The Bankruptcy Code provides for the payment of "reasonable fees, costs or charges" to an oversecured creditor—that is, a creditor with a lien on collateral that is worth more than the amount of its claim—if the relevant loan documents provide for the payment of such fees, costs or charges.²

This provision of the Bankruptcy Code naturally creates tension between the oversecured creditor and the debtor's unsecured creditors, because the return to unsecured creditors is reduced by each dollar used to reimburse a secured creditor for attorneys' fees or other charges. Apparent conflicts among §506(b) of the Bankruptcy Code, state laws governing attorneys' fees and contractual provisions requiring the payment of fees have spawned litigation since shortly after the Bankruptcy Code became effective in 1979.

The U.S. Court of Appeals for the Eleventh Circuit, sitting en banc, recently entered this fray in In re Welzel,³ a case that was unusual in several respects. The case featured a solvent debtor and an oversecured creditor, a combination that does not arise frequently in bankruptcy cases.⁴ Because a solvent debtor is entitled to any assets remaining after all creditors have been paid in full,⁵ the dispute regarding the creditor's attorneys' fees concerned only the secured creditor and the debtor himself. The second unusual aspect of the case was that Georgia law provides a statutory definition of what constitutes "reasonable" attorneys' fees, so that the courts were required to reconcile that definition with the use of the term "reasonable" in §506(b) of the Bankruptcy Code.

Background

Section 13-1-11 of the Georgia Code authorizes lenders and borrowers to agree that attorneys' fees will be payable upon the maturity of a promissory note in the amount of a specific percentage of the principal and interest owing on the note, up to fifteen percent.⁶ If the parties instead describe the obligation in terms of "reasonable" attorneys' fees without specifying a percentage, the provision is construed to mean 15 percent of the first $500 owing and 10 percent of the balance.⁷ For such a provision to be enforceable, the lender must provide written notice to the borrower after maturity regarding the attorneys' fees provision, and if the borrower makes payment in full of principal and interest within 10 days, the lender may not collect any attorneys' fees.⁸ If the borrower does not pay within 10 days, the statutory attorneys' fees become part of the principal debt.⁹ The Georgia courts have treated statutory fees as equivalent to liquidated damages, so that a lender may not collect more than the statutory percentage even if its actual attorneys' fees are higher.¹⁰

The basic facts in the Welzel case were simple: Mr. Welzel received the statutory 10-day notice from his lender, failed to make payment in full and filed for bankruptcy protection after the 10-day grace period expired. By the time the parties joined issue before the bankruptcy court on the question of attorneys' fees, the lender, Advocate Realty Investments, had incurred approximately $40,000 in fees, whereas application of the statutory percentage would have resulted in an award of about $148,000 in fees.¹¹ The bankruptcy court concluded that only the reasonable amount of attorneys' fees actually incurred by Advocate should be included in Advocate's secured claim under §506(b) of the Bankruptcy Code and that the balance of the statutory percentage should be allowed as an unsecured claim against Welzel's estate.¹²

Arguments on Appeal

Both parties appealed to the district court. Welzel argued that the statutory fees in excess of amounts actually incurred by Advocate should be disallowed entirely. Advocate, on the other hand, asserted that the entire statutory amount should be treated as a portion of the principal of its secured claim. The district court agreed with Welzel, limiting Advocate to attorneys' fees actually incurred and disallowing the balance of the claim.¹³

Each party renewed its all-or-nothing argument in the Eleventh Circuit, although Advocate argued in the alternative that the bankruptcy court's decision, allowing the "unreasonable" portion of the statutory fees as an unsecured claim, was correct. A divided panel affirmed the district court, holding that §506(b) preempted the Georgia statute and precluded Advocate from recovering statutory attorneys' fees in excess of the amount determined to be "reasonable" by the bankruptcy court.¹⁴ A dissenting judge did not take issue with the panel's conclusion that §506(b) requires a determination by the bankruptcy court of what fees are "reasonable" for purposes of inclusion in a creditor's secured claim.¹⁵ He argued forcefully, however, that nothing in the Bankruptcy Code permitted the balance of the statutory fees—which were valid and enforceable under applicable state law—to be disallowed.¹⁶

