Turning a Fee Application into a Release

The fee application process can have two effects. First (and more obvious), the professionals get paid from the estate for their work. Second (and much more subtle), claims or causes of action against the professionals might be released if they are not raised and dealt with before the fees are allowed. This recently occurred in a Texas case—much to the chagrin of a trustee who filed malpractice suits against the debtor's accountants and the turnaround consultants.¹

Intelogic Trace's Fast Track Chapter 22

Intelogic Trace had a sort of "fast track" bankruptcy experience. Below is a timeline of major events in the case.

Professionals Are Sued

The malpractice suit unearthed some rather interesting information. A memo from a member of the board of directors to the other directors revealed some startling facts for a company that was preparing to emerge from chapter 11. Complaining about the turnaround consultants, the director argued, "We now know that the budget numbers were flawed in important respects. This led to a serious understatement of working capital requirements...and the unforeseen need for the collateral liquidation proceeds of $1.4 million to fund operations. These are serious ramifications." He also observed that steps were being taken to preserve liquidity and "consequently, there is a good argument that the problem has not had the effect of changing the company's 'fitness' for coming out of bankruptcy."³

In discussing Intelogic's financial reports, he also complained that:

the sudden deterioration of the company's financial position raises questions as to the veracity of (the accountant's) audited numbers at the very time the company is being asked to pay them $218,000 in fees. I understand that the fees may not be related to the audit, but in my mind this arrangement does not seem right and...I wonder if Phil's suggested adjustments (to the fee applications) go far enough.⁴

The revelations in this memo drew a specific comment from the bankruptcy judge, who wrote that "we find particularly irksome the implication that the board may have thought that it could simply 'pull the wool over our eyes,' as it were, in order to proceed with the reorganization, knowing that there was trouble ahead."⁵

Professionals Win First Two Rounds

The professionals defended the lawsuit based on the final fee orders entered in Intelogic's first bankruptcy case. The bankruptcy court granted summary judgment for the professionals, ruling that no trial was required on the merits of the trustee's allegations. The district court, in a short opinion, affirmed that decision.

The trustee, appointed in the second case and well after the fee application hearings, argued that the lawsuit raised new issues that could not have been litigated in the fee applications. As most know, an action for monetary damages requires an adversary proceeding,6 and fee applications are merely contested matters.⁷

Both the bankruptcy and district courts rejected this distinction, noting that claims challenging the value of the services could and should have been raised in connection with the fee applications. While the claims against the professionals must be litigated in an adversary proceeding, they also had to be raised in the fee application process.

[A]llowing negligence and malpractice claims now to be brought against (the professionals) would be completely inconsistent with the bankruptcy judge's prior award of fees, as the bankruptcy judge correctly noted...The allowance of professional compensation by a bankruptcy court effects a finding as to the reasonableness of that compensation and the value of the services rendered to the estate. (citation omitted) Any question as to the quality of the professional services rendered goes directly to the value of those services to the estate and in turn to the reasonableness of that compensation.⁸

Similar Rulings on Other Issues

This is not the only case holding that matters resolved in contested matters also adjudicate key elements in causes of action triable only in adversary proceedings. While there is some debate about whether the doctrine should be called res judicata, claim preclusion or issue preclusion (collateral estoppel), the effect is the same—debtors cannot get a "second bite at the apple." For a claim to be precluded, there must be (a) claims that were or could have been raised in a prior proceeding, (b) a final judgment from a court of competent jurisdiction, (c) the same parties (or their privies) and (d) an involvement of the same cause of action. In re Heritage Hotel Partnership I, 160 B.R. 374, (9th Cir. BAP 1993), aff'd 59 F.3d 175, (9th Cir. 1995).

Orders allowing claims and plan confirmation orders have also effectively precluded later lawsuits by debtors.

In Sure-Snap Corp. v. Sun Street Bank & Trust Co., 948 F.2d 869, 870 (2d Cir. 1991), a debtor's lender liability claim against its bank was rejected because those claims could have been raised in the bankruptcy case. Sure-Snap's plan provided for the payment of the bank's claim, thereby precluding it from asserting claims against the bank in a separate proceeding.

In In re Baudoin, 981 F.2d 736 (5th Cir. 1993), the debtors' lender liability claim against their bank was likewise rejected. In that instance, the bankruptcy court had previously entered an order specifically allowing the bank's claim. The entry of the order establishing and allowing the amount of the bank's claim likewise precluded the debtors from pursuing a cause of action against the bank.

Other circuit courts have issued similar opinions precluding lawsuits in similar situations. D&K Properties Crystal Lake v. Mutual Life Insurance Company of New York, 112 F.3d 257, (7th Cir. 1997); In re Heritage Hotel Partnership I, 160 B.R. 374, (9th Cir. BAP 1993), aff'd 59 F.3d 175, (9th Cir. 1995).

Conclusion

Deciding that a claim against a creditor is precluded by an order allowing its claim, or the confirmation of a plan, is nothing new. Holding that a claim against a professional hired in the course of a bankruptcy proceeding is barred once those fees are allowed may be a first. Knowing that a simple order in an inconspicuous context can have very substantial effects requires vigilance in reviewing the rivers of paper flowing in each chapter 11 case. The certainty is that failing to object can vitiate an estate's claims.

Footnotes

¹ In re Intelogic Trace Inc., 226 B.R. 382, (W.D. Tex. 1998). Return to article

² The trustee alleged that the professionals (a) were negligent, grossly negligent and professionally negligent, (b) failed to provide all reasonable and necessary management consultant services and (c) breached their contract and warranty and failed to comply with the local deceptive trade practices laws. Return to article

³ In re Intelogic Trace Inc., p. 385. Return to article

⁴ In re Intelogic Trace Inc., p. 385. Return to article

⁵ In re Intelogic Trace Inc., p. 385. Return to article

⁶ Bankruptcy Rule of Procedure 7001. Return to article

⁷ Bankruptcy Rule of Procedure 9014. Return to article

⁸ In re Intelogic Trace Inc., p. 384. Return to article