Bankruptcy Court Cannot Surcharge Credit Bidding Asset Buyer with Expenses of Sale

The asset buyer (“Lender”) in Skuna had previously loaned the debtor $2.4 million on a secured basis. When the debtor was unable to continue operating its business, it hired, with bankruptcy court approval, an agent (“Agent”) to “sell substantially all of its assets at auction.” Id. at *2. In the court's order, Agent “would have the right to seek compensation” at a later time for its work in selling and marketing the property, including the right to surcharge under Bankruptcy Code (“Code”) ' 506(c) (” ' trustee may recover from property securing an allowed secured claim the reasonable, necessary costs and expenses of ' disposing of such property to the extent of any benefit to the holder of such claim ' .”). Id. at *2. The court further authorized “in a separate order” a sale procedure for the debtor's assets, “including the use of credit bids,” providing that the debtor's assets would be sold “free and clear of liens, claims, encumbrances ' with any liens, claims encumbrances attaching to the proceeds.” Id.

Agent advertised and attracted numerous third-party bidders. Nevertheless, Lender's “credit bid” of $705,000 for all of the assets prevailed. (Note, “'credit bidding' is a concept provided for in [Code ' ] 363(k) ' : 'At a sale ' of property that is subject to a lien that secures an allowed claim ' if the holder of such claim purchases such property, such holder may offset such claim against the purchase price of such property.'” Id. at *4.) Because the lender's $2.4 million secured claim exceeded its winning $705,000 credit bid, the debtor's estate received “no cash or tangible proceeds from the sale.” Id. at *3. The bankruptcy court later approved the sale free and clear of liens, claims and interests, and the debtor transferred all of the assets to the Lender. Id. at *3-*4.

Agent later sought compensation and reimbursement for its expenses. Despite Lender's objections, the bankruptcy court authorized compensation and “surcharged the 'assets of the debtor's bankruptcy estate' purportedly pursuant to [Code '] 506(c) ' and secured payment thereof by expressly impressing a judicial lien upon those assets.” Id. at *4. The assets, however, consisted of the property previously conveyed to Lender “free and clear of liens and encumbrances.” Id.

Administrative Expenses Paid from Debtor's
Unencumbered Assets

According to the Fifth Circuit, “when property is transferred out of a bankruptcy estate free and clear of all liens, the bankruptcy court ceases to have jurisdiction over that property.” Id. at *5, citing In re Edwards, 962 F.2d 641, 643 (7th Cir. 1992). Indeed, reasoned the court, “once the assets are sold unencumbered from the estate, they are no longer 'property securing an allowed secured claim,' and are not property of the estate, and therefore may not be surcharged under [Code '] 506(c).” Id. at *5-*6. Although “administrative expenses such as those incurred in the sale here are [ordinarily] satisfied out of unencumbered assets in the bankruptcy estate,” Code ' 506(c) “provides an exception to this general rule ' [thereby allowing] administrative expenses to be surcharged against a creditor's collateral.” Id. at *5. But this procedure “only applies to assets held within the bankruptcy estate.” Id.

The court rejected the debtor's argument that the court had jurisdiction to surcharge the transferred assets because the debtor had sued Lender for a determination as to the “priority and validity of the lender's secured claim.” Id. at *6. As the court explained, “the bankruptcy court's jurisdiction [in the pending lawsuit] could not serve to revive its jurisdiction over property that had already been sold and conveyed from and out of the bankruptcy estate.” Id. at *7. Indeed, said the court, had the “bankruptcy court wished to retain jurisdiction over the property, it should have withheld approval of the sale pending [Lender's] payment of [Agent's] fees,” or simply provided that any property sold would be “subject to lien securing applicable ' auction fees.” Id. Because the bankruptcy court merely retained jurisdiction over the proceeds of the sale which, in this case, “only amounted to a reduction in debt,” the bankruptcy court lacked the power “to surcharge the property purchased by the lender or to impress a judicial lien upon that property.” Id.

Comments

Financial Advisers Beware

This case shows how a financial adviser charged with selling a debtor's assets runs the risk of going unpaid. Agent should, at the very least, have insisted at the outset on establishing a fund for recovering its fees. In the typical credit bidding scenario, counsel for the debtor-in-possession and creditors' committee will negotiate with the credit bidding lender to provide a cash fund for administrative expenses such as professional fees. See In re California Webbing Inds., Inc., 2008 WL 1953018, at *2 (Bankr. D.R.I. 2007) (“carve-out” defined as “agreement between a secured lender, on the one hand, and the trustee or debtor-in-possession, on the other, providing that a portion of the secured lender's collateral may be used to pay administrative expenses.”), quoting Richard B. Levin, “Almost All You Ever Wanted to Know About Carve-Out,” 76 Am. Bankr. L. J. 445 (2002).

