When assets are in bankruptcy and payment on a secured interest is delayed or uncertain, secured creditors are understandably motivated to take the necessary measures to preserve the value of their collateral. Such efforts will not always come without cost. In light of a trustee or debtor-in-possession's (DIP's) power to surcharge the lender's collateral, the question arises: When do the secured creditor's actions to preserve the collateral constitute consent to surcharge?

While administrative expenses are ordinarily paid from the unencumbered bankruptcy estate assets rather than from a secured creditor's collateral, a pre-Code exception exists where expenses were incurred primarily for the benefit of the secured creditor, or where the secured creditor consented to the costs. In re Combined Crofts Corp., 54 B.R. 294, 297 (Bankr. W.D. Wis. 1985), citing In re Trim-X Inc., 695 F.2d 296 (7th Cir. 1982). Where a secured creditor "expressly or by its actions consents to services and payment for those services out of collateral, it cannot avoid making such payment on the grounds that it received no actual benefit." In re Lunan Family Restaurants LP, 192 B.R. 173, 182 (Bankr. N.D. Ill. 1996). However, a finding of consent "is not to be lightly inferred." In re Flagstaff Foodservice Corp., 739 F.2d 73, 77 (2d Cir. 1984).

The trustee's authority to surcharge collateral can be found at 11 U.S.C. §506(c). Simply put, a 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." 11 U.S.C. §506(c). The inquiry into what costs are reasonable, and to what extent they benefited the party being surcharged, is factual. Some factors courts may consider include whether (1) there was a reasonable expectation of confirming a plan that would benefit secured creditors, (2) the charges incurred were primarily intended to protect unsecured creditors and the debtor, (3) reasonable diligence and competence were exercised in bringing an unsuccessful reorganization proceeding to a conclusion, (4) the secured creditors benefited, (5) the secured creditor requested or waived objection to actions taken, and (6) the secured creditors caused delay or were uncooperative in the consummation of a plan. In re Bob Grissett Golf Shoppes Inc., 50 B.R. 598, 603 (Bankr. E.D. Va. 1985).

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[S]ecured lenders are at risk for being charged with costs where they take affirmative steps to protect their collateral, particularly where assets are known to be limited.

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"Mere Cooperation"

While a secured creditor does not necessarily need to give express consent to have its collateral surcharged, mere cooperation is insufficient to constitute consent. In re Flagstaff Foodservice, 739 F.2d at 76. In Flagstaff, the bankruptcy court directed payment of professionals' fees be made from the secured creditor's collateral. The pre-petition lender continued to infuse money into the debtor during its reorganization pursuant to a financing order that granted it a superpriority lien. Id. at 74-5. Despite the additional financing, the debtor was ultimately unable to successfully reorganize. Id. On appeal, the professionals argued that the creditor consented to surcharge by its "active involvement in devising a program aimed at reducing its secured claims...." Id. at 77.

The Second Circuit reversed, finding that "[t]o hold that mere cooperation with the debtor exposes a secured creditor to payment of all expenses of administration would...make it difficult, if not impossible, to induce new lenders to finance a chapter 11 operation." Id., quoting In re S&S Indus. Inc., 30 B.R. 395, 398 (Bankr. E.D. Mich. 1983). Flagstaff also recognizes the situation where the oversecured creditor becomes undersecured during the course of the debtor's reorganization. In Flagstaff the creditor took a risk by continuing to finance the debtor, which failed to pay off when the value of the assets were ultimately insufficient to repay the debt. By denying surcharge, the Second Circuit refused to discourage the lender by further burdening it with the costs of that gamble.

In In re Combined Crofts Corp., 54 B.R. 294 (Bankr. W.D. Wis. 1985), the bankruptcy court likewise held that mere cooperation or acquiescence does not constitute consent. Id. at 299. The secured creditor in Combined Crofts first opposed the debtor's plan, but later reluctantly permitted the reorganization plan to continue. Id. The court held that where consent "does not result from a fully voluntary and self-interested agreement arrived at between the secured party and the debtor, it is inequitable to apply a 'consent' theory to effect a reimbursement to the debtor." Id.¹

Steps Toward Surcharge

Courts are more likely to imply consent to surcharge where a secured creditor has taken affirmative actions in the bankruptcy case. For instance, it was held to be more than mere cooperation where the secured creditor stipulated to the debtor's right to pursue a private sale. In re Ferncrest Court Partners Ltd., 66 F.3d 778 (6th Cir. 1995). In Ferncrest, the successor-in-interest to the secured creditor was held to be bound by the creditor's prior consent and was liable for expenses incurred by the broker. Id. at 782. The holding was further supported by the successor's failure to object to the retention of the real estate broker until after the broker had performed under the contract. Id.

