Sale Proceeds: Better Get the Carve-Out Right the First Time

In re Stacy’s, Inc., 508 B.R. 370 (Bankr. D. S.C. 2014) –

A debtor sold substantially all of its assets after negotiating with its primary secured creditor for carve-outs from the sale proceeds for administrative priority and general unsecured claims.  When the administrative claims turned out to be greater than anticipated, the debtor sought court approval to use additional proceeds to pay income tax and other claims.

The debtor was in the business of growing and selling large quantities of plants wholesale to large retailers.  Immediately after filing a chapter 11 petition, the debtor sought to sell substantially all of its assets free and clear of liens in a Section 363 sale.  Its largest creditor (a bank) had a security interest in the debtor’s assets, including proceeds.

The debtor apparently did not negotiate or even notify the bank of its plans before filing bankruptcy.  Not surprisingly the bank objected to the proposed sale.  One of the major issues was a carve-out from the sale proceeds for payment of general unsecured claims and Section 503(b) administrative expense claims.  The day before the hearing on the sale motion the debtor filed an adversary proceeding against the bank disputing the bank’s claim and seeking to surcharge its collateral under Section 506(c) of the Bankruptcy Code.

The court delayed ruling on the sale motion to give the parties time to negotiate.  The debtor and the bank reached agreement on a consent order that authorized the sale and included a carve-out from the sale proceeds of $950,000 for administrative expense claims and $450,000 for general unsecured claims.  The order also provided that the bank would have an allowed secured claim in the maximum amount of ~$22.5 million.  The sale proceeded and the debtor dismissed its adversary proceeding with prejudice.

However, a few months later the debtor realized that the carve-out was not sufficient to cover all of the expenses as anticipated.  Consequently, it sought to use an additional ~$600,000 of sale proceeds for payment of expenses.  The primary focus of the request was estimated income tax liability of $525,000.  A tax analysis was prepared for the debtor that projected that there would be no income tax liability.  However, that analysis was in error and a proper analysis would have projected potential taxable income of ~$1.5 million.

The court proceeded on the basis that the sale proceeds constituted cash collateral subject to the bank’s security interests (since any objections by the debtor were waived).  Under Section 363(c)(2) a debtor may not use cash collateral unless it has the consent of the secured creditor or the court authorizes use – which typically requires consideration of whether the secured party’s interests in the cash collateral are adequately protected.

The debtor argued that the court should authorize its use of the additional sale proceeds primarily based on an unpublished 4th Circuit case that concluded that a bankruptcy court did not need to address adequate protection because the creditor had consented to use of its cash collateral to pay certain expenses.  The Stacy’s court rejected this argument since the facts were different, and then rejected the debtor’s request since it did not establish that there would be adequate projection of bank’s interests if the cash was used as proposed by the debtor.

The next avenue pursued by the debtor was to surcharge the collateral.  Generally administrative expenses are paid from unencumbered assets.  However Section 506(c) allows recovery “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, including the payment of all ad valorem property taxes with respect to the property.”  The intent is to prevent a secured creditor from receiving a windfall at the expense of the bankruptcy estate.

The court’s initial response was to reject the surcharge as precluded by res judicata.  Under federal common law the elements required for res judicata are (1) final prior judgment on the merits by a court of competent jurisdiction in accordance with due process, (2) parties are identical or in privity, and (3) the claims are based on the same cause of action.  The first two tests were met because the debtor dismissed its adversary proceeding against the bank, including its surcharge claim, with prejudice.

As to the third element, the court relied on cases holding that (1) claims are part of the same cause of action “when they arise out of the same transaction or series of transactions… or the same core of operative facts;”  (2) it is not relevant whether the party was aware of the newly asserted claim at the time of the prior judgment; and (3) claims can involve different harms or theories or measures of relief.

In this case, the debtor knew or should have known that the expenses could arise and would need to be paid.  In particular, it knew that income taxes from operations in bankruptcy are normally an administrative expense, and that its business had been performing better than expected.  So, the court concluded that res judicata barred the new attempt to surcharge the sale proceeds.

Even if res judicata was not applicable, the court was not persuaded that the expenses qualified for surcharge under Section 506(c).  While acknowledging that the 8th Circuit has held that the benefit can be general in nature, it noted that the 4th Circuit requires a “direct and quantifiable benefit,” which is consistent with other circuits.  The court then concluded that it was questionable whether the debtor made the required showing of direct and quantifiable benefit.

As an aside, the court commented in a footnote that Collier’s treatise stated that “if a creditor has a lien on all, or virtually all, of a debtor’s assets, the debtor is engaged in ongoing business operations, and the debtor’s continued operations preserve or enhance the value of the secured creditor’s collateral, items that may qualify as ‘necessary’ expenses chargeable against the collateral includes the debtor’s payroll costs, insurance costs, workers’ compensation expenses, and postpetition administrative taxes.”  However, the bankruptcy court obviously disagreed, noting that the only case cited to support this proposition involved unpaid workers’ compensation premiums where the surcharge opponent had consented to use of the collateral for necessary operating expenses, specifically including workers’ comp.

The third argument addressed by the court related to Section 552(b)(1) of the Bankruptcy Code, which generally provides that a security interest in prepetition collateral extends to proceeds acquired postpetition to the extent provided by non-bankruptcy law, “except to any extent that the court, after notice and a hearing and based on the equities of the case, orders otherwise.”  The bankruptcy court emphasized that the focus of this exception is on whether the debtor used unencumbered funds at the expense of unsecured creditors to increase the value of the secured creditor’s collateral.

In this case there was no showing that any unencumbered funds had been used.  Rather the debtor continued to operate only by using the secured creditor’s cash collateral.  Given that the secured creditor already agreed to carve out $1.4 million of the sale proceeds for administrative expenses and unsecured creditors, the court did not find that the equities exception was applicable to further reduce the bank’s collateral.

While some courts might take a more restrictive view on the scope of claims that are based on the same cause of action for res judicata purposes, and some courts might take a broader view of the types of expenses that qualify for a surcharge, the court’s ruling is not surprising.  When negotiating a carve-out with a secured creditor, it is not a good idea (to put it mildly) to count on being able to revisit the issue later if it turns out that the carve-out is insufficient.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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