Being a professional for a chapter 11 debtor has never been an easy job. Between the extensive and ever-expanding conflict checks, increasing initial disclosure requirements,¹ extensive fee applications, court supervision and fiduciary duties²—very real problems of getting paid by a financially distressed company—a chapter 11 debtor's counsel has perhaps the most difficult job that any attorney in civil litigation can face. Recently there has been an increasing trend for debtors,³ trustees⁴ or creditor representatives⁵ to bring malpractice suits against debtor's professionals for their actions during a chapter 11 case. This article discusses recent case law addressing: (1) whether such suits are precluded by a bankruptcy court's final approval of professional fees, and (2) whether the state court or the bankruptcy court has jurisdiction over such suits.

It's Not Over 'till It's Over: Issue⁶ and Claim⁷ Preclusion

In two recently decided cases, Matter of Southmark Corp., 163 F.3d 925 (5th Cir. 1999) (Southmark) and Matter of Intelogic Trace Inc., 200 F.3d, 382 (5th Cir. 2000) (Intelogic Trace), the Fifth Circuit addressed the issue of whether the final approval of a professional's final fee application would prevent a malpractice suit against the professional under either the doctrines of claim preclusion (res judicata) or issue preclusion (collateral estoppel).

In Southmark, the debtor filed a malpractice suit against the examiner's accountant for malpractice and breach of fiduciary duty in a Texas state court. The state court suit arose from allegations that the examiner's accountant failed to fully disclose the full extent of its relationship with Drexel Burnham Lambert Inc. and improperly downplayed the viability of the debtor's causes of action against Drexel, which ultimately resulted in the debtor not pursing its claims in Drexel's own chapter 11 proceedings.

Prior to filing the state court suit, the debtor filed a motion to require the accountant to disgorge all of its fees previously awarded in the Southmark bankruptcy proceeding (disgorgement suit). On April 4, 1995, the bankruptcy court ordered the accountant to pay the debtor $585,042.48 for the violation of its fiduciary duty by failing to make proper disclosure. However, the bankruptcy court also ruled that the accountant did not cause the debtor to fail to file a claim in the Drexel bankruptcy. The bankruptcy court refused to order the disgorgement of all of the accountant's fees, and this decision was not appealed.⁸

Shortly after the state court suit was filed, the accountant removed the case to bankruptcy court, which refused to abstain or remand the case to the state court.⁹ The bankruptcy court ultimately granted the accountant's motion for summary judgment on the grounds that the debtor's claims were barred by both issue and claim preclusion. The district court affirmed, and the matter was appealed to the Fifth Circuit.

In its opinion, the Fifth Circuit initially held that the bankruptcy court properly exercised its discretion in refusing to abstain and remand the case to state court.¹⁰ It then addressed the question of whether the debtor's lawsuit was barred by either issue or claim preclusion due to its ruling in the disgorgement suit.

On the matter of issue preclusion, the court found that the state court suit was barred by issue preclusion. The court held that the issues actually litigated and decided in the disgorgement suit were the same as the issue raised by the state court suit. In reaching this decision, the Fifth Circuit noted that the debtor failed to appeal the bankruptcy court's decision in the disgorgement suit and ruled that this failure to appeal prevented it from re-litigating these issues.¹¹

The Southmark court's discussion of claim preclusion was far less clear.¹² After noting that its discussion was dicta designed to address the bankruptcy and district court "reliance on claim preclusion,"¹³ the court stated that due to the Bankruptcy Code's "truncated procedures," the claim preclusion doctrine was more limited than in other federal court proceedings.¹⁴

Shortly thereafter, the Fifth Circuit got the chance to address whether approval of final fee applications would bar subsequent malpractice suits under the doctrine of claim preclusion. In January 2000, the case of Matter of Intelogic Trace Inc., 200 F.3d 382 (5th Cir. 2000), was decided by that court.

In Intelogic, the debtor filed its first chapter 11 case in August 1994 and confirmed its plan in December 1994. On Jan. 8, 1995, the debtor's accounting firm filed its final application for professional fees in the first bankruptcy case. At the time of this filing, the debtor was aware that the accounting firm may have committed malpractice related to its projections of the debtor's cash flow and working-capital requirements. Rather than object to the accounting firm's fee application or bring a malpractice suit at that time, the chapter 11 debtor decided to use its complaints to negotiate a $37,000 reduction in the accounting firm's fees. On Jan. 25, 1995, with the support of the debtor, the accounting firm's final fee application was approved. No appeal of this order was taken.

