Over-Secured Lenders and Requests for Attorneys' Fees

804 Congress, L.L.C. (the Debtor) owned an office building in Austin, TX. The building was encumbered by a first lien in favor of Wells Fargo Bank, N.A. (the Lender) and a second lien in favor of VIA Lending. The Debtor filed a Chapter 11 petition hours before a foreclosure sale previously scheduled by the Lender. Shortly thereafter, the Lender obtained an order modifying the automatic stay so it could conduct a non-judicial foreclosure sale in accordance with the deed of trust and Texas law. The sale resulted in sufficient proceeds to pay both the Lender and VIA in full, including their expenses, and to afford a dividend to the Debtor.

Two categories of expenses became the focus of litigation that culminated in the Fifth Circuit's decision. First, the deed of trust mandated payment of foreclosure expenses, including a commission to the trustee under the deed of trust equal to 5% of the sale proceeds, prior to any distribution to the Debtor. Second, the deed of trust mandated payment of the Lenders' attorneys' fees, also prior to any distribution to the Debtor. In accordance with these terms, the trustee sought payment of $217,750, and the Lender's counsel sought payment of $87,000. The Debtor objected to payment of both amounts.

Lower Court Rulings

The Lender and the trustee argued that the propriety of these charges was completely outside the scope of bankruptcy jurisdiction and authority, i.e., that so long as the deed of trust was clear and Texas law allowed payment of such items, the matter was beyond the purview of the bankruptcy court. The Debtor argued to the contrary, stating that the reasonableness standard applied to all fee requests by over-secured lenders, regardless of the applicable documentation or state law. The Debtor further argued that the amounts sought by the trustee and the Lender were unreasonable.

The bankruptcy court agreed with the debtor that section 506(b) of the Code imposes a reasonableness standard on all fees and charges sought by over-secured lenders, regardless of the applicable documentation and state law. It further found that the amounts sought by the Lender and the trustee were unreasonable. It did so in large part because ' inexplicably ' neither the Lender nor the trustee submitted any evidence in support of the reasonableness of the requests. That the Lender and the trustee chose to stand only on their legal argument proved to be a high-risk gamble: The trustee's $217,750 claim was allowed in the amount of only $7,500 because the trustee devoted only 20 hours of work to the matter at an hourly rate of $375, and the Lender's counsel's fees of $87,000 were disallowed in their entirety.

On appeal, the district court reversed. It held that “[b]y lifting the stay, the bankruptcy court allowed Wells Fargo to conduct a foreclosure sale outside of the bankruptcy proceeding and authorized the Property to be removed from the bankruptcy estate.” Wells Fargo Bank, N.A. v. 804 Congress, L.L.C. (In re 804 Congress, L.L.C.), 2012 U.S. Dist. LEXIS 43183, at 21 (W.D. Tex. Mar. 28, 2012). The district court found that “at the moment the sale of the Property occurred, all manner of interest in the Property and its proceeds were governed by Texas law rather than bankruptcy law.” Id. at 23. The district court held that the bankruptcy court erred in exercising jurisdiction over the foreclosure sale proceeds and ordered the proceeds to be disbursed in accordance with the deed of trust. Id. at 23-24. The Debtor appealed to the Fifth Circuit.

The Court of Appeals' Decision

The Fifth Circuit reversed the district court and agreed that the reasonableness standard of section 506(b) governs distributions to an over-secured creditor, notwithstanding contrary state law. In re 804 Congress, L.L.C., No. 12-50382, 2014 U.S. App. LEXIS 11819, at 7-8. Relying on its reasoning in Blackburn-Bliss Trust v. Hudson Shipbuilders, Inc. ( In re Hudson Shipbuilders, Inc.), 794 F.2d 1051 (5th Cir. 1986), the court noted that the bankruptcy court had jurisdiction to resolve the fee issue “pursuant to the [c]ongressional mandate expressed in 11 U.S.C. '506(b) to prevent [the first-priority creditor] from getting a windfall by extracting attorneys' fees in excess of what could legitimately be demanded in a bankruptcy proceeding.” Id. at 10. The court found nothing in the plain language of section 506(b) to distinguish between claims for pre- as opposed to post-petition legal fees nor between proceeds generated from a non-judicial foreclosure sale as opposed to a court-ordered sale. Id. at 12-15.

