News

Getting Paid Is One Thing, Keeping the Money Is Another

By Myron A. Bloom
April 14, 2006

Almost 10 years ago, in In re Renfrew Center of Florida, et al., Bankruptcy Judge Stephen Raslavich had occasion to address the question of whether a debtor's counsel who received an "advance payment retainer," i.e., a retainer paid by a client in advance of performance of legal services and in which ownership of the funds pass to counsel at the time of payment, must disgorge that retainer to a creditor who held a valid pre-petition lien in the debtor's accounts receivable. Based on the facts of that case, Raslavich held that counsel did not have to disgorge.

Recently, the U.S. Bankruptcy Court for the 9th U.S. Circuit Court of Appeals faced a slightly different question: Does a debtor's counsel who receives a security retainer have to disgorge some or all of that retainer if a case converts from Chapter 11 to Chapter 7 and where there are insufficient funds to pay in full all Chapter 11 costs of administration?

In In re Dick Cepek Inc., counsel for the debtor received a pre-petition retainer from its client in the approximate amount of $85,000. Receipt of the retainer was fully disclosed in counsel's Rule 2014 and 2016(b) statements. Nowhere in counsel's disclosures was a statement that counsel held a security interest in the retainer or that counsel considered itself a secured creditor as a result of having accepted the retainer. Moreover, there existed no written agreement between the debtor and its counsel regarding the nature of the retainer. The bankruptcy court approved counsel's employment, finding that counsel was disinterested.

Under local rules in effect in the Central District of California, counsel was allowed (following specified procedures) to draw down on the retainer on a monthly basis, provided that at periodic intervals counsel filed interim fee applications to have those monthly payments reviewed and, if found inappropriate, repaid the disallowed payments. Here, counsel drew down on the pre-petition retainer for five months. Thereafter, it filed an interim fee petition seeking compensation of approximately $100,000. Counsel noted in the application that it had drawn down the retainer from its trust account, and asked the bankruptcy court "to authorize deduction of its allowed fees and costs 'from the retainer funds on hand, to the extent such retainer funds are available or become available.'"

However, before the application could be heard, the case was converted from Chapter 11 to Chapter 7, and a trustee was appointed. Subsequently, counsel for the debtor filed a second and final fee application, incorporating the first application and requesting the same amounts sought in the first application.

The Chapter 7 trustee filed a final report, indicating that the estate was administratively insolvent at the Chapter 11 level. At the hearing to consider the trustee's report and rule on all fee applications, the bankruptcy court, sua sponte, raised the issue of whether counsel for the debtor should have to disgorge some or all of the retainer it had already applied to its services rendered in order to equalize distribution to all Chapter 11 administrative claimants.

Counsel for the debtor argued, for the first time, that the retainer was a security retainer. The trustee responded that if that were the case, then counsel was not "disinterested" under Section 327(a) of the Bankruptcy Code and all of the retainer had to be disgorged. The retort, by counsel, was that the fee arrangement had been fully disclosed and a finding of disinteredness had been made.

Ultimately, the bankruptcy court concluded that partial disgorgement of the retainer was required to achieve equality of distribution to all Chapter 11 administrative claimants, as required by Section 726(b) of the Bankruptcy Code. The record was unclear as to whether or not the bankruptcy court found that counsel held a security interest in the retainer.

Debtor's counsel appealed to the Bankruptcy Appellate Panel. The panel viewed its task as resolving two issues: First, if counsel held a security interest in the retainer, did counsel have to disgorge a portion of the retainer to achieve equality under Section 726(b); and second, did counsel in fact hold a security interest in the retainer. As will be discussed below, the panel also dealt with a third issue - whether counsel can hold a security interest in a retainer and still be disinterested.

A preliminary issue dealt with by the panel, however, was one neither party raised: Did the panel have jurisdiction to consider the Section 726(b) issue if the bankruptcy court made no ruling on the nature of the retainer? The panel concluded that it did have jurisdiction. According to the panel, the concept of ripeness, a factor in determining if an appellate court has jurisdiction, requires a court to evaluate the fitness of issues for judicial decision, and the hardship to the parties of withholding court consideration. The panel concluded that to not review the legal issue (the interplay between security retainers and Section 726(b) of the code), and merely to remand for a factual finding (whether counsel had a security interest in the retainer), would waste resources and act as a hardship on counsel. Thus, the panel agreed that the issue was ripe for determination.