Unfortunately, the debtor's financial problems continued, and in March 1995, it had to file a second chapter 11 case that was ultimately converted to a chapter 7 proceeding. After the accounting firm filed a claim for its unpaid fees from the first chapter 11 case, the chapter 7 trustee filed a suit against the accounting firm for malpractice and other related claims in Texas state court, which was ultimately removed to the bankruptcy court by the accounting firm.

The accounting firm moved for summary judgment on the grounds that the trustee's suit was barred by the doctrines of claim preclusion, issue preclusion and waiver. The motion was granted by the bankruptcy court on the grounds that the trustee's claims were barred by the doctrine of claim preclusion. The district court affirmed the bankruptcy court's order, In re Intelogic Trace Inc., 226 B.R. 382 (W.D. Tex. 1998),¹⁵ and this decision was appealed to the Fifth Circuit by the trustee.

Unlike its Southmark decision, the Fifth Circuit's decision in Intelogic was based on the doctrine of claim preclusion. The only issues before the Fifth Circuit¹⁶ as to whether the claim preclusion doctrine applied were the same causes of action involved in the litigation related to the accounting firm's final fee applications and the chapter 7 trustee's state court malpractice lawsuit.

Under the Restatement Second of Judgment transactional test adopted by the Fifth Circuit¹⁷ for determining whether the final fee application and the malpractice lawsuit involved the same causes of action, the court had to determine whether the two actions were based on the same nucleus of operative fact. The Intelogic court held that in order for claim preclusion to apply, (1) a plaintiff must have had a sufficient general awareness of the potential for claims against the defendant at the time of the first proceeding, and (2) the procedures of the first proceeding must provide the claimant an opportunity to litigate its claims.¹⁸

Employing this test, the Intelogic court found that the trustee's malpractice suit was barred by the doctrine of claim preclusion. First, the court found that the fee application involved the same operative facts as the legal malpractice suit. The Fifth Circuit held that fee applications involve the nucleus of a finding of the quality and value of the accounting firm's services. These issues are the same issues as those raised in the malpractice suit. This ruling is important, as technically all fee application hearings invoke such determinations.

Second, the court determined that, under the facts of this case, the claimant¹⁹ had actual knowledge of its claims against the defendant. The court based its conclusion on the fact that the chapter 11 debtor used its knowledge of potential claims to obtain a reduction in fees from the accounting firm.

Finally, the court held that a bankruptcy court could hear a legal malpractice claim in connection with a fee-application hearing.²⁰ Therefore, the claimant had the opportunity to litigate its claim in the first proceeding.

The importance of the Southmark and Intelogic decisions is twofold. First, the general holdings of these cases relating to claim and issue preclusion may make it harder for the debtor or a subsequent chapter 7 or 11 trustee to bring malpractice actions against the estate professionals whose fees have been finally approved by the bankruptcy court.

However, the second key element of these decisions is that both decisions are extremely fact-specific. In both of these cases, the debtors, at the time of the final fee application, were aware, at least in a general sense, of the existence of malpractice claims against the professionals. Without this fact being clearly established, it is unlikely that the professionals will be able to rely on either preclusion doctrine to prevent malpractice suits from being filed. In the case of In re R & C Petroleum Inc., 236 B.R. 355 (Bankr. E.D. Tex. 1999), the bankruptcy court refused to grant summary judgment under Southmark to a professional that had had its fees finally approved because a material unresolved issue of fact existed as to whether the claimed malpractice was discoverable at the time the professional fees were finally approved.²¹

Where Am I?

