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In re Colusa Regional Medical Center

United States Bankruptcy Appellate Panel of the Ninth Circuit

September 10, 2019

In re: Colusa Regional Medical Center, Debtor.
v.
J. Michael Hopper, Chapter 7 Trustee, Appellee. United States Department of Agriculture, Appellant,

          Argued and Submitted on June 20, 2019 at Sacramento, California

          Appeal from the United States Bankruptcy Court for the Eastern District of California Honorable Christopher D. Jaime, Bankruptcy Judge, Presiding

          Jeffrey James Lodge, Assistant United States Attorney, argued for appellant;

          Kristen Renfro of Desmond, Nolan, Livaich & Cunningham argued for appellee.

          Before: Taylor, Brand, and Spraker, Bankruptcy Judges.

          OPINION

          TAYLOR, BANKRUPTCY JUDGE:

         INTRODUCTION

         The Colusa Regional Medical Center provides the only hospital and emergency medical services to thinly-populated Colusa County, California. Facing financial problems, it ceased operations in 2016 and initiated a chapter 7 case.[1] The majority of its assets were over encumbered by liens, including those held by the United States Department of Agriculture (the "USDA").

         J. Michael Hopper was appointed trustee. He successfully orchestrated a sale of a substantial portion of Debtor's assets, and the record supports that the hospital thereafter reopened and hospital medical services resumed. The Trustee achieved excellent results in the case that benefitted both creditors and the citizens of Colusa County.

         The present appeal concerns the question of who should pay a substantial portion of the Trustee's attorney's fees and his entire interim statutory commission. By way of a surcharge motion, the Trustee argued that many of his fees and costs were devoted to preserving and protecting the USDA's collateral, that the USDA saw considerable benefit (including achievement of its expressed desire that Colusa County not be without hospital services), and, thus, that the USDA should shoulder these significant expenses. The USDA disagrees; it suggests that the estate (and, derivatively, other creditors) should cover these administrative costs. The bankruptcy court agreed with the Trustee.

         We determine that the bankruptcy court clearly erred in finding surcharge objectively appropriate; it did not employ the test required by Ninth Circuit precedent and, thus, it failed to make factual findings that support surcharge. It also erred when it considered evidence introduced only on reply and found that the USDA impliedly consented to surcharge or caused the administrative expenses that form the basis for the Trustee's surcharge request.

         Accordingly, we VACATE and REMAND for further proceedings.

         FACTS[2]

         Debtor was a nonprofit public benefit corporation that opened in 2001. It was the principal health care facility in Colusa County, California, and consisted of its only hospital, three family medical clinics, and a women's health center. Facing a financial crisis, it halted operations in April 2016 and filed a chapter 7 petition two months later.

         No one disputes that Colusa County had a critical need for reopening of the hospital. The County argued that as of the petition date Colusa County residents faced a 30 to 45 minute ambulance ride to reach an emergency room, sometimes in situations where time was a factor in survival. Thus, the public interest overwhelmingly favored a chapter 7 liquidation that allowed the hospital to resume operations.

         Fortunately for all concerned, the Trustee received an offer to purchase the assets necessary to reopen the hospital almost immediately. The billing statements in the case evidence that the Trustee and his attorney met with the eventual purchaser approximately three weeks after the Trustee's appointment and filed an initial motion to approve a sale to American Specialty Healthcare, Inc. ("American Specialty") a little more than a week later.[3] There were hurdles, but the American Specialty sale closed, and the hospital reopened to the benefit of many.

         Debtor's assets and liabilities.

         Debtor's assets included real and personal property leases and commercial real property. The estate also held other personal property, including licenses relating to its operations; various non-leasehold furniture, fixtures, and equipment; $565, 000 in cash or cash equivalents; approximately $11, 000, 000 in accounts receivable[4]; and a claim for recovery of a preference in the approximate amount of $160, 000.

         The USDA's lien encumbered many of these assets and secured an approximately $3, 000, 000 debt. In particular, the USDA held a first priority lien on accounts receivable and their proceeds, the real property lease between Colusa County and the Debtor, [5] as well as the equipment and other tangible and intangible personal property related to operation of the hospital.

         The USDA, however, did not hold a lien against Debtor's fee simple interest in the "Williams Family Health Center", a real property asset valued in Debtor's schedules at $861, 164 (the "Williams Property"). Another creditor held a lien on this asset that secured a debt in the approximate amount of $320, 000.[6]

         The schedules, thus, evidence that in any reasonable scenario there would be funds in the estate to pay administrative expenses. But the apparent availability of funds to pay administrative expenses meant that the Trustee was unable to avoid the estate's patient records obligations under applicable law. See 11 U.S.C. § 351. These responsibilities increased the costs of administration; for example, early in the case, the Trustee had to seek bankruptcy court permission to destroy stale patient records.