Surcharging a Secured Lender Is Difficult

The typical administrative expenses of the debtor's estate (e.g., professional fees) cannot be recovered from the secured lender's collateral because the trustee acts for the benefit of unsecured creditors, not the secured creditor. In re Flagstaff Foodservice Corp., 739 F.2d 73, 76 (2d Cir. 1984) (“Flagstaff I“). Code ' 506(c) provides an exception to the general rule, however, when the trustee incurs “properly identified” preservation expenses “primarily for the benefit of” the secured lender if the lender has either “caused” or consented to the accrual of these expenses. In re Flagstaff Foodservice Corp., 762 F.2d 10, 12 (2d Cir. 1984) (“Flagstaff II“). Thus, the trustee's legal fees may be surchargeable against the lender's collateral under ' 506(c) to the extent of the benefit provided, so long as: 1) the services were necessary for the preservation and disposal of the collateral; 2) the expenses are reasonable in amount; and 3) the expenses have been incurred for the primary benefit of the secured creditor. One court has held claims of professionals for a debtor-in-possession and a creditors' committee to be subordinate to a post-bankruptcy lender's priority claim and first lien in a financing order. Flagstaff I, 739 F.2d at 75-76. Another has stated that it has “interpreted this language to require a quantifiable and direct benefit to the secured creditor; indirect or speculative benefits may not be surcharged, nor may expenses that benefit the debtor or other creditors.” In re Blackwood Assocs. L.P., 153 F. 3d 61, 68 (2d Cir. 1998); In re Grimland, Inc., 243 F.3d 228, 232 (5th Cir. 2001).

The legal hurdles for a trustee's surcharging a lender's collateral are meaningful. As one court has stated, this is “not an easy standard to meet”; because of the “onerous burden of proof, it is unlikely that creditors will use this provision when any other provision of the Code is available.” In re Debbie Reynolds Hotel & Casino, Inc., 255 F.3d 1061, 1067-68 (9th Cir. 2001).

Only the Trustee or Debtor-In-Possession, Not an Unpaid Professional, Has Standing to Surcharge a Lender's Collateral

In Hartford Underwriters Inc. Co. v. Union Planters Bank, N.A., 530 U.S. 1 (2000), the Supreme Court held that an administrative expense claimant (a post-bankruptcy insurance provider) lacked standing under Code ' 506(c) to surcharge the lender's collateral. Relying on the Code's “plain language,” the court reasoned “that the trustee is the only party empowered to evoke” a ' 506(c) surcharge. Id. at 6. The bankruptcy court's financing order in Hartford had authorized the payment of insurance premiums and other budgeted post-bankruptcy expenses from the lender's post-bankruptcy loan proceeds and from the lender's cash collateral. The unpaid insurance company claimant, however, had never asked the trustee to pursue its administrative expense claim, and had never sought permission from the bankruptcy court to do so. Id. at 13*5. Rather, it “asserted an independent right to use ' 506(c),” which is what the court rejected. Id. The bankruptcy court in Skuna, therefore, improperly gave Agent a right to surcharge the potential sale proceeds for its compensation. Accord, Debbie Reynolds (held, applying Hartford, junior lender lacked standing to surcharge senior lender's collateral); In re Cooper Commons LLC, 512 f.533, 535 (9th Cir. 2008) (held, debtor's attorneys had no claim against lender's collateral; trustee negotiated loan agreement with “carve-out” only for trustee's fees and those of his professionals); In re California Webbing Inds., Inc., 2007 WL 1953018 (Bankr. D.R.I. 2007) (same).

Michael L. Cook, a member of this newslettter's Board of Editors, is a partner at Schulte Roth & Zabel LLP in New York.

The U.S. Court of Appeals for the Fifth Circuit held on March 25, 2009, that a bankruptcy court had improperly surcharged property in the hands of a credit bidding asset buyer with the expenses of the judicial sale. In re Skuna River Lumber, LLC, __F.3d ___, 2009 U.S. App. LEXIS 6175 (5th Cir. 3/25/09). Explaining that the “bankruptcy court had no jurisdiction to take such action,” the Fifth Circuit also vacated the district's court's improper ruling that the bankruptcy judge could enter a personal judgment against the asset buyer. Id. at *9.

