There are two types of foreclosure proceedings in the U.S.: judicial and nonjudicial. Both proceedings contain procedures for oversecured creditors to recover attorneys’ fees and costs from the proceeds of the collateral securing the indebtedness. Judicial foreclosure jurisdictions subscribe to the theory that loans secured by real property are liens (i.e., lien theory states), while nonjudicial foreclosure jurisdictions subscribe to the theory that the lender is the title owner of the real property until the borrower repays its obligations (i.e., title theory states).
In a judicial foreclosure proceeding, a court will adjudge the reasonableness of a lender’s attorneys’ fees after the lender and its attorneys submit evidence substantiating the fees sought. The court will then incorporate the attorneys’ fee into the foreclosure judgment. In nonjudicial foreclosure states, borrowers convey a deed of trust to a trustee to hold as security for repayment to the lender. In those jurisdictions, upon a default, after providing the borrower with the appropriate notice and opportunity to cure, the trustee will sell the property to satisfy the obligations that are owed to the lender. The trustee will then retain a statutory or contractual commission for his/her services and remit the outstanding balance of the indebtedness to the lender, including its requested attorneys’ fees. Laws in both judicial and nonjudicial foreclosure jurisdictions generally limit lenders’ recovery of attorneys’ fees to those that are “reasonable.” However, unlike judicial foreclosure states, there is rarely any judicial oversight or approval of attorneys’ fees in nonjudicial foreclosure states.
During the recent recession, real property values dropped dramatically, leaving many lenders undersecured and notions of actually recovering any fees or costs illusory. However, as real property values have risen over the past few years, turning some fortunate undersecured lenders into oversecured creditors, lenders are again focusing in on their rights and ability to recover attorneys’ fees and costs through their collateral.
As the possibility of distributions from real estate-based bankruptcies has risen recently, junior secured lenders, unsecured creditors and equityholders have sought to minimize senior lienholders’ attorneys’ fees by invoking the bankruptcy court’s jurisdiction to (re)examine their reasonableness. In In re 804 Congress LLC,[1] the Fifth Circuit recently analyzed whether bankruptcy courts have jurisdiction to determine the reasonableness of attorneys’ and trustee’s fees when a secured creditor is granted relief from the automatic stay to complete a foreclosure sale.
Background
In 804 Congress, the debtor purchased a commercial office building with financing provided by Wells Fargo Bank. The note was secured by a deed of trust, which granted Wells Fargo a first-priority security interest in the property. After the debtor defaulted on its obligations under the note and security agreement, Wells Fargo and the trustee initiated a foreclosure proceeding. The debtor filed a chapter 11 petition on the eve of the foreclosure sale, which stayed the sale.
Wells Fargo obtained relief from the stay in the bankruptcy case so that it could consummate the foreclosure sale. Thereafter, the trustee holding the deed of trust sold the property by way of a nonjudicial foreclosure sale, which yielded $4.355 million of proceeds. Pursuant to the terms of the deed of trust and consistent with Texas law, the trustee determined that the sale proceeds should be distributed as follows: (1) to the trustee, a commission of 5 percent in an amount equal to $217,750; (2) to Wells Fargo, its indebtedness (inclusive of fees and expenses) in an amount equal to $3,296,915; (3) to the second lienholder, its indebtedness in an amount equal to $618,639.28; and (4) to the debtor, the remaining balance, in an amount equal to $221,695.72.
The trustee filed a motion with the bankruptcy court for the authority to distribute the remaining funds to the debtor’s attorney (because the debtor did not have a debtor-in-possession (DIP) account), and the U.S. Trustee objected. Although the trustee withdrew his motion, the bankruptcy court indicated that it would exercise jurisdiction over the proceeds of the sale. Wells Fargo and the trustee filed claims to the proceeds. The debtor objected to the claims. The bankruptcy court directed the trustee to pay the second lienholder in full: Wells Fargo in the full amount of its principal, interest and expenses (but not its attorneys’ fees), and a commission of $7,500 to the trustee. In denying Wells Fargo’s attorneys’ fees, the bankruptcy court reasoned that Wells Fargo failed to substantiate the reasonableness of its attorneys’ fees. In limiting the trustee’s commission, the court found that the trustee’s contractual 5 percent commission was unreasonable under § 506(b) of the Bankruptcy Code because the trustee testified that she only spent 20 hours on the sale at a rate of $375/hour. On appeal, the district court reversed the bankruptcy court’s decision and found that when the stay was lifted, the bankruptcy court lost jurisdiction over the property and the proceeds of its sale.
