Supreme Court to Decide Creditors Standing Under 506(c)

Journal Issue

May 2000

Column Name

Journal HTML Content

ater this spring, the U.S. Supreme Court will likely resolve a split in the circuits and decide whether an
administrative creditor has standing under §506(c) of the Bankruptcy Code to surcharge a secured creditor's
collateral.<a href="#1" name="1a">1</a> The case before the Supreme Court is Hartford Underwriters Insurance Co. v. Union Planters
Bank (In re Hen House Interstate Inc.), Case No. 99-409. Oral argument was heard in the case on March
20.

The statutory construction issue presented in Hen House has divided courts of appeal for years along
philosophical lines. Two irreconcilable interpretations have emerged from six courts of appeal that have
addressed the standing of administrative claimants under §506(c). Four circuits have concluded that §506(c)
should be read broadly, and accordingly, have held that unpaid administrative creditors have standing to
recover payments on their own behalf.<a href="#2" name="2a">2</a> These decisions are based in large part on the courts' general
reluctance to permit windfalls upon the happenstance of bankruptcy. In contrast, two circuits have construed
§506(c) restrictively, limiting standing under the section to the trustee (or debtor-in-possession).<a href="#3" name="3a">3</a> Of the
two circuits in the minority, one (the Eighth) was once in the majority. The Eighth Circuit's recent switch
(in a 6-5 en banc decision after a rehearing) gave rise to the issue now before the Supreme Court.<a href="#4" name="4a">4</a>

<h3>Factual Background</h3>

The facts in the Hen House case are relatively straightforward. Hen House, an operator of roadside
restaurants, service stations and gift stores, filed for chapter 11 on Sept. 5, 1991, in the Eastern District of
Missouri. Hen House's pre-petition lender, Union Planters Bank, held a lien on all of Hen House's real and
personal property. Soon after Hen House filed its bankruptcy petition, it sought to borrow additional funds
from Union Planters to pay various operating expenses (including post-petition insurance premiums)
incurred during the reorganization proceedings. The bankruptcy court (Hon David P. McDonald) approved
the debtor-in-possession financing, and Hen House continued to operate its properties. Hen House's attempt
at reorganization ultimately failed, and the case was converted to chapter 7 on Jan. 20, 1993. Before the
conversion, however, Hen House was able to sell several of its properties as going concerns. Union Planters
received the proceeds of these sales in partial payment of its secured claim.

Hartford Underwriters provided workers' compensation insurance to Hen House from Sept. 1, 1991,
through Sept. 1, 1992. Hartford provided the insurance to Hen House through the so-called "assigned risk"
pool in Missouri; that is, it had to provide Hen House coverage as a condition of doing business in the state.
Significantly, Hen House failed to provide Hartford with notice of its bankruptcy case until March
1993—more than a month after the conversion of the case to chapter 7.

Three months after learning of Hen House's bankruptcy filing, Hartford filed an application for the
allowance and payment of its premium claim as an administrative expense, and alternatively sought to
surcharge Union Planters for the amount of its claim under §506(c). Following an evidentiary hearing, the
bankruptcy court found that Hartford's provision of workers' compensation insurance had directly benefited
Union Planters by allowing it to obtain the proceeds of the going-concern sales. Accordingly, the court
allowed Hartford's surcharge claim. The district court (Hon. Charles A. Shaw) and the Eighth Circuit panel
(in a decision written by Hon. Pasco M. Bowman) agreed. On rehearing en banc, the Eighth Circuit (also
in a decision by Judge Bowman) reversed 6-5 on the narrow issue of standing and found that, as a
non-trustee, Hartford could not surcharge Union Planters' collateral on its own behalf. The Supreme Court
granted Hartford's petition for certiorari on Nov. 8, 1999.

<blockquote><blockquote>
<hr>
<big><center>
The decision in Hen House will likely affect nearly every failed reorganization case where one or more
lienholders have received the lion's share of the estate's property.

</center></big>
<hr>
</blockquote></blockquote>

<h3>The Parties' Arguments</h3>

Hartford's arguments to the Supreme Court rest in large part on pre-Code practice that permitted
claimants to pursue their equitable rights directly against the secured party's collateral. Hartford argued that
§506(c) does not abrogate pre-Code practice and that existing equitable principles for preventing windfalls
in bankruptcy broaden the statutory provision. Under the Supreme Court's methodology for construing the
Bankruptcy Code, namely that it will not be read to alter pre-Code practice where Congress has not
explicitly stated an intent to do so, Hartford concluded that absent any express provision in the legislative
history or in the statute itself, §506(c) should not be construed to limit a creditor's equitable right to
surcharge collateral for expenses that preserve or enhance the collateral's value.

In particular, Hartford argued that the Supreme Court itself recognized the equitable surcharge right in
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…, Evansville of St. Louis R.R. v. Wilson, 138 U.S. 501 (1891)</a>, and that other decisions have
permitted administrative creditors to recover unpaid insurance premiums from insured property ahead of
the mortgagee's claims. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Franklin Mortgage Co. (In re Rotary Tire & Rubber Co.), 2 F.2d
364 (6th Cir. 1924)</a>. Hartford cited these and other decisions to support its conclusion that §506(c)
constituted only a partial codification of the pre-Code equitable surcharge right, and that absent a clear
indication that Congress intended to limit that right under the Bankruptcy Code, the broader right endures
to permit Hartford to pursue the priority of its claim directly.

