Supreme Court Resolves Issue Of Standing under Bankruptcy Code Section 506(c)

When a debtor's bankruptcy estate does not have sufficient unencumbered funds to pay all administrative expenses in full, the collateral of a secured creditor presents a very tempting target. Bankruptcy Code section 506(c) provides that the trustee (or debtor in possession) may surcharge the collateral of a secured creditor to pay the reasonable and necessary costs and expenses of preserving or disposing of the collateral to the extent of any benefit afforded to the secured creditor. This statutory provision has fueled a judicial split over the issue of whether persons other than the trustee or debtor in possession have standing to assert a section 506(c) surcharge claim.

The United States Supreme Court, in a unanimous decision in Hartford Underwriters Insurance Company v. Union Planters Bank ("Hen House"), recently settled the standing issue by holding that nontrustee third parties do not have standing under section 506(c) of the Bankruptcy Code to surcharge a lienholder's collateral. The Court found no statutory basis under the Bankruptcy Code to grant nontrustee administrative claimants standing under Bankruptcy Code section 506(c). As a result of the Supreme Court's decision, secured creditors will have more leverage in bankruptcy cases. Left unresolved by the decision is whether an administrative claimant may assert a derivative claim against collateral in the event the trustee or debtor in possession fails or refuses to pursue a section 506(c) claim at the administrative claimant's request.

Payment of Administrative Expenses Under the Bankruptcy Code

Administrative expense claims in bankruptcy cases are entitled to first priority ahead of all other general unsecured claims and, therefore, they are paid in full before all other unsecured claims to the extent there are available unencumbered funds in the debtor's bankruptcy estate. The rationale for according administrative expense claims first priority status in bankruptcy is to induce parties to do business with the debtor's bankruptcy estate.

In order for an administrative claim to be allowed as a first priority claim, it must arise during the pendency of the debtor's bankruptcy case (i.e., postpetition) and it must be for "actual, necessary costs and expenses of preserving the estate." Administrative expenses cover such disparate types of expenses as rent, wages, insurance, utilities, trade credit, etc. However, the fact that an expense is deemed a first priority administrative expense claim does not mean that there will be sufficient unencumbered funds in the debtor's bankruptcy estate to pay such a claim in full. If there are insufficient unencumbered funds to pay administrative claims, the debtor's estate is deemed to be administratively insolvent. Under these circumstances, creditors who provided goods or services to the debtor's estate postpetition and who remain unpaid may seek to surcharge a secured creditor's collateral on the ground that the secured creditor benefited from the postpetition goods or services that were provided.

As a general rule, administrative expenses cannot be charged against a secured creditor's collateral, but are chargeable only against the estate's unsecured assets. Bankruptcy Code section 506(c) thus stands as an exception to the general rule. It provides:

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.

In a chapter 11 case the debtor in possession performs the functions of a trustee and, thus, has section 506(c) standing. But must section 506(c) be read literally? That is, if the trustee or debtor in possession does not act, can an administrative claimant successfully invoke section 506(c)? The issue usually arises when a particular administrative expense claimant files a motion to surcharge collateral to pay its administrative expenses.

Before the Supreme Court's decision in Hen House, the circuit courts were split as to whether the trustee has exclusive standing to seek a surcharge under section 506(c). Courts that have adopted the more expansive view of standing reasoned that the particular claimant may be the only party with a financial incentive to seek a section 506(c) surcharge. Thus, denying standing to such a claimant would allow the secured creditor a windfall.

In United States v. Boatmen's First National Bank, the United States Court of Appeals for the Eighth Circuit held that the debtor's postpetition payroll taxes, interest, and penalties relating to those taxes could be charged against the secured lender's collateral. The Eighth Circuit also ruled that those charges could be directly asserted by the administrative claimant under section 506(c) of the Bankruptcy Code.

In JKJ Chevrolet Inc. v. Reynolds, the Fourth Circuit favored a literal reading of section 506(c) based on the "clear and unambiguous language" of the section, which grants only trustees the authority to seek recovery of postpetition costs and expenses from the secured creditor's collateral. The Fourth Circuit reasoned that allowing claimants to proceed directly against secured creditors undermines the fundamental purpose of the Bankruptcy Code, which is to provide equitable distribution to similarly situated creditors. When a trustee recovers postpetition costs and expenses, those funds are distributed in accordance with the Bankruptcy Code's priority scheme, thereby furthering the principle of equitable distribution. However, allowing individual claimants to recover directly circumvents the priority scheme of distribution under the Bankruptcy Code.

