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Your Retainer Pocket Aces or a 7-2 Off Suit

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Counsel is a gambler in [bankruptcy] proceedings like every other administrative creditor.
Specker Motor Sales Co. v. Eisen, 393 F.3d 659, 664 (6th Cir. 2004).

With those somewhat chilling words, the Sixth Circuit concluded its opinion in Specker Motors. Although a relatively small case involving the redistribution of $9,026.59 of a $10,000.00 retainer in a former chapter 11 case converted to a chapter 7 proceeding, Specker Motors is an extremely important case as it raises the question as to what, if anything, bankruptcy professionals can do to protect their fees against disgorgement.

Specker Motor's History

In Specker Motors, the debtor filed its chapter 11 petition in March 1997. At the time of the filing, the debtor's counsel was paid a retainer of $10,000. The retainer and the debtor's employment were approved by the court on April 21, 1997. During the course of the case, the court approved fees of $17,343.10 for debtor's counsel, but did not permit the debtor's counsel to apply the retainer to these fees.2

During the course of the chapter 11, the debtor operated its business and incurred unpaid chapter 11 administrative expenses of $194,799.743 in addition to the $17,343.10 unpaid administrative expense claim of the debtor's counsel for fees. In June 1997, the debtor sold its assets. In September 1997, the debtor's case was converted to a chapter 7 proceeding.

After the case was converted and administered by the chapter 7 trustee, only $1,494.67 was left to pay the chapter 11 administrative fees. The chapter 7 trustee proposed in his final report that the debtor's counsel disgorge $9,026.59 of his pre-petition retainer, which would give debtor's counsel its pro rata share of his chapter 11 administrative expenses of $973.41, or a 5.6 percent distribution on his allowed chapter 11 fees, the same distribution as received by other unpaid chapter 11 administrative creditors, rather than the 57.9 percent "distribution" he would realize if no disgorgement occurred. No other creditors were to be required to disgorge any post-petition administrative expense payments.

The bankruptcy court approved the trustee's final accounting and approved the distribution and disgorgement set forth without objection.4 The debtor's counsel filed a timely motion for reconsideration,5 which the bankruptcy court overruled.6 The bankruptcy court did not discuss the impact, if any, the debtor's counsel's holding of a retainer paid to him pre-petition by the debtor had in this matter.

On appeal, the district court, rejecting the debtor's counsel's argument that the bankruptcy court should not have ordered disgorgement by the debtor's counsel under the discretionary disgorgement standard set forth in the Sixth Circuit Bankruptcy Appellate Panel's (BAP's) decision in In re Unicast Inc.7 On appeal, the district court held that disgorgement of the retainer was mandatory under 11 U.S.C. §726(b) in the case of administrative insolvency.8 The district court also ruled that if the retainer was not disgorged, debtor's counsel would get an improper "super priority" claim.9 The only discussion the district court had concerning the fact that the disgorgement came from the debtor's counsel's pre-petition retainer was footnote 3 of its opinion, in which the district court stated:

The court also notes a retainer is the property of the estate until awarded as compensation. In re Downs, 103 F.3d 472, 478 (6th Cir. 1996). Therefore, the money paid to counsel in this action still belongs to the estate and for all intents and purposes cannot be claimed by counsel.10

Debtor's counsel appealed to the Sixth Circuit Court of Appeals, which affirmed the lower courts and overruled Unicast and the debtor's counsel's primary argument that disgorgement of professional fees was discretionary under 11 U.S.C. §726(b) in order to achieve the pro rata distribution required by that section.11 The Sixth Circuit agreed with the district court that permitting discretion on disgorgement of fees was both contrary to the statute and would give professionals a court-created "super-category" administrative priority. The Sixth Circuit also rejected the debtor's counsel's public policy arguments against mandating disgorgement of professional fees in administratively insolvent bankruptcy cases.12 The Sixth Circuit did not address what impact, if any, the award of the retainer had on the issue of disgorgement other than to note under its previous decision of In re Downs, 103 F.3d 472 (6th Cir. 1996), that retainers paid to professionals constitute property of the estate.13

