The Bankruptcy Code permits a bankruptcy trustee to “surcharge” a lender’s collateral when the cost will benefit the lender and there is also benefit to the bankruptcy estate. The friction arises when the collateral is worth less than the lender’s secured claim plus the surcharged expenses. In short, who is left holding the bag when the collateral is worth less than the trustee’s expenses and the secured debt? In some ways it’s a question of necessity, but as a practical matter it’s a question on appraisals.
I. The Surcharge
The bankruptcy code allows bankruptcy trustees to recover the reasonably necessary costs of preserving a lender’s collateral from the collateral under certain circumstances. Specifically, section 506(c) states:
“The trustee may recover from the 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.”
In the recent 5th circuit case, the court has stated that “to recover under this provision, the trustee bears the burden of proving the following: ‘(1) the expenditure was necessary, (2) the amounts expended were reasonable, and (3) the creditor benefited from the expense.’”
The underlying theory for all of this is that the estate should be reimbursed when it incurs expenses which the secured creditor would have incurred anyway while the estate moves to monetize value from the collateral as time moves on. The idea being, if the collateral is worth less than the debt, than the trustee would simply abandon the asset to the secured creditor because it would be of no value to the bankruptcy estate.
The whole analysis revolves around the value of the asset. Because; if the asset is worth less than the debt, there is no benefit to the estate to realize on by a sale and thus no reason to incur expense.
So, what happens if the appraisal is simply wrong and the asset is worth far less than the secured debt? Does the bankruptcy trustee get to surcharge the asset with a lien for expenses even though there is no hope of recovery for the bankruptcy estate from the asset?
In the Fifth Circuit, yes.
II. The Case
In the case of Southwest Securities, FSB v. Segner (In the Matter of Domistyle, Inc.), case 14-41463, pending in the United States Court of Appeals for the Fifth Circuit, the court found that the estate could surcharge the asset.
In short, the appraisal on real property collateral of the lender came back as millions more than the debt. The lender did not challenge the appraisal.
All parties assumed the appraisal was correct and permitted the bankruptcy trustee (now liquidating trustee) to attempt to sell the property.
After a diligent marketing attempt it because obvious that the collateral was, in fact, worth millions less than the debt. However, before figuring that out, the bankruptcy trustee had spent a significant amount of money on maintaining the property.
Thus, the question to the Fifth Circuit was: does a bankruptcy trustee get a super priority lien for expenses on the collateral when there was really no benefit at all to the bankruptcy estate in hindsight?
The answer in the Fifth Circuit is that a bankruptcy trustee can eat into the collateral value of expenses even when it becomes obvious that the collateral cannot be sold for any value to the bankruptcy estate.
III. Things to Consider
While the nuances of 506(c) deserve more attention than they are provided here, the headline message is that the lender needs to seek and assert an appraised value of collateral throughout a bankruptcy case.
If the lender in this case had shown early that there was no equity in the collateral, then it would not have to bear the burden of a new senior lien for expenses of maintaining the collateral while the secured creditor was held at bay. Rather, in this case the lender simply did not contest the value. (Which may mean that the lender’s appraised value also was higher than the debt).
While the opinion discusses the ins and outs of a surcharge under 506(c), the practical consideration is really how quickly and effectively can a lender assert an accurate collateral value to avoid the extra cost and expense of a bankruptcy surcharging against the collateral with no benefit at all to the bankruptcy estate.