How to Get Paid in a Bankruptcy Case Part II

New York Law Journal
October 18, 1999.

By Paul Hollender

"This article is reprinted with permission from the lawnewsnetwork.com edition of New York Law Journal (c) 1999 NLP IP Company"

This is part two of my article discussing the treatment of professionals in bankruptcy cases.

In part one, which ran Friday, I discussed the disclosures required as a condition for retention as debtor's counsel in a Chapter 11 case, and the reasons why retention might be denied.

Part two will review the role of the Code of Professional Responsibility in these conflicts rules, the implications of those factors at the time of making a fee application, and the impact of potential conflicts in Chapters 7 and 13 bankruptcy cases.

The question of retention of attorneys in bankruptcy cases is unique in that resolution touches upon both the federal Bankruptcy Code provisions, as well as provisions of the New York Code of Professional Responsibility, which are an appendix to the NYS Judiciary Law.

The code's Canon 5 reads as follows:

A Lawyer Should Exercise Independent Professional Judgment on Behalf of a Client. É he professional judgment of a lawyer should be exercised, within the bounds of the law, solely for the benefit of his client and free from compromising influences and loyalties. Neither his personal interests, the interests of other clients, nor the desires of third persons should be permitted to dilute his loyalty to his client.

    D.R. 1-105(b) reads as: [A] lawyer shall not continue multiple employment if the exercise of independent professional judgment in behalf of a client will be or is likely to be adversely affected by the lawyer's representation of another client, or if it would be likely to involve the lawyer in representing differing interests.

    Differing interests is defined in the Code of Professional Responsibility as every interest that will adversely affect either the judgment or the loyalty of a lawyer to a client, whether it be a conflicting, inconsistent, diverse, or other interest.

    The underlying bankruptcy concepts of disinterestedness and absence of an adverse interest or the representation of one, thus has grounding in state law as well as in federal law, with the basic concept being to avoid situations where debtor's counsel will be torn by divided loyalties.

    By preventing retention of professionals who might have a risk of falling victim to such divided loyalties, the bankruptcy court attempts to maintain a level playing field for the benefit of the creditors, who will be the ultimate beneficiary of a bankruptcy case.

    Fee Applications

    No professional can expect to get paid in a bankruptcy case unless he or she has first been retained by court order. As set forth in the first part of this article, the pre-conditions for retention are that the professional be disinterested and neither represent nor have any adverse interest. If a professional simply performs services without obtaining appropriate advance authorization from the court, compensation will likely be denied.

    Nunc pro tunc retention is sometimes allowed, but cannot be counted upon. In this circuit the courts frown upon nunc pro tunc retention orders, thus retention orders should be submitted prior to commencing services, or as a first day order when the case is filed.

    Even if an attorney has been properly retained by court order, he will still be at risk of not being paid, unless he continues to maintain such status as both disinterested and not having or representing any adverse interest.

    Any initial retainer received, as well as payment for ongoing work, is conditional upon a formal fee application to the court. Fee applications in bankruptcy are governed by ¤330 of the Bankruptcy Code. Section 330(a)(1) allows reasonable compensation and reimbursement for actual and necessary expenses, however, no compensation is allowed for services not reasonably likely to benefit the debtor's estate or necessary to the administration of the case.

    The burden of proof of reasonableness lies with applicant.

    What constitutes reasonableness is a matter of interpretation, and depends upon the test applied. One approach is to limit recovery based upon the actual benefit to the estate.

    Another approach, which seems to be applied in New York is the reasonable likelihood of benefit to estate.

    It has been stated that the court should scrupulously avoid applying a perfect hindsight standard for testing reasonableness.

    On the other hand, an attorney should not recklessly forge ahead to provide legal services without an analysis of whether it makes economic sense

    Fiduciary Duties

    It has been held that the Bankruptcy Court may deny fees due to serious breaches of fiduciary obligations.

    While an attorney may not initially be retained unless he is disinterested, if he subsequently loses that disinterestedness, the court has authority, under ¤328(c) to disallow otherwise allowable fees and expenses.

    For example, in Angelika Films 57th Inc., the court had originally approved retention notwithstanding certain concerns about disinterestedness, because certain steps were taken to remove actual conflicts of interest, leaving only potential conflicts. Since the attorneys, however, were unable to maintain that separateness during the course of representation, they ended up suffering when it came time to seek approval of their fees. Thus it has been held that the Bankruptcy Court has broad discretion to disallow part or all of a fee request, or even disgorgement of fees paid, weighing equities in each case.

