Just When You Thought You Were Out, They Pull You Back In

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ABL Advisor, October 8, 2014

It is a rare occasion for a secured lender to foreclose on collateral with a value in excess of the entire debt owed, particularly following a bankruptcy filing by the borrower, but on that rare occasion the lender should heed the cautionary tale set forth in the 5th Circuit Court of Appeals’ recent decision in Wells Fargo Bank, N.A. v. 804 Congress, LLC. 1.

In the bankruptcy case of 804 Congress, LLC, Wells Fargo obtained relief from the automatic stay to conduct a foreclosure sale on the debtor’s primary asset, an office building in Austin, Texas. The bankruptcy court’s order authorized Wells Fargo to conduct the sale pursuant to Texas law. The trustee under the deed of trust completed a non-judicial foreclosure sale of the property, which yielded proceeds in excess of the combined debt of both Wells Fargo and the junior lienholder. The trustee attempted to apply the sale proceeds first to the trustee’s 5% commission provided for under the terms of deed of trust, second to the senior debt owed to Wells Fargo (including pre and post-bankruptcy attorney’s fees), and third to the debt owed to the junior lienholder, with the remaining balance to the debtor. The debtor objected to the proposed distribution and the bankruptcy court entered an order directing the foreclosure trustee to pay (i) $7,500 to the trustee rather than the contractual 5% commission of $217,750, (ii) Wells Fargo in full except for its $87,000 in attorney’s fees and (iii) the junior lienholder in full.

The bankruptcy court ruled that Wells Fargo failed to follow the proper procedure for obtaining court approval of the attorney’s fees and did not present evidence that the fees were reasonable. Similarly, the court held that the trustee’s 5% commission was unreasonable and reduced the amount. The bankruptcy court relied on its authority under section 506(b) of the Bankruptcy Code to determine the reasonableness of fees, costs and charges sought by oversecured creditors. Section 506(b) entitles a creditor whose claim is secured by collateral worth more than the amount of its debt to include as part of its secured claim against the collateral, post-petition interest and its “reasonable” fees, costs and charges provided for under the loan documents or state law.

On appeal by Wells Fargo, the district court reversed, finding that once the bankruptcy stay was lifted and the foreclosure sale completed, the bankruptcy court no longer had jurisdiction over the foreclosure sale proceeds, which should be distributed in accordance with state law and the loan documents. On further appeal by the debtor, the 5th Circuit reversed the district court, holding (i) Bankruptcy Code section 506(b), not state law, governs the amount to be distributed to a secured creditor that is oversecured, (ii) the lifting of the automatic stay to allow Wells Fargo to foreclose was not tantamount to an abandonment of the bankruptcy estate’s interest in the property, (iii) section 506(b) applies to both pre and post-bankruptcy fees, costs and charges and (iv) as a result the bankruptcy court retained the authority under section 506(b) to determine the reasonableness and allowed amount of the trustee’s commission and Wells Fargo’s attorney’s fees.

The 5th Circuit’s opinion focuses primarily on its determination that a bankruptcy judge retains the authority to control the distribution of foreclosure sale proceeds to an oversecured creditor after evaluating the reasonableness of any fees and costs pursuant to Bankruptcy Code section 506(b). However, there are two novel aspects of the decision that may have ramifications for secured lenders. The first is a reminder that in some Circuits a bankruptcy judge has the authority to use section 506(b) to reach beyond amounts incurred during the bankruptcy case and disallow pre-bankruptcy fees, costs and charges even if those amounts are permissible under applicable state law and were incurred long before the bankruptcy case was filed.

In 804 Congress, LLC, the bankruptcy court disallowed all of Wells Fargo’s pre and post-bankruptcy attorney’s fees. Citing both 5th and 11th Circuit precedent, the Court concluded that section 506(b) does not draw a distinction between fees incurred before a bankruptcy filing and fees incurred after. Although Bankruptcy Code section 506(b) is more commonly viewed as applying only to the determination of whether a secured creditor is entitled to recover post-bankruptcy interest, fees costs and charges, in those jurisdictions that have extended section 506(b)’s reach, bankruptcy court approval may be required before applying foreclosure sale proceeds to standard pre-bankruptcy fees, costs and charges, such as unused line fees, collateral monitoring fees, late charges, valuation costs, and force-placed insurance.

The second interesting implication is the possibility that an order granting relief from the automatic stay, at least in the 5th Circuit, may no longer provide the exit from bankruptcy court most secured creditors have relied on in the past. One of the unanswered questions from the 5th Circuit’s decision is whether a secured lender will now need to return to the bankruptcy court for a separate order authorizing the distribution of foreclosure sale proceeds. The relief from stay order issued by the bankruptcy court in the case of 804 Congress, LLC explicitly authorized Wells Fargo to conduct a foreclosure sale “in accordance with applicable state law.” Similar language is standard in many bankruptcy district form orders across the country and most bankruptcy practitioners interpret such orders as granting a secured creditor the authority to both conduct a foreclosure sale and apply the foreclosure sale proceeds to the debt. That interpretation is called into question following the 804 Congress, LLC decision.

In reversing the district court’s ruling that upon relief from the automatic stay, the sale proceeds should be distributed in accordance with applicable state law, the 5th Circuit held that the bankruptcy court’s order lifting the stay simply allowed Wells Fargo to foreclose on the property in accordance with state law foreclosure procedures, but did not grant the trustee the authority to determine how the sale proceeds should be distributed. Moreover, while the 804 Congress, LLC decision focused on the application of the proceeds to the fees and costs of an oversecured creditor pursuant to section 506(b), the 5th Circuit’s reasoning in reversing the district court equally applies to the application of foreclosure sale proceeds to any portion of a secured creditor’s claim regardless of whether the creditor is over or under-secured. As a result, those parties relying on an order granting relief from the automatic stay to carry out certain actions, such as lenders, trustees, auctioneers and title insurers, should more closely consider the limits of such orders. One solution may be to request language in the relief from stay order authorizing the secured creditor to not only conduct the sale but also apply the sale proceeds in accordance with applicable state law and the loan documents. But some bankruptcy judges may be reluctant to give up their oversight authority before the amount of the sale proceeds is known.

It will be interesting to see how the bankruptcy courts apply the 5th Circuit’s decision in the near future. For now, secured lenders should be prepared to document and defend the reasonableness of all fees, costs and charges included in a secured claim, even those incurred well before the bankruptcy case was commenced, and also consider requesting authority to apply sale proceeds when obtaining relief from the automatic stay.

Endnote:
 1.  756 F.3d 368 (5th Cir. Tex. 2014).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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