As noted above, the first substantive issue addressed was whether a retainer is subject to disgorgement if counsel holds a security interest in it. The panel began by noting (as did Raslavich 10 years ago) that generally, retainers fall into three categories. The first is a "classic" retainer, where a client pays money to a lawyer to secure availability over a period of time. In such a case, ownership of the money passes to the attorney at the time of payment. The second is an "advance payment" retainer, where the attorney receives payment in advance for contemplated services and depletes the fund as services are performed. Again, ownership passes to the attorney at the time of payment. The third is the "security" retainer, the type counsel here argued it received. This retainer, unlike the others, is property of the client until the attorney applies it to charges for services actually rendered.

If a retainer is a "security" retainer, does Section 726(b) require a deviation from traditional state law concepts of lien priority to enforce the concept of pro rata distribution among administrative claimants? No, the panel stated. Before a court applies Section 726(b), the property of a debtor must first be reduced to cash. To the extent that a person - even counsel - holds collateral by virtue of a security interest in an asset (whether it be realty or personalty, which includes cash collateral), the value of the claim secured by the lien is first paid from the proceeds of the liquidation of that property. In a corporate case, where exemptions do not apply, it is only then that there exists "free," unencumbered assets, to which the provisions of Section 726(b) will apply.

In other words, even before Section 726(b) is implicated, claims subject to liens must be satisfied to the extent of the value of the collateral securing them. Thus, in the presence of a valid lien, disgorgement on the basis of Section 726(b) alone is impermissible. The panel cited to numerous decisions from other courts (including one from the bankruptcy court in the Middle District of Pennsylvania) holding to this effect.

The second issue addressed by the panel was whether the retainer received by counsel here was in fact a security retainer. The panel concluded that the bankruptcy court had not squarely addressed this issue, despite the argument of counsel for the debtor that as a matter of law, the retainer was secured by virtue of counsel's possession and retention of it. Indeed, some courts and Collier on Bankruptcy have so stated. The panel, however, concluded that "[p]rudence, ethical considerations and general proof requirements" all suggest that an appropriate record be made before concluding that a security interest has been created and whether that interest has been adequately disclosed. This issue, having not been adequately addressed by the bankruptcy court, had to be reviewed, stated the panel; remand was thus required.

The issue not expressly stated to be an issue on appeal was whether counsel holding a security interest in the retainer could be "disinterested." The panel, though in passing, examined the issue. Again referencing Colliers, the panel concluded that the retention of a security interest in the retainer did not render counsel disqualified per se, though this issue, too, required that a court inquire into the facts to be sure the taking does not create an actual or potential conflict of interest, citing the following from the 1st Circuit opinion: "It stands to reason that the statutory mosaic must, at the least, be read to exclude as a 'creditor' a lawyer, not previously owed back fees or other indebtedness, who is authorized by the court to represent a debtor in connection with reorganization proceedings - notwithstanding that the lawyer will almost instantaneously become a creditor of the estate with regard to the charges endemic to current and future representation."

A bankruptcy appellate panel consists of three bankruptcy judges. Here, the ruling was not unanimous. In fact, all three judges authored opinions. One judge, while concurring in the result, expressed "genuine concerns" over it, and while seeing no per se prohibitions on agreements giving attorneys a security interest in a retainer, noted that a decision to require such a retainer may lead to "difficult ethical concerns." However, Congress in Section 328(a) authorized employment "on any reasonable terms and conditions of employment, including a retainer." Thus, if a secured retainer seems necessary and appropriate, and if approved by the bankruptcy court, it may be approved. Congress, stated the concurring opinion, respected a professional's status as against the claims of others, and that respect should be honored.

The third judge stated, "The majority's premise is that an insolvent debtor's counsel's security retainer is tenable under the code in the first place. It is with this fundamental view that I disagree."

Referring to the concept of equality in a "distinctive form of collective proceeding," the idea that debtor's counsel should be singled out for special treatment through the state law concept of becoming secured is totally inconsistent with Congressional policy. A lawyer holding a lien is a creditor and by definition is not disinterested. Even if not disinterested at the outset, counsel certainly is not so upon conversion - counsel's position is directly at odds with others who have claims arising from the providing of professional services, and who did not receive retainers. The majority's ruling, stated the dissent, gives counsel with a security interest in a retainer what amounts to a "superpriority" over other costs of administration, a priority reserved for the "burial expenses" incurred by a Chapter 7 trustee and the holders of other approved Chapter 7 administrative claims. The majority's holding, stated the dissent, may discourage others from performing those burial services. The result: "We . . . turn our backs on a clear Congressional statutory mandate, lead bankruptcy law in the wrong direction, and enable nonbankruptcy state law concepts to obtain unwarranted supremacy over federal law."

Like so many cases in this field, we are left with an oft-asked question - what's a lawyer to do?

This article is reprinted with the permission from the April 14, 2006 issue of The Legal Intelligencer.  Copyright 2006 ALM Properties, Inc.  Further duplication without permission is prohibited.  All rights reserved.