Business Law

BAP vacates order surcharging a secured creditor for trustee’s fees

The following is a case update analyzing a recent case of interest:

Summary

In United States Dep’t of Agriculture v. Hopper (In re Colusa Reg’l Med. Ctr.), 604 B.R. 839 (9th Cir. BAP 2019), the U.S. Bankruptcy Appellate Panel of the Ninth Circuit vacated a bankruptcy court’s order surcharging a secured creditor for a substantial portion of the attorneys’ fees, and the entire statutory fee, of a chapter 7 trustee. The basis for the decision was that the bankruptcy court failed to correctly apply either the objective test for surcharge adopted by the Ninth Circuit (that the funds were expended directly, specifically and primarily for the benefit of the secured creditor) or the subjective test for surcharge (that the secured creditor consented to the expenditure).

To read the full published decision, click here.

FACTS

Colusa Regional Medical Center (the “Debtor”) provided the only hospital and emergency medical services to Colusa County, California.  After experiencing financial difficulties, the Debtor ceased operations and filed for chapter 7 in June 2016.  Within weeks of the bankruptcy filing, the chapter 7 trustee received an offer and eventually sold the Debtor’s hospital and its clinics to American Specialty Healthcare, Inc. (“American Specialty”).  The U.S. Department of Agriculture (“USDA”) held a $3 million lien secured by most of the Debtor’s assets, including the leasehold where the hospital was located, certain furniture, fixtures, and equipment, $565,000 in cash and cash equivalents, and $11 million in accounts receivable of which the Debtor believed only $1.5 million was collectible.  Other creditors held junior liens against the accounts receivable.

The USDA did not have a lien against certain real property called the “Williams Family Health Center” (“Williams Property”).  Instead, another creditor held a $320,000 lien against this property.  The Debtor valued the Williams Property at $861,164.

The chapter 7 trustee never filed a motion to operate the hospital or the clinics, but he needed to use cash collateral to pay for ongoing expenses to preserve value, such as for security, utilities, personnel to collect the accounts receivable, software to manage patient records, and insurance, including tail coverage for malpractice claims.  The USDA consented to some of the trustee’s proposed uses of cash collateral.  The bankruptcy court overruled the USDA’s objections to the use of cash collateral to pay for the tail coverage and to any uses beyond USDA’s desired sale closing date of September 27, 2016.  In exchange, the bankruptcy court granted the USDA a replacement lien on postpetition causes of action, but it did not grant a replacement lien against the Williams Property.  The bankruptcy court also ordered adequate protection payments of $20,000 per month to the USDA from its cash collateral.

The USDA directly benefited from some of the uses of cash collateral, such as for paying personnel to collect the accounts receivable.  For other uses of cash collateral, the USDA did not directly benefit or was not the only party who benefited.  The chapter 7 trustee sold the furniture, fixtures, and equipment that the estate owned, the hospital, and the clinic operations, including the Williams Property, to American Specialty for $1.1 million.  As part of the sale, American Specialty assumed responsibility for the Debtor’s patient records, relieving the estate of their ongoing administrative burden.  In November 2016, the bankruptcy court approved the sale free and clear of liens, except for the $320,000 lien against the Williams Property.  American Specialty assumed that lien as part of the sale. 

The USDA consented to the sale subject to receiving $550,000.  The trustee allocated the remaining $550,000 of the purchase price to the USDA and the balance on account of the Williams Property.  From the $550,000 allocated towards the Williams Property, the trustee paid $31,000 to other lienholders to obtain their consent to the sale.  The bankruptcy court granted the USDA relief from the automatic stay to collect the remaining accounts receivable.

Over a year later, the USDA filed a motion to compel the trustee to abandon $300,000 in cash collateral he was holding.  The trustee filed a motion under section 506(c) of the Bankruptcy Code to surcharge the USDA for $133,167.60 of his counsel’s fees and for his statutory commission.  At that time, the chapter 7 trustee had filed an interim application for $66,092.18 in trustee compensation.  The evidence in support of the surcharge motion did not discuss any specific interactions with the USDA that influenced the trustee’s actions, and it did not discuss the motivations and analysis behind the trustee’s sale to American Specialty as opposed to other alternatives.  In particular, the trustee made no effort to tie particular fees to a benefit to the USDA or its collateral.  The trustee argued the USDA had impliedly consented to the surcharge. 

