In re Domistyle, Inc.: When Is a Section 506(c) Surcharge Appropriate?

Practical Law Legal Update w-001-3587 (Approx. 6 pages)

In re Domistyle, Inc.: When Is a Section 506(c) Surcharge Appropriate?

by Practical Law Bankruptcy & Restructuring and Practical Law Finance

Background

Domistyle, Inc. (Debtor), was a manufacturer of home goods and owned a factory on several acres of land in Laredo, Texas (Property). From the onset of the bankruptcy proceedings, all parties believed the value of the Property exceeded the value of its three outstanding mortgages, the largest of which was held by Southwest Securities FSB (Southwest) valued at $3.69 million. The Debtor had been placed into receivership in April 2013 and the receiver quickly initiated Chapter 11 proceedings on behalf of the Debtor on the belief that the Debtor had enough equity to reorganize and successfully emerge from bankruptcy. Because recent appraisals had valued the Property at about $6 million, the receiver believed that there was sufficient equity in the Property to pay Southwest, as well as junior and unsecured creditors.

In early 2014, the bankruptcy court confirmed a plan of liquidation and established the receiver as trustee of a liquidating trust. The plan gave the trustee a deadline of May 1, 2014 by which he had to sell the Property "at a price that was sufficiently high to cover the value of the mortgage loan owed to [Southwest]." The trustee was also required to "maintain reasonable insurance" and own the Property "as a reasonably prudent owner would own it" (, at *1).

The trustee attempted to sell the Property before the bankruptcy court approved the plan of liquidation and marketed the Property through the services of a commercial real estate firm from August 2013 to May 2014. During this time, the trustee paid expenses, such as security, repairs, landscaping, and insurance on the Property. Despite the trustee's efforts, the only offer received for the Property was for $4 million and Southwest rejected the offer because the net proceeds at that price would not fully satisfy its lien. Southwest also rejected the trustee's request for reimbursement of a portion of the expenses for the preservation and maintenance of the Property.

The May 1 deadline passed and Southwest failed to elect either option available to it by the plan (foreclosure or a deed-in-lieu). Shortly after, the trustee informed Southwest that it intended to cease paying any expenses on the Property. Southwest objected on the basis that "'such action would virtually destroy any value remaining in the [Property]'" (, at *2). The trustee then filed a motion to abandon the Property as burdensome and inconsequential and while the motion was still pending before the bankruptcy court, the trustee also moved to surcharge its expenses for maintaining the Property from the onset of the bankruptcy case. Southwest objected to both the abandonment and paying the surcharge.

In August 2014, the parties reached a partial settlement that allowed the trustee to abandon the Property and required Southwest to reimburse the trustee for preservation and maintenance expenses from June 1, 2014 forward (shortly after the trustee expressed its intent to abandon). The trustee's request to surcharge for expenses incurred before June 1 remained contested. After hearing testimony and argument, the bankruptcy court granted the trustee's request to surcharge the Property for the pre-abandonment expenses. Southwest then appealed directly to the Fifth Circuit.

Outcome

The Fifth Circuit affirmed the bankruptcy court's decision, rejecting Southwest's argument that it had not benefited from the expenses paid by the trustee to preserve the Property.

The Fifth Circuit held that a surcharge against real property under section 506(c) of the Bankruptcy Code:

Is not limited to expenses incurred by the trustee with the specific and exclusive intent to benefit the secured creditor.
May be imposed when each dollar of pre-abandonment expenses preserved at least one dollar of value of the property.

Surcharges Are Not Limited to Expenses Incurred with a Specific and Exclusive Intent to Benefit the Secured Creditor

On appeal, Southwest argued that the section 506(c) surcharge is limited to expenses incurred with a specific and exclusive intent to benefit the secured creditor. In defense of its position, Southwest claimed that this was not the case here because the trustee aimed to sell the Property to also provide some recovery to junior creditors and relied on other decisions from the Fifth Circuit "requiring that the claimant incur the expenses primarily for the benefit of the secured creditor" (In re Delta Towers, Ltd., 924 F.2d 74, 77 (5th Cir. 1991) (emphasis added)).

While a general principle of bankruptcy is that administrative expenses cannot be satisfied from collateral property, section 506(c) of the Bankruptcy Code provides an exception stating:

"The 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, including payment of all ad valorem property taxes with respect to the property."

(§ 506(c), Bankruptcy Code (emphasis added)).

Focusing on the language of the Bankruptcy Code, the Fifth Circuit rejected Southwest's argument and instead focused on whether the secured creditor benefited from the expenses. Specifically, the Fifth Circuit adopted a "backwards-looking" approach which examines whether the secured creditor received any benefit from the amounts expended to preserve the collateral.

The Court held that there was a direct relationship between the surcharge and the collateral in the instant case because all of the surcharged expenses went towards the preservation of the Property. The Court also noted that the objective of section 506(c) is to prevent unjust enrichment of a secured creditor: a secured creditor should not obtain the benefit of actions taken to preserve its collateral without shouldering the costs.

The Court then rejected Southwest's argument that expenses incurred before abandonment of the Property are excluded from a section 506(c) surcharge because:

It is contrary to the general understanding that a section 506(c) analysis is a case specific inquiry.
It runs the risk of unjustly enriching the secured creditor.
It limits surcharges to the period when the trustee attempts to abandon the property but has not yet been authorized to do so.

Quantifying the Benefit to the Secured Creditor

Lastly, the Fifth Circuit addressed Southwest's argument that the trustee did not adequately quantify the benefit Southwest received as required under section 506(c) of the Bankruptcy Code. Relying on prior opinions, the Court framed this aspect of the benefit analysis as requiring that the secured creditor received a "direct and quantifiable" benefit from the trustee's actions (see In re Senior-G & A Op. Co., Inc., 957 F.2d 1290, 1300 (5th Cir. 1992)).

After considering the type of expenses paid for by the trustee, the Fifth Circuit found it was "obvious that Southwest obtained some benefit from the expenses" because without their expenditure Southwest would have "been left trying to sell a vacant building damaged by vandalism, filled with overgrown weeds, and saddled with a leaking roof" (, at *7). The Fifth Circuit also relied on the record below where the trustee provided expert testimony to demonstrate the Property's value relative to the secured creditor's interest. Because Southwest failed to provide its own witness or effectively cross-examine the trustee's, the Fifth Circuit found it within the bankruptcy court's right to find that "the value preserved was at least as much as the amount expended" (, at *8).

Practical Implications

In In re Domistyle, Inc., the Fifth Circuit directly interprets the statutory language of section 506(c) when determining if a trustee may surcharge a secured creditor's collateral. The case demonstrates that, while always a fact specific inquiry, to recover under section 506(c) of the Bankruptcy Code:

The expenditures must be necessary.
The amount expended must be reasonable.
The secured creditor must benefit from the expense.

This case may have implications in the Fifth Circuit because the Court permitted a trustee to surcharge a secured creditor's collateral for expenses incurred before it abandoned the property, despite the fact that the preservation of collateral may also bring a benefit to the estate.

For more information on section 506(c) surcharges see Practice Note, The Section 506(c) Surcharge on Collateral.

In re Domistyle, Inc.: When Is a Section 506(c) Surcharge Appropriate? | Practical Law