Representing the Oversecured Creditor Eleventh Circuit Allows Claim for Attorneys Fees Based on Statutory Formula

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Jul/Aug 2002

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The Bankruptcy Code provides for the payment of "reasonable fees, costs or charges"
to an oversecured creditor—that is, a creditor with a lien on collateral that is worth
more than the amount of its claim—if the relevant loan documents provide for the
payment of such fees, costs or charges.<a href="#2" name="2a">2</a>

This provision of the Bankruptcy Code naturally creates tension between the
oversecured creditor and the debtor's unsecured creditors, because the return to
unsecured creditors is reduced by each dollar used to reimburse a secured creditor for
attorneys' fees or other charges. Apparent conflicts among §506(b) of the
Bankruptcy Code, state laws governing attorneys' fees and contractual provisions
requiring the payment of fees have spawned litigation since shortly after the Bankruptcy
Code became effective in 1979.

The U.S. Court of Appeals for the Eleventh Circuit, sitting en banc, recently
entered this fray in In re Welzel,<a href="#3" name="3a">3</a> a case that was unusual in several respects. The
case featured a solvent debtor and an oversecured creditor, a combination that does not
arise frequently in bankruptcy cases.<a href="#4" name="4a">4</a> Because a solvent debtor is entitled to any assets
remaining after all creditors have been paid in full,<a href="#5a" name="5a">5</a> the dispute regarding the
creditor's attorneys' fees concerned only the secured creditor and the debtor himself. The
second unusual aspect of the case was that Georgia law provides a statutory definition
of what constitutes "reasonable" attorneys' fees, so that the courts were required to
reconcile that definition with the use of the term "reasonable" in §506(b) of the
Bankruptcy Code.

<h3>Background</h3>

Section 13-1-11 of the Georgia Code authorizes lenders and borrowers to
agree that attorneys' fees will be payable upon the maturity of a promissory note in
the amount of a specific percentage of the principal and interest owing on the note,
up to fifteen percent.<a href="#6" name="6a">6</a> If the parties instead describe the obligation in terms of
"reasonable" attorneys' fees without specifying a percentage, the provision is construed
to mean 15 percent of the first $500 owing and 10 percent of the balance.<a href="#7" name="7a">7</a>
For such a provision to be enforceable, the lender must provide written notice to
the borrower after maturity regarding the attorneys' fees provision, and if the
borrower makes payment in full of principal and interest within 10 days, the lender
may not collect any attorneys' fees.<a href="#8" name="8a">8</a> If the borrower does not pay within 10
days, the statutory attorneys' fees become part of the principal debt.<a href="#9" name="9a">9</a> The Georgia
courts have treated statutory fees as equivalent to liquidated damages, so that a
lender may not collect more than the statutory percentage even if its actual attorneys'
fees are higher.<a href="#10" name="10a">10</a>

The basic facts in the Welzel case were simple: Mr. Welzel received the statutory
10-day notice from his lender, failed to make payment in full and filed for
bankruptcy protection after the 10-day grace period expired. By the time the parties
joined issue before the bankruptcy court on the question of attorneys' fees, the
lender, Advocate Realty Investments, had incurred approximately $40,000 in
fees, whereas application of the statutory percentage would have resulted in an award
of about $148,000 in fees.<a href="#11" name="11a">11</a> The bankruptcy court concluded that only the
reasonable amount of attorneys' fees actually incurred by Advocate should be included
in Advocate's secured claim under §506(b) of the Bankruptcy Code and that the
balance of the statutory percentage should be allowed as an unsecured claim against
Welzel's estate.<a href="#12" name="12a">12</a>

<h3>Arguments on Appeal</h3>

Both parties appealed to the district court. Welzel argued that the statutory fees
in excess of amounts actually incurred by Advocate should be disallowed entirely.
Advocate, on the other hand, asserted that the entire statutory amount should be
treated as a portion of the principal of its secured claim. The district court agreed
with Welzel, limiting Advocate to attorneys' fees actually incurred and disallowing the
balance of the claim.<a href="#13" name="13a">13</a>

