The employment of professionals by a bankruptcy estate is vital to the reorganization process. Since such professionals are compensated from bankruptcy estate assets, Congress included many procedural safeguards to protect the interests of the bankruptcy estate. These procedural safeguards include provisions for the employment of professionals such as attorneys, accountants and appraisers and, more importantly, the award of compensation to such professionals.

It is, after all, only fair that professionals serving a bankruptcy estate are adequately compensated for the reasonable and necessary services provided. Likewise, it is inherent that bankruptcy courts address alleged malfeasance of bankruptcy professionals. Indeed, if the services provided are not reasonable and necessary, or are tortious, then such professionals should be held responsible.

Accordingly, a bankruptcy estate may object to a fee application and request disgorgement of fees, in addition to seeking damages for malpractice, which most would assert are inherently different. Lately, however, certain cases have held that a bankruptcy court's rulings at a fee application/disgorgement hearing may preclude litigation in a subsequent malpractice action. See Southmark Corp. v. Coopers & Lybrand (In the Matter of Southmark Corp.), 163 F.3d 925 (5th Cir. 1999), and Osherow v. Ernst & Young LLP (In the Matter of Intelogic Trace Inc.), 200 F.3d 382 (5th Cir. 2000). Due to these cases, practitioners must consider the implications of fee application/disgorgement hearings and their application to subsequent malpractice actions due to issue and claim preclusion.

Preclusion

The application of issue and claim preclusion is by no means novel. For years, courts have applied these principals to prevent the litigation of previously determined issues and claims. Issue and claim preclusion, however, differ in their application. The application of issue preclusion, f/k/a collateral estoppel, requires that (1) the issue at stake must be identical to the one involved in the prior action; (2) the issue must have been actually litigated in the prior action; and (3) the determination of the issue in the prior action must have been a part of the judgment in the earlier action. Southmark, 163 F.3d at 932; citing RecoverEdge L.P. v. Pentecost, 44 F.3d 1284, 1290 (5th Cir. 1995).

On the other hand, claim preclusion, f/k/a res judicata, requires that (1) the parties are identical or in privity; (2) the judgment in the prior action was rendered by a court of competent jurisdiction; (3) the prior action was concluded to a final judgment on the merits; and (4) the same claim or cause of action was involved in both actions. Intelogic, 200 F.3d at 386; citing Nilsen v. City of Moss Point, Miss., 701 F.2d 556, 559 (5th Cir. 1983).

As demonstrated by the Fifth Circuit, not only do the two forms of preclusion differ in their elements, they also differ in the results of their application. For example, the Fifth Circuit recently held that the concept of issue preclusion does not require an exact replication of the claim, only the existence of similar issues such as causation. Southmark, 163 F.3d at 932.

Southmark/Issue Preclusion

In Southmark, the bankruptcy court approved the appointment of Coopers & Lybrand as accountants for the court-appointed examiner. While serving as the examiner's accountants, Coopers allegedly downplayed the viability of claims against Drexel Burnham Lambert, an underwriter for various Southmark offerings. Consequently, the debtor later alleged that, based on Coopers's advice, it did not pursue claims against Drexel and missed the Drexel claims bar date.

The debtor, therefore, moved the bankruptcy court to reconsider and disgorge the previous award of fees to Coopers as the examiner's accountants. After extensive proceedings, the bankruptcy court ordered Coopers to disgorge $585,042.48, which represented a mere fraction of Coopers's previously approved applications for multimillion dollar fees.

The bankruptcy court ordered disgorgement based on the lack of value for the services Coopers provided in relation to Drexel. The bankruptcy court further ordered the disgorgement of an amount equal to triple the amount of the Drexel-related fees based on Coopers's actions. Id. at 934. The bankruptcy court did not order disgorgement of the entire amount, or even an amount equal to the debtor's alleged claim against Drexel, based on its findings that Coopers's malfeasance did not actually cause the debtor to miss the Drexel claims bar date.

Three days later, the debtor commenced an accounting malpractice lawsuit in state court. Coopers removed the lawsuit to federal district court, which referred it to the bankruptcy court. The bankruptcy court granted summary judgment based on issue and claim preclusion that stemmed from the disgorgement hearing.

Upon review, the Fifth Circuit in Southmark focused on the proposition that relitigation of an issue is not precluded unless the facts and the legal standard are the same in both proceedings—i.e., causation. Southmark, 163 F.2d at 932, citing RecoverEdge L.P. v. Pentecost, 44 F.3d at 1291. The Fifth Circuit, therefore, examined the bankruptcy court's unwillingness to find that Coopers's alleged malpractice caused the debtor to not file a claim in Drexel's bankruptcy proceeding. Southmark, 163 F.3d at 933-34.

The Fifth Circuit held that the bankruptcy court's finding of no causation was necessary to the disgorgement hearing because the amount of disgorgement depended in part on the amount of harm. Id. at 933; citing In re Kendavis Indus. Int'l Inc., 91 B.R. 742, 762 (Bankr. N.D. Tex. 1988). Accordingly, the Fifth Circuit found that the causation-of-damages issue was identical and part of the judgment in the earlier action, and that causation was actually litigated. Thus, the Fifth Circuit found that issue preclusion prohibited relitigation in a subsequent malpractice action.