Eleventh Circuit Unanimously Supports Creditor

The appeals court then granted en banc review and vacated the panel's decision. In a unanimous decision, the full court held that the bankruptcy court's analysis was correct. The court first concluded that §506(b) requires a bankruptcy judge to evaluate a secured creditor's claim for attorneys' fees for reasonableness, notwithstanding state law.¹⁷ On this issue, the court's decision is consistent with decisions of other appellate courts, which have held that the reasonableness of attorneys' fees for purposes of §506(b) is governed by federal law.¹⁸ In so holding, however, the Eleventh Circuit expressly overruled a prior decision arising under the Bankruptcy Act of 1898, in which it had held that statutory attorneys' fees became part of the principal indebtedness and could be collected in full by a secured creditor (as Advocate argued).¹⁹

The en banc court reversed the district court with respect to the treatment of the "unreasonable" portion of Advocate's statutory fees, holding that these fees should not be disallowed but should instead be allowed as an unsecured claim.²⁰ The court recognized that §506(b) does not provide for the disallowance of any claim; rather, it describes the items that are included in the secured claim of an oversecured creditor. Allowance and disallowance of claims are governed instead by 11 U.S.C. §502, which provides a limited number of grounds on which a claim may be disallowed.²¹ Because none of these grounds applied to Advocate's claim for attorneys' fees, the Eleventh Circuit concluded that the entire claim should be allowed, even if only the "reasonable" portion of it could be recovered as part of Advocate's secured claim.²²

Significance of the Ruling for Creditors and Debtors

The Eleventh Circuit's holding in Welzel is significant for several reasons. If statutory attorneys' fees could be disallowed in bankruptcy, solvent debtors might seek bankruptcy protection for strategic reasons. The ability to escape valid and enforceable state-law obligations by filing a bankruptcy petition would result in windfalls for debtors who otherwise might have no need for the protection provided by the Bankruptcy Code. Such windfalls would not be limited to attorneys' fees, but also could arise in cases involving prepayment penalties, above-market interest rates and other contractual provisions that borrowers sometimes come to regret. As the Eleventh Circuit recognized, to permit disallowance of these obligations based on their perceived unreasonableness "would only increase litigation and do a disservice to the parties' contractual expectations."²³

The principles of Welzel also are important beyond the solvent-debtor, oversecured-creditor context in which the case arose. Unsecured and undersecured creditors with a contractual right to attorneys' fees can take comfort from the decision. Because §506(b) never comes into play for these creditors, reasonableness is not an issue. However, the Eleventh Circuit's holding that §502 does not permit disallowance of enforceable state-law claims for attorneys' fees bolsters these creditors' claims.²⁴ Indeed, one of the factors taken into consideration by the Eleventh Circuit was the anomaly that would result if unsecured creditors' "unreasonable" claims for attorneys' fees were allowed but oversecured creditors' claims were disallowed.²⁵

In many bankruptcy cases, of course, an unsecured claim has little economic value. Even where the returns to unsecured creditors are low, however, a creditor may gain a significant advantage from holding an unsecured claim. For example, in a chapter 11 case, creditors vote to accept or reject a reorganization plan by classes.²⁶ Holding a large unsecured claim for attorneys' fees, a prepayment penalty or some other contractual right may enable a creditor to control a class of unsecured creditors and to insist on better treatment of that class by the debtor. Similarly, depending on the circumstances of the case, the addition of an unsecured claim for attorneys' fees or other amounts may make an election under §1111(b)(2) of the Bankruptcy Code more valuable.

It is important to note that Welzel does not govern the enforceability of a claim for attorneys' fees under state law. Georgia law is clear that a percentage-based claim for attorneys' fees is enforceable, but the law in other states differs. For example, the Ninth Circuit in 268 Ltd. reached the same conclusion as the Eleventh Circuit in Welzel—that "unreasonable" attorneys' fees are allowed as a unsecured claim.²⁷ Later in the same case, however, the Supreme Court of Nevada, responding to a certified question from the Ninth Circuit, held that the percentage-based attorneys' fees at issue were unreasonable and unenforceable as a matter of state law.²⁸ In such a situation, §502(b)(1) of the Bankruptcy Code would require the disallowance of the unreasonable fees.