In JKJ Chevrolet, the Fourth Circuit countered the policy argument that the trustee or debtor in possession lacked incentive to pursue a section 506(c) claim by noting that a trustee and debtor in possession both "owe fiduciary duties to the creditors of the estate. A failure to seek recovery of a qualifying claim under section 506(c) may constitute a breach of those duties." The Fourth Circuit also noted that if the trustee or debtor in possession fails to pursue a potentially valid section 506(c) claim, an interested party could request that the bankruptcy court either compel the trustee or debtor in possession to bring the claim or remove the trustee.

Background of the Hen House Case

On September 5, 1991, the debtor filed a voluntary petition under chapter 11 of the Bankruptcy Code. The debtor's secured creditor, Union Planters Bank (the successor to Magna Bank) (the "Bank"), whose $4.1 million in prepetition loans were secured by virtually all of the debtor's real and personal property, agreed to lend the debtor additional funds to keep the business operating. The Bank also consented to the use of cash collateral to pay administrative expenses, which included the payment of workers' compensation insurance premiums. During its attempted reorganization, the debtor obtained workers' compensation from Hartford Underwriters who, at the time, was not aware that the debtor was in bankruptcy. Despite the fact that the debtor failed to make its monthly premium payments, Hartford continued to provide insurance. On June 20, 1993, the debtor's case was converted to a liquidation proceeding under chapter 7. At the time of conversion, the debtor lacked the unencumbered funds to pay the $50,000 it owed to Hartford in premium payments. Hartford therefore attempted to recoup the outstanding premiums from the Bank pursuant to section 506(c) of the Bankruptcy Code.

The Lower Court's Decisions

The bankruptcy court followed the reasoning of the Eighth Circuit's decision in Boatmen's and held that Hartford had standing to invoke section 506(c) and proceed directly against the Bank. Magna next appealed to a three judge panel of the Eighth Circuit, which affirmed the judgment in favor of Hartford holding, among other things, that Boatmen's was controlling. Notably, two members of the panel expressed their belief that Boatmen's had been wrongfully decided and should be considered by a full panel of the Eighth Circuit (en banc). Magna sought and was granted a rehearing by a full panel of the Eighth Circuit.

The En Banc Decision
In a 6-5 decision, the Eighth Circuit en banc reversed the panel decision and overruled its prior decision in Boatmen's "to the extent it construes section 506(c) to empower a nontrustee to surcharge an allowed secured creditor's collateral under that section." As a result, the court held that Hartford, a nontrustee claimant, lacked standing to assert a section 506(c) claim.

In support of its holding the court found the reasoning expressed in the Fourth Circuit's JKJ decision to be persuasive - the language of section 506(c) is "clear and unambiguous." The court noted, as did the Fourth Circuit in JKJ, that to give section 506(c) an expansive reading with respect to standing would invite a "floodgate of satellite litigation" by ordinary creditors seeking to surcharge the secured creditor's collateral.

The Supreme Court's Decision
The Supreme Court confined its decision to the issue of standing under section 506(c) of the Bankruptcy Code and assumed, for the purposes of this case, that only workers' compensation benefits provided a benefit to the Bank, as required by section 506(c).

Hartford argued before the Supreme Court that section 506(c) should not be restricted to only a trustee or debtor in possession because it does not specify that only the trustee may bring a claim. In Hartford's view, if Congress had meant to confine section 506(c) to the trustee only, it would have done so explicitly, as it has in other areas of the Code. Hartford also argued that section 1109(b) of the Bankruptcy Code evidences the right of a nontrustee to recover under section 506(c), as section 1109(b) provides that a party in interest "may raise and appear to be heard on any issue in a case under chapter 11." Finally, Hartford argued that pre-Code practice and policy considerations militate against denying parties in interest standing under section 506(c). With respect to policy considerations in particular, Hartford argued that the purpose of section 506(c) would be thwarted by confining standing to trustees because, in many cases, a trustee lacks the incentive to pursue a section 506(c) claim.