    Likewise, although the court allowed former counsel to be retained for bankruptcy purposes under circumstances where there were two distinct factions having an interest in the debtor-business, debtor's counsel was subsequently denied fees for work assisting one faction of debtor's shareholders against another, having lost disinterestedness post-petition.

    More extreme consequences flow from intentional deception. The failure to disclose disinterestedness in the retention application; e.g. performing services, and receiving payment for same, from limited partners of debtor, can lead to total denial of fees for services as debtor's counsel. However, to the extent the Bankruptcy Court determines that services were rendered as special counsel, lack of disinterestedness is not a requirement for retention or payment.

    The debtor's consent to billing arrangements does not obviate the need for disclosure to the court, and failure to provide details of billing arrangements warrants denial of all fees.

    Counsel should be aware that obtaining retainers, guarantees or mortgages from the principals of a corporate debtor could cause the firm to lose status as disinterested, since to assure payment, the firm's loyalty might be to the principals, rather than to the debtor-entity and its creditors.

    If, after commencement of services it is subsequently determined that counsel is serving the interests of the principals to the detriment of the debtor, the risk exists that all fees paid by debtor are subject to a disgorgement motion.

    If the proper safeguards are implemented, however, court approval of a retainer paid or guaranteed by a principal is not out of the question.

    Important Factors

    The factors to be considered are as follows:

      Full disclosure of the billing arrangement to the debtor and the third-party insider;

      Consent of the debtor;

      Third-party must obtain independent counsel and must understand that the bankruptcy attorney's loyalty will be only to the debtor entity;

      All facts must be disclosed to the Bankruptcy Court with the retention application, and;

      The debtor's attorney's applicant convinces the court that no facts exist which would otherwise create non-disinterestedness, actual conflict, or impermissible potential for a conflict of interest.

    1. In one case, following this analysis, the firm's retention was approved, since the court was convinced it was the only way the debtor was able to obtain competent counsel, but the court conditioned retention upon placing the entire retainer in escrow pending an interim or final fee application.

      Counsel's best course would be to disclose all relevant facts impacting upon the issue of disinterestedness, and then to develop methods of dealing with potential conflicts, as part of the retention order. Then, to maximize the chances of getting paid, counsel should make interim fee applications, which are allowed under ¤331 of the Bankruptcy Code.

      This approach is more advisable than that developed by counsel in In re Cupboards Inc.17 There, debtor's counsel sought to avoid the problem of having to wait until the end of the case to make a fee application, by arranging for post-petition billing to the debtor-in-possession by a fictitious company, whose receipts were funneled back to counsel. When this subterfuge was discovered, the attorney was ordered to disgorge all funds received, including a $5,000 disclosed pre-petition retainer, and the matter was referred for disciplinary proceedings.

      Prior representation of a specific creditor no longer automatically precludes counsel from representing the creditors committee.18 While employed by a committee, however, counsel may not represent any other entity having an adverse interest, although the simultaneous representation of a member of the same class as represented by the committee does not per se constitute an adverse interest.

      The rules governing employment of counsel for a debtor, for the most part, also apply to retention of counsel for a committee, disinterestedness, and neither having nor representing an adverse interest.20 Likewise, rules governing fee applications for committee counsel tend to follow those governing debtors' counsel, as discussed above. Bankruptcy courts keep a watchful eye to prevent the potential for conflicts in other relationships as well. For example, where a debtor's former counsel appeared in a case, now representing a creditor in litigation brought by the debtor, the court disqualified him from continuing.

      Counsel should be cautioned about overzealous representation of their creditor clients. In In re New Valley Corporation, an overly aggressive landlord/creditor apparently fabricated evidence and took a litigation position which did not have any basis in fact. Under the doctrine of unclean hands, the court disallowed the creditor's entire $2.8 million claim.

      Retention by Trustee

      If a trustee retains a professional knowing that such person is not qualified to be retained due to absence of disinterestedness, or the existence of an adverse interest, or if the trustee fails to make diligent inquiry into such facts, the court may deny the trustee compensation.23 In Granite Partners24 the trustee lost $50,000 of his commission for failure to disclose such relevant information to the court, making his own determination whether counsel he was employing was disinterested and represented no adverse interest.

      A trustee should not retain his own law firm absent a showing of good cause; e.g. the need to act quickly, to save the estate money, or because there is relatively little work to do. It has been held that a retention of the trustee's own firm creates a conflict of interest, since attorney's natural inclination will be to seek to maximize his law firms' fees. Such decisions must be made on a case-by-case basis.

      In this regard, it may be necessary to show cause to retain own firm.