The USDA opposed the motion.  The USDA disputed that the trustee had established a benefit for the USDA or that the USDA had consented to the surcharge.  With his reply, the trustee submitted a supplemental declaration recounting two conversations he had with the USDA.  In those conversations, the USDA purportedly stated: (i) the USDA desired to have its collateral preserved; and (ii) the USDA was open to reducing its loans to secure a buyer as it did not want to leave the community without health services.  At the hearing, the USDA orally objected to the declaration on multiple grounds, including that it exceeded the scope of what was appropriate for a reply. 

The bankruptcy court overruled the objections to the supplemental declaration because, according to the court, the objections should have been in writing.  Then the court granted the motion using both an objective and a subjective test.  The bankruptcy court reasoned that the USDA could not have duplicated the benefit received from the sale or from the trustee’s collection of the accounts receivable and concluded that the USDA would not have received significantly more than the $565,000 in cash collateral available on the petition date.  The bankruptcy court further faulted the USDA for failing to submit evidence as to the value of its furniture, fixtures, and equipment collateral and determined that the USDA would not have received more than $100,000 for the furniture, fixtures, and equipment.  Based largely on the evidence submitted by the trustee with his reply brief, the bankruptcy court also found that the USDA impliedly consented to the surcharge.

REASONING

The USDA made three arguments on appeal: (1) the surcharge motion was untimely; (2) the supplemental declaration submitted with the reply brief should not have been considered; and (3) the bankruptcy court erred by surcharging the USDA’s collateral.  The BAP quickly dispatched the USDA’s first argument.  Though the sale to American Specialty had closed a year before the trustee filed his surcharge motion, the motion was not untimely because the trustee could seek to surcharge other, remaining items of the USDA’s collateral that still existed and secured the same debt as the USDA collateral that was sold as part of the sale. 

As to the USDA’s second argument, the BAP ruled that the bankruptcy court abused its discretion by considering the supplemental declaration and relying on it for its decision.  Following Ninth Circuit precedent, the BAP admonished that a party must have an adequate opportunity to address the evidence against it both in writing and by producing counterevidence.  The bankruptcy court allowed the declaration based on its belief that civil and local rules required that evidentiary objections be made in writing before the hearing.  The BAP could not find a rule that supported that conclusion.  The BAP therefore found that the bankruptcy court abused its discretion by allowing the late-filed evidence without providing the USDA with an opportunity to respond.  As the bankruptcy court largely relied upon the declaration, the error was not harmless.

The BAP next concluded that the trustee had failed to show he was entitled to surcharge under either an objective or a subjective test.  With respect to the objective test, the BAP emphasized that the party seeking to impose a surcharge bears the burden of proof.  Moreover, cooperation by secured creditors in bankruptcy cases is to be encouraged, particularly in cases involving a public policy overlay.  Thus, a secured creditor’s willingness to consider a reduction to its secured claim in order to assist in the retention of medical services to a rural area, is not, in isolation, sufficient for surcharge.  “Deterrence of creditor cooperation through fear of surcharge is particularly to be avoided where critical public benefits are at issue.” 

Citing Ninth Circuit authority, the BAP observed that the benefit to the creditor cannot be a hypothetical or a generalized benefit to the estate.  The expense must be incurred primarily for the secured creditor’s benefit.  Further, the expense needs to be tied to a corresponding, quantifiable benefit, not just incidental to the preservation of collateral.  Accordingly, the bankruptcy court erred because it justified the surcharge by comparing the USDA’s overall payout in the case to the cash on hand as of the petition date and assuming the sale had not occurred.  The BAP concluded that this global analysis approach, as opposed to an analysis of the quantifiable benefit to the secured creditor from each expense, is inconsistent with Ninth Circuit precedent.