Each party renewed its all-or-nothing argument in the Eleventh Circuit, although
Advocate argued in the alternative that the bankruptcy court's decision, allowing the
"unreasonable" portion of the statutory fees as an unsecured claim, was correct. A
divided panel affirmed the district court, holding that §506(b) preempted the
Georgia statute and precluded Advocate from recovering statutory attorneys' fees in
excess of the amount determined to be "reasonable" by the bankruptcy court.<a href="#14" name="14a">14</a> A
dissenting judge did not take issue with the panel's conclusion that §506(b)
requires a determination by the bankruptcy court of what fees are "reasonable" for
purposes of inclusion in a creditor's secured claim.<a href="#15" name="15a">15</a> He argued forcefully,
however, that nothing in the Bankruptcy Code permitted the balance of the statutory
fees—which were valid and enforceable under applicable state law—to be disallowed.<a href="#16" name="16a">16</a>

<h3>Eleventh Circuit Unanimously Supports Creditor</h3>

The appeals court then granted en banc review and vacated the panel's decision.
In a unanimous decision, the full court held that the bankruptcy court's analysis
was correct. The court first concluded that §506(b) requires a bankruptcy judge
to evaluate a secured creditor's claim for attorneys' fees for reasonableness,
notwithstanding state law.<a href="#17" name="17a">17</a> On this issue, the court's decision is consistent with
decisions of other appellate courts, which have held that the reasonableness of
attorneys' fees for purposes of §506(b) is governed by federal law.<a href="#18" name="18a">18</a> In so
holding, however, the Eleventh Circuit expressly overruled a prior decision arising
under the Bankruptcy Act of 1898, in which it had held that statutory
attorneys' fees became part of the principal indebtedness and could be collected in
full by a secured creditor (as Advocate argued).<a href="#19" name="19a">19</a>

The en banc court reversed the district court with respect to the treatment of
the "unreasonable" portion of Advocate's statutory fees, holding that these fees should
not be disallowed but should instead be allowed as an unsecured claim.<a href="#20" name="20a">20</a> The court
recognized that §506(b) does not provide for the disallowance of any claim;
rather, it describes the items that are included in the secured claim of an
oversecured creditor. Allowance and disallowance of claims are governed instead by <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
U.S.C. §502</a>, which provides a limited number of grounds on which a claim may
be disallowed.<a href="#21" name="21a">21</a> Because none of these grounds applied to Advocate's claim for
attorneys' fees, the Eleventh Circuit concluded that the entire claim should be
allowed, even if only the "reasonable" portion of it could be recovered as part of
Advocate's secured claim.<a href="#22" name="22a">22</a>

<h3>Significance of the Ruling for Creditors and Debtors</h3>

The Eleventh Circuit's holding in Welzel is significant for several reasons. If
statutory attorneys' fees could be disallowed in bankruptcy, solvent debtors might seek
bankruptcy protection for strategic reasons. The ability to escape valid and enforceable
state-law obligations by filing a bankruptcy petition would result in windfalls for
debtors who otherwise might have no need for the protection provided by the Bankruptcy
Code. Such windfalls would not be limited to attorneys' fees, but also could arise
in cases involving prepayment penalties, above-market interest rates and other contractual
provisions that borrowers sometimes come to regret. As the Eleventh Circuit
recognized, to permit disallowance of these obligations based on their perceived
unreasonableness "would only increase litigation and do a disservice to the parties'
contractual expectations."<a href="#23" name="23a">23</a>

