Retainer Protects Chapter 11 Attorneys Fees From Disgorgement under Section 726(b)

By: Jonathan Abramovitz

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

Recently, in In re Two Gales, Inc.,[1] the United States Bankruptcy Appellate Panel for the Sixth Circuit (the “Panel”) held that 11 U.S.C. § 726(b) is not intended to serve as a basis for denying a claim for attorney’s fees, but rather serves as a priority scheme for dealing with distributions on allowed claims.[2] The law firm of Cupps & Garrison, LLC (“C & G”) represented Two Gales, Inc. (the “Debtor”) as its bankruptcy counsel before the case was converted from chapter 11 to chapter 7.[3] The bankruptcy court ordered C & G to disgorge its $10,000 retainer because the Debtor was administratively insolvent and, under section 726(b), chapter 7 administrative expenses are entitled to priority in proceedings converted from chapter 11 to chapter 7 where the debtor is administratively insolvent.[4] The Panel reversed, holding that before ordering disgorgement of C & G’s retainer, the lower court should have determined whether C & G had a properly perfected lien on its prepetition retainer under state law.[5]

Section 726(b) requires that claims within a particular class be paid pro rata, with the exception that administrative expenses in chapter 7 are to be paid ahead of chapter 11 administrative expenses if the case has been converted from chapter 11 to chapter 7.[6] The trustee in the instant matter claimed that Specker Motor Sales Co. v. Eisen[7]and section 726(b) require that chapter 7 administrative expenses receive priority over any amounts due to C & G for representing the debtor during its chapter 11 proceedings.[8] The Panel disagreed and distinguished Specker because that case did not address the effect of a properly perfected lien under state law, which C & G claimed to have in this case.[9] The Panel determined that the holder of a properly perfected state law lien is not subject to the distribution scheme prescribed by section 726(b).[10]  As such, the case was remanded to allow the bankruptcy court to determine whether C & G had a valid lien in the security retainer under state law.[11]

When Specker was decided in 2004, it raised concerns among bankruptcy professionals as to how they could protect their fees against disgorgement in cases where the estate subsequently became administratively insolvent.[12] To protect their fees, attorneys were encouraged to seek court approval of their retainers and of a related security interest in these retainers as part of their employment agreements with debtors.[13] Attorneys also attempted to protect their fees through court approved carveouts, which are agreements by secured creditors to permit a portion of their collateral to be used to pay certain administrative expenses.[14] To the relief of many bankruptcy professionals, recent decisions in the Sixth Circuit have interpreted Specker narrowly, and have held that because Specker does not address cases where an attorney has a valid lien in the security retainer under state law, such a lien prevents section 726 from mandating disgorgement of the retainer.[15] The decision in Two Gales goes a step further in protecting the fees earned by bankruptcy professionals in cases where there is a retainer. The court here raised, sua sponte, a ripeness issue, and held that before applying section 726, a bankruptcy court must determine whether the necessary steps were taken to perfect a lien in the retainer under state law, even if no party has raised the issue.[16] Bankruptcy professionals can rest easier knowing that before distributing retainer fees to other debtors, the court will examine whether a valid lien in the security retainer under state law will allow them to keep their fees despite the priority scheme of section 726(b).