Disgorgement: The Ultimate Four- (well, Twelve-) Letter Word in the World of Bankruptcy Professional Fees

The only issue raised and directly decided by the Sixth Circuit was whether disgorgement of professional fees is required,14 when it is necessary to provide for pro rata distributions under 11 U.S.C. §726(b)15 or whether disgorgement of professional fees is discretionary.16 The Sixth Circuit, relying primarily on the clear
and unambiguous language of 11 U.S.C. §726(b),17 found that the language "shall be made pro rata among claims of the kind specified in each such paragraph" of §726(b) required disgorgement to the extent necessary to allow a pro rata distribution18 to similarly situated creditors. This decision, although it overruled a prior BAP decision from the Sixth Circuit, was fairly straightforward and represents the majority view in this area.

The Issue That Was Not There: Retainers and Professionals' Interests in Them

However, it is not the important but narrow issue of the appropriate interpretation of 11 U.S.C. §726 as it concerns disgorgement of professional fees that should interest professionals, but rather the treatment (or lack thereof) by the Sixth Circuit of the issue of whether a retainer paid either pre or post-petition to a professional is subject to disgorgement in the case of the administrative insolvency. As noted above, the courts that reviewed the Specker Motor case were not presented with this issue and did not address it, although they uniformly ordered the disgorgement of most of the debtor's counsel's pre-petition retainer.

Generally, courts that have reviewed the questions of retainers paid to professionals have generally found that there are four types of retainers permitted by state law: (1) classic retainers, which are paid to secure an attorney's services and earned upon receipt regardless of whether any services are actually performed for the client;19 (2) security retainers, where the retainer is given to the attorney as security for the payment of future services by the attorney;20 (3) advance fee retainers, which are a type of security retainer where some or all of the retainer deemed earned and title to that portion of the retainer passes to the professional on payment of the retainer for services to be performed by the professional;21 and (4) evergreen retainers, which contemplate that the original retainer will remain intact throughout the case either by being constantly replenished throughout the engagement or by current fees being paid by the client.22 In most bankruptcy proceedings, pre-petition retainers are considered to be security retainers where the estate retains an interest in the retainer, but the retainer is security for an attorney's future fees.23

In the majority of decisions where courts have actually considered the potential disgorgement of pre-petition retainers due to the administrative insolvency of the case, courts have held that professionals do not have to return retainers for redistribution due to the professional's security interest in the retainer.24 This position seems to be appropriate under the Code's priority rules, although there are decisions such as Specker Motors, where courts have ordered the turnover of retainers without discussion of the professional's security interest.25

Removing the Specker of Disgorgement: Possible Measures to Take in Light of Specker

While hopefully a remote problem, there are at least two (reasonably) simple steps that professionals can take to protect retainers and other approved payments from disgorgement.

1. 11 U.S.C. §328: It's not just for non-attorneys now! As previously discussed in this column,26 11 U.S.C. §328 can and should be used by professionals in obtaining court approval of the terms and fee structure of employment agreements with a debtor, trustee or committee. In light of Specker Motors, attorneys and other professionals should, as part of their employment application, seek approval of their retainers and of a related security interest in these retainers as part of that employment application. This requested relief should be highlighted in any employment application filed by the professional.

However, before taking this step, proposed professionals for chapter 11 debtors-in-possession (DIPs), trustees or committees should carefully review the controlling law of jurisdiction to ensure the case law permits the approval of such a security interest in the retainer, as a minority of courts have held that such security interests are improper.27 Further, care must be taken not to overreach in developing such a security interest in retainers.28