Addressing the reasonableness of the requested fees, the court found no abuse of discretion in the bankruptcy court's determination that $7,500 was a reasonable commission for the trustee. Id. at 19. With respect to the Lenders' legal fees, the court concluded, “the bankruptcy court was within its discretion in finding that there was no documentation of the time that was spent and no testimony as to what was a reasonable fee.” Id. at 20. Hence, the bankruptcy court did not err in finding the Lenders' legal fees unsubstantiated, and thus, unreasonable. Id.

Implications and Suggestions

The Fifth Circuit's ruling on the law should come as no surprise. Indeed, the U.S. Trustee typically is vigilant in Chapter 11 cases in ensuring that any terms of a proposed plan of reorganization that contemplate payment of lenders' or other stakeholders' fees specify that such fees are subject to reasonableness review. However, there are at least two take-aways from the Fifth Circuit's ruling.

The first is to be prepared. One seeking a fee or other charge cannot rely solely on the language of the governing documentation, but instead must be prepared to affirmatively establish that its requested fee or charge is reasonable. To support the argument that a particular fee or charge is reasonable, counsel or other advisors arguably should consider following some form of “best practice” guidelines traditionally employed by professionals formally retained in a Chapter 11 case who need court approval to be paid.

In the rules governing professionals retained by a debtor or an official committee, there is nothing that requires over-secured lenders to follow these very specific and stringent requirements. An over-secured lender can carry its burden of establishing reasonableness without following all these rules. At a minimum, however, professionals will need to document in some detail all fees and expenses incurred, including full and accurate time records describing with specificity the services rendered and the time expended. In order to enhance the prospects of payment, each activity performed should have a separate description and time allotment; lumping of time should be avoided.

Second, depending on the circumstances, the over-secured lender also should consider whether its fees and charges can be paid simply by relying on section 502(b) of the Code. As the Fifth Circuit recognized in 804 Congress , section 506(b) arguably only delineates standards applicable to priorities of claims; it arguably does not speak to the allowance of claims as such. The latter is the province of 502(b), which largely respects state law in connection with the determination of claim amounts. It certainly says nothing to the contrary with respect to the claims of a lender's fees and charges, and it imposes no reasonableness requirement.

Apparently, the lender never raised section 502 before the Fifth Circuit. Had it done so, the fight over reasonableness may have been avoided entirely, as the sale resulted in enough proceeds to pay everyone in full. However, the Fifth Circuit chose to duck the issue and to remand to the bankruptcy court. While the Fifth Circuit therefore did not speak to the matter, other courts have. See, e.g., UPS Capital Bus. Credit v. Gencarelli (In re Gencarelli), 501 F.3d 1 (1st Cir. 2007) (fees that are unreasonable under 506(b) nonetheless may be allowed under 502). In short, in the relatively rare case of a solvent estate, UPS Capital and similar rulings arguably dispense with the reasonableness requirement altogether.

Mark A. McDermott is a partner in the Corporate Restructuring practice of Skadden, Arps, Slate, Meagher & Flom LLP in New York. He can be reached at'[email protected]. Christine A. Okike is a New York-based associate and can be reached at [email protected].

The United States Court of Appeals for the Fifth Circuit recently reaffirmed the long-established rule that an over-secured lender's legal and other fees are subject to court approval as reasonable under section 506(b) of the Bankruptcy Code. See, Wells Fargo Bank, N.A. v. 804 Congress, L.L.C. (In re 804 Congress, L.L.C.), No. 12-50382, 2014 U.S. App. LEXIS 11819 (5th Cir. June 23, 2014). This rule is embodied in the plain language of section 506(b), which provides that an over-secured creditor may recover “'fees, costs, or charges provided for under the agreement ' under which such claim arose' ' but only to the extent that the fees, costs, or charges are reasonable.” Id. at 8.

