Surcharging Collateral: Amazing How Long People Can Fight over Money

Peters v. Clark (In re Bryan), 857 F.3d 1078 (10th Cir. 2017)

After a convoluted history of appeals and remands, issues relating to the sale of a residence by a chapter 7 trustee once again came before the 10th Circuit. This time the court addressed whether the trustee could properly surcharge a judgment creditor’s interest in the sale proceeds for expenses related to litigation involving the creditor’s liens.

Under section 506(c) of the Bankruptcy Code, a trustee may recover from a secured party’s collateral the reasonable and necessary costs of preserving or disposing of the collateral to the extent of any benefit to the secured party. The ability to surcharge litigation expenses became a focal point in this case. The Bankruptcy Appellate Panel (BAP) categorized the litigation as follows:

  • Sham trust: Over the years the residence was transferred back and forth between the debtor, his wife and a family trust a number of times (mostly in connection with financings). Some of the trustee’s litigation involved successfully seeking recovery of assets, including the residence, from the family trust. – It was determined that these litigation expenses could be surcharged.
  • Sale order: Initially the sale order did not address the judgment creditor lien because no one (including the creditor) was aware that it had a lien. After the judgment lien was discovered by a title company, the sale order was amended to authorize a partial distribution of proceeds, with the rest subject to resolution of the lien priority disputes. – It was determined that these litigation expenses could be surcharged.
  • Lien priority: When the disputes were not resolved, the trustee commenced a new adversary proceeding (as directed by the bankruptcy court) to determine the validity, priority and extent of the various claims. The trustee also sought a surcharge against the sale proceeds of all fees and costs incurred in connection with the various litigation. – These litigation expenses with the focus of the 10th Circuit opinion.

The bankruptcy court had issued an opinion determining lien priorities and disposition of the sale proceeds. It concluded that the judgment creditor did not hold a valid lien against the property. Although the District Court agreed with the bankruptcy court, the 10th Circuit concluded that the judgment creditor did have a valid lien, although it was a junior lien.

On remand from the initial lien priority appeals the bankruptcy court made further priority determinations, and concluded that the doctrine of marshaling did not apply because there was no common debtor. (Under marshaling, a creditor that has access to two funds to satisfy its debt may not apply the funds so as to defeat a second creditor who has access to only one of the funds. This requires (1) two creditors of the same debtor, (2) two funds or properties of that debtor, and (3) one creditor with a claim to both funds while the other creditor has a claim to only one fund. In this case the two sources of payment were not owned by the same party.) The bankruptcy court also granted the trustee’s surcharge request.

On appeal (yet again) the BAP affirmed the bankruptcy court, except with respect to surcharging the judgment creditor proceeds for expenses incurred in contesting the validity of its lien. The BAP then remanded for allocation of costs among the three categories of litigation.

Surprise, several parties appealed the BAP decision to the 10th Circuit. The court generally adopted the BAP decision (which it attached as an appendix since the BAP opinion was unpublished), although it went on to specifically address some of the surcharge arguments.

First, the BAP determined that the lien priority litigation expenses were not properly chargeable against the judgment creditor since the litigation did not benefit the creditor. As a general rule, the expense of administration in a chapter 7 case may not be surcharged against secured collateral. This is because “the trustee acts on the authority of the court and for the interest of the general creditors, not on authority of the secured creditors and for their particular interests.”

However, the trustee argued that the litigation was necessary since the matter could not be settled otherwise. Also, some courts suggest that the “benefit” requirement can be met if the secured creditor caused or consented to the expenses. The trustee also relied on equitable considerations, arguing that without the surcharge the judgment creditor would be obtaining a windfall at the expense of the bankruptcy estate. The BAP had responded 2 these arguments in detail and concluded that the benefit requirement was not met for the lien priority litigation expenses. The 10th Circuit fully endorsed the BAP interpretation.

The trustee also argued that the judgment creditor failed to preserve the surcharge issue. The court rejected that argument as inconsistent with the facts.

Finally, the trustee contended that the BAP erred by disregarding a bankruptcy court finding that the trustee’s commission could have been included in the surcharge. Since that amount exceeded the disallowed lien priority litigation costs, the trustee argued that the error in the surcharge “benefit” analysis was harmless. The 10th Circuit dismissed this argument on the basis that the trustee chose not to include the commission as a litigation strategy, which did not create a benefit to the creditor I don’t think it’s fair where none existed. The harmless error doctrine applies only to errors that do not affect substantial rights of the parties. In this case the error – surcharging expenses that did not benefit the secured creditor – affected a substantial right, namely the amount of money the creditor was entitled to receive.

This last issue triggered a dissenting opinion. The bankruptcy court had accepted a proposal by the trustee to take the commission out of the bankruptcy estate instead of including it in the surcharge – which he was entitled to do. The dissenting judge felt that this fact was not given adequate consideration, and the only appropriate remedy was a remand to the bankruptcy court to reconsider treatment of the commission in light of the circumstances.

In considering the lessons of this case, the following words of wisdom offered by the BAP are worth considering:

One of the unwritten rules of bankruptcy practice is this: when you are fighting over a piece of property, convert it into cash. While most property cannot be cut into pieces (how does one dissect a house or 1957 Chevy?), money is easily divided. Once property has been sold, the parties usually tire of watching their money dwindle as the attorneys’ fees amount and reach an agreement as to who gets what. The rule has its exceptions. This case is one of them. Here, the players have been fighting over a parcel of residential real estate for more than ten years.

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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