2. Whitl'n to protection: carveouts. Another manner in which professionals can protect their post-petition fees is through court approval of professional "carveouts" in cash collateral and post-petition financing orders. Simply stated,29 carveouts are agreements by secured creditors to permit a portion of their collateral to be used to pay certain administrative expenses. In negotiating these carveouts, professionals may wish to include appropriate language in both the motions and orders containing carveout agreements, which provide that all carveouts for professional fees made under the carveout agreement are made pursuant to 11 U.S.C. §506(c) solely to pay the professional fees for which the carveouts are granted and that if they are not used for those purposes shall be returned to the creditor granting the carveout. While such strict designations may not be approved by courts,30 if approved, they will resolve the problems raised by In re Ben Franklin Retail Store Inc.,31 which ruled that consensual carveouts are general estate property and not directed payments to the designated administrative creditors.32 Secured creditors should also be in favor of such precise wording of carveouts because, if such language is approved, they will not have to give the carveout funds to the estate to be used to pay general administrative expenses.33

Conclusion

While administratively insolvent bankruptcy estates are fortunately rare, the ruling in Specker Motors to disgorge a pre-petition retainer raises the somewhat disheartening prospect that retainers will become noting more than administrative conveniences, rather than security for at least a portion of a professional's fees. While it is clear that the Specker Motors courts never considered the nature of the retainer in making their decision, it is equally true that the Sixth Circuit did order the disgorgement of a pre-petition retainer, holding that disgorgements of a professional's interim compensation were required to make pro rata distributions under 11 U.S.C. §726(b). Therefore, professionals must take all appropriate steps to protect their fees, or they may become the unlucky gamblers referred to in this column's opening sentence.


Footnotes

1 For those of you who do not follow either the World Series of Poker or the World Poker Tour, two aces is the best opening hand in Texas hold 'em poker and a 7 and 2 of different suits is the worst. See Brunson, Doyle, The Super System: A Course in Power Poker (1979). Return to article

2 In re Specker Motor Sales Co., 289 B.R. 870, 871 (Bankr. W.D. Mich. 2003). Return to article

3 The administrative expenses included unpaid U.S. Trustee fees and unpaid state and federal taxes. Return to article

4 Specker Motor Sales Co., 300 B.R. 687, 690 (W.D. Mich. 2003). Return to article

5 289 B.R. at 871. Strangely, the debtor's chapter 11 counsel did not originally object to the proposed disgorgement and filed its motion for reconsideration in the name of the debtor, not as an administrative creditor. These technical issues did not impact the appeals court's decision in this matter. See Specker Motor Sales v. Eisen, 393 F.3d 659, 662 (6th Cir. 2004). Return to article

6 The bankruptcy court rejected Unicast's holding that "§726(b) requires disgorgement of interim compensation in every case of administrative insolvency in order to achieve the "pro rata" distribution." Return to article

7 219 B.R. 741 (BAP 6th Cir. 1998). Return to article

8 300 B.R. at 390. Return to article

9 Id. at 391. Return to article

10 Id. at 390 n. 3. Return to article

11 393 F.3d at 663. Return to article

12 Id. at 664. Return to article

13 393 F.3d at 662. Although the author was unable to review the briefs filed in the appeals court from a review of the briefs filed in the district court, it is clear that the only issue raised by the parties was whether disgorgement was mandatory or discretionary under §726(b). Return to article

14 In re Kingston Turf Farms Inc., 176 B.R. 308 (Bankr. D. R.I. 1995); In re Groffena, 175 B.R. 386, 392 (Bankr. D. Mont. 1994). Return to article

15 See, generally, Metropolitian Elec. Supply Corp., 185 B.R. 505 (Bankr. E.D. Va. 1995). Return to article

16 In re Unicast Inc., 219 B.R. 741 (BAP 6th Cir. 1998); In re Anolik, 207 B.R. 34 (Bankr. D. Mass. 1997). Return to article

17 Payment on claims of a kind specified in paragraph (1), (2), (3), (4), (5), (6), (7) or (8) of §507(a) of this title, or in paragraph (2), (3), (4) or (5) of subsection (a) of this section, shall be made pro rata among claims of the kind specified in each such particular paragraph, except that in a case that has been converted to this chapter under §1009, 1112, 1208 or 1307 of this title, a claim allowed under §503(b) of this title incurred under this chapter after such conversion has priority over a claim allowed under §503(b) of this title incurred under any other chapter of this title or under this chapter before such conversion and over any expenses of a custodian superseded under §543 of this title. Return to article

