What remains of this unfortunate venture is the newly opened Greek Isles Hotel & Casino, some Debbie Reynolds Hotel Casino memorabilia for sale on ebay.com, and a really good Ninth Circuit case for a chapter 11 debtor's counsel.

Debbie Reynolds Hotel & Casino Inc. v. Calstar Corp. (In re Debbie Reynolds Hotel & Casino Inc.), 255 F.3d 1061 (9th Cir. 2001), provides lawyers retained to represent debtors-in-possession (DIPs) an excellent way to ensure that their fees are paid and that their adversaries' counsel's fees are—if the case goes poorly—not. The dispute before the Ninth Circuit arose out of a liquidating chapter 11 plan under which the casino was to be sold to an entity called Central Florida Investments (CFI). When the unsecured creditors' committee opposed the plan, the bankruptcy court approved a sale process designed to solicit higher and better offers for the casino. CFI's $15.6 million bid was the successful bid, but when CFI pulled out after completing its due diligence, the backup bidder, Calstar Corp., agreed to pursue its $15.5 million backup bid by lending the debtor $150,000 on a superpriority basis under Bankruptcy Code §364(c)(1) to keep the casino open during Calstar's due diligence period. In this fashion, Calstar's $150,000 loan was to be repaid ahead of all other administrative expenses and unsecured claims.¹

When Calstar pulled out of the sale, the debtor asked the bankruptcy court to sell the casino at public auction, which it did, for $10,650,000, to the World Wrestling Federation.² Although the Ninth Circuit's decision is not explicit on this point, it can be assumed that the $10,650,000 in sale proceeds was insufficient to satisfy in full the senior secured claim against the casino, held by Resort Funding Inc. (RFI), and all accrued administrative claims, which included Calstar's superpriority administrative claim.

But for a little ingenuity and prescience, it is likely that the debtor's counsel, like all other administrative claimants, would have been forced to skulk away from the craps table with far less than they came with. While the parties awaited the bankruptcy court's final approval of the auction sale, the debtor entered into a settlement agreement with RFI that provided for the allowance of RFI's secured claim and permitted the debtor's counsel to collect $50,000 in fees from the proceeds of RFI's collateral—a consensual surcharge under Bankruptcy Code §506(c).³

While not conceding that the debtor's counsel had provided any benefit to RFI's collateral, RFI essentially bought peace on its secured claim for $50,000, with the surcharge providing that "RFI's secured and unsecured claims shall be irrevocably allowed and no debtor, administrative claimant or party in interest may...(5) seek to surcharge any of RFI's collateral pursuant to 11 U.S.C. §506(c)."⁴

Understandably, Calstar objected to the settlement agreement, arguing that the agreement precluded Calstar from seeking its own surcharge for the $150,000 loan and that its claim for repayment of the loan should come ahead of the debtor counsel's administrative claim. The bankruptcy court approved the settlement agreement over Calstar's objection, but the Bankruptcy Appellate Panel (BAP) reversed, holding that the $50,000 surcharge should have been paid to the estate, not directly to the debtor's counsel.⁵

The Ninth Circuit reversed the BAP and approved the settlement agreement. In fairness to the BAP, it is not the panel's fault that they got it wrong. The Supreme Court did not issue its controlling decision in Hartford Underwriters Ins. Co. v. Union Planters Bank (In re Hen House Interstate Inc.), 530 U.S. 1 (2000), until after the BAP had issued its ruling in Debbie Reynolds, which was based on an earlier Ninth Circuit precedent, In re Palomar Truck Corp., 951 F.2d 229 (9th Cir. 1991), a decision that read §506(c) to permit surcharge actions by parties other than the trustee or DIP.