         And not surprisingly, there were numerous junior secured creditors, unsecured creditors, and priority creditors.

         Cash collateral.

         While the hospital was not operational and the Trustee never filed a § 721 motion authorizing him to operate a business, the Trustee had a critical need for cash collateral in the early stages of the case. First, he needed security guards to protect the hospital physical plant. Second, absent immediate turnover of assets to the USDA, he needed personnel knowledgeable in the collection of medical receivables and accounting records software. Third, he needed software to manage electronic patient records. Fourth, he needed to pay for insurance, including a tail policy that would provide the estate with a defense to malpractice claims filed postpetition. Fifth, he needed to pay utilities. And finally, he needed limited office space.

         The USDA was the focus of cash collateral negotiation, although the Trustee acknowledged that Debtor's cash and accounts receivable assets were subject to other junior competing lien interests held by Amerisource-Bergen Drug Corporation, River Valley Community Bank, Cardinal Health, and FlexCare LLC.

         In the initial cash collateral motion, the Trustee acknowledged partial USDA consent and noted that the Debtor had about $565, 000 in cash on the petition date, that he anticipated that this amount would soon exceed $1, 000, 000, and that he could increase collection recoveries by using USDA cash collateral to finance collection efforts. And before the cash collateral hearing, he advised that the USDA now supported all proposed cash collateral uses except for the payment for malpractice tail insurance. The bankruptcy court later overruled the USDA's objection and allowed all cash collateral use as proposed by the Trustee.

         To adequately protect the USDA, the cash collateral order provided it with replacement liens on all postpetition causes of action, including avoidance actions, but the order clarified that the replacement liens would not encumber the Williams Property or its income and proceeds. The order also allowed the USDA to receive payments from its cash collateral of $20, 000 a month.

         The USDA directly benefitted from some of the requested cash collateral use. The security guards protected its tangible collateral. The personnel collecting receivables did so for its benefit. And the accounting software, as well as the patient records software, assisted in these collections.

         But the USDA was not the only party who benefitted. The patient records software, paid for with USDA cash collateral, preserved patient records, even if not necessary for collection, and, thus, eliminated or limited the use of unencumbered estate assets to maintain patient records. Also, USDA cash collateral use was requested in relation to utility payments for the Williams Property and Arbuckle clinic locations to the extent the rental income was insufficient to pay debt service on the Williams Property and all building operational costs as to all three clinic locations. And the requested use for insurance directly protected others as well. In particular, tail insurance provided no obvious benefit to the USDA; to the extent late-filed malpractice claims could not be defended, this would increase unsecured claims, but it would not result in senior claims against the USDA's collateral.

         The Trustee later obtained two additional cash collateral orders. The second order largely duplicated the first except that the Trustee did not request use for office rent and insurance premiums. The third motion largely duplicated the second but also requested use to pay renewal fees for licenses critical to both hospital operations and completion of the American Specialty sale. In this motion, the Trustee noted: "The services of the Debtor's former employees have provided substantial assistance to the Trustee in navigating the complexities involved with the Debtor's billing and collection operations and the management of the Debtor's records, and maintaining access to and security for the records is necessary to facilitate further collections and satisfy requests for records."

         The USDA objected to use of cash collateral after September 27, 2016. In short, it asserted that the estate should cover expenses from other sources if the American Specialty sale had not then closed by that date. The bankruptcy court overruled its objections and allowed use as requested by the Trustee. The USDA also sought stay relief as to the accounts receivable collateral. The bankruptcy court granted its motion.

         Sale of assets.

         As noted, the Trustee very rapidly identified a buyer for the hospital and clinic operations, including the Williams Property, for $1, 000, 000. The proposed sale to American Specialty would be free and clear of liens except as to the Williams Property, which was sold subject to the existing lien.

         In support of his sale motion, the Trustee argued, in part, that creditors would benefit from both the sale proceeds and a reduction of administrative expenses as a result of the buyer's assumption of responsibility for medical records. In other words, the Williams Property's proceeds-available for payment of administrative expenses and unsecured claims-would not be diminished by any ongoing patient-record obligations. Thus, the allocation of sale proceeds to the Williams Property provided a benefit to the estate even beyond the allocated proceeds of sale. In sum, the Trustee contended: "the proposed sale to the Buyer is a good faith effort by the Trustee to maximize the net return to the estate on account of the Sale Assets."

