The U.S. Court of Appeals for the Fifth Circuit recently held that section 506(c) of the Bankruptcy Code, 11 U.S.C. § 506(c), permits a trustee to recover from a secured creditor the expenses the trustee incurred while maintaining a property during bankruptcy.
A copy of the opinion in In re Domistyle, Inc. is available at: Link to Opinion.
The debtor in this case was placed into receivership in April 2013. The receiver initiated Chapter 11 proceedings on the belief that the debtor had enough equity to reorganize. One of the debtor’s most valuable assets was an industrial building situated on 17 acres of real property. The primary lienholder on the property held a lien of $3.69 million. Because recent appraisals had valued the property at approximately $6 million, the receiver believed that equity in the property could pay the primary lienholder as well as junior and unsecured creditors.
In early 2014, a plan of liquidation established the receiver as trustee of a liquidating trust. The plan allowed the liquidating trust until May 1, 2014, to sell the property at a price high enough to cover the value of the mortgage loan owed to the primary lienholder. The plan also required the liquidating trust to “maintain reasonable insurance” and “own the Real Property as a reasonably prudent owner would own it.”
The trustee attempted to sell the property before the plan of liquidation was finalized and confirmed. From approximately August 2013 until May 2014, the trustee marketed the property through the services of a commercial real estate firm. During this time, the trustee paid for security, repairs, upkeep, utilities and insurance on the property. However, despite the trustee’s best efforts to sell the property, the only offer made on it was for $4 million, and the primary lienholder rejected this offer because the net proceeds from the potential sale would not have fully paid its lien.
The sale deadline came and went with the property still not sold. The trustee continued to pursue a deal with the potential buyer who offered $4 million, but that deal was lost on May 22, 2014. Soon after, the trustee informed the primary lienholder that it intended to cease paying any expenses on the property. The primary lienholder objected because the cessation “would virtually destroy any value remaining in the [property].”
The trustee moved to abandon the property, to which the primary lienholder objected, and while that motion was pending the trustee moved to surcharge its expenses incurred. The primary lienholder objected to paying the surcharge. In August 2014, the parties reached a partial settlement that allowed the liquidating trust to abandon the property as of Sept. 13, 2014, and the primary lienholder would pay the surcharge from June 1, 2014, which was a few days after the trustee expressed an intent to abandon the property, to the present.
The bankruptcy court heard testimony and argument as to whether it should grant the trustee the surcharge on the expenses prior to June 1, 2014. It awarded the trustee the expenses in the form of a priming lien. The primary lienholder timely appealed, and the Fifth Circuit approved a direct appeal.
The Fifth Circuit noted that the general rule in bankruptcy cases is that administrative expenses cannot be satisfied out of collateral property “but must be borne out of the unencumbered assets of the estate.” 4 COLLIER ON BANKRUPTCY ¶ 506.05 (16th ed. 2015).
However, the Court also noted that section 506(c), 11 U.S.C. 506(c), provides a “narrow” and “extraordinary” exception that allows for recovery of “the reasonable, necessary costs and expenses of preserving, or disposing of, such property to the extent of any benefit to the holder of such claim.” To recover under section 506(c), the expenditure must be necessary, the amounts expended must be reasonable, and the creditor must benefit from the expense.
The primary lienholder argued that it should not have to pay the surcharge because it did not benefit from the expense. The trustee argued that the primary lienholder benefited by receiving the property with its value preserved and avoiding preservation costs while the property was part of the liquidating trust.
The primary lienholder’s argument contained two components: First, it argued that the bankruptcy court erred in finding that the expenses were incurred primarily for its benefit because it was the only creditor who received payment on the property. Second, the primary lienholder argued that even if the expenses were incurred primarily for its benefit, the bankruptcy court had insufficient evidence of the amount of the benefit it received.
As to the first component, the primary lienholder argued that recovery under section 506(c) is limited to expenses incurred “with a specific and exclusive intent to benefit the secured creditor.” According to the primary lienholder, that was not present in this matter because the trustee aimed to sell the property so that junior and unsecured creditors could also benefit. The primary lienholder supported its position by reference to other cases in which the Fifth Circuit previously required that the claimant incur expenses primarily for the benefit of the secured creditor.
The Fifth Circuit noted that the “primarily for the benefit” language was not in the text of the statute, and held that section 506(c) did not require “that the money be spent with any particular beneficiary in mind.”
Instead, the Court focused on whether the secured creditor benefited from the expenses. The Fifth Circuit held that the standard for receiving a benefit under section 506(c) is whether the expense preserved or increased the value of the property. The Court also noted that the objective of section 506(c) is to prevent unjust enrichment whereby the secured creditor shoulders no costs for preserving the property, while the costs, conversely, are borne out from the general estate, encompassing both junior and unsecured creditors. According to the Court, no such iniquity is present when the trust pays general administrative expenses and the benefit to the secured creditor is merely incidental.
The Fifth Circuit discussed examples in which the trustee attempted to have a secured creditor pay for general administrative expenses and found them inapposite to this case. Instead, the Court held that there was a direct relationship between the surcharge and the collateral in this case. According to the Court, all of the claimed expenses related to preserving the property and preparing it for sale. Accordingly, the Fifth Circuit ruled, the expenses were made primarily for the benefit of the primary lienholder and could be recovered from the primary lienholder under section 506(c).
As to the second component, whether the bankruptcy court had sufficient evidence of the amount of the benefit the primary lienholder received, the Court held that it did. The Fifth Circuit noted that the section 506(c) required a determination as to how much benefit the creditor received. Previously, the Court characterized this aspect of the benefit analysis as requiring a “direct and quantifiable” benefit.
The Fifth Circuit found no clear error by the bankruptcy court in its determination of the amount of the benefit received by the primary lienholder. The testimony of the trustee’s experienced real estate broker was that the value preserved on the property was at least as much as the amount expended by the trustee. The primary lienholder did not offer a competing expert or contradict the valuation method of the real estate broker other than through cross-examination.
As a result, the Fifth Circuit did not disturb the bankruptcy court’s findings as to the amount of the benefit.