The ruling is of critical importance not only to transactional and lenders' counsel, but also to financial advisers who seek to be paid from sale proceeds. Indeed, because of the current financial downturn, secured lenders are frequently credit bidding to start the asset sale process, and often end up owning their collateral. Credit bidding has thus become a routine tactic for lenders.

Facts

The asset buyer (“Lender”) in Skuna had previously loaned the debtor $2.4 million on a secured basis. When the debtor was unable to continue operating its business, it hired, with bankruptcy court approval, an agent (“Agent”) to “sell substantially all of its assets at auction.” Id. at *2. In the court's order, Agent “would have the right to seek compensation” at a later time for its work in selling and marketing the property, including the right to surcharge under Bankruptcy Code (“Code”) ' 506(c) (” ' trustee may recover from property securing an allowed secured claim the reasonable, necessary costs and expenses of ' disposing of such property to the extent of any benefit to the holder of such claim ' .”). Id. at *2. The court further authorized “in a separate order” a sale procedure for the debtor's assets, “including the use of credit bids,” providing that the debtor's assets would be sold “free and clear of liens, claims, encumbrances ' with any liens, claims encumbrances attaching to the proceeds.” Id.

Agent advertised and attracted numerous third-party bidders. Nevertheless, Lender's “credit bid” of $705,000 for all of the assets prevailed. (Note, “'credit bidding' is a concept provided for in [Code ' ] 363(k) ' : 'At a sale ' of property that is subject to a lien that secures an allowed claim ' if the holder of such claim purchases such property, such holder may offset such claim against the purchase price of such property.'” Id. at *4.) Because the lender's $2.4 million secured claim exceeded its winning $705,000 credit bid, the debtor's estate received “no cash or tangible proceeds from the sale.” Id. at *3. The bankruptcy court later approved the sale free and clear of liens, claims and interests, and the debtor transferred all of the assets to the Lender. Id. at *3-*4.

Agent later sought compensation and reimbursement for its expenses. Despite Lender's objections, the bankruptcy court authorized compensation and “surcharged the 'assets of the debtor's bankruptcy estate' purportedly pursuant to [Code '] 506(c) ' and secured payment thereof by expressly impressing a judicial lien upon those assets.” Id. at *4. The assets, however, consisted of the property previously conveyed to Lender “free and clear of liens and encumbrances.” Id.

Administrative Expenses Paid from Debtor's
Unencumbered Assets

According to the Fifth Circuit, “when property is transferred out of a bankruptcy estate free and clear of all liens, the bankruptcy court ceases to have jurisdiction over that property.” Id. at *5, citing In re Edwards, 962 F.2d 641, 643 (7th Cir. 1992). Indeed, reasoned the court, “once the assets are sold unencumbered from the estate, they are no longer 'property securing an allowed secured claim,' and are not property of the estate, and therefore may not be surcharged under [Code '] 506(c).” Id. at *5-*6. Although “administrative expenses such as those incurred in the sale here are [ordinarily] satisfied out of unencumbered assets in the bankruptcy estate,” Code ' 506(c) “provides an exception to this general rule ' [thereby allowing] administrative expenses to be surcharged against a creditor's collateral.” Id. at *5. But this procedure “only applies to assets held within the bankruptcy estate.” Id.

The court rejected the debtor's argument that the court had jurisdiction to surcharge the transferred assets because the debtor had sued Lender for a determination as to the “priority and validity of the lender's secured claim.” Id. at *6. As the court explained, “the bankruptcy court's jurisdiction [in the pending lawsuit] could not serve to revive its jurisdiction over property that had already been sold and conveyed from and out of the bankruptcy estate.” Id. at *7. Indeed, said the court, had the “bankruptcy court wished to retain jurisdiction over the property, it should have withheld approval of the sale pending [Lender's] payment of [Agent's] fees,” or simply provided that any property sold would be “subject to lien securing applicable ' auction fees.” Id. Because the bankruptcy court merely retained jurisdiction over the proceeds of the sale which, in this case, “only amounted to a reduction in debt,” the bankruptcy court lacked the power “to surcharge the property purchased by the lender or to impress a judicial lien upon that property.” Id.

