Contributed by Victoria Vron
Much debate is had over whether secured creditors should be able to obtain waivers of section 506(c) of the Bankruptcy Code, which generally provides that a claimant may recover from property securing a secured claim the costs and expenses of preserving, or disposing of, such property to the extent of any benefit to the holder of such claim. Secured creditors typically ask for waivers of section 506(c) in financing orders, and debtors and unsecured creditors often try to fight off those requests. But how imminent is the threat of section 506(c) surcharge by a claimant anyway? The United States Court of Appeals for the Third Circuit in In re Towne, Inc. recently reaffirmed its prior view that applicability of section 506(c) should be “sharply limited.”
In Towne, the debtors, a franchisee and landlord of certain property, retained a law firm to sell certain assets of the debtors, which constituted collateral of a secured lender. Although the law firm found a buyer for the collateral, the sale never closed. The purchase price was less than the amount of the secured lender’s lien, and the lender refused to consent to the sale unless the debtors signed certain releases, which the debtors refused to do. Several months later, the bankruptcy court converted the chapter 11 case to chapter 7 and appointed a trustee. Upon conversion of the case, the law firm withdrew as special counsel. The chapter 7 trustee executed the releases on behalf of the debtors and sold the collateral.
The law firm then filed a motion pursuant to section 506(c) of the Bankruptcy Code seeking to have its fees and expenses paid out of proceeds of the sale of the collateral. The law firm argued that section 506(c) allowed it to surcharge the collateral alleging that (1) its legal services were reasonable and necessary to the preservation and disposition of the collateral, (2) the secured lender was estopped from denying that it benefited from the law firm’s services because it secretly collaborated with the buyer and others to achieve various unlawful objectives, and (3) its efforts to sell collateral were thwarted only by the secured lender seeking releases in violation of New York law. The bankruptcy court found each of these arguments unpersuasive and denied the motion. Both the district court and the Third Circuit agreed and affirmed the bankruptcy court’s decision.
The Third Circuit’s Decision
At the outset, the Third Circuit emphasized that the purpose of section 506(c) is to prevent a windfall to the secured creditor at the expense of a claimant and that section 506(c) permits a claimant to recover expenses from secured collateral only in sharply limited circumstances. Accordingly, to recover under section 506(c), a claimant must demonstrate that (1) the expenditures are reasonable and necessary to the preservation or disposal of the property and (2) the expenditures provide a direct benefit to the secured creditors. The Third Circuit rejected the premise advocated by the law firm that it is sufficient to show a potential benefit to a secured creditor (i.e., that the secured creditor could reasonably have been expected to benefit).
In applying the test to the law firm’s first argument, the Third Circuit held that the law firm failed to show that its services were necessary to the ultimate sale of the collateral. The fact that the law firm found a buyer was irrelevant because that was not the sale that ultimately closed. According to the buyer, the law firm was not responsible for the buyer’s interest in, or eventual purchase of, the collateral. The law firm tried to argue that its efforts prevented termination of the franchise, thereby preserving the value of the collateral. The Third Circuit found this assertion purely speculative. The Third Circuit also found that the law firm did not provide a direct benefit to the secured lender, but rather a benefit to the debtors. The Third Circuit looked through the services provided and noted that many of the services were contrary to the interests of the secured lender, such as the law firm’s efforts to reduce the secured lender’s lien.
Finally, the Third Circuit swiftly disposed of the law firm’s last two arguments holding that (1) the law firm failed to show that the type of estoppel it was arguing for has ever been recognized and (2) that even if the releases were contrary to New York law, violation of law is not grounds for surcharging collateral under section 506(c).
As the Towne decision shows, it takes more than just assisting in the sale of collateral to be able to surcharge it. The Third Circuit’s decision should give some comfort to lenders who are unsuccessful in obtaining a waiver of section 506(c), as the bar to surcharge a lender’s collateral is not low.