While the rule is relatively clear, many consensual reorganization plans provide for payment of secured lenders' and other stakeholders' fees that, while subject to reasonableness review, often are not actually reviewed in any meaningful detail by a bankruptcy court. Indeed, if a plan is consensual and no one objects, there arguably is no need. But 804 Congress is a reminder that the standard nonetheless is there, and that the burden is on the professional to establish reasonableness when the amount of the fees is being challenged.

Facts

804 Congress, L.L.C. (the Debtor) owned an office building in Austin, TX. The building was encumbered by a first lien in favor of Wells Fargo Bank, N.A. (the Lender) and a second lien in favor of VIA Lending. The Debtor filed a Chapter 11 petition hours before a foreclosure sale previously scheduled by the Lender. Shortly thereafter, the Lender obtained an order modifying the automatic stay so it could conduct a non-judicial foreclosure sale in accordance with the deed of trust and Texas law. The sale resulted in sufficient proceeds to pay both the Lender and VIA in full, including their expenses, and to afford a dividend to the Debtor.

Two categories of expenses became the focus of litigation that culminated in the Fifth Circuit's decision. First, the deed of trust mandated payment of foreclosure expenses, including a commission to the trustee under the deed of trust equal to 5% of the sale proceeds, prior to any distribution to the Debtor. Second, the deed of trust mandated payment of the Lenders' attorneys' fees, also prior to any distribution to the Debtor. In accordance with these terms, the trustee sought payment of $217,750, and the Lender's counsel sought payment of $87,000. The Debtor objected to payment of both amounts.

Lower Court Rulings

The Lender and the trustee argued that the propriety of these charges was completely outside the scope of bankruptcy jurisdiction and authority, i.e., that so long as the deed of trust was clear and Texas law allowed payment of such items, the matter was beyond the purview of the bankruptcy court. The Debtor argued to the contrary, stating that the reasonableness standard applied to all fee requests by over-secured lenders, regardless of the applicable documentation or state law. The Debtor further argued that the amounts sought by the trustee and the Lender were unreasonable.

The bankruptcy court agreed with the debtor that section 506(b) of the Code imposes a reasonableness standard on all fees and charges sought by over-secured lenders, regardless of the applicable documentation and state law. It further found that the amounts sought by the Lender and the trustee were unreasonable. It did so in large part because ' inexplicably ' neither the Lender nor the trustee submitted any evidence in support of the reasonableness of the requests. That the Lender and the trustee chose to stand only on their legal argument proved to be a high-risk gamble: The trustee's $217,750 claim was allowed in the amount of only $7,500 because the trustee devoted only 20 hours of work to the matter at an hourly rate of $375, and the Lender's counsel's fees of $87,000 were disallowed in their entirety.

On appeal, the district court reversed. It held that “[b]y lifting the stay, the bankruptcy court allowed Wells Fargo to conduct a foreclosure sale outside of the bankruptcy proceeding and authorized the Property to be removed from the bankruptcy estate.” Wells Fargo Bank, N.A. v. 804 Congress, L.L.C. (In re 804 Congress, L.L.C.), 2012 U.S. Dist. LEXIS 43183, at 21 (W.D. Tex. Mar. 28, 2012). The district court found that “at the moment the sale of the Property occurred, all manner of interest in the Property and its proceeds were governed by Texas law rather than bankruptcy law.” Id. at 23. The district court held that the bankruptcy court erred in exercising jurisdiction over the foreclosure sale proceeds and ordered the proceeds to be disbursed in accordance with the deed of trust. Id. at 23-24. The Debtor appealed to the Fifth Circuit.

