Third Circuit Decision in In re Towne Reaffirms Rule That It Is Not Easy To Surcharge A Secured Lender’s Collateral Under 506(c)

As a general rule, the costs and expenses of administering a bankruptcy proceeding must be borne out of the unencumbered assets of the estate, absent an agreement to the contrary.  One narrow exception to this rule arises from Section 506(c) of the Bankruptcy Code, which enables a debtor in possession to surcharge a secured lender’s collateral to pay reasonable and necessary administrative expenses that are incurred preserving or disposing such collateral.  Recently, in In re Towne, Inc., et al. 2013 BL 232068 (3d Cir. Aug. 29, 2013), the Third Circuit Court of Appeals upheld lower court decisions denying a motion by a debtor’s counsel to surcharge the proceeds of a secured lender’s collateral to pay its legal fees, reinforcing prior Third Circuit decisions on the issue and demonstrating the difficulties a debtor faces in seeking to surcharge a secured lender’s collateral.  

In Towne, a BMW dealership filed for relief under chapter 11 and hired The Margolis Law Firm as special counsel.  The secured lender to the debtors, BMW Financial Services, NA, LLC, immediately sought relief from the automatic stay to foreclose on its collateral.  The Bankruptcy Court granted the requested relief, but BMW Financial agreed to delay foreclosure to provide the dealership with an opportunity to sell their assets in the chapter 11 case.  Margolis identified a potential purchaser offering to pay approximately $6 million for the debtors’ assets, substantially less than BMW Financial’s $9 million secured claim.  Because the debtors were unwilling to grant BMW Financial releases, BMW Financial refused to consent to the sale.  A few months later, the Bankruptcy Court converted the case to a case under chapter 7, at which point the chapter 7 trustee granted BMW Financial the releases it demanded and promptly sold the collateral to a new purchaser for approximately $5.5 million.  BMW Financial permitted a carve-out of the sale proceeds to pay for the chapter 7 trustee’s fees and fund a 10% distribution to general unsecured creditors.

Margolis was owed approximately $90,000 in legal fees from its work during the chapter 11 case, and it filed a motion to surcharge the proceeds from the sale BMW Financial’s collateral in an attempt to be paid.  As articulated by the Third Circuit in Towne, a secured lender’s collateral can only be surcharged under the “sharply limited” circumstances where the administrative expense (i) was reasonable and necessary to the preservation/disposal of the collateral and (ii) provided a direct benefit to the secured creditor.  Furthermore, despite the language of 506(c)—which permits a surcharge of collateral for the necessary and reasonable costs of preserving or disposing of collateral “to the extent of any benefit to the holder of such claim” (emphasis added)—the Third Circuit explicitly rejected the argument that a surcharge is appropriate where the secured creditor “could reasonably have been expected to benefit,” holding that a “direct benefit” to the secured creditor is required.

Applying this standard, the Court found that Margolis could not demonstrate that its fees were necessary to preserve or dispose of the BMW Financial’s collateral, or that its efforts directly benefited BMW Financial.  In reaching this conclusion, the Third Circuit first rejected Margolis’s argument that its efforts to find bidders and document a sale benefitted the secured lender because such efforts did not result in an actual sale.  The Third Circuit then rejected Margolis’s argument that its efforts to prevent termination of the dealership franchise agreement preserved the value of the lender’s collateral because Margolis couldn’t demonstrate that the franchise would have been terminated without its efforts.  The Third Circuit also noted that some of the services provided by Margolis were specifically contrary to the secured lender’s interests, such as efforts to reduce the value of its lien.

Although the opinion issued by the Third Circuit in Towne was designated as “not-precedential,” it nevertheless provides an important reminder of the challenges facing debtors and other parties in interest who try to use section 506(c) to fund the administration of a bankruptcy case, particularly in the Third Circuit, where the standard for demonstrating that an expense conferred a benefit to the secured creditor appears to be more rigorous than the plain language of the Bankruptcy Code might otherwise suggest.

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