Debate Intensifies on Substantial Contribution Claims in Chapter 7 Cases | Jones Day
To encourage creditors, equity interest holders, indenture trustees, and unofficial committees to take actions that benefit a chapter 9 or chapter 11 estate, the Bankruptcy Code confers administrative expense status on claims for expenses incurred by them in making a “substantial contribution” in such cases. Administrative expense status is also given to claims for reimbursement of reasonable professional fees incurred by such entities in making a substantial contribution.
Courts disagree over whether substantial contribution claims can also be allowed in cases under chapter 7 of the Bankruptcy Code. The U.S. Bankruptcy Court for the Northern District of Illinois examined this thorny issue in In re Concepts Am., Inc., 625 B.R. 881 (Bankr. N.D. Ill. 2021). The court ruled that “[t]he plain and unambiguous language of § 503(b)(3)(D) is conclusive—substantial contribution claims are allowed as administrative expenses only in Chapters 9 and 11, not in Chapter 7.”
Administrative Expense Priority for Making a “Substantial Contribution”
Section 503(b) of the Bankruptcy Code provides that, after notice and a hearing, the bankruptcy court shall allow as administrative expenses certain costs and expenses, “including” nine categories of claims, such as postpetition employee wages, postpetition taxes, professional compensation claims, and certain prepetition vendor claims. One of those categories is for “actual, necessary expenses” incurred by certain individual creditors, including creditors that file involuntary bankruptcy petitions (section 503(b)(3)(A)), creditors that recover estate property transferred or concealed by the debtor (section 503(b)(3)(B)), and creditors involved in the prosecution of criminal offenses relating to a bankruptcy case or to a debtor’s business or property (section 503(b)(3)(C)).
Additionally, pursuant to section 503(b)(3)(D), administrative expense claims include the actual, necessary expenses incurred by “a creditor [or certain other parties-in-interest] in making a substantial contribution in a case under chapter 9 or 11 of this title.” Relatedly, section 503(b)(4) grants administrative-expense priority for “reasonable compensation for professional services rendered by an attorney or an accountant of an entity whose expense is allowable under” section 503(b)(3)(D) and “reimbursement for actual, necessary expenses incurred by such attorney or accountant.”
These provisions are an “accommodation between the two objectives of encouraging meaningful creditor participation in the reorganization process and keeping administrative expenses and fees at a minimum to maximize the estate for creditors.” In re AmFin Fin. Corp., 468 B.R. 827, 831 (Bankr. N.D. Ohio 2012).
The Bankruptcy Code neither defines “substantial contribution” nor sets forth criteria to be used in determining whether a creditor or other qualified entity has made a substantial contribution in a chapter 9 or chapter 11 case. The legislative history of the provisions similarly provides little clarity. The issue, therefore, of whether a creditor has made a “substantial contribution” is a question of fact, with the moving party bearing the burden of proof. Most courts narrowly construe what constitutes a “substantial contribution,” and most have taken the position that substantial contribution claims, like other section 503(b) claims, should be strictly limited. See generally Collier on Bankruptcy (“Collier”) ¶ 503.10[a] (16th ed. 2021).
Courts generally distinguish between creditors’ actions that “incidentally” benefit the estate and those that provide direct and demonstrable benefit. A conflict has developed among the circuits regarding whether a court, in weighing whether the benefit was incidental, should consider a creditor’s motivation in undertaking an assertive role.
For example, in the Third and Tenth Circuits, actions motivated solely by self-interest are generally not compensable under section 503(b)(3)(D). See Lebron v. Mechem Financial, Inc., 27 F.3d 937 (3d Cir. 1994); In re Lister, 846 F.2d 55 (10th Cir. 1988).
In Lebron, the Third Circuit explained that, in order to be “substantial,” the contribution “must be more than an incidental one arising from activities the applicant has pursued in protecting his or her own interests.” Lebron, 27 F.3d at 944. Therefore, a court is required to apply a presumption of self-interest, which the creditor may overcome only by demonstrating that its efforts have transcended self-protection.
In Lister, the Tenth Circuit similarly emphasized that “[e]fforts undertaken by a creditor solely to further his own self-interest … will not be compensable, notwithstanding any incidental benefit accruing to the bankruptcy estate.” Lister, 846 F.2d at 57.
