Beneath The Trees, LLC

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IN THE UNITED STATES BANKRUPTCY COURT
FOR THE EASTERN DISTRICT OF NORTH CAROLINA
WILMINGTON DIVISION
IN RE:
BENEATH THE TREES, LLC, 	07-01664-8-JRL
Debtor. 	Chapter 11
______________________________________________________________________________
AMENDED ORDER
This case is before the court on the United States’ motion to reconsider allowance of attorney
fees and non-operating expenses in the interim cash collateral order entered June 19, 2007.
The debtor is a limited liability company that owns and operates an assisted living facility
in Brunswick County, North Carolina, known as Corinthian Place (“the Project”). The Project is
funded by a first mortgage loan of $4,084,200.00 at 5.95% per annum through Love Funding
Corporation (“Love Funding”), which loan is insured by the United States Department of Housing
and Urban Development (“HUD”). On November 30, 2004, the debtor entered into a Regulatory
Agreement for MultiFamily Housing Projects (“Regulatory Agreement”) with HUD. In return for
insuring the mortgage, the owners of the Project are required to abide by the terms of the Regulatory
Agreement. The Regulatory Agreement is incorporated into the “Deed of Trust and Assignment of
SO ORDERED.
SIGNED this 02 day of August, 2007.
________________________________________
J. Rich Leonard
United States Bankruptcy Judge
____________________________________________________________
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Rents, Profits and Income (Multifamily),” which is recorded in Brunswick County as a lien on the
real property included in the debtor’s estate. Love Funding has elected to assign the first mortgage
loan to HUD, which assignment was in the negotiation phase at the time of the hearing on the United
States' motion.
The debtor retained bankruptcy counsel and provided a retainer of $36,039.00. On May 4,
2007, the debtor filed for relief under Chapter 11. Since that time, the debtor has been operating
under cash collateral orders. The United States objects to certain payments in the monthly budget
presented at the cash collateral hearing on June 4-5, 2007, which budget was later incorporated into
an order entered June 19, 2007. Specifically, the United States objects to the pre-petition retainer
and the amount of $5000 allocated to attorney fees. The United States asserts that payment of
attorney fees in connection with the debtor’s bankruptcy case is impermissible under the Regulatory
Agreement because the attorney fees are not “reasonable operating expenses.”
In order to address whether payment of the attorney fees are permissible, the court must
consider the language of the Regulatory Agreement. 	The Regulatory Agreement restricts the
owners’ use of Project funds. Specifically, paragraph 6 of the Regulatory Agreement states:
Owners shall not without the prior written approval of the Secretary:
(b) Assign, transfer, dispose of, or encumber any personal property of the project,
including rents, or pay out any funds except from surplus cash, except for reasonable
operating expenses and necessary repairs.
Form HUD-92466, ¶6(b) (11/2002). Paragraph 13(f) of the Regulatory Agreement defines “surplus
cash” as follows:
(f) “Surplus cash” means any cash remaining after:
(1) the payment of:
(i) All sums due or currently required to be paid under the terms of any mortgage or
note insured or held by the Secretary;
(ii) All amounts required to be deposited in the reserve fund for replacements;
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(iii) All obligations of the project other than the insured mortgage unless funds for
payment are set aside or deferment of payment has been approved by the Secretary;
and
(2) the segregation of:
(i) An amount equal to the aggregate of all special funds required to be maintained
by the project; and
(ii) All tenant security deposits held.
Form HUD-92466, ¶13(f) (11/2002).
The debtor failed to pay its February 2007 and March 2007 mortgage payments. While the
debtor made a large payment in April 2007 in an effort to catch up its mortgage arrearage, the debtor
remained delinquent on mortgage payments at the time of filing bankruptcy. Even though the debtor
was authorized under cash collateral orders to pay for property insurance, the debtor became
delinquent on those payments as well. While it made a payment to avoid a post-petition lapse of
insurance, there still remained arrearage on the insurance at the time of the hearing. The debtor
concedes that it has no surplus cash; however, even without surplus cash, the Regulatory Agreement
states that the owners of the Project can pay reasonable operating expenses and necessary repairs.