Union Planters argued for a narrower interpretation of §506(c) under a plain-meaning analysis. In sum,
Union Planters argued that §506(c) is clear on its face and that the Supreme Court should not consult the
legislative history or prior practice to determine its scope and meaning. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… States v. Ron Pair
Enters. Inc., 489 U.S. 235, 242 (1989)</a>. Moreover, the bank argued, permitting the trustee alone to pursue
surcharge claims would ensure that the proceeds of any recovery would be available for general creditors,
not just for the party whose services enhanced a secured party's collateral.

<h3>Oral Argument</h3>

During oral argument on March 20, the Supreme Court concentrated on several key aspects of the
parties' arguments. During Hartford's argument, Chief Justice William H. Rehnquist, along with Justice
Sandra Day O'Connor, asked several questions regarding the relevance of pre-Code practice in light of the
text of §506(c). Counsel for Hartford, G. Eric Brunstad Jr. of Bingham Dana LLP, responded that the court
has held that it "will not read the Bankruptcy Code to erode past bankruptcy practice absent a clear
indication that Congress intended such a departure."<a href="#5" name="5a">5</a> Mr. Brunstad added that §506(c) amounts to only a
partial codification of pre-Code equitable rules.

Later in the argument, Chief Justice Rehnquist asked a related question: "Well, isn't it possible Congress
might have wanted to change [pre-Code practice], figuring that what you describe as pre-Code practice
would attract a certain amount of leeches who wanted to get at the secured property?"<a href="#6" name="6a">6</a> Mr. Brunstad
responded, "[T]he rule, I think, is one which initially five courts of appeals, and the Eighth Circuit changed
its mind, had adopted and the courts had no [trouble] administering. I don't think there's any evidence...that
Congress intended to change the [pre-Code] practice."<a href="#7" name="7a">7</a> Mr. Brunstad later listed other equitable principles
that co-exist with related Bankruptcy Code provisions, including recoupment (notwithstanding §553's
provisions with respect to setoff rights), and earmarking (notwithstanding §547(c)'s list of defenses to
preference claims).<a href="#8" name="8a">8</a>

Justice Antonin Scalia asked Mr. Brunstad whether Hartford's position was supported under the plain
meaning of §506(c), prompting Mr. Brunstad to respond that although a strict reading of §506(c) could
support the construction that a trustee could recover a claim under §506(c) only after the trustee had first
paid the expense, trustees under pre-Code practice were sometimes permitted to pursue surcharge claims
before they paid the expense in question.<a href="#9" name="9a">9</a>

A number of other questions from the court concentrated on how funds recovered under §506(c) would
be distributed in the bankruptcy case. Justice Anthony M. Kennedy inquired who would share in any
recoveries made under §506(c). Mr. Brunstad responded that if more than one creditor were entitled to
priority under §506(c), all would share ratably in the recovery from the secured party's collateral.<a href="#10" name="10a">10</a>

Justice O'Connor asked Mr. Brunstad what Hartford could conceivably have done in the case to protect
itself. Mr. Brunstad responded that Hartford could have done little more than it actually did because it had
no notice of Hen House's bankruptcy filing until after the case had been converted. Even assuming that
notice had been given, Mr. Brunstad added, Hartford still could not have protected itself because it was an
involuntary creditor under the state's assigned risk pool for workers' compensation carriers. By analogy,
Mr. Brunstad referred to cases where the United States has sought to surcharge collateral to cover its
clean-up expenses in connection with polluted property. "Just like when the United States comes in and
cleans up an environmental site post-petition, and the cleanup of the site benefits the secured party by
increasing the value of the collateral, the United States in that situation, courts have recognized, can then
come to court and say, 'the trustee has not paid our administrative expense for cleanup because the trustee
has no unencumbered funds to do so,' and the courts have said, 'well, you may surcharge the collateral
to the extent that it benefit[s] the secured party.' Now, if that were not the rule, and the trustee had no
funds to pay the United States's cleanup cost, then essentially the United States would be subsidizing the
recovery of the secured party, who would walk away with the full value of the collateral,...[but] that is
not the bankruptcy rule."<a href="#11" name="11a">11</a>

The court addressed similar questions to Union Bank's counsel, Robert H. Brownlee of Thompson
Coburn LLP. Justice O'Connor reiterated her question regarding what Hartford could have done under the
circumstances of the case to avoid losing its claim. Mr. Brownlee responded that Hartford could have sued
the trustee to compel him to act. In response to questions from Justice Stephen G. Breyer and Justice David
H. Souter, Mr. Brownlee added that Hartford could have sought derivative standing in the bankruptcy court
to assert its §506(c) claim in place of the trustee.<a href="#12" name="12a">12</a>