The Court of Appeals' Decision

The Fifth Circuit reversed the district court and agreed that the reasonableness standard of section 506(b) governs distributions to an over-secured creditor, notwithstanding contrary state law. In re 804 Congress, L.L.C., No. 12-50382, 2014 U.S. App. LEXIS 11819, at 7-8. Relying on its reasoning in Blackburn-Bliss Trust v. Hudson Shipbuilders, Inc. ( In re Hudson Shipbuilders, Inc.), 794 F.2d 1051 (5th Cir. 1986), the court noted that the bankruptcy court had jurisdiction to resolve the fee issue “pursuant to the [c]ongressional mandate expressed in 11 U.S.C. '506(b) to prevent [the first-priority creditor] from getting a windfall by extracting attorneys' fees in excess of what could legitimately be demanded in a bankruptcy proceeding.” Id. at 10. The court found nothing in the plain language of section 506(b) to distinguish between claims for pre- as opposed to post-petition legal fees nor between proceeds generated from a non-judicial foreclosure sale as opposed to a court-ordered sale. Id. at 12-15.

Addressing the reasonableness of the requested fees, the court found no abuse of discretion in the bankruptcy court's determination that $7,500 was a reasonable commission for the trustee. Id. at 19. With respect to the Lenders' legal fees, the court concluded, “the bankruptcy court was within its discretion in finding that there was no documentation of the time that was spent and no testimony as to what was a reasonable fee.” Id. at 20. Hence, the bankruptcy court did not err in finding the Lenders' legal fees unsubstantiated, and thus, unreasonable. Id.

Implications and Suggestions

The Fifth Circuit's ruling on the law should come as no surprise. Indeed, the U.S. Trustee typically is vigilant in Chapter 11 cases in ensuring that any terms of a proposed plan of reorganization that contemplate payment of lenders' or other stakeholders' fees specify that such fees are subject to reasonableness review. However, there are at least two take-aways from the Fifth Circuit's ruling.

The first is to be prepared. One seeking a fee or other charge cannot rely solely on the language of the governing documentation, but instead must be prepared to affirmatively establish that its requested fee or charge is reasonable. To support the argument that a particular fee or charge is reasonable, counsel or other advisors arguably should consider following some form of “best practice” guidelines traditionally employed by professionals formally retained in a Chapter 11 case who need court approval to be paid.

In the rules governing professionals retained by a debtor or an official committee, there is nothing that requires over-secured lenders to follow these very specific and stringent requirements. An over-secured lender can carry its burden of establishing reasonableness without following all these rules. At a minimum, however, professionals will need to document in some detail all fees and expenses incurred, including full and accurate time records describing with specificity the services rendered and the time expended. In order to enhance the prospects of payment, each activity performed should have a separate description and time allotment; lumping of time should be avoided.

Second, depending on the circumstances, the over-secured lender also should consider whether its fees and charges can be paid simply by relying on section 502(b) of the Code. As the Fifth Circuit recognized in 804 Congress , section 506(b) arguably only delineates standards applicable to priorities of claims; it arguably does not speak to the allowance of claims as such. The latter is the province of 502(b), which largely respects state law in connection with the determination of claim amounts. It certainly says nothing to the contrary with respect to the claims of a lender's fees and charges, and it imposes no reasonableness requirement.

Apparently, the lender never raised section 502 before the Fifth Circuit. Had it done so, the fight over reasonableness may have been avoided entirely, as the sale resulted in enough proceeds to pay everyone in full. However, the Fifth Circuit chose to duck the issue and to remand to the bankruptcy court. While the Fifth Circuit therefore did not speak to the matter, other courts have. See, e.g., UPS Capital Bus. Credit v. Gencarelli (In re Gencarelli), 501 F.3d 1 (1st Cir. 2007) (fees that are unreasonable under 506(b) nonetheless may be allowed under 502). In short, in the relatively rare case of a solvent estate, UPS Capital and similar rulings arguably dispense with the reasonableness requirement altogether.

Mark A. McDermott is a partner in the Corporate Restructuring practice of Skadden, Arps, Slate, Meagher & Flom LLP in New York. He can be reached at'[email protected]. Christine A. Okike is a New York-based associate and can be reached at [email protected].