Brighton Beach Surcharges: Part II

This is Part 2 of an article about the Lorick case,[1] concerning the disposition of the proceeds of the bankruptcy sale of a valuable property in Brighton Beach, Brooklyn, in which Wells Fargo was an oversecured creditor. Part 1[2] of this article laid out the factual background and discussed which expenses the court permitted Wells Fargo to add to its claim.

Surcharges

The U.S. Bankruptcy Code provides that a trustee or debtor in possession “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.”[3] Such costs and expenses are referred to as “surcharges.”

According to the court, the Loricks sought to surcharge Wells Fargo for their attorneys’ fees, the receiver’s fees, the receiver’s attorneys’ fees, and various disbursements made by the receiver. The requested surcharges totaled about $1.23 million.[4]

Surcharges are an odd corner of bankruptcy law. On the one hand, it’s sensible and equitable for a secured party to have to bear its fair share of, for instance, taxes or broker’s fees that it would have had to incur itself in holding or marketing a piece of property. On the other hand, it’s tricky to pay one party for the expenses it supposedly incurred on behalf of another, as it can create incentive for opportunism. For this reason, courts tend to cast a gimlet eye on such claims, particularly when there is a history of rancor between the parties.

Surcharges are even harder to obtain when they are sought against an oversecured creditor. After all, increases in the value of collateral will benefit the debtor, not the already-oversecured creditor. Additionally, creditors may have contractual or state law rights to charge the expenses of preservation or disposition of the property against the debtor; thus, it’s not the creditor but the debtor who would have had to pay these expenses in the end, anyway.[5]

In its analysis, the Lorick court noted that compensable costs and expenses must either have been consented to or caused by the creditor, or must have been reasonable, necessary and of direct benefit to the creditor. The court focused on whether Wells Fargo caused or consented to the charges, and whether they were to its “direct benefit.”

As to most charges, the court easily concluded that the answer to both questions was “no” due to Wells Fargo’s status as oversecured (with a significant cushion) and its contractual right to charge costs against the debtors. It was the debtors and their creditors, not Wells Fargo, who benefitted from any enhancements in the value of the collateral.[6]

In addition, the court held that while Wells Fargo advocated in bankruptcy court for the receiver to maintain possession of the property and for the property to be sold (rather than retained and refinanced by the debtors), neither of those facts meant that Wells Fargo “caused” or “consented to” the receiver’s fees or sale fees in the relevant sense.

The court did permit Wells Fargo to be surcharged for the claim of a contractor retained pre-petition by the receiver — apparently at Wells Fargo’s behest or at least without its objection — to perform environmental remediation work.[7] (The surcharge is conditional on the claim being allowed.[8]) The opinion describes the claim as arising “from a situation wholly outside of the Debtors’ control, involving an issue between the court-appointed receiver and Wells Fargo’s preferred contractor.”[9] The court felt comfortable surcharging Wells Fargo for that amount due to its pre-petition consent to the contractor’s retention. The court found the claim was not chargeable against the debtor under the underlying agreement. It then found that even if it were, it would be unenforceable: “[T]he Court sees no basis for concluding that a creditor can cause any expense and evade responsibility under § 506(c) because of the terms of an underlying agreement.”[10]

It is hard to understand what it is that sets this particular claim apart, to be borne solely by the significantly oversecured creditor. First, if the agreement had permitted the creditor to impose these remediation costs on the debtors, and the agreement would have been enforceable in state court, wouldn’t the rationale for denying surcharge for other costs apply here as well? As the court recognized, “in cases where a debtor is contractually responsible for these costs, and the creditor could have recovered its full claim if it had been permitted to foreclose, it cannot generally be said that the creditor fared ‘any better as a result of a bankruptcy auction than it would have in the context of [a] pending non-bankruptcy foreclosure.’”[11] That principle would seem to apply to the contractor’s claim, too.

Second, even if, as the court found, the underlying agreements don’t permit the addition of such costs to Wells Fargo’s claim, § 506(c) seems still to require that surcharge be made only “to the extent of any benefit to the holder of such claim.” The repair work presumably was helpful to preservation or sale of the property. Thus, didn’t these costs benefit — additionally or perhaps exclusively — the debtors and other creditors, who received the excess after Wells Fargo was paid? Assuming the court wasn’t implicitly making a finding that Wells Fargo had behaved inequitably or that the underlying work wasn’t helpful,[12] is the fact that the receiver’s retained contractor was “consented to,” pre-petition, by an oversecured Wells Fargo enough to hang its claim on Wells Fargo alone? These aren’t rhetorical questions; the facts raise legitimately complicated questions. One is left with the impression that this part of the ruling is not easily generalizable to other cases and may emerge from the court’s familiarity with the particular context of this contentious case.

Conclusion

Ideally, debtors and secured creditors reach advance agreement on the costs and disposition of § 363 sales proceeds, such as in a cash-collateral budget. When that is not possible, complicated litigation can result. Lorick provides a concise, well-researched discussion of several interesting issues that arise in the hurly burly of real estate lending, foreclosure and bankruptcy work. Whether advocating for debtor, trustee or creditor, it is worth keeping in the files.