Brighton Beach Surcharges, Part 1

What expenses can an oversecured creditor tack on to its claim, and what expenses related to the sale of a mortgaged property can be surcharged against the claims of such a creditor?

Judge Nancy Hershey Lord recently considered these questions in a contentious case involving property at 3126 Coney Island Avenue in Brooklyn — a valuable apartment building only a couple of blocks from the fabled Brighton Beach Boardwalk.[1]

Introduction

The creditor was Wells Fargo, as trustee for a series of mortgage-backed securities. Wells Fargo brought a state court foreclosure action in January 2013 and obtained a judgment, dated June 8, 2016, ordering the property’s receiver to conduct a foreclosure sale. At that time, Wells Fargo was owed $3.76 million on the judgment itself, along with about $100,000 in interest. The receiver, in coordination with Wells Fargo and under state court supervision, prepared the property for sale in part by engaging contractors to perform environmental remediation work. (The property is near a former dry-cleaning facility.) The Loricks, who owned the property, forestalled foreclosure by a filing a joint individual chapter 11 petition on Dec. 15, 2016.[2]

By July 2017, the bankruptcy court had ordered a sale of the property under § 363 of the Bankruptcy Code. The auction yielded $7.35 million; the court then had to determine the destination of the sale proceeds.

The court ordered an initial distribution of just over $4 million to Wells Fargo — partially, the court noted, to reduce the “interest-bearing portion” of its claim — but held over the rest for further consideration. The first distribution included the foreclosure judgment amount and certain interests and attorneys’ fees already determined in or at the time of that judgment.

Wells Fargo’s remaining claim was more than $1 million. Pushing against Wells Fargo, the debtors urged the court to award their bankruptcy estate a sizeable surcharge against Wells Fargo. Thus, the court had to determine (1) what further amounts Wells Fargo could collect from the sale proceeds, and (2) whether Wells Fargo’s entitlements should be reduced by surcharges as a result of the debtors’ expenditures. Part 1 of this article will consider the first question; Part 2 will consider the second.

Wells Fargo’s Claim

As to the question of what Wells Fargo was entitled to add to its claim, the court noted that the Bankruptcy Code permits oversecured creditors to collect interest on their claims, as well as “reasonable fees, costs, or charges provided for under the agreement or State statute under which such claim arose.”[3] Here, the creditor was certainly oversecured, and the underlying contracts permitted various expenses, costs and professional fees (including attorneys’ fees) related to collection, foreclosure or other enforcement of the mortgage obligations to be added to the sum owing to Wells Fargo.

The court awarded almost $500,000 in remaining interest and expenses, not counting attorneys’ fees. Then the court scrutinized the attorneys’ fee applications, reducing them by approximately 30%, on several bases. Two of these reasons — failure to itemize activities (in other words, “lumping” activities) and redacting too aggressively to permit proper review of activities — are no doubt familiar to bankruptcy practitioners.

The third basis for reducing the fees was more complicated. Wells Fargo sought to recover fees for defending a suit against it and its lawyers brought by a would-be buyer at the § 363 sale. The court conceded that the suit “is related to Wells Fargo’s collection efforts in the superficial sense that it arose out of the sale,” but stated that the matter “do[es] not go directly toward collecting, protecting, or foreclosing on the mortgage.” Instead, “[t]he action is a separate matter altogether, and does not affect Wells Fargo’s ability to collect on its claim.”[4] Because fees incurred in such a suit were “not contemplated” by the mortgage documents, they were not awardable.[5]

Given that the suit was initiated by an apparently unrelated third party, the court’s decision on this issue certainly seems defensible. That said, one could imagine circumstances in which lawsuits emerging from sale proceedings would be sufficiently related to the underlying commercial relationship that a court might allow the fees as a way of making the lender “whole” for collection efforts that it would have not incurred absent the debtor’s default and subsequent actions. Even more easy to imagine would be a circumstance where a debtor was so closely related to a third party, or had somehow become involved in the lender’s relationship with the third party (or even had a hand in the dispute), such that the court might hold that the third-party action, rather than being tangential to the underlying collection suit, was in fact intertwined with it. In other words, if a future court is faced with a sufficiently close nexus between the third-party action and the underlying collection efforts, a court might be more likely to award fees than Judge Lord was in Lorick. Further, it seems that if such fees had been provided for in mortgage documents (loan agreements with broader indemnification rights for the lender are not uncommon), the Code might have contemplated the award of those fees.

Even thus reduced, the attorneys’ fees and expenses approved by the court totaled more than $600,000.

Having resolved which expenses Wells Fargo could tack onto its claim, the court then turned to whether the debtor was entitled to surcharge any of its or the estate’s expenses against Wells Fargo. Part 2 of this article will discuss that issue.