On June 23, 2014, the US Court of Appeals for the Fifth Circuit in Wells Fargo Bank, N.A. v. 804 Congress, LLC (In re 804 Congress, LLC) held that an oversecured lender's recovery of its legal fees from the proceeds of its collateral at a court-ordered non-judicial foreclosure sale was subject to the reasonableness standard of section 506(b) of the Bankruptcy Code. Further, because the lender did not substantiate these fees, the Fifth Circuit found they were unreasonable and not allowable as a secured claim, but remanded the case to the bankruptcy court to determine whether they could be treated as an unsecured claim under section 502 of the Bankruptcy Code (Wells Fargo Bank, N.A. v. 804 Congress, LLC (In re 804 Congress, LLC), No. 12-50382, (5th Cir. June 23, 2014)).

Wells Fargo Bank, N.A. (Wells Fargo) financed the purchase of a building by 804 Congress, LLC (Debtor). In return, Wells Fargo received a Real Estate Lien Note (Note) which was secured by a Deed of Trust Security Agreement (Deed of Trust) granting Wells Fargo a first-priority lien on the property. The Note entitled Wells Fargo to receive all reasonable attorneys' fees and collection fees following a default.

In response to a scheduled foreclosure sale by Wells Fargo, the Debtor filed for Chapter 11 bankruptcy. The bankruptcy court lifted the automatic stay to enable Wells Fargo to conduct a non-judicial foreclosure sale in accordance with applicable state law. The foreclosure sale was conducted in accordance with the Deed of Trust, and yielded about $4.355 million.

The bankruptcy court exercised jurisdiction over the entire proceeds of the foreclosure sale. Wells Fargo and the trustee for the Deed of Trust (Trustee) each filed claims for the amount they were owed under the Deed of Trust. The bankruptcy court directed the Trustee to pay Wells Fargo in full except for its attorneys' fees which it completely disallowed because Wells Fargo had not "filed a proper application for fees" and did not provide "supporting documentation or testimony that the fees were reasonable."

Wells Fargo appealed to the district court which reversed the holding of the bankruptcy court and remanded for further proceedings. The district court held that the bankruptcy court ceased to have jurisdiction over the property and sale proceeds when it lifted the automatic stay and the foreclosure sale occurred. The district court held that the distribution of the sale proceeds should be governed by Texas law rather than federal bankruptcy law. The Debtor appealed to the Fifth Circuit.

The Fifth Circuit reviewed the findings and held that the bankruptcy court had not erred in disallowing Wells Fargo's legal fees under section 506(b). Section 506(b) of the Bankruptcy Code entitles an oversecured creditor to a claim for postpetition interest and any reasonable fees, costs or charges provided for in the agreement under which the claim arose. The Court did not interpret section 506(b) to apply only when a sale occurs by the trustee in a bankruptcy under section 363 of the Bankruptcy Code.

The Fifth Circuit held that:

The Fifth Circuit held that the bankruptcy court did not abuse its discretion in finding that Wells Fargo failed to prove reasonable attorneys' fees. Although Wells Fargo provided evidence that it had paid its attorneys the amount requested, the bankruptcy court was within its discretion in finding that there was no documentation of the time that was spent and no testimony as to what was a reasonable fee. Therefore, the Fifth Circuit held that the bankruptcy court did not err in finding under section 506(b) that the amount of attorneys' fees sought was not substantiated, and therefore, not reasonable. The Fifth Circuit also noted that even if Texas law governed the issue, the fees would still be subject to a reasonableness requirement.

Wells Fargo and the Trustee asserted that even if the attorneys' fees are not granted under section 506(b), they should still be recoverable as an unsecured claim under section 502 of the Bankruptcy Code. While the Court noted that other circuits have allowed fees deemed unreasonable to be treated as an unsecured claim, it left this question for the bankruptcy court to decide because Wells Fargo and the Trustee had not fully briefed the issue and it was unclear whether they raised it in the bankruptcy court.

Oversecured lenders should substantiate all legal fees, costs and expenses with documentation, such as time records, to support an argument that they are reasonable, and therefore recoverable, under section 506(b), in the event of bankruptcy. In addition, oversecured lenders should request that the order lifting the stay to permit foreclosure include a provision that the foreclosure and distribution of proceeds will be governed exclusively by applicable state law.

For more information on oversecured creditors' rights to postpetition fees, costs and charges, see Practice Note, Postpetition Interest, Fees, Costs, and Charges in Bankruptcy.