The principles of Welzel also are important beyond the solvent-debtor,
oversecured-creditor context in which the case arose. Unsecured and undersecured creditors
with a contractual right to attorneys' fees can take comfort from the decision.
Because §506(b) never comes into play for these creditors, reasonableness is not
an issue. However, the Eleventh Circuit's holding that §502 does not permit
disallowance of enforceable state-law claims for attorneys' fees bolsters these creditors'
claims.<a href="#24" name="24a">24</a> Indeed, one of the factors taken into consideration by the Eleventh
Circuit was the anomaly that would result if unsecured creditors' "unreasonable" claims
for attorneys' fees were allowed but oversecured creditors' claims were disallowed.<a href="#25" name="25a">25</a>

In many bankruptcy cases, of course, an unsecured claim has little economic
value. Even where the returns to unsecured creditors are low, however, a
creditor may gain a significant advantage from holding an unsecured claim. For
example, in a chapter 11 case, creditors vote to accept or reject a
reorganization plan by classes.<a href="#26" name="26a">26</a> Holding a large unsecured claim for attorneys'
fees, a prepayment penalty or some other contractual right may enable a creditor
to control a class of unsecured creditors and to insist on better treatment of that
class by the debtor. Similarly, depending on the circumstances of the case, the
addition of an unsecured claim for attorneys' fees or other amounts may make an
election under §1111(b)(2) of the Bankruptcy Code more valuable.

It is important to note that Welzel does not govern the enforceability of a claim
for attorneys' fees under state law. Georgia law is clear that a percentage-based
claim for attorneys' fees is enforceable, but the law in other states differs. For
example, the Ninth Circuit in 268 Ltd. reached the same conclusion as the
Eleventh Circuit in Welzel—that "unreasonable" attorneys' fees are allowed as a unsecured
claim.<a href="#27" name="27a">27</a> Later in the same case, however, the Supreme Court of Nevada, responding
to a certified question from the Ninth Circuit, held that the percentage-based
attorneys' fees at issue were unreasonable and unenforceable as a matter of state
law.<a href="#28" name="28a">28</a> In such a situation, §502(b)(1) of the Bankruptcy Code would require
the disallowance of the unreasonable fees.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> King & Spalding represented an amicus curiae in support of the creditor in the Welzel appeal. <a href="#1a">Return to article</a>

<a name="2">2</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §506(b)</a>. <a href="#2a">Return to article</a>

<a name="3">3</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Advocate Realty Invs. LLC (In re Welzel), 275 F.3d 1308 (11th Cir. 2001) (en banc)</a> (hereinafter

Welzel III). <a href="#3a">Return to article</a>

<a name="4">4</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… III, 275 F.3d at 1319</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §726(a)(6)</a>. <a href="#5a">Return to article</a>

<a name="6">6</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. §13-1-11(a)(1)</a>. <a href="#6a">Return to article</a>

<a name="7">7</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; §13-1-11(a)(2)</a>. <a href="#7a">Return to article</a>

<a name="8">8</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; §13-1-11(a)(3)</a>. <a href="#8a">Return to article</a>

<a name="9">9</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Atlantic Nat'l. Bank, 95 S.E. 219, 219 (Ga. 1918)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Kiser, 31 S.E. 45,
45 (Ga. 1898)</a>. <a href="#9a">Return to article</a>

<a name="10">10</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Phillips, 158 S.E. 797, 800 (Ga. 1931)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of Lumpkin v. Farmers' State Bank, 133
S.E. 307, 308 (Ga. Ct. App. 1926)</a>. <a href="#10a">Return to article</a>

<a name="11">11</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… III, 275 F.3d at 1311</a>. <a href="#11a">Return to article</a>

<a name="12">12</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Advocate Realty Invs. LLC (In re Welzel), 243 B.R. 916, 919 (S.D. Ga. 1999)</a> (hereinafter
Welzel I) (summarizing bankruptcy court's decision). <a href="#12a">Return to article</a>

<a name="13">13</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 922-23</a>. <a href="#13a">Return to article</a>

<a name="14">14</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Advocate Realty Invs. LLC (In re Welzel), 245 F.3d 1283, 1286 (11th Cir. 2001)</a>
(hereinafter Welzel II). <a href="#14a">Return to article</a>

