On August 29, 2013, the US Court of Appeals for the Third Circuit issued a non-precedential opinion in In re Towne, Inc. denying a law firm's motion to collect its fees and expenses out of the proceeds of a sale of a secured lender's collateral by surcharging that collateral under section 506(c) of the Bankruptcy Code. The Third Circuit denied the request because the law firm's services were not necessary to the ultimate disposal of the collateral, nor did the law firm provide a direct benefit to the lender.

Towne, Inc. and DMD Town, LLC (Debtors) owned a franchised BMW dealership and the real property on which the dealership was located. The Debtors together owed BMW Financial Services, NA, LLC (BMW) approximately $9 million. BMW held a perfected first priority lien on most of the Debtors' assets (Collateral). The Debtors filed Chapter 11 bankruptcy petitions. The Bankruptcy Court consolidated the cases and appointed The Margolis Law Firm (Margolis) as special counsel to sell the Collateral.

In addition to soliciting bids for the Collateral, Margolis performed many services that were contrary to BMW's interests, such as attempting to reduce the value of BMW's lien and conducting research that led to an administrative state court proceeding against BMW. Margolis eventually located a potential buyer that offered $6 million for the Collateral. BMW refused to consent to the sale for an amount less than the amount of its lien unless the Debtors signed certain releases. The Debtors refused and the offer was withdrawn. Several months passed without further action.

The Bankruptcy Court converted the case to a Chapter 7 proceeding and appointed a Chapter 7 trustee (Trustee). Margolis then withdrew from the case. The Trustee executed the releases for the Debtors and eventually sold the Collateral for about $5.525 million. The Bankruptcy Court approved about $88,000 in fees and expenses for Margolis's services as special counsel. Margolis filed a motion arguing that under section 506(c) of the Bankruptcy Code it was entitled to satisfy these fees and expenses out of the proceeds of the sale of the Collateral.

Generally, a claimant may not recover fees and expenses from the proceeds of a sale of collateral. However, section 506(c) of the Bankruptcy Code allows a claimant to recover from the property securing an allowed claim the reasonable, necessary costs and expenses of preserving or disposing of the property, to the extent of any benefit to the secured creditor. The purpose of section 506(c) is to prevent a windfall to the secured creditor at the expense of the claimant.

The Bankruptcy Court denied Margolis' motion and the District Court affirmed. Margolis appealed to the Third Circuit, arguing that it should be able to recover its fees from the sale of the Collateral because:

The Third Circuit affirmed the decision of the two lower courts.

The Third Circuit began by rejecting Margolis' argument that the proper inquiry under section 506(c) of the Bankruptcy Code is whether a secured creditor benefited or could reasonably have been expected to benefit from a claimant's services. Instead, the Third Circuit stated that recovery under section 506(c) is permitted only under "sharply limited" circumstances, requiring a claimant to show that:

The Third Circuit found that Margolis met neither requirement, explaining that Margolis failed to demonstrate that:

Alternatively, Margolis argued that BMW consented to the surcharge. However, the Third Circuit found that BMW's limited cooperation with Margolis' initial efforts to sell the Collateral did not demonstrate consent to the surcharge.

Addressing Margolis' second argument, the Third Circuit found no legal support for the idea that BMW should be estopped from objecting to the surcharge due to its "secret collaboration" with the subsequent purchasers. Because Margolis failed to show that this form of estoppel has ever been recognized, the Third Circuit found no reason to address the merits of this claim.

Similarly, the Third Circuit rejected Margolis' third argument that the surcharge should be approved because BMW impeded the sale of the Collateral to secure releases in a manner allegedly inconsistent with New York law. The Third Circuit held that this was irrelevant to its section 506(c) analysis and found that even if BMW had violated New York law, this was not grounds for relief under section 506(c).

This case demonstrates that parties participating in the sale of collateral must both provide necessary services to the preservation or disposal of the collateral and a direct benefit to the secured creditor to recover fees and expenses from the proceeds of the sale under section 506(c) of the Bankruptcy Code. Merely assisting in the sale by, for example, bringing a purchaser to the table that does not eventually purchase the assets, potentially benefits the secured creditor, but does not rise to the level of providing necessary services or a direct benefit. Therefore, even if secured lenders cannot obtain a waiver of section 506(c) in a DIP financing order, they should take some comfort in knowing that the judicial gloss on section 506(c) has made it difficult to recover fees and expenses through a surcharge on collateral. The Third Circuit has made clear that showing only a potential benefit to a secured creditor is not sufficient.