Third Circuit Creates the Hidden Administrative Claim in Chapter 11 Cases

Third Circuit Creates the Hidden Administrative Claim in Chapter 11 Cases

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Prior to 1994, courts were split on whether or not individual committee members could recover reasonable and necessary expenses incurred as a result of performing their duties on the committee. For example, if a committee member traveled for a meeting, not all courts would reimburse that committee member for those expenses. In 1994, Congress amended the Bankruptcy Code to make it very clear that "actual, necessary expenses, other than compensation and reimbursement specified in paragraph (4)" would be entitled to an administrative expense priority in a bankruptcy. See §503(b)(3)(F). The "paragraph (4)" referred to is another subsection of §503(b), which provides that "reasonable compensation for professional service rendered by an attorney or an accountant of an entity whose expense is allowable under paragraph (3) of this subsection" is also entitled to be reimbursed as an administrative expense.

Enter the Third Circuit. In In re First Merchants Acceptance Corp., ___ F.3d ___ (3rd Cir. Dec. 14, 1999), an interesting situation arose. First Merchants Acceptance Corp. (FMAC) filed chapter 11, and a creditors' committee was formed. One of the creditors serving on that committee, and indeed its chair, was a company named J. C. Bradford & Co. The committee hired not one but two law firms to assist it. Presumably it also hired some sort of financial advisor or accounting help.

The case resulted in a confirmed plan of reorganization. At the conclusion of the case, the estate professionals for the debtor and the committee submitted applications for approval of their fees as administrative expenses. So far, so good. Also submitted was a fee application for a law firm hired by Bradford to assist it in discharging its fiduciary duties as a member and chair of the creditors' committee. Bradford's law firm had not been retained by the estate, and if the opinion is any indication, the fee application caught the debtor (and perhaps even the committee counsel) by surprise.

Bradford argued that under §503(b) it was entitled to reimbursement because, as a committee member, the legal fees of its law firm were an "expense...incurred in the performance of the duties of...the committee" pursuant to §503(b)(3)(F). As a committee member, it was an "entity whose expense is allowable under paragraph (3)" of §503(b)(4). As such, combining §503(b)(3)(F) and (b)(4) led to the conclusion that it was entitled to be reimbursed for its attorneys' fees.

Conversely, the debtor and the U.S. Trustee argued that §503(b)(4) was already in the Code when Congress amended Section §503(b)(3) to include the subsection allowing committee members to be reimbursed for their expenses. Pointing to the legislative history, they argued that the 1994 amendment was intended only to allow members reimbursement for their incidental out-of-pocket expenses and was not intended to include compensation for professional services.1 Moreover, as a policy matter, allowing attorneys or accountants who render services for committee members could create a substantial amount of administrative expenses against an estate that are, in effect, "hidden."

The bankruptcy court agreed with the debtor and the U.S. Trustee, as did the district court, in affirming the bankruptcy court. The Third Circuit, in a case of first impression, reversed those decisions and remanded the case. Specifically, the Third Circuit found that when the statute is clear on its face, there is no need to resort to legislative history (however persuasive or otherwise clarifying it might be). The Third Circuit opined that Bradford was an "entity" whose expense is allowable under paragraph (3) of §503(b). As such, §503(b)(4) provided that "reasonable compensation for professional services rendered by an attorney or an accountant" of Bradford would be allowed as an administrative expense.

The Third Circuit decision is fascinating on many levels. First, it flies in the face of the general concept that professionals rendering services to the bankruptcy estate must be appointed and otherwise comply with the appropriate disclosure requirements of the Bankruptcy Code and Rules. In FMAC, the counsel at issue did not file any disclosures or was ever otherwise appointed.

Second, it creates "hidden" administrative expenses. Bradford's request to be reimbursed for professional fees apparently took both the debtor and the committee by surprise. When a debtor is attempting to do feasibility analyses and otherwise determine its cash needs to have a plan go effective, it needs to have an idea as to what the professional fees will be. FMAC's committee was an eight-member committee. Under the Third Circuit analysis, presumably all eight members could have retained their own lawyers and accountants to advise them in the discharge of their duties and every one of them could have submitted a fee application.

The Third Circuit states that the bankruptcy court can, of course, always determine reasonableness. That is really not the point. It is not beyond the pale that a creditors' committee and equity committee could each have their own set of attorneys and accountants, and each member of those committees have their own attorney and accountant. The cumulative effect of these fees can be devastating on an estate.

Third, the irony of the Third Circuit's decision is also noteworthy. A creditors' committee has a fiduciary duty to maximize return to creditors. The Third Circuit's decision in FMAC will open a virtual Pandora's box of potential administrative claims that the parties may not know are even in existence until the end of the case, thereby reducing recovery to unsecured creditors.


1The House Report involving the amendment to §503(b)(3) provided in pertinent part as follows:

This section of the bill amends §503(b) of the Bankruptcy Code to specifically permit members of chapter 11 committees to receive court-approved reimbursement of their actual and necessary out-of-pocket expenses. The new provision would not allow the payment of compensation for services rendered by or to committee members.
H.R. Rep. No. 103-385, at 39 (1994), reprinted in 1994 U.S.C.C.A.N. 3340, 3348 (emphasis added). Return to article
Journal Date: 
Wednesday, March 1, 2000