An important related issue to the doctrines of claim and issue preclusion is whether state or federal bankruptcy courts should hear malpractice suits against the bankruptcy estate professionals at all. This issue has recently risen to a high level of importance in light of the greater willingness of state courts to find that legal malpractice claims are not precluded by the doctrines of claim and issue preclusion²² and the threat of a larger damage awards.²³

Initially, it is important to note that bankruptcy courts do not have exclusive jurisdiction over professional malpractice claims arising from bankruptcy cases.²⁴ While the Fifth Circuit noted that "a malpractice claim...involves the nature of the services performed for the debtor's estate and the fees awarded under the superintendence of the bankruptcy court,"²⁵ and refused to remand²⁶ the malpractice case to state court, it did not hold that state courts lacked jurisdiction over such claims.²⁷

However, if a malpractice suit is filed in state court, a defendant has the right to remove the action to federal court.²⁸ If the case is removed to federal court,²⁹ the opposing party may either move to remand the case under 28 U.S.C. §1452 or have the bankruptcy court abstain from hearing the case.³⁰ A determination to either abstain or remand is discretionary with the bankruptcy court and involves similar factors.³¹ However, bankruptcy court rulings on abstention cannot be appealed to courts of appeal or to the Supreme Court,³² and therefore parties seeking to return to state court should always seek to have a case remanded as well as to request the bankruptcy court to abstain from hearing the malpractice suit.

Although the case law is sparse, two cases illustrate the problems bankruptcy professionals face in malpractice suits brought against them in state courts. In Magee v. Charmoy, 26 Conn. L. Rptr. 307 (Conn. Super. 2000), an individual who filed a chapter 11 case, which was converted to a chapter 7 proceeding, was permitted to maintain a malpractice suit against his former chapter 11 counsel³³ even though the bankruptcy court had overruled the plaintiff's objections to its fee applications. The court rejected the bulk of the Intelogic and Southmark decisions, holding that the plaintiff did not have an adequate opportunity to litigate his malpractice claims and the adequacy of the chapter 11 counsel's legal performance was not determined by the hearings on counsel fees.³⁴

Of even greater concern is the Merry-Go-Round malpractice settlement, where the bankruptcy court upheld a contingent fee award to the law firm that represented the bankruptcy trustee as special counsel in a lawsuit against the debtor's former accounting firm for malpractice and fraud arising out of its activities in a failed chapter 11 case.³⁵ The suit settled on the eve of the trial for $185 million, and the law firm received an award of $71.2 million. The case is of interest because of its discussion of the underlying lawsuit. The law firm receiving the contingent fee award did not commit malpractice. Although of little precedential value, this settlement demonstrates the highlighted risk of massive damage awards in cases argued before state court juries.

Conclusion

While both the Intelogic and Southmark decisions give some comfort to bankruptcy practitioners, these decisions are limited in three key respects.

First, the professional's fees in both Southmark and Intelogic had been finally approved before the malpractice suits were filed. Thus, it seems clear that without a final fee award, neither claim nor issue preclusion would apply.

Second, the plaintiffs or their predecessors-in-interest had actual knowledge of potential claims against the professionals at the time the professional fees were finally approved. The Southmark and Intelogic courts noted the importance of this knowledge, and it seems unlikely that the Fifth Circuit would have reached the same decisions had the plaintiffs not known of their claims at the time of the final fee award.

Third, the Southmark and Intelogic cases were heard in federal courts, in actions connected to the underlying bankruptcy case. While this author does not believe that bankruptcy courts are soft on malpractice, it seems apparent from the case law that state courts will give more favorable consideration to malpractice claims against bankruptcy professionals and are less likely to find technical defenses to those claims.

Therefore, although the recent decisions from the Fifth Circuit stand in sharp contrast to the tide of increased malpractice suits against bankruptcy professionals, they do not give any degree of comprehensive protection to malpractice suits. As always, only competence, diligence and good malpractice insurance provide relatively complete security against such actions.

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Footnotes

¹ See, generally, Seider, "Getting Retained and Keeping the Money," A.J. Bankr. L. & Prac. 231 (2000); Cook and Lubben, "Retention, Payment, Ethical and Other Obstacles for Non-Legal Professionals in Chapter 11 Reorganization," 66 PLI/NY 175 (1999). Return to article

²Rapport & Bowles, "Has the DIP's Attorney Become the Ultimate Creditors' Lawyer in Bankruptcy Reorganization Cases?" 5 Am. Bank. Inst. L.R. 47 (1997). Return to article

³ Matter of Southmark Corp., 163 F.3d 925 (5th Cir. 1999); Mager v. Charmoy, 26 Conn. L. Rptr. 407, 2000 WL 175, 763 (Slip op. Conn. Super. 2000). Return to article