The Fifth and Eleventh Circuits, on the other hand, apply an objective standard, which recognizes, as expressed by the Fifth Circuit, that “nothing in the Bankruptcy Code requires a self-deprecating, altruistic intent as a prerequisite to recovery of fees and expenses under section 503.” Hall Fin. Grp. v. DP Partners, Ltd. P’shp (In re DP Partners, Ltd. P’shp), 106 F.3d 667, 673 (5th Cir. 1997). The Fifth Circuit further noted in DP Partners that “[t]he benefits, if any, conferred upon an estate are not diminished by selfish or shrewd motivations,” and that “a creditor’s motive in taking actions that benefit the estate has little relevance in the determination whether the creditor has incurred actual and necessary expenses in making a substantial contribution to a case.” Id. In Speights & Runyan v. Celotex Corp. (In re Celotex Corp.), 227 F.3d 1336, 1338 (11th Cir. 2000), the Eleventh Circuit similarly held that “[e]xamining a creditor’s intent unnecessarily complicates the analysis of whether a contribution of considerable value or worth has been made.”
Substantial Contribution Claims in Chapter 7 Cases?
Although section 503(b)(3)(D) expressly refers to expenses incurred in making a substantial contribution in a “chapter 9 or 11” case, some courts have held that substantial contribution claims may be allowed in chapter 7 cases. Most prominent among them is the only circuit court of appeals that has directly addressed the issue to date.
In In re Connolly N. Am., LLC, 802 F.3d 810 (6th Cir. 2015), a divided panel of the Sixth Circuit reversed lower court rulings denying a substantial contribution claim asserted by three unsecured creditors in a chapter 7 case that successfully prevailed in litigation to remove the chapter 7 trustee for misfeasance. The Sixth Circuit majority concluded that, despite the language of section 503(b)(3)(D), a bankruptcy court can confer administrative expense priority upon expenses not specifically mentioned in the provision using its broad equitable authority.
The majority reasoned that, because the term “including” in the introductory paragraph of section 503(b) “is not limiting,” lawmakers did not intend to confine the scope of allowable expenses to the nine categories expressly enumerated in the provision but anticipated that “bankruptcy courts would encounter a variety of administrative expenses and circumstances warranting reimbursement, which [they] could then evaluate on a case-by-case basis.” Id. at 816. According to the majority, “[i]t makes good sense that in providing” examples of common administrative expenses in section 503(b), “Congress would expressly mention Chapter 9 and 11 in the context of creditor activity making a ‘substantial contribution,’ but not Chapter 7 … [because] in all but the most atypical Chapter 7 case,” the Office of the U.S. Trustee (“UST”) devotes resources to benefit the estate as the “watch-dog” to prevent fraud, dishonesty, and overreaching in bankruptcy. Id. at 817.
In a dissenting opinion, Circuit Judge Kathleen O’Malley faulted the majority approach under principles of statutory construction:
Under the majority’s interpretation of § 503(b), § 503(b)(3)(D) would be superfluous. If substantial contributions in a Chapter 7 proceeding can be considered an administrative expense under the broad “including” provision of § 503(b), then there is no reason why substantial contributions in Chapter 9 and 11 proceedings could not also have been considered administrative expenses under that same language, making § 503(b)(3)(D) unnecessary.
Id. at 821 (dissent). Judge O’Malley also stated that “[a]lthough the majority reads much into Congress’s use of ‘including’ in § 503(b), Congress’s failure to include Chapter 7 in § 503(b)(3)(D) seems to be far more indicative of its intent, especially where Congress used the term ‘including’ in § 503(b)(1)(A) and did not do so in § 503(b)(3).” Id. at 824. She also noted that a previous panel of the Sixth Circuit recognized (albeit in dicta) that substantial contribution claims are limited to chapter 9 and 11 cases in In re Trailer Source, Inc., 555 F.3d 231 (6th Cir. 2009), and the vast majority of district and bankruptcy courts have expressly held that substantial contributions in a chapter 7 case are not administrative expenses.
Other courts have followed Connolly, but this represents the minority view. See, e.g., In re Thacker, 2020 WL 4000864 (Bankr. N.D. Fla. May 28, 2020); In re Javed, 592 B.R. 615 (Bankr. D. Md. 2018); In re Maust Transp., Inc., 589 B.R. 887 (Bankr. W.D. Wash. 2018); In re Maqsoudi, 566 B.R. 40 (Bankr. C.D. Cal. 2017); see generally Collier at ¶ 503.10 (noting that Connolly is the minority view and citing cases).
Courts have also held that substantial contribution claims under section 503(b)(3)(D) may not be allowed in chapter 12 and 13 cases. See In re Peterson, 152 B.R. 612 (D.S.D. 1993) (chapter 12); In re Chavez, 2006 WL 3832858 (Bankr. E.D. Cal. Dec. 27, 2006) (chapter 13); In re Rakosi, 99 B.R. 47 (Bankr. S.D. Cal. 1989) (same).
