In several circuits, complete disgorgement is the default sanction for a debtor’s attorney’s failure to disclose fee arrangements and payments.

To impose any lesser sanction requires “sound reasons supported by solid evidence,” the Tenth Circuit held in an August 14 opinion.

Counsel for a chapter 7 debtor received about $350,000 for work in connection with the bankruptcy. Whether the money came from assets that should have been estate property was unclear. The attorney disclosed neither his contingency fee arrangement nor the payment as required by Section 329(a) and Bankruptcy Rule 2016(b).

The payments and the fee arrangement came to light later in disputes between the debtor and the largest creditor. The attorney disclosed the agreement and payments only after being ordered to do so by the bankruptcy judge.

The disclosures came two years after the fee agreement was made and one year after the payment.

The debtor’s largest creditor filed a motion seeking disgorgement of the fee. The bankruptcy judge required disgorgement of only $25,000.

Justifying the small disgorgement, the bankruptcy judge made an analogy to Rule 11 and said that $25,000 was sufficient to discourage similar violations in the future. The judge noted that the lawyer’s services had aided in liquidating a major estate asset. Although there was no evidence in the record about the lawyer’s financial condition, the bankruptcy judge said that disgorging even a substantial portion of the fees would be “financially catastrophic” for the lawyer, who was a single practitioner.

The bankruptcy judge justified her reliance on mitigating factors outside of the record based on common sense and her 30 years in private practice.

The creditor appealed, but the Bankruptcy Appellate Panel affirmed. The creditor appealed a second time and won a reversal and remand in the Tenth Circuit’s opinion by Circuit Judge Harris L. Hartz.

Judge Hartz said that Section 329(a) and Bankruptcy Rule 2016(b) are “a check on debtor attorneys” to ensure prompt disclosure of fee arrangements and payments. Basically, the two together require disclosure within 14 days of the order for relief of all fee arrangements and payments within one year of filing, and disclosure of all payments within 14 days.

Judge Hartz said that the attorney had “egregiously” violated the statute and rules. He cited the Second Circuit for holding that sanctions for violations of Section 329(a) and Bankruptcy Rule 2016(b) should be “harsh” and go “far beyond” the need to compensate for damage. Futuronics Corp. v. Arutt, Nachamie & Benjamin (In re Futuronics Corp.), 655 F.2d 463, 470 (2d Cir. 1981). He cited the Sixth and Ninth Circuits for similarly requiring full disgorgement.

Except for the case at bar, Judge Hartz said that lower courts in the Tenth Circuit had “consistently” required disallowance of all fees.

Judge Hartz said that an analogy to Rule 11 was “inapposite.” Instead, he said that sanctions for nondisclosure are akin to sanctions for breach of fiduciary duty.

Judge Hartz held that full disgorgement “should be the default sanction, and there must be sound reasons for anything else.” He was careful to say, though, that full disgorgement is not always appropriate. He did not attempt to list “all potentially mitigating circumstances. But,” he said, “they must be compelling ones” based on “sound reasons supported by solid evidence.”

Judge Hartz reversed and remanded. “We believe,” he said, that “the bankruptcy judge’s experience and participation in the proceedings could support its determination that [the attorney] had provided exceptional representation to his clients. But a conclusory statement does not suffice.”