<a name="15">15</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1287</a> (Cox, J., dissenting). <a href="#15a">Return to article</a>

<a name="16">16</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1288-89</a>. <a href="#16a">Return to article</a>

<a name="17">17</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… III, 275 F.3d at 1314-15</a>. The court concluded that <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. §13-1-11</a> was relevant to the
question of enforceability of a claim for attorneys' fees but did not control the question of reasonableness. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1315</a>. <a href="#17a">Return to article</a>

<a name="18">18</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Creditors' Committee v. Walter E. Heller & Co. S.E. Inc. (In re K.H. Stephenson Supply Co.), 768
F.2d 580, 585 (4th Cir. 1985)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Trust v. Hudson Shipbuilders Inc. (In re Hudson Shipbuilders Inc.),
794 F.2d 1051, 1056 (5th Cir. 1986)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… W. Bank & Trust v. Drewes (In re Schriock Constr. Inc.), 104
F.3d 200, 202 (8th Cir. 1997)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F. Sanson Inv. Co. v. 268 Ltd. (In re 268 Ltd.), 789 F.2d
674, 677 (9th Cir. 1986)</a>. <a href="#18a">Return to article</a>

<a name="19">19</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. East Side Investors (In re East Side Investors), 694 F.2d 242, 246 (11th Cir. 1982)</a>,
supplemented on reh'g.; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.2d 214, 215 (11th Cir. 1983)</a>. Welzel III also abrogated several other decisions by
implication, including <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Life Assurance Soc'y. v. Sublett (In re Sublett), 895 F.2d 1381, 1385 & n.9 (11th
Cir. 1990)</a> (holding that reasonableness of charges under §506(b) is determined by reference to state law); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Acceptance Co.
v. Zusmann, 379 F.2d 351, 354 (5th Cir. 1967)</a> (holding that the bankruptcy referee could not reduce statutory attorneys'
fees); and <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Mortgage Co. v. Powers, 278 U.S. 149, 154-55 (1928)</a> (in case arising in Georgia, concluding that
validity of lien for attorneys' fees was governed by state law). <a href="#19a">Return to article</a>

<a name="20">20</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… III, 275 F.3d at 1316</a>. <a href="#20a">Return to article</a>

<a name="21">21</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §502(b)</a>. <a href="#21a">Return to article</a>

<a name="22">22</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… III, 275 F.3d at 1318</a>. <a href="#22a">Return to article</a>

<a name="23">23</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1319</a>. <a href="#23a">Return to article</a>

<a name="24">24</a> Unsecured and undersecured creditors' claims for attorneys' fees have been sustained frequently by the appellate courts. See, e.g.,
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Assocs. v. Kahn (In re Hemingway Transport Inc.), 954 F.2d 1, 9 (1st Cir. 1992)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Merchants & Mfrs.
Inc. v. Equitable Life Assurance Soc'y. (In re United Merchants & Manufacturers Inc.), 674 F.2d 134, 137-39 (2d
Cir. 1982)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Frost Nat'l. Bank, 391 F.2d 687, 691 (5th Cir.), cert. denied, 393 U.S. 979
(1968)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Hanover Trust Co. v. Bartsh (In re Flight Transportation Corp. Securities Litigation), 874 F.2d 576,
583-84 (8th Cir. 1989)</a>. <a href="#24a">Return to article</a>

<a name="25">25</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… III, 275 F.3d at 1319</a>. <a href="#25a">Return to article</a>

<a name="26">26</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §§1126(c)</a> and 1129(a)(8). <a href="#26a">Return to article</a>

<a name="27">27</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Ltd., 789 F.2d at 678</a>. <a href="#27a">Return to article</a>

<a name="28">28</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F. Sanson Inv. Co. v. 268 Ltd., 795 P.2d 493, 497 (Nev. 1990)</a>. <a href="#28a">Return to article</a>

Journal Authors

Brian C. Walsh

Journal Date

Monday, July 1, 2002 - 12:00

Bankruptcy Rule

2002