         Thereafter, there were several objections from secured lenders and parties with executory contracts. And a supplemental motion to approve a sale agreement followed. The revised sale included additional assets (the non-leasehold furniture, fixtures, and equipment) and an increased purchase price of $1, 100, 000. In describing how lienholders would be treated, the Trustee represented that the USDA consented to the sale on the condition that it receive $550, 000 from the sale proceeds. The Trustee, thus, allocated the remainder of the sale proceeds ($550, 000) to the Williams Property.[7] This amount was available to pay administrative creditors and to make payment to priority creditors and possibly unsecured creditors. The Trustee also allocated $31, 000 of this amount to pay three lienholders other than the USDA to obtain their consent.

         In November 2016, the bankruptcy court entered its order granting the supplemental sale motion (the "Sale Order").

         Subsequent Administration and the Trustee's surcharge request.

         The Trustee thereafter sought interim approval of $154, 878.58 in attorney's fees and expenses. In the motion, the Trustee noted that he might file a § 506(c) surcharge motion.

         Over a year later, the USDA filed a motion to compel the Trustee to abandon its remaining $300, 000 in cash collateral. The Trustee then filed a first interim application to approve $66, 092.18 in Trustee's compensation based on $1, 428, 072.80 in disbursements. He concurrently filed a motion seeking to recover an amount equal to his commission and $133, 167.50 of his counsel's fees from USDA collateral. He explained: "Working in conjunction with various interested parties trying to preserve both the economic value of the hospital and associated assets, and the public interest in preserving the hospital and health services in Colusa County, the Trustee undertook" the task of attempting a sale of the hospital and its related assets.

         The Trustee initially supported the surcharge motion with his own declaration. It consisted of an outline of case progress, an overview of the asserted secured claims, and a broad overview of disbursements in the case. The Trustee also provided time records for himself and his attorneys and a schedule of the disbursements that justified his statutory commission. But the Trustee discussed the USDA's involvement in the case only in brief.[8] Nowhere in the declaration did the Trustee discuss any specific interactions with the USDA that allegedly influenced his actions in the case. He similarly failed to discuss the alleged motivations and analysis that led him to accept the offer from American Specialty as opposed to pursuing sale of the Williams Property and abandoning other assets. And he made no effort to tie particular fees to a benefit to the USDA and its collateral.

         The Trustee sought surcharge for fees broadly related to sale of the hospital and the vast majority of other case activity from the petition date through closing of the sale. The Trustee conceded that the USDA did not expressly consent to surcharge but argued that it impliedly consented.

         Not surprisingly, the USDA opposed. It broadly disputed the appropriateness of surcharge and specifically disputed that the Trustee adequately established a benefit to the USDA or consent by the USDA for the purposes of surcharge.

         In connection with his reply, the Trustee submitted his own brief supplemental declaration. In it, he recounted two conversations for the first time:

• "On June 10, 2016, I spoke with Jeffrey A Streiffer, counsel for the [USDA], about the USDA's claim and the USDA's desire for me to preserve its collateral. Mr. Streiffer told me that the USDA was open to reducing its loans to secure a buyer for the Debtor's hospital and related assets and that the USDA did not want to leave the Colusa community without the health services provided by the hospital."
• "I also spoke numerous times with Anita Lopez, the community facilities director with the USDA that was handling this case, who told me at the outset of this case that the USDA wanted to preserve health services in Colusa and later indicated to me that it was not prepared to pursue its own collection activities."

         At the hearing on the surcharge motion, the USDA argued as outlined in its opposition. It also objected to the supplemental declaration on multiple theories including that it exceeded the scope of what was appropriate for a reply and, thus, that the USDA could not provide a meaningful response.

         The bankruptcy court then provided an oral ruling. It overruled the USDA's objection to the second declaration, reasoning that unspecified civil rules and local rules required pre-hearing written objections.[9] Noting that surcharge is evaluated under two tests, an objective test and a subjective test, it concluded that the Trustee satisfied both.

         In its evaluation of both tests, it found that the USDA obtained a benefit and that the USDA could not have duplicated the benefit provided by the American Specialty sale and the collection of receivables by the estate. It concluded that, without the Trustee's efforts, the USDA would not have received significantly more than the $565, 000 in cash available on the petition date. Indeed, it added that it was "not persuaded that USDA could or would have collected any receivables." Hr'g Tr. (Sept. 11, 2018) 18:3-4. And it continued: "In fact, according to its community facilities director, USDA was not prepared to do that at the inception of the case, and it also made no effort to do that after the automatic stay was terminated in November of 2016 for the express purpose of allowing USDA to collect accounts receivable." Id. at 18:4-9.

         It also reasoned that the USDA would have realized nothing on account of its lease, license, and intangible collateral.

         Finally, it faulted the USDA for failing to submit evidence about the value of the furniture, fixtures, and equipment, and concluded that it would not have received more than the $100, ...


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