The Ninth Circuit called the holding in Hen House "clear and unambiguous,"⁶ which it is: "The statute appears quite plain in specifying who may use §506(c)—the trustee."⁷ Hen House stands for the direct proposition that the trustee (or DIP) and only the trustee (or DIP) has standing to seek a surcharge against a secured creditor's collateral under §506(c). Creditors on their own accord may not seek to be reimbursed from a secured creditor's collateral for amounts spent on behalf of the estate.⁸

Therefore, so long as the Ninth Circuit determined that the Supreme Court's ruling in Hen House was to be given retroactive effect in Debbie Reynolds, the Ninth Circuit would be constrained to conclude that Calstar lacked the standing to oppose the surcharge, or the prohibition against others seeking or obtaining a surcharge, contained in the settlement agreement. Said the Ninth Circuit, "Because Calstar was not the trustee (or the DIP), it could not seek a §506(c) surcharge. The settlement agreement, in effect, abrogated a legal right that no longer exists."⁹ Accordingly, Calstar lacked the standing to appeal the bankruptcy court's order.¹⁰

Under the recent retroactivity standard articulated in the Supreme Court's ruling in Harper v. Va. Dep't. of Taxation, 509 U.S. 86 (1993),¹¹ it would seem that Hen House's standing doctrine applies retroactively to the bankruptcy court's approval of the settlement agreement between the debtor and RFI in Debbie Reynolds—and that is precisely what the Ninth Circuit held.¹²

The Ninth Circuit also rejected Calstar's argument that the $50,000 surcharge "became part of the general assets of the estate and should be distributed according to the statutory priority schedule."¹³ If Calstar's argument were to have prevailed, its superpriority administrative claim for $150,000 would have come ahead of any other claims of the estate and Calstar would, presumably, have been entitled to the $50,000 coming from the surcharge. Not so, however, since the Ninth Circuit reiterated what other courts had previously held: "A §506(c) surcharge is not an administrative claim, but an assessment against a secured party's collateral. As such, it does not come out of the debtor's estate, but rather comes directly from the secured party's recovery. Consequently, §506(c) expenses do not fall within the priority scheme of the Bankruptcy Code at all."¹⁴

Because a strict reading of Hen House leaves open the question of how a surcharge is to be distributed,¹⁵ the Ninth Circuit concluded that Palomar Truck survived Hen House to the extent of the former Ninth Circuit holding that proceeds of a §506(c) surcharge pass directly to the claimant and bypass the estate entirely.¹⁶

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[I]n cases where a DIP lender "takes out" a pre-petition lender, it is likely that a consensual surcharge in favor of a debtor's lawyer will replace the more traditional superpriority administrative expense...

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Because a party seeking to surcharge a secured creditor's collateral must prove that its expenses were reasonable, necessary and provided a "concrete and quantifiable benefit" to the secured creditor, a burden the Ninth Circuit accurately regards as "onerous,"¹⁷ it is unlikely that a creditor would even bother asking the trustee or DIP to seek a surcharge on the creditor's behalf. This is all the more true when the debtor has been able to obtain a surcharge for its own counsel on a consensual basis, meaning that the secured creditor has allowed the debtor's counsel to sidestep that "onerous burden."

In short, the Ninth Circuit's ruling in Debbie Reynolds sanctions an agreement between a debtor and its secured lender that contains a consensual surcharge for only the debtor's counsel. Interestingly, the Ninth Circuit seems to misconstrue, or at least underestimate, the practical implications of its ruling. Consider its statement, at the end of its decision, that "After [Hen House], it is unlikely that a secured creditor would be willing to enter into such an agreement. The assurances that constituted [the] debtor's consideration [that no other party could seek a surcharge] have no legal effect. RFI agreed to pay $50,000 and received nothing in return. Consequently, the underlying facts of this controversy are unlikely to repeat."¹⁸

That is not right, and here is why: The valuable benefit RFI "received in return" was not the protection against other parties seeking to surcharge its collateral, but rather the assurance from the debtor that it would not challenge or otherwise seek to avoid RFI's secured claim.¹⁹ This was of particular value to RFI, as it would be to any secured creditor. RFI avoids having to pay its own counsel to defend its claim and its liens against attack from the debtor, and because other parties (except perhaps a committee) would usually be ill-equipped to bring an action against the secured creditor, obtaining a waiver of any such action by the debtor will usually ensure the allowance of the secured creditor's claim in full. In this case, RFI (particularly if it were concerned about something—say, the perfection of its liens, or improper pre-petition conduct) would be happy to pay $50,000 to buy total peace as to its multi-million dollar secured claim. It seems likely that senior secured creditors in many cases (excepting the largest, most complex cases with multiple layers of secured debt) would welcome such a bargain. It buys peace with the one lawyer most equipped to cause the creditor heartburn for an amount that the creditor would likely have to pay its own lawyer to defend against an attack on its liens or its overall claim. (This is doubly true if the secured creditor believes it may ultimately wind up undersecured, since its own attorney's fees would not be included in its secured claim under §506(b).²⁰)