There is no definition for “reasonable operating expenses” in the Regulatory Agreement, but courts
view those expenses as “arising from the everyday operation and maintenance of the project.”
United States v. Coleman, 200 F.Supp.2d 561, 567 (E.D.N.C. 2002). Reasonable operating expenses
are considered for the benefit of the Project and not the benefit of the owners. Coleman, 200
F.Supp.2d at 567.
Courts have concluded that attorney fees to prepare, file and maintain a bankruptcy case
benefit the owners of the project rather than the project itself; therefore, they are not reasonable
operating expenses. United States v. Harvey, 68 F.Supp.2d 1010, 1019 (S.D. Ind. 1998); In re RLA
of Madison, Inc., 177 B.R. 78, 80 (Bankr. M.D. Tenn. 1994); In re Tampa Bay Briarwood Assoc.,
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Ltd., 118 B.R. 126, 129 (Bankr. M.D. Fla. 1990); In re Garden Manor Assoc., 70 B.R. 477, 482
(Bankr. N.D. Cal. 1987); In re EES Lambert Assoc., 62 B.R. 328 (Bankr. N.D. Ill. 1986); In re
Michigan Beach Apartments, 61 B.R. 446, 450 	(Bankr. N.D. Ill. 1986). Filing bankruptcy is a
means for the owners of the Project to protect their investment, thus bankruptcy attorney fees are
considered personal expenses of the owners. See RLA of Madison, Inc., 177 B.R. at 80. In fact,
courts have awarded double damages to HUD in civil suits brought under 12 U.S.C. § 1715z-4a
where project funds have been impermissibly used for the payment of bankruptcy attorney fees.
United States v. Envicon Development Corp., 153 F.Supp.2d 114, 126 (D. Conn. 2001); Harvey, 68
F.Supp.2d at 1020-21. In short, every court that has looked at this issue has concluded that fees of
bankruptcy counsel may not be paid from project funds.
While the district court in Coleman concluded that HUD Handbooks have no binding force
like a regulatory agreement, see Coleman, 200 F.Supp.2d at 569-570 , it is noteworthy that the case
law is entirely consistent with the HUD Handbook that sets forth policies and procedures for the
servicing of multifamily housing projects. The pertinent provision of the Handbook states that
“project funds may not be used to defend a foreclosure action or to pay for a bankruptcy action.”
HUD Handbook 4350.1 REV-1, ¶ 10-17 (Sept. 1992).
The debtor attempts to distinguish its circumstances from the cases rejecting bankruptcy
attorney fees as reasonable operating expenses. The debtor contends that, unlike the debtors in other
cases, its motivation for filing bankruptcy was not to avoid a HUD foreclosure proceeding, but rather
to prevent the general contractor from enforcing his lien against the property for the debtor’s failure
to make final payment. The debtor contends that HUD had not formally declared a default at the
time the debtor filed bankruptcy and that the debtor was not using HUD funds to fight HUD. The
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court finds the debtor’s argument unpersuasive. What is determined to be a reasonable operating
expense does not hinge upon HUD’s actions or inaction against the debtor. There is nothing in the
Regulatory Agreement to support that interpretation. However, even if that was a factor for
consideration, the debtor was aware of its noncompliance with HUD requirements and knew that
HUD was completely dissatisfied with its performance when it filed bankruptcy. In the months
preceding the bankruptcy filing, HUD staff conducted a meeting in Greensboro, North Carolina,
with the owners of the project and Love Funding. HUD was concerned with, among other things,
the debtor’s lack of proper management and repeated failure to provide adequate financial
information. Thereafter, through several letters of correspondence, HUD pinpointed violations of
HUD requirements, such as failure to operate under a HUD-approved management company. In a
letter dated April 19, 2007, HUD acknowledged the debtor’s mortgage default and stated that it
could begin the foreclosure process upon assignment of the loan. Now, Love Funding is in the
process of assigning its loan to HUD. Whether or not the debtor was motivated to file bankruptcy
as a result of HUD’s actions or not, the debtor received the benefit of preserving the investment of
its owners and preventing HUD from taking action against the property. The court finds that the
bankruptcy attorney fees are not reasonable operating expenses.
