In Ruffini v. Norton Law Group PLLC,[1] the bankruptcy court permitted the debtors’ estate to recover pre-petition legal fees under § 548 of the Bankruptcy Code and §§ 271-273 of New York Debtor Creditor Law as fraudulent conveyances. In its decision, the court was careful to state that there is no bright-line test for determining whether pre-petition legal fees are avoidable as constructively fraudulent transfers in bankruptcy. Rather, the case may be instructive where a bankruptcy estate appears to have been depleted pre-petition by professional fees for substandard services, or if pre-petition invoices were grossly excessive in light of the benefit provided to the debtor. In such cases, a professional may be required to disgorge fees exceeding the reasonable value of its services.
Two years prior to the petition date, the Ruffini debtors defaulted on a mortgage loan and retained the defendant law firm. In their retainer agreement, the defendant agreed to charge the debtors a flat fee of $3,300 for specific loss-mitigation and loan-modification services. Debtors fully paid the flat fee, but the record indicates that the defendants charged hourly fees for services within the scope of their retainer agreement. One of the debtors also testified that the law firm demanded additional payments of $1,000 or more every two weeks, threatening to permit foreclosure on their home if they did not pay; the record indicates that the debtors complied with such demands.
The law firm was not able to negotiate a long-term modification of the debtors’ loan, and a foreclosure action was commenced. Soon after, the defendants instructed the debtors to execute a second retainer agreement for legal services in connection with the foreclosure action. The second retainer agreement required a $5,000 retainer (which was deemed a “minimum fee” for the defendants’ services), plus hourly fees. The record indicates that the second retainer agreement was not understood by the debtors, so they continued to make bi-weekly payments to the defendants as they did under the first retainer agreement. The decision details substandard legal services and multiple violations of the New York Rules of Professional Conduct. The total amount of the pre-petition legal fees paid to the defendants was contested, but the complaint sought to recover transfers totaling approximately $46,000, and the defendant’s law firm admits that it received at least $26,000 from the debtors.
After a trial, the court found most of the pre-petition legal fees to be constructively fraudulent, and the defendants were ordered to disgorge all but the original flat fee of $3,300. To make this determination, the court explained that it must “compare what was given with what was received.” For fees charged prior to the commencement of the foreclosure action, the defendants did not perform any services beyond the scope of the first retainer agreement. Therefore, any amounts paid in excess of the flat fee did not constitute “reasonably equivalent value” under § 548(a)(1)(B) of the Bankruptcy Code. For the same reason, the court held that such amounts were constructively fraudulent under New York law because they were paid to the defendants by the debtors without “fair consideration.”[2]
For the fees charged after commencement of the foreclosure action, the court held 100 percent of the legal fees received by the defendants under the second retainer agreement to be constructively fraudulent. Although payments made pursuant to a valid and enforceable contract are generally presumed to have been made for reasonably equivalent value, where a contract is illegal or unenforceable it does not support the inference of reasonably equivalent value. In this case, the court found the second retainer agreement to be unenforceable under New York law because the defendants breached the implied covenant of good faith and fair dealing, and because there was no meeting of the minds when debtors signed the agreement without understanding it. Further, the court stated that even if it had found the second retainer agreement to be enforceable, it still would have found that the debtors did not receive reasonably equivalent value or fair consideration in exchange for the legal fees paid, in light of the numerous deficiencies in the defendants’ legal services set forth in the record.
In sum, the Ruffini court did not set forth a rule or a test for evaluating pre-petition legal fees, nor did it imply that legal fees should be scrutinized more closely than other pre-petition transfers. Furthermore, it seems unlikely that the Ruffini decision will be construed to require legal fees to be disgorged simply because a debtor did not obtain the desired outcome in a pre-petition legal matter. However, professionals who do not adhere to ethical rules regarding billing practices and client communication, or who fail to manage their caseloads diligently and competently, will be vulnerable to fraudulent transfer claims by former clients who file for bankruptcy.
[1] Ruffini and Ruffini v. Norton Law Group, PLLC (In re Ruffini and Ruffini), 2014 WL 714732 (Bankr. E.D.N.Y. Feb. 25, 2014).
[2] See NYDCL §§ 271-273 as made relevant by 11 U.S.C. §544, which allows for the use of state laws for the avoidance of transfers.