Under the Bankruptcy Code, a creditor may be reimbursed its actual and necessary expenses in making a “substantial contribution” in a chapter 9 or 11 case. Whether a creditor has made a substantial contribution is a question of fact, but generally requires that a creditor demonstrate a tangible benefit to the estate. It is unlikely that a creditor would “throw good money after bad” and attempt to make a substantial contribution in a chapter 7 case where creditor recoveries are typically limited to pennies on the dollar. There may nevertheless be instances where a creditor’s actions substantially contribute to a chapter 7 case and yield an increase recovery for all creditors. Despite the lack of express authority to reimburse such expenses as an administrative expense outside of chapter 9 or 11, a divided United States Court of Appeals for the Sixth Circuit recently concluded that a creditor could be awarded its expenses that substantially benefit a chapter 7 estate. See In re Connolly North America, LLC, No. 13-2489 (6th Cir. Sept. 21, 2015).
Lower Courts Denied Creditors’ Request for Reimbursement
Connolly North America was a debtor in a chapter 7 case in the United States Bankruptcy Court for the Eastern District of Michigan. In 2005, the chapter 7 trustee at that time commenced an adversary proceeding. The proceeding ultimately was dismissed with prejudice because the court found that the trustee had breached his discovery obligations due to gross negligence. Thereafter, upon the request of three unsecured creditors, the chapter 7 trustee was removed. The successor trustee filed a complaint against the initial chapter 7 trustee, his counsel, and his professional-liability insurer for damages. The bankruptcy court ultimately approved a settlement of the lawsuit, the result of which was new funds coming into the estate for distribution to creditors.
Two of the three creditors that had requested the removal of the initial chapter 7 trustee applied to the court for reimbursement of their attorney fees. The creditors argued they had contributed substantially to the lawsuit and related settlement, helping increase significantly the amount of funds available for distribution to creditors. Although it acknowledged that the fees paid by the creditors to their attorneys “substantially benefited the bankruptcy estate and the unsecured creditors,” the bankruptcy court denied the application. According to the bankruptcy court, the failure to expressly provide for the allowance of substantial contribution expenses in a chapter 7 case reflected “a Congressional intent” to prelude the reimbursement of such expenses. On appeal, the district court affirmed the bankruptcy court’s decision.
The Sixth Circuit Disagrees with the Lower Courts
Section 503(b) of the Bankruptcy Code states that “[a]fter notice and a hearing, there shall be allowed administrative expenses … including” the actual and necessary expense incurred by a creditor in making a substantial contribution in a chapter 9 or 11 case. According to the Sixth Circuit, the term “including” indicates that the list of administrative expenses set forth in section 504(b) is not exhaustive. Rather, the list serves as guidance or examples for the courts.
In a chapter 7 context, it is rare that a creditor would incur expenses to benefit an estate by, as occurred in this instance, engaging counsel to replace a chapter 7 trustee. Instead, according to the Sixth Circuit, the Office of the United States trustee would typically perform the function of “bankruptcy watch-dog” and, if appropriate, replace a trustee. “Thus, in a properly administered case under Chapter 7, a creditor will not be in a position to ‘substantially contribute’ to the estate by pursuing the acting trustee’s removal and prosecuting a claim on behalf of the estate.” It was therefore reasonable for Congress not to refer to chapter 7 in the context of allowing substantial contribution claims as administrative expenses. However, according to the Sixth Circuit, “Congress was fully capable of stating that § 503(b) excludes reimbursement in Chapter 7 cases if that is what it actually intended the statute to do.” Congress did not so state and, therefore, courts should not impose that limitation. Moreover, prohibiting a court from reimbursing a creditor for its expenses that ultimately benefit an estate would disincentivize creditor participation and contradict the equitable nature of bankruptcy. Therefore, the Sixth Circuit held that a bankruptcy court has the authority to allow reimbursement of reasonable expenses of creditors that substantially benefit a bankruptcy estate and creditors in a chapter 7 case.
Take-Away
Having suffered a loss for which they will not be paid in full, creditors are typically reluctant to spend more than necessary to assert their claims against a debtor in bankruptcy. In certain instances, however, a creditor may decide to take additional actions that could increase not only its recovery, but the recovery of all creditors. In the Sixth Circuit, a bankruptcy court may allow a creditor’s expenses in making a substantial contribution as an administrative expense in a chapter 7 case (and possibly, a chapter 13 case)—the authority is not limited to chapter 9 or 11 cases, notwithstanding the language of Bankruptcy Code section 503(b). However, a creditor should think carefully before taking costly actions in a chapter 7 case outside of the Sixth Circuit. Indeed, the dissent in Connolly identified several courts, including the Court of Appeals for the Third Circuit, that have held that substantial contribution claims in a chapter 7 case are not to be allowed as administrative expenses.