No Surcharge For You: Third Circuit Rules That Section 506(C) Surcharge Is 'Sharply Limited'

The ability to "surcharge" a secured creditor's collateral in bankruptcy is an important resource available to a bankruptcy trustee or chapter 11 debtor in possession ("DIP"), particularly in cases where there is little or no equity in the estate to pay administrative costs, such as the fees and expenses of estate-retained professionals. However, as demonstrated by a ruling handed down by the Third Circuit Court of Appeals, the circumstances under which collateral may be surcharged are narrow. In In re Towne, Inc., 2013 BL 232068 (3d Cir. Aug. 29, 2013), the court of appeals affirmed an order denying a motion by special counsel to direct payment of its fees and expenses by surcharging the proceeds of a secured creditor's collateral because the law firm's services did not directly benefit—and in some cases sought to disadvantage—the secured creditor.

SURCHARGE OF COLLATERAL

Section 506(c) of the Bankruptcy Code provides an exception to the general rule that the payment of expenses associated with administering a bankruptcy estate, including the administration of assets pledged as collateral, must derive from unencumbered assets. Under section 506(c), a trustee or DIP "may recover from property securing an allowed 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." The purpose of the provision is to prevent secured creditors from obtaining a financial windfall at the expense of the estate and unsecured creditors by ensuring that the secured creditors are responsible for the same collateral disposition costs within a bankruptcy case that normally would arise in a foreclosure or similar state law proceeding outside bankruptcy. See Loudoun Leasing Development Co. v. Ford Motor Credit Co. (In re K & L Lakeland, Inc.), 128 F.3d 203 (4th Cir. 1997); In re TIC Memphis RI 13, LLC, 498 B.R. 831 (Bankr. W.D. Tenn. 2013).

Three elements must be satisfied in order to surcharge collateral under the terms of section 506(c): (i) the expenditure must be necessary; (ii) the amounts expended must be reasonable; and (iii) the secured creditor must benefit from the expense. The inquiry into what costs are reasonable and necessary, and the extent to which they benefit the party being surcharged, is factual, and the party seeking recovery has the burden of establishing those elements. See 4 COLLIER ON BANKRUPTCY ¶ 506.05[9] (16th ed. 2014). If an expense...