This type of arrangement works particularly well where a chapter 11 case is filed primarily for the purpose of selling the debtor's assets, all of which are secured by the senior lender's liens. In many of these cases—which are, to be sure, common—neither the debtor nor the lender is sure what the assets will bring at a sale. The debtor's counsel does not want to run the risk that sale proceeds will be insufficient to fund administrative expenses, and the secured creditor does not want to run the risk that it will get far less in a foreclosure than if the sale is conducted in a chapter 11 context. Obviously, the chapter 11 case does not happen if the debtor is unable to find a lawyer to do it, so the secured lender is willing to consent to a surcharge in order to encourage the debtor's lawyer to do the case and obtain the benefits and protections of implementing a sale within the bankruptcy context.

With all respect to the Ninth Circuit, this is a deal between a debtor and its lender that bankruptcy courts will see more often in the wake of Hen House and Debbie Reynolds than before. Secured creditors will know that they can agree to pay the fees of the debtor's lawyer without also having to pay other administrative claims, such as the fees of what could be a hostile (or largely out-of-the-money) unsecured creditors' committee, and lawyers for debtors will be more inclined to conduct a bankruptcy sale process for the primary benefit of a secured creditor, knowing that they have greatly reduced their fee risk.

Particularly when a debtor and its secured lender are able to negotiate the terms of a consensual cash collateral order, and also in cases where a DIP lender "takes out" a pre-petition lender, it is likely that a consensual surcharge in favor of a debtor's lawyer will replace the more traditional superpriority administrative expense "carve-out" granted to counsel in stipulated cash-collateral and financing orders. Debtor's lawyers may insist on it, and secured creditors may be more apt, in the face of Debbie Reynolds, to agree to it. The unsinkable Debbie Reynolds may have closed her casino, but the Ninth Circuit has dealt debtor lawyers a nice little hand.

Footnotes

¹ 255 F.3d at 1063-64. Return to article

² Id. at 1064. Return to article

³ Id. Section 506(c) provides that 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." Return to article

⁴ Id. Return to article

⁵ Id. at 1064-65. Return to article

⁶ 255 F.3d at 1066. Return to article

⁷ 530 U.S. at 6. Return to article

⁸ Id. at 13. Return to article

⁹ 255 F.3d at 1066. Return to article

¹⁰ Id. Return to article

¹¹ Harper held that "a rule of federal law, once announced and applied to the parties to the controversy, must be given full retroactive effect by all courts adjudicating federal law." 509 U.S. at 96. Return to article

¹² Debbie Reynolds, 255 F.3d at 1067. Return to article

¹³ Id. Return to article

¹⁴ Id. (citations omitted). Return to article

¹⁵ Hen House, 530 U.S. at 11 n.4. Return to article

¹⁶ Debbie Reynolds, 255 F.3d 1067. Return to article

¹⁷ Id. at 1068. Return to article

¹⁸ Id. Return to article

¹⁹ See Id. at 1064; see, also, text of settlement agreement quoted at In re Debbie Reynolds Hotel & Casino Inc., 238 B.R. 831, 835 n.4 (9th Cir. BAP 1999): "Upon approval of this agreement, RFI's secured claims and unsecured claim shall be irrevocably allowed, and no debtor, creditor, administrative claimant or party in interest may (1) object to the allowance of or the payment of the first priority secured claim, the third priority claim and the unsecured claim of RFI, (2) seek subordination of any claim held by RFI against any of the debtors, (3) seek to avoid any lien held by RFI against the real property except as provided in the order confirming sale, (4) seek disgorgement of any payment made to RFI by the debtors, or (5) seek to surcharge any of RFI's collateral pursuant to 11 U.S.C. §506(c)." Return to article

²⁰ See In re Timbers of Inwood Forest Assocs. Ltd., 484 U.S. 365 (1988). Return to article