purchased assets, which were sold free and clear of any liens, claims, and encumbrances under section 363(f). The bankruptcy court permitted the surcharge, a ruling that the district court upheld on appeal. The lenders appealed to the Fifth Circuit Court of Appeals.
The Fifth Circuit's Analysis
The Fifth Circuit reversed. Citing the Seventh Circuit's 1992 ruling in In re Edwards, the court of appeals determined that once Skuna's assets were transferred pursuant to the sale order, the bankruptcy court's jurisdiction over the assets ended. EPI contended that jurisdiction over the purchased assets remained, because an adversary proceeding was still pending against the lenders to determine the priority and validity of their claims and liens. In rejecting this argument, the Fifth Circuit determined that the pending proceeding was irrelevant, because the nature of the section 506(c) inquiry related directly to (derivative) rights of EPI in property (i.e., the purchased assets) that was no longer part of the bankruptcy estate. The Fifth Circuit elected not to address any policy implications of denying EPI's requested relief, despite policy concerns articulated by the bankruptcy and district courts below pertaining to the importance of ensuring that bankruptcy professionals rendering services to a debtor are paid.
Ramifications of Skuna River Lumber
Skuna River Lumber is a cautionary tale for all bankruptcy professionals. Although unquestionably a bad development for EPI, Skuna River Lumber is instructive because it creates a road map helping professionals in similar situations to avoid the same result. The Fifth Circuit explained that the bankruptcy court could have withheld approval of the sale pending the lenders' agreement to pay EPI's fees and expenses or directed in the sale order that the proceeds were subject to a lien in an amount sufficient to satisfy the fees and expenses. Skuna River Lumber provides an important lesson to professionals who regularly work with debtors in bankruptcy cases, by reinforcing the importance of resolving fee-related issues, including their collectability, prior to accepting an engagement within a bankruptcy case, particularly if administrative insolvency is a potential concern.
In re Skuna River Lumber, LLC, 564 F.3d 353 (5th Cir. 2009).
In re Edwards, 962 F.2d 641 (7th Cir. 1992).
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