A New Derivative Right for Surcharge Of A Secured Creditors' Collateral in Bankruptcy
A secured creditor that acquires the assets of a debtor in bankruptcy by credit bidding may find that it has to pay real money to the trustee or debtor-in-possession pursuant to Section 506(c) of the Bankruptcy Code. That section provides that “[t]he trustee may recover from property securing an allowed secured claim 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, including the payment of all ad valorem property taxes with respect to the property.” 11 U.S.C. §506(c) (emphasis added). While it may seem odd that secured creditors have to pay debtors to use collateral, this provision allows debtors to surcharge a secured creditor’s collateral for any benefit the secured creditor received by reason of the debtor’s preservation or disposition of such collateral.
Before 2000, some Courts held that §506(c) gave the right to surcharge collateral not only to the trustee or debtor-in-possession but also to administrative creditors, such as accountants or attorneys, who perform services for a debtor during a bankruptcy case. However, in 2000 the Supreme Court of the United States held that, in light the plain language of the statute, only the trustee (or debtor in possession) may bring an action predicated on the relief provided in Section 506(c). See Hartford Underwriters Insurance Company v. Union Planters Bank, N.A., 530 U.S. 1, 120 S. Ct. 1942 (2000).
This holding, which resolved a split of authority amongst courts, foreclosed the sole remedy for administrative creditors to get paid when they provided a benefit to secured creditors. The prejudice to administrative creditors was especially pronounced because normal plans of reorganization require payment of all administrative expenses. A sale pursuant to 11 U.S.C. §363, known as a “363 sale,” where the debtor sells all of its assets free and clear of all liens and encumbrances can leave debtors incapable of paying the parties that enabled the sale to occur. For secured creditors, a 363 sale is preferred when a debtor’s business has a “going concern” value, because a normal foreclosure would severely disrupt business operations (e.g. automatic and often incurable breach of employment and other contracts). A secured creditor can also credit bid at a 363 sale. The 363 sale strategy used in the Chrysler, GM, and Lehman Brothers bankruptcies is common: “liquidating Chapter 11 cases [after a §363 sale of all of the Debtor’s assets], for better or worse, have been the rule and not the exception in this Court and others over the last decade, if not longer.” In re Applied Theory Corp., (Bankr. S.D.N.Y. Apr. 24, 2008) (Gerber, J. Case No. 02-11868 (REG)).
Recently, Robinson Brog Leinwand Greene Genovese & Gluck, P.C. persuaded the United States Bankruptcy Court for the Eastern District of New York to recognize a derivative right to bring a §506(c) claim, which was never thought to exist post-Hartford Underwriters. In In re Champion Motor Group, Inc. (Trust, J. Case No. 09-71979 (AST)), the debtor sold substantially all of its assets to a credit bidding secured creditor, leaving no funds for the debtor’s unsecured creditors or for the debtor’s attorneys, Robinson Brog. Robinson Brog argued that it should be granted derivative standing on the debtor’s behalf under §506(c) to surcharge the secured creditor because all of the debtor’s principals were employed by the secured creditor after the 363 sale. This presented a classic conflict of interest whereby the debtor’s principals could not be expected to cause the debtor to seek a §506(c) surcharge of the principals’ new employer.
Robinson Brog argued that a footnote from Hartford Underwriters expressly did not foreclose its derivative right: “[w]e do not address whether a bankruptcy court can allow other interested parties to act in the trustee's stead in pursuing recovery under § 506(c)…[for example] the practice of some courts of allowing creditors or creditors' committees a derivative right to bring avoidance actions when the trustee refuses to do so, even though the applicable Code provisions…mention only the trustee.” Since debtors have fiduciary duties to maximize the value of their estates and the debtor’s principals were conflicted by their later employment by the secured creditor that acquired the debtor’s assets, the Court held that, if the debtor did not do so itself then Robinson Brog had standing to bring surcharge proceedings derivatively, or on on behalf of the debtor.
Often, secured creditors use the services of professionals- who become administrative creditors- to enhance the value of the debtor’s assets. Secured creditors who use the bankruptcy process to acquire a business as a going concern, should budget for compensation those who helped the secured creditor to achieve its goals, receive court approval for the Debtor to waive its rights under §506(c), or face surcharge proceedings. The Champion Motor Group holding may create a check on the growing popularity of the 363 sale in Chapter 11 case strategy. Further, this holding may also lessen the finality of §506(c) waivers by debtors, usually done in exchange for the use of the secured creditor’s cash collateral or for new monies lent. Overall, we are pleased to have contributed to an area of bankruptcy law that is widely used in reorganizations.
*Kavneet Singh Sethi is a law student clerking at Robinson Brog, who contributed to the briefing in the Champion Motor Group case discussed in this article.