An overvalued property may now have a bigger impact on a secured creditor’s bottom-line during bankruptcy.  Splitting with the Seventh Circuit, the Fifth Circuit in Southwest Securities, FSB v. Segner (In the Matter of Domistyle, Inc.), 2015 WL 9487732, held that a bankruptcy trustee may surcharge its expenses for maintaining a property even before moving to abandon the property.

The Scenario

The debtor in Domistyle owned a factory in Laredo, Texas.  The trustee, Milo Segner, attempted to market the property because he believed that the estate could recover more than $6 million from its sale (about $2 million more than the secured creditor’s lien).  During that time, he accrued expenses for security, utilities, roof repairs and lawn mowing.  As it turns out, the property was overvalued and no one would buy it at a price that would result in any recovery to the estate.  After about a year of trying, the trustee gave up on selling the property and abandoned it to the lender. This suit arose when the trustee sought to surcharge the lender for his maintenance expenses.

The Law

The general rule in bankruptcy is that maintenance expenses must be paid for out of the unencumbered assets of the estate. Section 506(c) provides for a “narrow” and “extraordinary” exception to this rule:

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 the payment of all ad valorem property taxes with respect to the property.

This exception generally only applied when preservation expenses are incurred either “primarily for the benefit of the secured creditor” or where the creditor caused or consented to such expenses.  In re Trim-X, Inc., 695 F.2d 296 (7th Cir. 1982).   Lenders are only usually charged for expenses for the time pending between when a trustee seeks and the court approves abandonment.  The Fifth Circuit in Domistyle departs from the “primarily for the benefit” formulation, arguing that the test in not appropriate because that language does not appear in § 506(c).  Instead, the court chose to focus on whether the expenses were connected to the preservation of the collateral, and concluded that they were because “all of the surcharged expenses related only to preserving the value of the Property and preparing it for sale.”

This is not a surprising result on these facts.  The court noted that the lender signed an agreement with the trustee agreeing to pay a surcharge for the maintenance of the property.  The lender here believed that the property was worth more than the debt and that the sale would result in a payoff.  When that was proven false, the lender attempted to have its cake and eat it too.  While the lender did not actually benefit from the sale effort, in the court’s view it would have been entirely unjust not to charge the lender for these costs which were incurred with its explicit consent.

How to Avoid Paying Excess Surcharges?

So where does Domistyle leave secured creditors?  There are a few things a prudent lender can do to avoid paying excess surcharges.

  • For starters, lenders should pay close attention to appraisals during bankruptcy. A bankruptcy trustee will only attempt to liquidate a property if it believes that the estate will recover enough from the sale of the property to pay off senior lienholders. In Domistyle, if the lender had shown earlier in the proceedings that there was no equity in the collateral, then the trustee would have abandoned the property before accruing any expenses and the lender’s recovery may have been greater.
  • Another option is for the secured creditor to establish a record that it would have conducted an immediate foreclosure sale. The court in Domistyle wrote that “To the extent that a trustee holds an asset longer than necessary to determine and realize its value, and the value turns out to be less than the creditor’s secured interest, the creditor can challenge the necessity of the costs incurred by the trustee.” If the lender had established some record that it planned to conduct an immediate foreclosure sale, it may have an argument that the trustee was holding the asset for longer than necessary.