Congressional Mandate in § 506(b)
On appeal, the Fifth Circuit noted that the issues before it were whether (1) “after an automatic stay in bankruptcy has been lifted and a creditor is permitted to foreclose on real property, federal or state law governs an oversecured creditor’s recovery of attorneys’ and other fees from the sale proceeds,”[2] and (2) “the bankruptcy court has jurisdiction over the sale proceeds for purposes of determining the creditor’s right to recover [the] attorneys’ fees and the Deed of Trust trustee’s right to recover a contractually-specified commission for conducting the nonjudicial foreclosure sale.”[3] Wells Fargo and the trustee argued that (1) the bankruptcy court relinquished jurisdiction over the sale proceeds when it granted relief from the stay, and (2) that its claim for attorneys’ fees and charges are governed by state law.
The Fifth Circuit disagreed and held that “federal law governs what is to be distributed to a secured claimant that is oversecured.”[4] Citing § 506(b), the Fifth Circuit found that federal law limits an oversecured creditor’s ability to recover fees and costs to those that are “reasonable.”[5] The Fifth Circuit reiterated a proposition advanced in its own controlling precedent that in exercising jurisdiction over what an oversecured creditor is entitled to recover, the “bankruptcy court acted pursuant to the congressional mandate in 11 U.S.C. § 506(b) to prevent the first-priority creditor from getting a windfall by extracting attorneys’ fees in excess of what could legitimately be demanded in a bankruptcy proceeding.”[6]
In examining the reasonableness of the attorneys’ fees and commission under § 506(b), the Fifth Circuit noted that “the language of § 506(b) does not indicate that just because a given fee arrangement is enforceable under state law, it should be exempt from the reasonableness standard.”[7] The 804 Congress court rejected the “creditor’s assertion that if the contractual attorneys’ fee provision is valid under state law, it must be enforced by the bankruptcy court, and that in such cases, the bankruptcy court is without power to arrive at what it otherwise perceives to be a reasonable fee,” and found that the notion is “contrary to the weight of judicial precedent and is betrayed by a legislative intent indicating that awards are to be made reasonable under § 506(b).”[8]
The Fifth Circuit pondered whether lifting the automatic stay in bankruptcy and a subsequent nonjudicial foreclosure conducted under state law somehow “changes the equation.” Ultimately, the 804 Congress court determined that it could “discern no intent from § 506(b) that oversecured creditors who are permitted to foreclose are to be treated differently from oversecured creditors whose claims are satisfied within the bankruptcy proceeding.”[9] It noted that “[l]ifting the automatic stay to allow Wells Fargo to foreclose was not tantamount to an abandonment of the property”[10] and emphasized that lifting the automatic stay “did not have the effect of insulating the debtor or any of the creditors from the reach of § 506(b).”[11] Thus, it concluded that the bankruptcy court properly exercised jurisdiction over the proceeds of the nonjudicial foreclosure sale.
Ultimately, the Fifth Circuit concluded that the trustee’s commission was unreasonable given the amount of time spent by the trustee in administering the property.[12] It also concluded, although noting that it was a much closer call than the trustee’s commission, that the bankruptcy court did not abuse its discretion in finding that the attorneys’ fee claim was unsupported by sufficient evidence.[13]
Undecided: § 506(b) vs. § 502
Notably, the Fifth Circuit declined to answer whether that portion of an oversecured creditor’s fee that is found unreasonable is otherwise recoverable as a general unsecured claim pursuant to § 502 of the Bankruptcy Code. However, it did spend a considerable amount of time discussing the issue in dicta.