In addition, the United States objects to the use of Project funds for payment of attorney
fees in connection with a lawsuit filed April 15, 2007 in the Superior Court of New Hanover County
by Rufus Grainger, a dissenting member of the debtor. Mr. Grainger has sued the debtor, the other
members, and Corinthian Place, Inc. Mr. Grainger is alleging claims against the defendants for
breach of fiduciary duty, for an accounting, for the appointment of a receiver, and for constructive
fraud. Mr. Grainger claims that the other members have made damaging decisions that have caused
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the debtor to be in noncompliance with HUD requirements. The United States asserts that any
attorney fees expended in connection with this lawsuit do not qualify as reasonable operating
expenses under the Regulatory Agreement. The court agrees. As noted above, reasonable operating
expenses are considered for the benefit of the Project, not the benefit of the owners. Coleman, 200
F.Supp.2d at 567. This lawsuit involves disagreement among members regarding management
decisions, and any fees expended in connection with this lawsuit are not necessary for the operation
and maintenance of the Project, as the Project could operate under different ownership. At this time,
the state lawsuit is stayed by the bankruptcy filing, but any attorney fees expended in connection
with the state lawsuit are not reasonable operating expenses that may be paid from Project funds
when there is no surplus cash. The record supports that there was no surplus cash when this lawsuit
was filed.
The United States also objects to the use of Project funds in the amount of $450.00 for a
“Potential Administrator’s License.” Wayne Bryant has received his license and is currently the
administrator for the Project. In North Carolina, an assisted living facility must have a licensed
administrator. N.C. Gen. Stat. § 90-288.12. The court finds that the $450.00 towards the
administrator's license is a “reasonable operating expense,” as the Project needs a licensed
administrator in order to operate.
The United States further objects to the payment of key man insurance, which is to protect
a business upon the death of an executive or key member. There is no specific entry on the 30-day
budget for key man insurance, and the United States did not provide any evidence of this insurance
and its terms to support its objection. The court, therefore, denies this objection to the cash collateral
order without prejudice.
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1The court is aware of the quandary created for the debtor by this ruling. However, the
debtor is not necessarily deprived of counsel. The members, whose equity investment is
ultimately at stake here, are free to pay counsel from other funds. Alternatively, attorney fees
may eventually be paid as a priority claim if the debtor is able to confirm a plan that cures all
defaults in a fashion that generates surplus cash. Or the debtor may accept the appointment of an
operating trustee, as HUD has indicated its acquiescence to payment of a trustee’s expenses.
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Based on the foregoing, the court grants in part and denies in part the United States’ motion.
The debtor shall not use Project funds to pay bankruptcy-related attorney fees, as they are not
reasonable operating expenses and cannot be paid with Project funds when there is no surplus cash.
The debtor must disgorge and return the retainer and any attorney fees paid from Project funds in
connection with this bankruptcy case. The debtor shall not use Project funds to pay attorney fees in
connection with the state lawsuit brought by Mr. Grainger, as those fees are not reasonable operating
expenses and cannot be paid from Project funds when there is no surplus cash. The court finds that
it was permissible for the debtor to allocate and use Project funds towards an administrator’s license.
Because the United States provided insufficient evidence regarding its objection to the use of Project
funds for key man insurance, the court denies that objection to the cash collateral order without
prejudice.1
END OF DOCUMENT
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