A New Jersey law firm's experience offers a stern warning against attempting to collect legal fees and costs from the secured collateral of debtor clients in a bankruptcy case.

A federal appeals court held on Aug. 29 that firm's legal fees did not qualify under Bankruptcy Code § 506(c) as reasonable and necessary costs of preserving or disposing of property securing an allowed, secured claim "to the extent of any benefit to the holder of such claim."

Towne Inc., owner of a BMW dealership in Oyster Bay, N.Y., and DMD Towne, which owned the property, each filed voluntary Chapter 11 petitions. BMW Financial Services held a perfected first priority security interest in most of Towne's assets and also held a perfected first priority lien on DMD's property. Together, the debtors owed BMW Financial $9 million.

The bankruptcy court consolidated the cases and appointed the Margolis Law Firm in Roseland as special counsel to pursue a sale.

Margolis found a bidder who offered $6 million, but BMW Financial set sale conditions, and the deal fell apart.

The firm withdrew from the case when it was converted to Chapter 7 and a trustee was appointed. The property was eventually sold for $5.5 million.

The court later approved fees of $84,585 and expenses of $3,627 for Margolis' services as special counsel.

Such fees and expenses are ordinarily chargeable only against the surplus of a debtor's estate, but there was no surplus because the dealership owed more than $9 million to BMW Financial Services, holder of a perfected, first priority security interest.

So the firm invoked § 506(c), arguing it was entitled to dip into the $5.5 million sale proceeds because its services were reasonable and necessary. Prior to the case's conversion to Chapter 7, Margolis offered the franchise and facilities for sale, and solicited and handled prospective bids. It also claimed BMW Financial was estopped from denying it benefited from its services.

Both U.S. Bankruptcy Judge Donald Steckroth and U.S. District Judge Katharine Hayden rejected the argument, and the U.S. Court of Appeals for the Third Circuit agreed in In re Towne Inc. and DMD Towne.

The panel said Margolis could not show its expenditures were necessary to preserve or dispose of the collateral, or that its efforts directly benefited BMW Financial.

It was BMW Financial that found a buyer after Margolis withdrew. In addition, Margolis did not show it provided a direct benefit to BMW Financial.

Similarly, the court rejected Margolis' argument that BMW Financial consented to be surcharged for its efforts.

Margolis cited In re Flagstaff Foodserv. Corp., 739 F.2d 73 (2d Cir. 1984), in which a secured creditor's consent was considered in analyzing a claim under 506(c).

But U.S. Circuit Judges Kent Jordan and Thomas Vanaskie (along with U.S. District Judge Jed Rakoff, sitting by designation) said BMW Financial provided only limited cooperation with Margolis' initial sale efforts, undercutting the claim it consented to be charged for Margolis' efforts.

Margolis' Seth Dobbs, who argued before the Third Circuit, and Joann Sternheimer, of Deily, Mooney & Glastetter in Albany, N.Y., who represented BMW Financial, did not return calls.