Justice Ruth Bader Ginsberg asked Union Planters' counsel whether his client's view of §506(c) would
apply equally in a case where the government provides the benefit to the secured party. Mr. Brownlee
responded that it would, absent some super-priority applicable to such claims, and that Congress would be
the proper party to fix the problem identified in Hartford's argument.<a href="#13" name="13a">13</a> In response to a question regarding
the proper allocation of funds received from the secured party under §506(c), Mr. Brownlee advised the
court that a §506(c) creditor would share equally with administrative creditors—even those that did not
satisfy §506(c)'s specific requirements.<a href="#14" name="14a">14</a>

Justice John Paul Stevens asked Mr. Brownlee several questions designed to clarify the issue before
the court, including whether the benefit to Union Planters from Hartford's workers' compensation
insurance was at issue. Mr. Brownlee responded that Union Planters had lost on that issue below and
that the matter was not before the court.<a href="#15" name="15a">15</a>

<h3>Case Implications</h3>

The decision in Hen House will likely affect nearly every failed reorganization case where one or more
lienholders have received the lion's share of the estate's property. Under current practice in the circuits that
follow the minority view, administrative creditors whose services directly benefit the secured party are
simply out of luck if the trustee has no estate funds to pursue their §506(c) claims or if the trustee decides
for whatever reason not to pursue them. Under either scenario, the administrative creditor is left without
a remedy. This scenario would become the rule in all circuits if the court follows Union Planters' position.

If Hartford prevails, administrative creditors will be permitted to pursue their own claims where the
trustee has no incentive to assert the surcharge claim. Such creditors will nevertheless be put to their
proof—just as the trustee would be—to show that particular administrative expenses have preserved or
enhanced the secured party's collateral.

On a more fundamental level, the court's decision in Hen House may likely affect bankruptcy practice
beyond §506(c), including the extent that bankruptcy courts should apply pre-Code equitable principles to
flesh out current Code sections and the proper methodology courts should use to interpret the Bankruptcy
Code as a matter of statutory construction. The court's ruling is expected by June.

Editor's Note: The American Insurance Association and National Union Fire Insurance Company of
Pittsburgh, represented by Mark F. Horning and Sidney P. Levinson of Steptoe and Johnson LLP, filed an
amicus brief in support of Hartford's position. The Commercial Finance Association, represented by Carter
G. Phillips of Sidley & Austin, filed an amicus brief in support of Union Planters. Hartford's trial counsel
was Wendi Alper-Pressman of the St. Louis-based firm Susman, Schermer, Rimmel & Shifrin LLP. David
D. Farrell of Thompson Coburn LLP assisted Mr. Brownlee as counsel for Union Planters. The author, an
associate in Bingham Dana LLP's Hartford office, assisted Mr. Brunstad as counsel for Hartford.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Section 506(c) of the Bankruptcy Code provides that "the 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." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §506(c)</a>. <a href="#1a">Return to article</a>

<a name="2">2</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Steel Shearing Inc. v. Fremont Fin. Corp. (In re Visual Indus. Inc.), 57 F.3d 321, 325 (3d Cir.
1995)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… County Jeep & Renault Inc. v. General Elec. Capital Corp. (In re Palomar Truck Corp.), 951 F.2d 229,
232 (9th Cir. 1991); cert. denied, 506 U.S. 821 (1992)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Parque Forestal Inc., 949 F.2d 504,
511-12 (1st Cir. 1991)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Orleans Pub. Serv. Inc. v. First Fed. Sav. & Loan Ass'n. (In re Delta Towers Ltd.),

924 F.2d 74, 77 (5th Cir. 1991)</a>. <a href="#2a">Return to article</a>

<a name="3">3</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Underwriters Ins. Co. v. Magna Bank N.A. (In re Hen House Interstate Inc.), 177 F.3d 719, 721
(8th Cir. 1999)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Motor Credit Co. v. Reynolds & Reynolds Co. (In re JKJ Chevrolet Inc.), 26 F.3d 481,
484 (4th Cir. 1994)</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> Before Hen House, the Eighth Circuit had held that administrative creditors have standing under §506(c). See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… States,
Internal Revenue Serv. v. Boatmen's First Nat'l Bank, 5 F.3d 1157 (8th Cir. 1993)</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> Oral Argument Transcript, at 4. <a href="#5a">Return to article</a>

<a name="6">6</a> Id. at 20. <a href="#6a">Return to article</a>

<a name="7">7</a> Id. at 20-21. <a href="#7a">Return to article</a>

<a name="8">8</a> Id. at 28, 31. <a href="#8a">Return to article</a>

<a name="9">9</a> Id. at 30. <a href="#9a">Return to article</a>

<a name="10">10</a> Id. at 22-23. <a href="#10a">Return to article</a>

<a name="11">11</a> Id. at 25-26. <a href="#11a">Return to article</a>

<a name="12">12</a> Id. at 36-37. <a href="#12a">Return to article</a>

<a name="13">13</a> Id. at 49-50. <a href="#13a">Return to article</a>

<a name="14">14</a> Id. at 50-51. <a href="#14a">Return to article</a>

<a name="15">15</a> Id. at 56. <a href="#15a">Return to article</a>

Journal Authors