Comments

Financial Advisers Beware

This case shows how a financial adviser charged with selling a debtor's assets runs the risk of going unpaid. Agent should, at the very least, have insisted at the outset on establishing a fund for recovering its fees. In the typical credit bidding scenario, counsel for the debtor-in-possession and creditors' committee will negotiate with the credit bidding lender to provide a cash fund for administrative expenses such as professional fees. See In re California Webbing Inds., Inc., 2008 WL 1953018, at *2 (Bankr. D.R.I. 2007) (“carve-out” defined as “agreement between a secured lender, on the one hand, and the trustee or debtor-in-possession, on the other, providing that a portion of the secured lender's collateral may be used to pay administrative expenses.”), quoting Richard B. Levin, “Almost All You Ever Wanted to Know About Carve-Out,” 76 Am. Bankr. L. J. 445 (2002).

Surcharging a Secured Lender Is Difficult

The typical administrative expenses of the debtor's estate (e.g., professional fees) cannot be recovered from the secured lender's collateral because the trustee acts for the benefit of unsecured creditors, not the secured creditor. In re Flagstaff Foodservice Corp., 739 F.2d 73, 76 (2d Cir. 1984) (“Flagstaff I“). Code ' 506(c) provides an exception to the general rule, however, when the trustee incurs “properly identified” preservation expenses “primarily for the benefit of” the secured lender if the lender has either “caused” or consented to the accrual of these expenses. In re Flagstaff Foodservice Corp., 762 F.2d 10, 12 (2d Cir. 1984) (“Flagstaff II“). Thus, the trustee's legal fees may be surchargeable against the lender's collateral under ' 506(c) to the extent of the benefit provided, so long as: 1) the services were necessary for the preservation and disposal of the collateral; 2) the expenses are reasonable in amount; and 3) the expenses have been incurred for the primary benefit of the secured creditor. One court has held claims of professionals for a debtor-in-possession and a creditors' committee to be subordinate to a post-bankruptcy lender's priority claim and first lien in a financing order. Flagstaff I, 739 F.2d at 75-76. Another has stated that it has “interpreted this language to require a quantifiable and direct benefit to the secured creditor; indirect or speculative benefits may not be surcharged, nor may expenses that benefit the debtor or other creditors.” In re Blackwood Assocs. L.P., 153 F. 3d 61, 68 (2d Cir. 1998); In re Grimland, Inc., 243 F.3d 228, 232 (5th Cir. 2001).

The legal hurdles for a trustee's surcharging a lender's collateral are meaningful. As one court has stated, this is “not an easy standard to meet”; because of the “onerous burden of proof, it is unlikely that creditors will use this provision when any other provision of the Code is available.” In re Debbie Reynolds Hotel & Casino, Inc., 255 F.3d 1061, 1067-68 (9th Cir. 2001).

Only the Trustee or Debtor-In-Possession, Not an Unpaid Professional, Has Standing to Surcharge a Lender's Collateral

In Hartford Underwriters Inc. Co. v. Union Planters Bank, N.A. , 530 U.S. 1 (2000), the Supreme Court held that an administrative expense claimant (a post-bankruptcy insurance provider) lacked standing under Code ' 506(c) to surcharge the lender's collateral. Relying on the Code's “plain language,” the court reasoned “that the trustee is the only party empowered to evoke” a ' 506(c) surcharge. Id. at 6. The bankruptcy court's financing order in Hartford had authorized the payment of insurance premiums and other budgeted post-bankruptcy expenses from the lender's post-bankruptcy loan proceeds and from the lender's cash collateral. The unpaid insurance company claimant, however, had never asked the trustee to pursue its administrative expense claim, and had never sought permission from the bankruptcy court to do so. Id. at 13*5. Rather, it “asserted an independent right to use ' 506(c),” which is what the court rejected. Id. The bankruptcy court in Skuna, therefore, improperly gave Agent a right to surcharge the potential sale proceeds for its compensation. Accord, Debbie Reynolds (held, applying Hartford, junior lender lacked standing to surcharge senior lender's collateral); In re Cooper Commons LLC, 512 f.533, 535 (9th Cir. 2008) (held, debtor's attorneys had no claim against lender's collateral; trustee negotiated loan agreement with “carve-out” only for trustee's fees and those of his professionals); In re California Webbing Inds., Inc., 2007 WL 1953018 (Bankr. D.R.I. 2007) (same).

Michael L. Cook, a member of this newslettter's Board of Editors, is a partner at Schulte Roth & Zabel LLP in New York.