Creditor on the Hook For Property Upkeep Costs

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By Stephanie Cumings

Jan. 6 — A creditor can be held liable for the cost of upkeep on a debtor's property, even when the attempt to sell it for the creditor's benefit is a bust (Southwest Sec., FSB v. Segner (In re Domistyle, Inc.), 2015 BL 429369, 5th Cir., No. 14-41463, 12/29/15)

When a Texas property didn't fetch the $6 million price tag the parties involved were hoping for, the bankruptcy court found that one of the creditors should be liable for the cost of maintaining the property through the long, unsuccessful sale process, because those expenses were incurred primarily for the creditor's benefit. The Fifth Circuit agreed.

In doing so, the Fifth Circuit criticized a Seventh Circuit case that “downplayed the importance” of the relevant bankruptcy statute.

‘Everyone Was Wrong.'

A bankrupt purveyor of home goods, Domistyle Inc., was confident that the 17-acre property that housed its industrial building was worth around $6 million. Domistyle and the bankruptcy trustee hoped the sale would provide more than enough money to pay back the $3.69 million Domistyle owed to the primary lienholder, Southwest Securities FSB.

But even though everyone involved in the case thought the $6 million figure was realistic, as the court put it, “[e]veryone was wrong.”

‘Burdensome' Property

The best offer to come in was $4 million, which wasn't enough to pay Southwest's claim and the superior tax claims in full. Southwest refused to approve the sale and it fell through.

During this time, the bankruptcy trustee was paying various expenses to maintain the property, including security costs, repairs, landscaping, utilities, and insurance. After the $4 million proposed sale fell through, the trustee threatened to stop paying some of these expenses, and Southwest argued this would “virtually destroy any value remaining” in the property. Shortly thereafter, the trustee moved to abandon the property as “burdensome and of inconsequential value” to the bankruptcy estate.

Southwest agreed to let the trustee abandon the property to Southwest, but argued it shouldn't have to reimburse the trustee for all the upkeep costs. The bankruptcy court found Southwest should be liable under Section 506(c) of the Bankruptcy Code, which authorizes a trustee to recover “the reasonable, necessary costs and expenses” of preserving property to “the extent of any benefit” to the creditor.

Primary Beneficiary?

On a direct appeal to the Fifth Circuit, Southwest argued that Section 506(c) is limited to expenses that the trustee incurred with a specific creditor in mind, and in this case the trustee was hoping the sale would benefit more creditors than just Southwest. But the court said that Section 506(c) “does not include an express requirement that the money be spent with any particular beneficiary in mind.”

Several courts have added the requirement that the expenses be “primarily for the benefit of the secured creditor,” so that a creditor can't be forced to pay more general administrative costs, like attorneys' fees, that it did in fact benefit from but to no greater extent than other creditors. In applying this rule, “[a] number of courts of appeals have made explicit the necessary connection between the expense and the collateral,” the court said.

“The necessary direct relationship between the expenses and the collateral is obvious here; all of the surcharged expenses related only to preserving the value of the [p]roperty and preparing it for sale,” the court held.

Seventh Circuit Criticized

The court made a point to criticize a Seventh Circuit case relied on by Southwest, In re Trim-X, Inc., 695 F.2d 296 (7th Cir. 1982). In Trim-X, the Seventh Circuit wouldn't compensate a trustee for expenses incurred before the trustee's attempted abandonment of the property because it worried “placing the responsibility for these expenses on a secured creditor would discourage a trustee from taking reasonable steps to assess an estate's position.”

The Fifth Circuit said there were “a number of problems with a rule foreclosing the possibility of Section 506(c) surcharge for any expenses incurred prior to attempted abandonment.” The court said that this approach is “largely unmoored from the statutory text” and that the Seventh Circuit “downplayed the importance of the statute's text in order to reach its holding.”

Furthermore, the court said that the Seventh Circuit's concerns are already addressed by the statute because the trustee's recovery is limited to “necessary” expenses.

“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,” the Fifth Circuit said.

The Fifth Circuit is the first court to criticize the 33-year-old holding in Trim-X, a case that's been cited favorably over 100 times. But it's also the first circuit court to actually discuss the case rather than just cite to it, according to research conducted by Bloomberg BNA.

Vacant, Vandalized Building

Finally, Southwest argued that the bankruptcy court failed to quantify the benefit it received. The Fifth Circuit said it was obvious Southwest obtained some benefit from the expenses incurred because without them, “Southwest may have been left trying to sell a vacant building damaged by vandalism, filled with overgrown weeds, and saddled with a leaking roof.”

“Although Southwest claims that the court lacked any evidence of the extent to which Southwest benefited from the expenses, the testimony of [the trustee's] experienced real estate broker was that the value preserved was at least as much as the amount expended,” the court said. “Southwest cross examined the broker but did not offer a competing expert or a contradictory valuation. Based on the testimony of [the trustee's] witness, the bankruptcy court found a benefit to Southwest that was, at minimum, equal to the amount of the expenses paid.”

Judge Gregg Costa wrote the opinion for the three judge panel, which included Judges Fortunato Benavides and James Dennis.

Southwest was represented by Paul Barnet Geilich and Kirte Matheu Kinser of Fishman Jackson, PLLC, Dallas.

The trustee was represented by Davor Rukavina and Edward Lee Morris of Munsch, Hardt, Kopf & Harr, PC, Dallas.

To contact the reporter on this story: Stephanie Cumings in Washington at sacree@bna.com

To contact the editor responsible for this story: Jay Horowitz at jhorowitz@bna.com