Code vs. Contract: Fifth Circuit holds that Section 506(b) Governs Recovery of Proceeds from a Foreclosure Sale After the Automatic Stay Has Been Lifted

Contributed by Debra McElligott
When an oversecured creditor forecloses on a debtor’s property after the automatic stay has been lifted, does the Bankruptcy Code (as opposed to state law) govern recovery of attorney’s fees and other amounts from the sale proceeds? Does the bankruptcy court have jurisdiction over the distribution of such proceeds? In Goldsby v. 804 Congress LLC (In re 804 Congress), the United States Court of Appeals for the Fifth Circuit answered both questions in the affirmative, citing, among other things, the legislative intent of the Bankruptcy Code and the bankruptcy court’s role in resolving lienholder disputes.      
Foreclosure and Dispute over Proceeds
In 804 Congress, the debtor’s only significant asset was an office building upon which Wells Fargo had a first-priority lien through a deed of trust. Another creditor, VIA Lending, had a second-priority lien. The debtor sought bankruptcy protection after Wells Fargo scheduled a foreclosure sale on the building, which led Wells Fargo to file an emergency motion for relief from stay to proceed with a nonjudicial sale of the property. The United States Bankruptcy Court for the Western District of Texas issued an order permitting the sale “in accordance with applicable state laws” if the debtor had not met certain conditions before a certain date. After the debtor failed to meet these conditions, the trustee under the deed of trust conducted a sale of the property.
The bankruptcy court exercised jurisdiction over the sale, and the creditors filed proofs of claim for the amounts to which they were entitled under the deed of trust. The debtor, however, disagreed with the distribution of the proceeds under the deed of trust (specifically, Wells Fargo’s recovery of attorney’s fees and the trustee’s commission), and sought an order to direct the trustee to pay only the principal and interest due to both lienholders and to pay the remaining funds to the debtor pending resolution of claims against those funds. The bankruptcy court both decreased the trustee’s commission and disallowed recovery of Wells Fargo’s requested attorneys’ fees, finding that neither amount could be considered reasonable under section 506(b) of the Bankruptcy Code, which allows creditors to recover “any reasonable fees, costs, and charges” provided for in an agreement under which a claim arises. Wells Fargo appealed, and the United States District Court for the Western District of Texas reversed and remanded, holding that the bankruptcy court no longer had jurisdiction over the property and sale proceeds once the stay was lifted. The debtor appealed to the Fifth Circuit.
Section 506(b) vs. Texas State Law
The Fifth Circuit first held that section 506(b) governs distributions to an oversecured creditor and that its application is not limited to sales under section 363. The court cited to its decision in Blackburn-Bliss Trust v. Hudson Shipbuilders, Inc. (In re Hudson Shipbuilders Inc.), in which it held that section 506(b) applies to the recovery of prepetition attorneys’ fees even if a valid contract provides otherwise. In that case, the court stated that when Congress enacted section 506(b), it “intended that federal law should govern the enforcement of attorneys’ fees provisions, notwithstanding contrary state law,” and that leaving the bankruptcy court without the power to decide whether a fee is reasonable is not only contrary to that legislative intent, but “contrary to the weight of judicial precedent.” The 804 Congress court found Blackburn-Bliss to be controlling even though that case applied only to prepetition fees and 804 Congress involved both pre- and postpetition fees. The court relied on dicta in the United States Supreme Court’s opinion in U.S. v. Ron Pair Enterprises for the premise that section 506(b) governs postpetition claims as well.
With respect to the question of whether the bankruptcy court had jurisdiction over the distribution of the sale proceeds, the court stated that it could not find any congressional intent within section 506(b) to treat oversecured creditors who are permitted to foreclose differently from those whose claims are satisfied within the bankruptcy. The court noted that strictly applying the terms of the deed of trust would have given the trustee the power not only to determine its own recovery and that of Wells Fargo, but also to determine the recovery of subordinate lienholders. Such an application would leave the bankruptcy court without the power to resolve disputes about claims of junior lienholders.
The court also cited to Hudson Shipbuilders, noting that the congressional mandate in section 506(b) gave the bankruptcy court jurisdiction to resolve attorneys’ fees issues by preventing senior lienholders “from getting a windfall by extracting attorneys’ fees in excess of what could legitimately be demanded in a bankruptcy proceeding.” Ultimately, the court found that although lifting the stay allowed Wells Fargo to avail itself of foreclosure proceedings under Texas state law, it did not insulate the debtor or its creditors from the reach of section 506(b).
The decision in 804 Congress reinforces the bankruptcy court’s power to determine the reasonableness of fees, costs, and charges under section 506(b), even where a creditor’s claim arises out of an agreement or proceeding governed by state law. The opinion also suggests that even where the parties agree upon fees, costs, and charges before a bankruptcy, under certain circumstances, section 506(b) may trump the provisions of their contract.