Restructuring

Contributed by Maurice Horwitz
It has long been the case that secured creditors could be charged for the reasonable and necessary costs incurred to preserve the value of their collateral.  This equitable principle emerges out of case law that predates not only the current Bankruptcy Code, but also its immediate predecessor, the Bankruptcy Act of 1938.  As now codified in section 506(c) of the Bankruptcy Code, surcharges may be authorized if the surcharge claimant demonstrates “reasonable” and “necessary” expenses “to the extent of any benefit” to the secured creditor. 
Of course, a secured creditor may also expressly consent to a surcharge.  Courts in the past have recognized the ability to imply a secured creditor’s consent to surcharges.  Consent certainly makes life easier for the party claiming the surcharge, as it dispenses with the need to prove the statutory elements of section 506(c) – necessity, reasonableness, and a quantifiable benefit to the secured creditor.
In 2000, however, the Supreme Court issued a decision, Hartford Underwriters Ins. Co. v. Union Planters Bank N.A., that cast some doubt on this principle.  In Hartford, the Supreme Court considered the issue of who has standing to assert a surcharge claim and concluded that only the “trustee” of a bankruptcy estate (and not other administrative claimants) may do so.  In discussing the statutory provision, the Court focused solely on the plain language of section 506(c) and neglected to mention the consent standard.  The Court’s silence left some wondering if the Court implicitly chose not to recognize consent as a basis for surcharging collateral.
Recently, however, a California bankruptcy court has held that implied consent is alive and well in the Ninth Circuit.  The debtors in this case, In Re Tollenaar Holsteins, were three California and Oklahoma based dairies.  Their two secured creditors were owed approximately $12.8 million and held liens on substantially all of the debtors’ assets, including their cash.  Early in the cases, the debtors proved incapable of providing adequate assurance to the secured lenders for the use of cash collateral.  In the absence of adequate protection, the lenders took the position that they would only consent to the use of cash collateral if either a chapter 11 trustee or some equivalent fiduciary were appointed.  A trustee was appointed and proceeded to liquidate the debtors’ assets for the ultimate benefit of the secured creditors.
When the trustee later moved to surcharge the secured creditors’ collateral, the secured creditors opposed the motion, arguing that the trustee had not satisfied the statutory requirements of section 506(c) and that they had never consented to the surcharge.  Upon an examination of the record, the United States Bankruptcy Court for the Eastern District of California was able to trace $107,412.00 of surcharges to specific and detailed activities that were both reasonable and necessary, and that produced a quantifiable benefit to the secured creditors, insofar as they prevented a diminution or loss of value in the debtors’ dairies.  These expenses satisfied the statutory requirements of section 506(c) and could easily be admitted.  That left a balance of $161,942.82.
The bankruptcy court posed two questions with respect to implied consent.  First, the bankruptcy court asked whether consent is still a viable basis under section 506(c) to surcharge a secured creditor’s collateral.  If so, then that begs a second question: whether the elements of section 506(c) must be satisfied in addition to consent – i.e., whether the existence of consent merely bolstered, or could serve as complete alternative to the statutory requirements of section 506(c).
The bankruptcy court first considered the history of consent as a basis for surcharging collateral and noted its roots both in § 77 of the Bankruptcy Act of 1933 and in § 246 of chapter X of the Bankruptcy Act of 1938, which gave “the judge discretion to determine whether, and to what extent, mortgage creditors should be charged with the general costs of an unsuccessful reorganization proceeding.”
The bankruptcy court also cited a line of cases under the current Bankruptcy Code recognizing that “[t]hese pre-Code equitable principles were captured and codified in § 506(c).”  But the court paused to consider the Supreme Court’s decision in Hartford, as well as a more recent decision by the Ninth Circuit’s Bankruptcy Appellate Panel, which expressed doubt about the continued vitality of this equitable principle.  The BAP was concerned not only about the Supreme Court’s silence on the question of consent, but also a decision issued by the Ninth Circuit a mere six weeks after Hartford, which made no mention of the Hartford decision.  According to the BAP,

The Supreme Court in [Hartford] emphasized that the language of § 506(c) is plain and unambiguous.  Since § 506(c) does not include reference to a “consent” standard, it may well foreshadow the ultimate abandonment of the subjective test.  But though the objective test appears to be in the ascendant, we have no clear direction from our [Ninth Circuit] Court of Appeals or the Supreme Court whether the subjective test has continuing vitality.

About a year after the BAP’s expression of uncertainty, the Ninth Circuit issued a decision permitting a surcharge under section 506(c), stating that “[i]n light of the Lender’s consent, there was no need for § 506(c) as a statutory hook.”  The bankruptcy court found this decision to be significant because it confirmed not only that consent remains a viable basis to surcharge collateral, but also that the statutory elements and consent are in fact alternative grounds for surcharging collateral.
The only question remaining, then, was whether the secured creditors in Tollenaar did, in fact, consent.  The bankruptcy court recognized that “limited cooperation with a trustee, even under a consensual cash collateral order, is insufficient” to infer consent.  In Tollenaar, however, “involvement [by the secured creditors] extended well beyond mere cooperation.”  In fact, the secured creditors “orchestrated the preservation, liquidation, and/or recovery of their collateral through the trustee and the trustee’s professionals.”  Specifically, they sought the trustee’s appointment early on in the case, motivated solely by a desire to have the trustee preserve and rapidly liquidate their collateral, with knowledge that the debtors’ estates were administratively insolvent.  Furthermore, the secured creditors placed restrictions on the trustee’s use of cash collateral, limiting the trustee’s focus “to matters affecting their respective interests and collateral.”  They were closely involved with the trustee’s marketing of their collateral, and the record demonstrated that even prior to the petition date, their sole objective had been the marketing and sale of their collateral.  Finally, the secured creditors never sought relief from the automatic stay, and instead, benefitted from the trustee’s sale of their collateral without bearing any of the costs of seeking stay relief.
Given these facts, on the whole, the bankruptcy court found that the secured creditors had “milked these estates for what they were worth” (pun intended, we assume) and allowed the balance of the trustee’s expenses priority over the secured creditors’ recovery.
Maurice Horwitz is an Associate at Weil Gotshal & Manges, LLP in New York.