However, hiring counsel to represent the lender in the bankruptcy does not amount to consent. Kivitz v. The CIT Group/Sales Finance Inc., 272 B.R. 332 (D. Md. 2000). A secured creditor may also safely move for the appointment of a trustee where it expressly refused to consent to surcharge. In re Stein and Day Inc., 89 B.R. 290 (Bankr. S.D.N.Y. 1988) (But, see In re Hotel Assoc. Inc., 6 B.R. 108 (Bankr. E.D. Pa. 1980), holding that creditor consented to paying for costs of trustee where creditor moved for trustee's appointment.)

Additional protection is afforded to the cooperative secured lender where limited consent is expressly granted. In In re Cascade Hydraulics and Utility Service Inc., 815 F.2d 546 (9th Cir. 1987), the court held that a lender's "consent to the payment of designated expenses, limited in amount, is not a blanket consent to be charged with additional expenses not included in the consent agreement." Id. at 549.²

Sins of Omission

The balance becomes even more delicate where courts have implied consent from a creditors failure to act. In In re Croton River Club Inc., 162 B.R. 656 (Bankr. S.D.N.Y. 1993), the court recognized the Flagstaff holding that consent is not to be lightly inferred, but held that consent was implied by the creditor's consent to a cash collateral stipulation. Id. at 660. Also relevant, the Croton River court held, was that the lender never requested relief from stay, "sat back" and allowed the debtor to proceed with litigation that ultimately allowed collateral to be sold, and did not object to the debtor's retention of an expert witness for trial. Id. at 661.³

Conclusion

Generally, mere cooperation or acquiescence in a chapter 11 bankruptcy will not result in a secured creditor's collateral being surcharged. However, secured lenders are at risk for being charged with costs where they take affirmative steps to protect their collateral, particularly where assets are known to be limited. To avoid surcharge, lenders should consider expressly refusing to pay administration expenses, or expressly consenting to pay limited costs incurred.

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Footnotes

¹ See, also, In re Compton Impressions Ltd., 217 F.3d 1256 (9th Cir. 2000) (bank's joinder in cash-collateral stipulation and willingness to defer foreclosure proceedings did not cause the debtor to incur the expenses sought to be surcharged and did not constitute consent); In re Lunan Family Restaurants LP, 192 B.R. 173 (Bankr. N.D. Ill. 1996) (support for a cash-collateral order is not consent); and In re Sports Information Data Base Inc., 64 B.R. 824 (Bankr. S.D.N.Y. 1986) (acquiescence to auction of collateral is not consent); however, see In re Machinery Inc., 287 B.R. 755 (Bankr. E.D. Mo. 2002) (applying the more liberal Eighth Circuit approach that if a creditor consents to the debtor's continued operation, it impliedly consents to surcharge, and holding that consent to the debtor's use of cash collateral constitutes consent to surcharge). Return to article

² See, also, In re Famous Restaurants Inc., 205 B.R. 922 (Bankr. D. Ariz. 1996) (holding that consent to payment of expenses upon the creditor's approval does not imply consent when requisite approval was not obtained), and In re Glickman Berkovitz, Levinson & Weiner, 186 B.R. 883 (Bankr. E.D. Pa. 1995) (joinder in cash collateral stipulation for one month would limit surcharge to those specific amounts). Return to article

³ See, also, In re Modica, 55 B.R. 605 (Bankr. W.D. Va. 1985) (surcharge was appropriate where creditor never sought relief from the stay, and allowed the trustee to preserve rental payments upon which it claimed a lien), and In re Salzman, 83 B.R. 233 (Bankr. S.D.N.Y. 1988) (second and third mortgagees would not be held liable for a proportionate share of administration expenses where they did not object to the trustee's sale of encumbered real estate). Return to article