Plunging into a circuit split, Washington, D.C.’s Bankruptcy Judge S. Martin Teel, Jr. ruled that recoveries from surcharging a secured lender’s collateral under Section 506(c) must be distributed pro rata to administrative creditors, not just to the professionals that gave rise to the surcharge. In other words, Judge Teel concluded that Section 506(c) is a recovery provision for the benefit of the estate, not a distribution provision supplementing Section 726(b).
Judge Teel agreed with a 2006 decision by former Bankruptcy Judge Eugene Wedoff of Chicago, who is this year’s president of the American Bankruptcy Institute.
Differing with a recent bankruptcy court decision from another district, Judge Teel decided that he could require disgorgement from professionals to achieve parity among administrative claimants in an administratively insolvent chapter 7 case.
In a converted chapter 11 case, the chapter 7 trustee had recovered more than $34 million, but not enough to pay all administrative claims. Through interim distributions, the chapter 7 trustee had received more than $1 million and his counsel had taken in over $2.5 million. The interim payments to the trustee and his counsel amounted to more than 97% of their final fee requests.
A landlord and the U.S. Trustee objected to the trustee’s proposed final distribution of about $340,000 that would give the trustee and his counsel some 99% of their claims, while the landlord and the U.S. Trustee would receive only 62% of their administrative claims.
The trustee contended that disparate recoveries were proper because he would be distributing proceeds from surcharging a secured lender’s collateral under Section 506(c). The trustee argued that the distribution should go only to administrative creditors that provided benefit to the secured creditor’s collateral.
The circuits are split, with no opinion from the District of Columbia Circuit. In 2001, the Ninth Circuit held that collateral surcharges should go directly to the claimants who provided benefits to the secured creditor.
To the contrary, the Fourth Circuit held in 1994 that money recovered under Section 506(c) becomes an unencumbered asset for distribution to unsecured creditors under the priority rules.
Section 506(c) allows a trustee to “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 . . . .”
Judge Teel concluded in his Sept. 29 opinion that the section “is a recovery provision created for the benefit of the estate, not any specific claimant,” an interpretation in line with the purpose of the statute to prevent a windfall to a secured creditor at the expense of the estate.
If he were to rule otherwise, Judge Teel said he “would be creating a special priority scheme.”
Judge Teel also sided with Judge Wedoff, who said in his 2006 decision that giving the recovery only to some creditors would create a conflict of interest by giving the trustee incentive to settle in exchange for payment only of the trustee’s expenses.
The U.S. Trustee and the landlord also urged Judge Teel to order disgorgement from the trustee and his counsel to achieve an ultimately pro rata distribution to administrative claimants.
Judge Teel stuck by his 1994 Kearing decision, holding that the court has discretion to order disgorgement from professionals. He disagreed with a 2016 bankruptcy court decision from another district holding there is no power to order disgorgement following Law v. Siegel, 134 S. Ct. 1188 (2014), where the Supreme Court ruled that the bankruptcy court does not have a “roving commission” to do equity.
The trustee argued that only two provisions of the Bankruptcy Code provide for disgorgement from professionals: Sections 329(b) and 330(a)(5). Because the case at bar fit under neither section, the trustee contended that Law prohibits the court from creating a remedy.
Judge Teel disagreed, based on the purpose and legislative history of those sections.
Having held that a bankruptcy court has the power, Judge Teel said that it was proper to exercise discretion and order disgorgement from the trustee and the trustee’s counsel, to equalize their ultimate recoveries with the landlord’s and U.S. Trustee’s. He said that administrative claimants like the landlord “should not be penalized because they are unable to collect interim payments.” Likewise, he said, professionals “should not enjoy a windfall because they can collect interim payments.”
Were there no disgorgement, Judge Teel said he “would be creating a superpriority for the trustee and his law firm.”