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Footnotes

¹ King & Spalding represented an amicus curiae in support of the creditor in the Welzel appeal. Return to article

² 11 U.S.C. §506(b). Return to article

³ Welzel v. Advocate Realty Invs. LLC (In re Welzel), 275 F.3d 1308 (11th Cir. 2001) (en banc) (hereinafter Welzel III). Return to article

⁴ See Welzel III, 275 F.3d at 1319. Return to article

⁵ See 11 U.S.C. §726(a)(6). Return to article

⁶ See O.C.G.A. §13-1-11(a)(1). Return to article

⁷ See Id. §13-1-11(a)(2). Return to article

⁸ See Id. §13-1-11(a)(3). Return to article

⁹ See Evans v. Atlantic Nat'l. Bank, 95 S.E. 219, 219 (Ga. 1918); Morgan v. Kiser, 31 S.E. 45, 45 (Ga. 1898). Return to article

¹⁰ See Spence v. Phillips, 158 S.E. 797, 800 (Ga. 1931); Bank of Lumpkin v. Farmers' State Bank, 133 S.E. 307, 308 (Ga. Ct. App. 1926). Return to article

¹¹ See Welzel III, 275 F.3d at 1311. Return to article

¹² See Welzel v. Advocate Realty Invs. LLC (In re Welzel), 243 B.R. 916, 919 (S.D. Ga. 1999) (hereinafter Welzel I) (summarizing bankruptcy court's decision). Return to article

¹³ See Id. at 922-23. Return to article

¹⁴ See Welzel v. Advocate Realty Invs. LLC (In re Welzel), 245 F.3d 1283, 1286 (11th Cir. 2001) (hereinafter Welzel II). Return to article

¹⁵ See Id. at 1287 (Cox, J., dissenting). Return to article

¹⁶ See Id. at 1288-89. Return to article

¹⁷ See Welzel III, 275 F.3d at 1314-15. The court concluded that O.C.G.A. §13-1-11 was relevant to the question of enforceability of a claim for attorneys' fees but did not control the question of reasonableness. See Id. at 1315. Return to article

¹⁸ See Unsecured Creditors' Committee v. Walter E. Heller & Co. S.E. Inc. (In re K.H. Stephenson Supply Co.), 768 F.2d 580, 585 (4th Cir. 1985); Blackburn-Bliss Trust v. Hudson Shipbuilders Inc. (In re Hudson Shipbuilders Inc.), 794 F.2d 1051, 1056 (5th Cir. 1986); First W. Bank & Trust v. Drewes (In re Schriock Constr. Inc.), 104 F.3d 200, 202 (8th Cir. 1997); Joseph F. Sanson Inv. Co. v. 268 Ltd. (In re 268 Ltd.), 789 F.2d 674, 677 (9th Cir. 1986). Return to article

¹⁹ See Mills v. East Side Investors (In re East Side Investors), 694 F.2d 242, 246 (11th Cir. 1982), supplemented on reh'g.; 702 F.2d 214, 215 (11th Cir. 1983). Welzel III also abrogated several other decisions by implication, including Equitable Life Assurance Soc'y. v. Sublett (In re Sublett), 895 F.2d 1381, 1385 & n.9 (11th Cir. 1990) (holding that reasonableness of charges under §506(b) is determined by reference to state law); National Acceptance Co. v. Zusmann, 379 F.2d 351, 354 (5th Cir. 1967) (holding that the bankruptcy referee could not reduce statutory attorneys' fees); and Security Mortgage Co. v. Powers, 278 U.S. 149, 154-55 (1928) (in case arising in Georgia, concluding that validity of lien for attorneys' fees was governed by state law). Return to article

²⁰ See Welzel III, 275 F.3d at 1316. Return to article

²¹ See 11 U.S.C. §502(b). Return to article

²² See Welzel III, 275 F.3d at 1318. Return to article

²³ Id. at 1319. Return to article

²⁴ Unsecured and undersecured creditors' claims for attorneys' fees have been sustained frequently by the appellate courts. See, e.g., Woburn Assocs. v. Kahn (In re Hemingway Transport Inc.), 954 F.2d 1, 9 (1st Cir. 1992); United Merchants & Mfrs. Inc. v. Equitable Life Assurance Soc'y. (In re United Merchants & Manufacturers Inc.), 674 F.2d 134, 137-39 (2d Cir. 1982); LeLaurin v. Frost Nat'l. Bank, 391 F.2d 687, 691 (5th Cir.), cert. denied, 393 U.S. 979 (1968); Manufacturers Hanover Trust Co. v. Bartsh (In re Flight Transportation Corp. Securities Litigation), 874 F.2d 576, 583-84 (8th Cir. 1989). Return to article

²⁵ See Welzel III, 275 F.3d at 1319. Return to article

²⁶ See 11 U.S.C. §§1126(c) and 1129(a)(8). Return to article

²⁷ See 268 Ltd., 789 F.2d at 678. Return to article

²⁸ See Joseph F. Sanson Inv. Co. v. 268 Ltd., 795 P.2d 493, 497 (Nev. 1990). Return to article