      Trustee's counsel musthave no adverse interest and must be disinterested. Under the facts of one case, prior representation of a creditor did not preclude the trustee's counsel's appointment.

      A lawyer cannot represent a trustee for the purpose of investigating the alleged wrongdoing of another, valuable client.

      A trustee cannot employ former counsel for debtor or debtor's principal.

      Trustee's counsel will not be disqualified, on eve of trial, for seeking to obtain confidential information from debtor's former counsel.

      But, query what would have been the result if the motion had been made sooner.

      Questions arise as to potential conflicts when proposed counsel for trustee also represents some of secured creditors. No actual conflict is required; merely the potential for split loyalties.

      The Third Circuit applies a balancing test : a) Absolute bar to retention for actual conflict; b) Court discretion for potential conflict; c) No bar for mere appearance of impropriety.

      It is possible to take precautionary measures to allow retention notwithstanding conflict; e.g. erect a Chinese wall around the attorney with conflict and limitations on scope of representation.

      In reviewing a trustee's counsel's fee applications, benefit to estate is paramount. A trustee should not consider selling assets if administration expenses will consume the net estate. Counsel will not be paid for entries which constitute work of the trustee: calls regarding exemptions and turnover; review as to equity; calls regarding sale of asset.

      Accountants

      It is unlikely that debtor's counsel will be able to get far into the case without being retained, thus the risk of non-payment due to absence of a retention order is slight. However, other professionals can easily fall into this trap. For example, debtor's accountant can perform services without realizing the need to be retained by court order first. This is what happened to the CPA in In reWake.

      Although his services resulted in recovery of a tax refund for the benefit of the estate, the court denied him compensation because it held him not disinterested. Even if properly retained, accountants run the risk of not getting properly paid because they may be unfamiliar with the concept of keeping detailed time records. It is not enough to submit entries such as Òpreparation of income tax return.

      Just as with attorneys, accountants may not be retained unless they are disinterested and neither have nor represent any adverse interests. Thus, if an accounting firm gets retained without disclosing such information, and the existence of conflicts is discovered in the future, the firm may risk not only denial of additional compensation, but disgorgement of all fees paid. That is exactly what happened in Southmark Corp. v. Coopers & Lybrand37. The firm failed to disclose that a potential target of investigation was a major audit client of the firm. It was forced to disgorge fees paid, and then was sued for malpractice based upon the collateral estoppel effect of the bankruptcy court disgorgement decision.

      Debtor's Counsel

      It has been held that the attorney who represented a corporate debtor in its Chapter 11 case should not thereafter represent the corporation's principal in a Chapter 7 case.

      However, an attorney representing a corporate debtor in Chapter 7, may resign to enable counsel to represent individual principals, as defendants in adversary proceedings brought by Chapter 7 trustee.

      The court in that case noted that the president of a corporate debtor cannot consent to the multiple representation by the attorney, because the trustee, by operation of law has succeeded to management the corporate debtor, and has sole authority to issue such consent. Once there is litigation between the trustee and the principal of the corporate debtor, trustee cannot waive such conflict, without violating his fiduciary duty. Thus, the court, considering the discretionary nature of its duty to supervise such matters, allowed former debtor's counsel to represent the principals, applying a balancing test.

      In business Chapter 7 cases, the installation of a trustee supplants management. Debtor's counsel has to recognize that he cannot take steps which interfere with the trustee's job of the collection of assets. In one case, post-petition, the debtor attempted to sell it's liquor license, the proceeds of which would have been property of the estate.

      Rather than continuing with the sale and turning proceeds over to Chapter 7 trustee, efforts were made by debtor's liquor counsel and purchaser's counsel, to cancel the sale. Both attorneys were held in civil contempt because they knew of proposed order requiring turnover of funds to trustee. Furthermore, debtor's bankruptcy attorney was also held in contempt, since, rather than aggressively assisting trustee, his advice to liquor counsel was merely passive; i.e. debtor did not have capacity to transfer.

      Thus, debtor's counsel who fails to recognize the authority of the Chapter 7 trustee may have a problem larger than whether he will be paid and in fact may have to pay over money himself.

      Conclusion

      A professional's ability to get paid in a bankruptcy case is determined by the chapter under which the case is proceeding, the extent and veracity of disclosure at the time of retention, of information relating to possible conflicts, the extent to which disinterestedness continues throughout the case, and of course the time invested and results obtained.

      The real force driving the creation of inventive means for getting paid is the high cost of office overhead, which must be met by professionals pending completion of Chapter 11 cases. So long as Congress persists in requiring bankruptcy professionals to meet standards of retention and to be subject to billing oversight not applied to professionals in other fields, attorneys, accountants and other professionals will have to be overly careful before agreeing to handle bankruptcy cases.