⁴ In re Merry-Go-Round Enterprises Inc., 244 B.R. 327 (Bankr. D. Md. 2000); In re Merry-Go-Round Enterprises Inc., 222 B.R. 254 (D. Md. 1998). Return to article

⁵ In re R & C Petroleum Inc., 236 B.R. 355 (Bankr. E.D. Tex. 1999). Return to article

⁶ Issue preclusion, also sometimes referred to as collateral estoppel, applies when the following elements are met: (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 that earlier action. Return to article

⁷ The test for claim preclusion has four elements: (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. Southmark at 934, citing Swate v. Hartwell, 99 F.3d 1282, 1286 (5th Cir. 1996). Return to article

⁸ Id. at 928. Return to article

⁹ The Fifth Circuit noted the oddity of a chapter 11 debtor attempting to keep litigation out of the bankruptcy court, stating: "It is somewhat disingenuous for Southmark to pry these claims out of their bankruptcy setting." Id. at 931. Return to article

¹⁰ See Section B for a more detailed discussion of the issue of jurisdiction over bankruptcy malpractice claims. Return to article

¹¹ Id. at 933, n. 11. Return to article

¹² Matter of Intelogic Trace Inc., 200 F.3d 382, 390 (5th Cir. 2000) (discussing the confusion arising from the Southmark court reserving judgment as to whether claims preclusion could apply to bankruptcy proceedings). Return to article

¹³ 163 F.3d at 934. Return to article

¹⁴ Id. at 935. Return to article

¹⁵ The Intelogic case district court decision was reviewed by John D. Penn in his Last in Line column in the February 1999 issue of the ABI Journal. Penn, John D., "Speak Now, or Forever Hold Your Peace (and Give Them a Release)," 18 ABI Journal 38 (1999). Return to article

¹⁶ 200 F.3d at 386 ("The critical issue under the determination is whether the two actions under consideration are based on the same nucleus of operative facts.") Return to article

¹⁷ Id. Return to article

¹⁸ Id. at 387-388. Return to article

¹⁹ The chapter 7 trustee was charged with the knowledge of the chapter 11 debtor in the proceeding. Id. at 384-386. Return to article

²⁰ Id. at 389-390. Return to article

²¹ The R & C court also considered the issue of whether the suit by the trustee of the Unsecured Creditor's Trust's suit was barred because the alleged malpractice claim was a compulsory counterclaim under Rule 13 of the Federal Rules and Procedure. The R & J court refused to determine the issue in the case, but did rule that Rule 13 would apply under these circumstances. Return to article

²² See Magee v. Charmoy, 2000 WL 175763 at *3. Return to article

²³ See, generally, In re Merry-Go-Round Enterprises Inc., 244 B.R. 327 (Bankr. D. Md. 2000) (discussing a $185 million settlement of a professional malpractice claim for actions taken in connection with a chapter 11 case). Return to article

²⁴ See, generally, Matter of Southmark Corp., 163 F.3d 925 (5th Cir. 1999); In re Merry-Go-Round Enterprises Inc., 222 B.R. 254 (D. Md. 1998); Magee v. Charmoy, 26 Conn. L. Rpt. 407, 2000 WL 175763 (Sup. Conn. 2000). Return to article

²⁵ Matter of Southmark Corp., 163 F.3d at 931. Return to article

²⁶ Id. at 932. Return to article

²⁷ In fact of the cases cited in this article, only in In re R & C Petroleum Inc. was the malpractice lawsuit originally brought in the bankruptcy court. None of these cases ever questioned a state court's jurisdiction to try malpractice cases against estate professionals. Return to article

²⁸ See 28 U.S.C. §1452. Return to article

²⁹ Under 28 U.S.C. §1452, cases are technically removed to the district court and transferred to the bankruptcy court via the district court's standing order of reference. Return to article

³⁰ In re Merry-Go-Round Enterprises Inc., 222 B.R. at 256. Return to article

³¹ Id. Return to article

³² See 28 U.S.C. §1334(d). Return to article

³³ Magee v. Charmoy, 2000 W.L. 17576 at *2. It is interesting to note that the state court never discussed the issue of whether the malpractice claim was property of the bankruptcy estate. Return to article

³⁴ Id. at *3. Return to article

³⁵ In re Merry-Go-Round Enterprises Inc., 244 B.R. 327. Return to article