In support of its conclusion, the BAP made three incidental determinations.  First, the trustee was trying to double dip and twice recover administrative expenses from the accounts receivable collected.  As the trustee admitted, neither he nor his counsel were involved with the collections.  Instead, the trustee exclusively used the Debtor’s former employees to collect the accounts receivable.  The USDA consented to the use of cash collateral to retain and pay those employees.  Thus, there was no benefit to the USDA for the trustee’s commission or his counsel’s fees that could be associated with the collection services.  It was therefore wrong to include the accounts receivable collected as part of any analysis of a benefit received by the USDA for surcharge purposes.

Second, the sale only incidentally benefited the USDA although it benefited the bankruptcy estate overall.  Other lienholders, the estate, and the community all benefited from the sale, not just the USDA.  Thus, the surcharge request was improper.    To emphasize this point, the BAP noted that the USDA only received half of the sale proceeds yet the trustee sought to surcharge the USDA for all of the sale’s expenses.  In support of this reasoning, the BAP reiterated earlier decisions which stand for the proposition that the effort must be expended primarily and directly for the lienholder.  Otherwise, the benefit is merely incidental and surcharge is inappropriate.

Third, the USDA did not receive a benefit justifying a surcharge for 100% of the trustee’s commission.  Among other things, the trustee calculated his commission based on adequate protection payments made to the USDA and payments made to third parties that were not associated with the sale.  The BAP ruled that mere turnover of a creditor’s collateral does not create a surchargeable benefit.  Further, the trustee was again trying to collect on his commission generated by passively making payments under an approved cash collateral budget, some of which was not even related to the USDA’s collateral.  Nor should the trustee be able to surcharge the USDA for payments he proposed to make to his counsel, none of which gave any benefit to the USDA.

The BAP also rejected the idea that the trustee satisfied the subjective test for surcharge by showing that the USDA impliedly consented to the surcharge or caused expenses to be incurred.  Since the benefit must be concrete and quantifiable, it was improper to consider the USDA’s counsel’s statement that the USDA received some benefit from the sale.  Further, the statement was taken out of context.  Next, the USDA did not hold a blanket lien on all of the Debtor’s assets.  It is therefore implausible that the USDA consented to the payment of expenses not associated with its collateral.  In addition, there was no evidence that the USDA expressly suggested or sought the American Specialty sale.  As the case benefited many parties, the BAP ruled that implied consent should not be found where the secured creditor merely acquiesces in case activity.  There was also no evidence that there was ever a concern that the estate was administratively insolvent, hence no reason to believe there was an understanding that the secured creditor was receiving a windfall.

The BAP similarly rejected the bankruptcy court’s conclusion that the USDA caused the sale or that the USDA was the only reason the trustee pursued the sale.  There was no evidence in the record supporting such a conclusion as the trustee’s own declaration never specifically stated as much.  This conclusion was also contradicted by the trustee’s time records, which showed discussions with American Specialty within the first month of the case and few communications with the USDA.  Nor did the USDA control the case or cause the sale.  The trustee never said as much in his declaration, the trustee consistently protected the Williams Property from a replacement lien for the USDA, and the bankruptcy court overruled the USDA’s objections to its use of cash collateral, all of which showed that the USDA did not control the case. 

Consequently, the BAP vacated the bankruptcy court’s decision and remanded the matter for further proceedings, commenting that it might be possible for the trustee to show that some specific expenses could be surcharged based on a more thorough record.

AUTHOR’S COMMENTARY

This is a fairly lengthy and thorough discussion by the BAP that contains a useful guide for prosecuting and defending against surcharge requests.  The decision is notable both for summarizing the objective test for surcharge in the Ninth Circuit and for including elaboration, not previously provided by the Ninth Circuit, on what may satisfy the subjective test for surcharging collateral.  Unfortunately, the BAP buried the lede in footnote 8, which makes clear that this is a case about what turned out to be an undersecured creditor and an estate with unencumbered assets where the trustee tried to stick the undersecured creditor with footing the bill for substantially all administrative expenses.

These materials were written by Michael J. Gomez of Frandzel Robins Bloom & Csato, L.C. in Fresno, California (mgomez@frandzel.com).  Editorial contributions were provided by Mary H. Rose of Buchalter, P.C. in Los Angeles, California (mrose@buchalter.com).  Mr. Gomez and Ms. Rose are members of the Insolvency Law Committee.

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