18 An interesting question not addressed by either the Sixth Circuit or this article is whether 11 U.S.C. §726(b) requires either the debtor-in-possession (DIP) or trustees to seek the disgorgement of all administrative payments made during a case and not just payments to professionals. See In re Kingston Turf Farms Inc., 176 B.R. 308 (Bankr. 1995). Return to article

19 See In re Pan American Hospital Corp., 312 B.R. 706, 709 (Bankr. S.D. Fla. 2004); In re McDonald Bros. Construction Inc., 114 B.R. 989 (Bankr. N.D. Ill. 1990). Return to article

20 312 B.R. at 709; In re Production Associates Ltd., 264 B.R. 180, 185 (Bankr. N.D. Ill. 2001); In re Printcrafters Inc., 233 B.R. 113, 118 (D. Colo. 1999); In re North Bay Tractor Inc., 191 B.R. 186, 187 (Bankr. N.D. Cal. 1996). Return to article

21 114 B.R. at 1000. Return to article

22 In re Benjamin's-Arnolds Inc., 123 B.R. 839, 842 (Bankr. D. Minn. 1990). See, also, In re Cottrell International LLC EIN, 2000 WL 1180282 (Bankr. D. Colo. July 19, 2000). Return to article

23 In re Printcrafters Inc., 233 B.R. at 118, and cases cited therein. Return to article

24 In re Printcrafters Inc., 233 B.R. at 120; In re Pennebaker Custom Cabinet Corp., 198 B.R. 453 (Bankr. M.D. Pa. 1996); In re North Bay Tractor Inc., 191 B.R. 186 (Bankr. N.D. Cal. 1996). See, also, In re Cottrell International, 2000 WL 1180282 at *4; In re Printing Dimensions Inc., 153 B.R. 715 (Bankr. M.D. Md. 1993). Return to article

25 See In re Rittenhouse, 76 B.R. 610 (Bankr. S.D. Ohio 1987). Return to article

26 Bowles, "Faith, Hope and Clarity," 23 ABI J. 22 (Nov. 2004); Bowles, "Ethical Trilogy: Something Old, Something New, Something Borrowed," 22 ABI J. 18 (June 2003). Return to article

27 See In re Printcrafters, 233 B.R. at 119, discussing that the bankruptcy court refused to find that the debtor's professional had security interest in a retainer because such a security interest would make professional "not disinterested" for purposes of 11 U.S.C. Return to article

28 See In re W&W Protection Agency Inc., 200 B.R. 615 (Bankr. S.D. Ohio 1996) (the bankruptcy court refused to approve an employment application that included a $30,000 super-priority lien on the debtor's real estate as a retainer, treatment of the debtor's counsel compensation as a superpriority administrative claims and a $5,000 evergreen retainer). Return to article

29 For an excellent discussion of carveouts, see Levin, "Almost All You Ever Wanted to Know about Carveout," 76 Am. Bkr. L.J. 445 (2002). Return to article

30 See, generally, In re Channel Master Holdings Inc., 309 B.R. 855, 860 (Bankr. D. Del. 2004) (questioning whether courts should honor separate carveout limits for debtor and committee professionals); In re Scott Cable Communications, 287 B.R. 1 (Bankr. D. Conn. 2002) (carveout may be subject to disgorgement). Return to article

31 210 B.R. 315 (Bankr. N.D. Ill. 1997). Return to article

32 For cases approving designation of carveout funds to certain creditors that cannot be disgorged, see In re Debbie Reynolds Hotel & Casino Inc., 255 F.3d 1061 (9th Cir. 2001); In re Nuclear Imaging Systems Inc., 270 B.R. 365 (Bankr. E.D. Pa. 2001). Return to article

33 See, generally, In re Blackwood Associates L.P., 153 F.3d 61 (2nd Cir. 1998) (secured creditor unsuccessfully sued to disgorge adequate protection payments in order to fund unpaid carveouts). Return to article

Journal Date: 
Sunday, May 1, 2005

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