The Supreme Court found that the most natural reading of section 506(c) supports the interpretation that only the trustee may seek recovery under that section. Pursuant to principles of statutory interpretation, the Supreme Court held that where a statute specifically names the parties who are granted the right to invoke a provision, only those parties may act under that provision. The Supreme Court found that the trustee's "unique role in bankruptcy proceedings" supports the interpretation that Congress provided the power in section 506(c) to the trustee and not to others. Indeed, the Court stated that "had Congress intended the provision to be broadly available it could have said so, as it did in describing the parties who could act under other sections of the Code."

The Supreme Court noted that section 506(c)'s provision for the charge of certain administrative expenses against a secured creditor's collateral "continues a practice that existed under the Bankruptcy Act of 1898" (the statutory predecessor to the current Bankruptcy Code). However, the Court found scant case law under the Bankruptcy Act to support the notion that nontrustees had standing to assert surcharge claims against a secured creditor's collateral. The Court stated "[w]e have no confidence that the allowance of recovery from collateral by nontrustees is 'the type of "rule" that . . . Congress was aware of when enacting the Code.'" Thus, the Court concluded that "[p]re-Code practice cannot transform section 506(c)'s reference to 'the trustee' to 'the trustee and other parties in interest.'"

The Supreme Court also dismissed the argument that trustees may lack the incentive to pursue section 506(c) claims. It found that such situations would be "limited by the fact that the trustee is obliged to seek recovery under the section whenever his fiduciary duties so require." The Court did not elaborate on the type of situation which would compel the trustee to bring an action. The Court also cited competing policy arguments, stating that Hartford's interpretation could impair the ability of the bankruptcy court and the trustee to administer a case and could make secured creditors less willing to provide postpetition financing.

Finally, the Court noted that limiting section 506(c) standing to trustees and debtors in possession did not "leave those who provide goods or services that benefit secured interests without other means of protecting themselves as against other creditors." Namely, they could insist on cash payment, contract directly with the secured creditor and, of course, pay attention to the status of their accounts.

Impact of the Supreme Court's Decision
While the Supreme Court found that third parties do not have standing to surcharge a secured creditor's collateral under section 506(c) of the Bankruptcy Code, it did not shut the door entirely on the ability of third parties to seek recovery under section 506(c). A footnote specifically left open the possibility that an administrative claimant can bring an action on its behalf in the name of the trustee. The Court also observed that a trustee is required to bring an action on behalf of an administrative claimant whenever his fiduciary duties so require.

Typically, at the outset of a chapter 11 case a "carve-out" is negotiated with the secured lender who lends new money or allows its collateral to be used. The "carve-out" permits certain professionals retained by the estate and certain postpetition creditors to be reimbursed out of the secured creditor's collateral up to a specific dollar limit in the event there are insufficient unencumbered funds in the bankruptcy estate. Because it is not clear when a trustee's fiduciary duties require an action to be brought under section 506(c), nor when a third party may act in a trustee's stead, the Supreme Court's decision will likely impact negatively on third parties who failed to obtain specific consent from the secured creditor for a carve-out. To avoid financing the debtor's operations at their own expense if the debtor becomes administratively insolvent, third parties should heed the Supreme Court's admonition and take additional precautions before financing postpetition charges.

These precautions may take the form of an agreement under which the debtor in possession promises to make cash payments or to pursue any section 506(c) claim on the third party's behalf. Alternatively, a creditor may enter into an agreement directly with the secured creditor to recoup directly from the secured creditor any costs and expenses or the creditor may attempt to obtain superpriority status under the Bankruptcy Code to prime the secured creditor's collateral.

In contrast to its effect on unsecured creditors, the Hen House decision will strengthen the position of secured creditors. Removal of the threat of section 506(c) claims asserted directly by individual creditors may enhance the leverage of secured creditors in a chapter 11 case. Debtors in chapter 11 may also benefit from the secured creditors' increased position of strength, as secured creditors may be more willing to provide postpetition financing.

Hartford Underwriters Insurance Company v. Union Planters Bank, N.A., 120 S. Ct. 1942 (2000).
United States v. Boatmen's First National Bank, 5 F.3d 1157 (8th Cir. 1993).
JKJ Chevrolet Inc. v. Reynolds, 26 F.3d 481 (4th Cir. 1994).