Interestingly enough, the Fifth Circuit found that claim preclusion "did not obviously apply here" because the two actions were not based on "the same nucleus of operative facts." Southmark, 163 F.3d at 934-35; citing In re Baudoin, 981 F.2d 736, 743 (5th Cir. 1993). The application of claim preclusion, however, arose less than a year later in Intelogic.

Intelogic/Claim Preclusion

In Intelogic, the debtor employed Ernst & Young to assist in accounting matters including the development of cash-flow projections. In January 1995, after Ernst & Young filed a fee application in excess of $200,000, the debtor began developing concerns regarding Ernst & Young's professional services.

Despite these concerns, the debtor decided not to object to Ernst & Young's fee application in order to not alert the bankruptcy court as to problems with its reorganization. Instead, the debtor used its concerns and potential objections to negotiate a $37,000 fee reduction. Based on the lack of objections, the bankruptcy court approved Ernst & Young's reduced fee application.

Subsequently, the debtor's reorganization efforts failed, and the debtor filed a second chapter 11 proceeding, which was later converted to a chapter 7 proceeding. The chapter 7 trustee filed a state court malpractice action against Ernst & Young alleging various causes of action. Ernst & Young removed the case to the bankruptcy court and moved for summary judgment claiming that the trustee's claims were barred by claim preclusion, which the bankruptcy court granted and the district court affirmed.

Upon review by the Fifth Circuit, the parties agreed on three of the four claim preclusion elements, leaving only one question: Did the same claim or cause of action exist in both the fee application and the malpractice action? Thus, the critical issue became whether the two actions were based on "the same nucleus of operative facts." Intelogic, 200 F.3d at 386; citing In re Howe, 913 F.2d 1138, 1144 (5th Cir. 1990).

Here, the same nucleus of operative facts, according to the Fifth Circuit, was that the central transaction involved in both proceedings was the provision of accounting services, because an award of fees represents a determination of the nature, extent and value of such services. Intelogic, 200 F.3d at 387. The Fifth Circuit further held that by granting the fee application, the bankruptcy court implied a finding of quality and value in the services provided, whereas the malpractice action arose from alleged omissions in rendering the services previously considered by the bankruptcy court. Id. Thus, the malpractice claims challenged the sufficiency and value of the services provided. Id. at 388; citing In re Southmark Corp., 163 F.3d 925, 931 (5th Cir. 1999).

In Intelogic, however, there was no litigation at the fee-application hearing. In Southmark, on the other hand, the issue of causation was actually litigated at the disgorgement hearing. Though this difference appears troublesome, the Fifth Circuit noted that claim preclusion bars subsequent actions that the debtor "could have or should have asserted in the earlier proceeding." Id. Consequently, since the debtor was sufficiently aware of accounting errors, the debtor could have and/or should have asserted such claims at the fee application hearing. Intelogic, 200 F.3d at 388.

The Fifth Circuit further held that although a fee-application hearing is a contested matter since the debtor could have objected to the fee application and included an affirmative claim for relief on account of the alleged malpractice, the matter would have become an adversary proceeding. Thus, the fee-application hearing provided an effective forum for the debtor to present its claims. Id. at 388-390; citing Jones v. Sheehan, Young & Culp P.C., 82 F.3d 1334, 1341 (5th Cir. 1994); 9 Lawrence P. King, Collier on Bankruptcy §3007.01[5] at 3007-7 (15th Ed. 1983); In re Baudoin, 981 F.2d 736, 744 (5th Cir. 1993); see, also, Micro-Time Management Systems Inc. v. Allard & Fish P.C., 983 F.2d 1067, Nos. 91-2260, 91-2261, 1993 WL 7524 (6th Cir. Jan. 12, 1993).

Conclusion

Although these cases demonstrate how preclusion may apply to fee applications and subsequent malpractice actions, they are limited by their particular facts. For example, in Southmark, had the debtor not actually litigated the issue of causation, issue preclusion may not apply. Further, in Intelogic, if the debtor was unaware of the alleged accounting malpractice, claim preclusion may not apply.

Practitioners must question the practical implications of these cases. For example, must a debtor investigate or otherwise attempt to discover malpractice issues prior to fee application hearings, or is actual knowledge the litmus test? After all, in Southmark, the debtor did not object at the fee-application hearing, but subsequently moved for disgorgement. Further, if a debtor suspects malpractice prior to a fee application hearing, what steps must it take (i.e., the employment of additional accountants and/or attorneys to review and investigate alleged malpractice)?

Based on these issues, perhaps the Fifth Circuit's rulings should be limited to cases with similar fact patterns in order to not require additional duties. Regardless, beware the fee application, as its outcome may impact more than the bill.

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Journal Date:  Friday, September 1, 2000 © American Bankruptcy Institute. All rights reserved. ABI is a (501)(c)(3) non-profit business (52-1295453)