      They will have to assure that they do not run the risk of having divided loyalties, either at the time of retention, or at any time prior to approval of final fee applications. If they do, they will find that they may lose all or part of the fees for work already performed.

      So long as this double standard exists, subjecting bankruptcy professionals to limitations on their contractual fee agreements, qualified professionals may decide that Congress and the courts, by converting hourly retainer agreements into contingency fee agreements, have created incentives for such specialized professionals to decline representation in the bankruptcy field.

      But for those who continue to practice in this area, it is hoped that the guidance offered by this article will provide a roadmap to minimize the risk of not getting paid for services competently performed.


        NY Code of Professional Responsibility EC 5-1

        11 U.S.C. ¤330(a)(4)(A).

        In re JLM Inc., 210 B.R.19, 24 (2d Cir. BAP 1997); In re Keene, 205 B.R. 690, 695 (Bankr, SDNY 1997).

        In re Ryan, 82 B.R.929, 931-32 (N.D. Ill. 1987)

        In re Ames Dept. Stores Inc., 76 F3d 66, 71-72 (2d Cir. 1996)

        In re Rancourt, 207 B.R. 338, 341 (Bankr. DNH 1997))

        In re Hunt 124 B.R. 263, 267 (Bankr. S.D. Ohio 1990)

        In re Wilde Horse, 136 B.R. 830, 844 (Bankr. C.D.Cal 1991)

        Gray v. English, 30 F3d 1319, 1324 (10thCir. 1994)). Rome v. Braunstein 19 F3d 54, 62; In re Caldor Inc. 193 B.R. 165, 171 (Bankr. SDNY 1996

        Angelika Films, 227 B.R. 29 at 43

        Entertainment Inc. 225 B.R. 412 (Bankr. N.D. Illinois, 1998)

        Hansen, Jones & Leta, P.C. v. Segal, 220 B.R. 434 (D.Utah 1998).

        In re Halbert, 225 B.R. 336 (E.D. Mi. 1998).

        In re Kendavis Industries International, Inc. 91 B.R. 742 (Bankr, Tx, 1988)

        ÒConflicts, the Appointment of ÔProfessionals, Ôand Fiduciary Duties of Major Parties ain Chapter 11' 8 Bankr. Dev. J. 349, 389 (1991)

        In re Kelton Motors 109 B.R. 641 (Bankr. D. Vt. 1989)

        190 B.R. 969 (Bankr. M.D. Fla. 1996

        11 U.S.C. ¤327(c)

        11 U.S.C. ¤1103(b)

        11 U.S.C. ¤327, Rule 2014 Rules of Bankr Procedure

        PGH International Inc. 222 B.R. 401(Bankr. D Ct. 1998)

        222 B.R. 722 (D. N.J. 1998)

        11 U.S.C. ¤326(d)

        219 B.R. 22, 40

        In re Kurtzman, 220 B.R. 801, 804 (Bankr., SDNY 1998)

        In re Cee Jay Discount Stores Inc. 171 B.R. 173, 176 (Bankr. EDNY 1994)

        In re Cleveland Trinidad Paving Co. 218 B.R. 385 (Bankr, N.D. Ohio, 1998)

        Granite Partners 219 B.R. 22, 37

        In re Manshul Construction Corp., 1998 WL 405039 (SDNY July 20, 1998)

        In re Manshul Construction Corp., 1999 WL 16378 (Bankr. SDNY 1999)

        See, e.g. U.S. Trustee's Objections to retention of counsel in In re County Seat Stores Inc., et al. 99B-10010(CB).

        In re Marvel Entertainment Group Inc. et al. 140 F3d 463 (3rd Cir, 1998)

        See e.g. In re Lawrence 215 B.R. 658 (Bankr, Fla., 1998)

        In re Kusler 222B.R. 357 and 224 B.R. 180 (Bankr, N.D. Okla, 1998)

        222 B.R. 35, 32 Bankr.Ct.Dec. 974 (Bankr, WDNY, 1998)

        In re Kusler, supra.

        1999 W.L. 303 (5th cir)

        Rome v. Braunstein, 19 F3d 54, 60 (1st) Cir. 1994)

        Allboro Waterproofing Corp., 224 B.R. 286 (Bankr, EDNY, Feller, J. 1998)

        In re Carrico, 206 B.R. 447 (Bankr. S.D. Ohio 1997).


      1. Paul Hollender is a partner at Corash & Hollender PC in Staten Island, N.Y

        The secret to our success is that we care about our clients