First, the court noted that several other circuits have answered the question in the affirmative, including the First, Ninth and Eleventh Circuit Courts of Appeals. In particular, the Fifth Circuit found persuasive the Ninth Circuit’s reasoning that “to bar [an oversecured creditor] from seeking the balance of its fees as an unsecured claim would make it worse off in bankruptcy than it would have been if its claim were unsecured.”[14] It also found persuasive the rationale espoused by the First Circuit that in situations where the debtor is a single-asset entity and the creditor is oversecured (i.e., all creditors are paid in full), “no useful purpose would be served by inquiring into whether the [charges] are reasonable (and thus deserving of priority) within the contemplation of section 506(b).”[15]
However, the Fifth Circuit was concerned with the tension that was arguably created by allowing otherwise-unreasonable fees and costs under § 502 with the rationale espoused by the U.S. Supreme Court in United Savings Ass’n of Texas v. Timbers of Inwood Forest Associates.[16] In Timbers, the Supreme Court found that with respect to interest, § 506(b) had the “substantive effect of denying undersecured creditors post-petition interest on their claims.”[17] The Fifth Circuit noted that an argument could be made that § 506(b) has the same substantive effect with respect to an oversecured creditor’s fees, costs and charges that are found to be unreasonable.[18] However, it also noted that the Timbers holding is easily distinguished, as interest of an undersecured creditor is specifically disallowed by § 502(b)(2).[19]
The Fifth Circuit declined to answer the question because it was not adequately preserved on appeal. It remains to be seen whether the 804 Congress decision is better known for its comments on the perceived tension between §§ 506(b) and 502 than for what it actually resolved.
Conclusion
The 804 Congress court repeatedly identified the foreclosure sale at issue as a nonjudicial foreclosure sale with little oversight and review of the creditors’ fees. One can only infer that the lack of due process in nonjudicial foreclosure sales may impact whether a bankruptcy court has an independent duty to review oversecured creditors’ fees for reasonableness. The Fifth Circuit arguably left open the issue of a bankruptcy court’s duty to assess foreclosing creditors’ fees that had already been deemed reasonable by a state foreclosure court after reviewing substantiating evidence. One can imagine the res judicata arguments posed by such creditors.
The lesson in 804 Congress for oversecured creditors is to use hindsight in real time. If a creditor’s agreement provides for fees, costs and charges that are recoverable pursuant to state law, but may not be found reasonable under § 506(b), then it would be prudent to include the language in the stay relief order that allows the creditor to liquidate and recover those fees in the foreclosure proceeding without the need for further bankruptcy court orders.
[1] 756 F.3d 368 (5th Cir. 2014).
[2] Id. at 371.
[3] Id.
[4] Id. at 373.
[5] 11 U.S.C. § 506(b).
[6] In re 804 Congress, 756 F.3d at 374 (citing Blackburn-Bliss Trust v. Hudson Shipbuilders Inc. (In re Hudson Shipbuilders Inc.), 794 F.2d 1051 (5th Cir. 1986)).
[7] 756 F.3d at 374 n.19 (quoting Welzel v. Advocate Realty Invs. LLC (In re Welzel), 275 F.3d 1308, 1311 (11th Cir. 2001)).
[8] 756 F.3d at 374.
[9] Id. at 375.
[10] Id. at 376 (citing Catalano v. Comm’r, 279 F.3d 682, 687 (9th Cir. 2002) (holding that “an order lifting the automatic stay by itself does not release the estate’s interest in the property”).
[11] 756 F.3d at 376.
[12] Id. at 377.
[13] Id.
[14] Id. at 378 (quoting Joseph F. Sanson Investment Co. v. 268 Ltd. (In re 268 Ltd.), 789 F.2d 674 (9th Cir. 1986)).
[15] 756 F.3d at 378 (citing In re Welzel, 275 F.3d at 1318).
[16] 484 U.S. 365, 108 S. Ct. 626, 98 L. Ed. 2d 740 (1988).
[17] Id. at 372; 108 S. Ct. 626.
[18] In re 804 Congress, 756 F.3d at 378.
[19] Id.