In May 2011, an affiliate of Concepts America, Inc. (“CA”), an Illinois-based restaurant management company, leased restaurant premises from Galleria Mall Investors LP (“Galleria”). After the affiliate breached the lease, Galleria sued, and a Texas state court entered a judgment against the affiliate and CA, which had guaranteed the lease.
Stymied in its efforts to collect on the judgment, Galleria joined with two other creditors in 2014 to file an involuntary chapter 7 petition against CA in the Northern District of Illinois. After CA consented to the entry of an order for relief, the chapter 7 trustee retained special counsel to investigate fraudulent transfer claims against CA and its affiliates. The trustee later sued more than 20 defendants based on those claims.
Galleria asserted that it “did the important work of unearthing” the facts and documents that gave rise to the claims asserted by the trustee. It accordingly sought allowance of an administrative expense claim under section 503(b)(3)(A), 503(b)(3)(D), and 503(b)(4) in the amount of more than $240,000, arguing, among other things, that Galleria made a substantial contribution in the bankruptcy case.
The Bankruptcy Court’s Ruling
The bankruptcy court denied Galleria’s substantial contribution claim because it concluded that such claims are not permitted in a chapter 7 case.
Applying well-established principles of statutory construction, Bankruptcy Judge David. D. Cleary reasoned as follows:
- The language of section 503(b)(3)(D) clearly and unambiguously limits such claims to chapter 9 and chapter 11 cases, and applying the plain meaning of the provision would not be absurd or “produce a result demonstrably at odds” with lawmakers’ intent.
- The purpose of allowing substantial contribution claims is “to recognize that the creditor ‘substantially contributed[d] to the reorganization efforts during the pendency of a chapter 11 case'” (citation omitted), and because there is no reorganization in chapter 7, “it is not absurd to read § 503(b)(3)(D) as applying only to Chapters 9 and 11.”
- Following the provision’s plain language comports with the “American Rule” that each litigant should bear its own attorneys’ fees, regardless of the outcome, unless a statute or contract provides otherwise, which is not the case here.
- Other subsections of section 503(b)(3) are not expressly limited to cases under certain chapters, indicating that lawmakers knew what they were doing when limiting substantial contribution claims to chapter 9 and 11 cases, and necessarily meant to exclude such claims in cases under other chapters.
- The specific limitations stated in 503(b)(3)(D) (limiting such claims to chapter 9 and 11 cases) take precedence over the “general permission” given in section 503(b), which states that the nine listed categories of administrative expense claims are not exclusive.
In addition, Judge Cleary noted that the majority of courts that have considered the issue have limited substantial contribution claims to chapter 9 and 11 cases.
He faulted the Sixth Circuit’s holding in Connolly as “a flawed interpretation of ‘including’ in section 503(b).” Judge Cleary acknowledged that, in section 503(b)(1)(A) (conferring administrative expense priority on the “actual, necessary costs and expenses of preserving the estate”), “including” is not limited to the listed examples “but could extend to a variety of other items.”
However, he explained, only one of the other eight categories in section 503(b)—section 503(b)(8), which confers administrative expense status on certain health care business closure costs and expenses—contains the word “including.” “The other seven do not,” Judge Cleary wrote, and “are therefore limited to the situations described,” which is “also true for the six subcategories of actual, necessary expenses in § 503(b)(3).” According to Judge Cleary, lawmakers would not have specifically provided for substantial contribution claims in chapter 9 and 11 cases “if they could simply be swept into a new category of actual, necessary expenses.”
Judge Cleary also noted that there are other remedies for creditors who provide benefits in chapter 7 cases, including: (i) section 543(c)(1) of the Bankruptcy Code, which requires the court to “protect all entities to which a custodian has become obligated”; and (ii) the ability to have their attorneys retained and compensated directly by the chapter 7 estate.
Finally, Judge Cleary emphasized that a bankruptcy court’s equitable powers can be exercised only within the confines of the Bankruptcy Code, which in this case prohibits substantial contribution claims in cases other than chapter 9 or 11 cases. He also wrote that “the power to correct a statute—if correction is needed—lies with the legislature alone.”
Concepts America does not stake out any new ground in the debate over substantial contribution claims in cases other than chapter 9 or 11 cases. Even so, the decision contains a careful and detailed analysis of the issue based on accepted rules of statutory construction and bankruptcy policy considerations. It therefore provides useful guidance regarding a conflict that is likely to continue absent additional appellate precedent or legislative action.
A version of this article was published in Lexis Practical Guidance. It has been reprinted here by permission.