Hedging Anticipated Contingency Fees is Deemed Impermissible Fee Sharing

By: David Bloom

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

Although a “hedging” arrangement between attorneys retained by a Chapter 7 Trustee and a lender did not appear to offend policy considerations underlying 11 U.S.C. §504, such an agreement could not be approved as a means to obtain downside protection against risks associated with an appeal.  In the case of In re Winstar Communications, Inc.,

[1]

the Trustee’s special litigation counsel and a consultant sought permission to assign part of their anticipated contingency fees to their lender.

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  Under the proposed agreement, the lender agreed to pay an undisclosed fixed price to Trustee’s counsel and consultant.

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  In exchange, the lender would receive the actual amount of contingency fees awarded, up to $10,000,000.00.

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  If the contingency fees were to exceed $10,000,000.00, the counsel and consultant would share the fees in excess of that amount.

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  Moreover, the lender agreed to waive any right to object to the Trustee’s settlement or other disposition of the adversary proceeding.

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  The Court concluded that this arrangement constituted impermissible “sharing” of fees within the meaning of §504, and denied the motion to approve the transaction.

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Fee sharing among attorneys is generally prohibited under the Bankruptcy Code unless the relationship falls within one of the narrow exceptions.

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  Under §504 of the Code, “a person receiving compensation or reimbursement under section 503(b)(2) or 503(b)(4) of this title may not share or agree to share—(1) any such compensation or reimbursement with another person; or (2) any compensation or reimbursement received by another person under such sections.”

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  It is worth noting that essentially all of the cases that address §504 discuss the role of the attorneys in the context of their professional ethics, rather than merely addressing the scope of the statute or other rule, thereby highlighting the importance of these considerations in the bankruptcy context.  Although legislative history is sparse, §504 illustrates a congressional intent to preserve the integrity of the bankruptcy process so that professionals engaged in bankruptcy cases attend to their duty as officers of the bankruptcy court, rather than treat their interest in bankruptcy cases as “matters of traffic.”

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  There are two important policy considerations underlying this section.  First, whenever fees or other compensation are shared, there is incentive to adjust upward the compensation sought in order to offset any diminution to one’s own share, which can inflate the cost of a bankruptcy case to the debtor and therefore to the creditors.

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  Second, fee sharing subjects the professional to outside influences over which the court has no control, which tends to transfer from the court some degree of power over expenditures and allowances.

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What is noteworthy about the In re Winstar decision is the court’s admission that the proposed hedge transaction does not appear to offend the policy considerations underlying §504.

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  Although the court recognized that estate professionals may develop creative methods to attract and support law firms that undertake complex and expensive litigation on behalf of a debtor’s estate or to provide “downside” protection, the court failed to recognize this “novel and unfamiliar financing transaction” (as it was described by Trustee’s counsel), as a valid arrangement.

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  The court found the language of the statute to be unambiguous, and defined the verb “share” as “to divide and distribute in shares: apportion…” and “to grant or give a share.”

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  In the larger context of bankruptcy law and professional ethics, the overall goal of preserving the integrity of the bankruptcy process is evidenced by the court’s plain meaning approach to statutory interpretation.  This decision implies that attorneys seeking fee arrangements protecting against risks associated with litigation will have to overcome the hurdle of the bankruptcy courts’ strict adherence to the language of the Code.  It remains to be seen if there are any strategies available that are creative enough to overcome this hurdle.