Third Circuit Creates the Hidden Administrative Claim in Chapter 11 Cases

Prior to 1994, courts were split on whether or not individual committee members could recover
reasonable and necessary expenses incurred as a result of performing their duties on the committee. For
example, if a committee member traveled for a meeting, not all courts would reimburse that committee
member for those expenses. In 1994, Congress amended the Bankruptcy Code to make it very clear that
"actual, necessary expenses, other than compensation and reimbursement specified in paragraph (4)"
would be entitled to an administrative expense priority in a bankruptcy. <em>See</em> §503(b)(3)(F). The
"paragraph (4)" referred to is another subsection of §503(b), which provides that "reasonable
compensation for professional service rendered by an attorney or an accountant of an entity whose
expense is allowable under paragraph (3) of this subsection" is also entitled to be reimbursed as an
administrative expense.

</p><p><a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=… the Third Circuit. In </a><a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=… re First Merchants Acceptance Corp.,</i> ___ F.3d ___ (3rd Cir. Dec. 14,
1999)</a>, an interesting situation arose. First Merchants Acceptance Corp. (FMAC) filed chapter 11, and
a creditors' committee was formed. One of the creditors serving on that committee, and indeed its chair,
was a company named J. C. Bradford &amp; Co. The committee hired not one but two law firms to assist it.
Presumably it also hired some sort of financial advisor or accounting help.

</p><p>The case resulted in a confirmed plan of reorganization. At the conclusion of the case, the estate
professionals for the debtor and the committee submitted applications for approval of their fees as
administrative expenses. So far, so good. Also submitted was a fee application for a law firm hired by
Bradford to assist it in discharging its fiduciary duties as a member and chair of the creditors' committee.
Bradford's law firm had not been retained by the estate, and if the opinion is any indication, the fee
application caught the debtor (and perhaps even the committee counsel) by surprise.

</p><p>Bradford argued that under §503(b) it was entitled to reimbursement because, as a committee member,
the legal fees of its law firm were an "expense...incurred in the performance of the duties of...the committee" pursuant to
§503(b)(3)(F). As a committee member, it was an "entity whose expense is allowable under paragraph
(3)" of §503(b)(4). As such, combining §503(b)(3)(F) and (b)(4) led to the conclusion that it was
entitled to be reimbursed for its attorneys' fees.

</p><p>Conversely, the debtor and the U.S. Trustee argued that §503(b)(4) was already in the Code when
Congress amended Section §503(b)(3) to include the subsection allowing committee members to be
reimbursed for their expenses. Pointing to the legislative history, they argued that the 1994 amendment
was intended only to allow members reimbursement for their incidental out-of-pocket expenses and was
not intended to include compensation for professional services.<small>^{<a href="#1" name="1a">1</a>}</small> Moreover, as a policy matter, allowing
attorneys or accountants who render services for committee members could create a substantial amount
of administrative expenses against an estate that are, in effect, "hidden."

</p><p>The bankruptcy court agreed with the debtor and the U.S. Trustee, as did the district court, in affirming
the bankruptcy court. The Third Circuit, in a case of first impression, reversed those decisions and
remanded the case. Specifically, the Third Circuit found that when the statute is clear on its face, there is
no need to resort to legislative history (however persuasive or otherwise clarifying it might be). The Third
Circuit opined that Bradford was an "entity" whose expense is allowable under paragraph (3) of §503(b).
As such, §503(b)(4) provided that "reasonable compensation for professional services rendered by an
attorney or an accountant" of Bradford would be allowed as an administrative expense.

</p><p>The Third Circuit decision is fascinating on many levels. First, it flies in the face of the general
concept that professionals rendering services to the bankruptcy estate must be appointed and otherwise
comply with the appropriate disclosure requirements of the Bankruptcy Code and Rules. In <i>FMAC,</i> the
counsel at issue did not file any disclosures or was ever otherwise appointed.

</p><p>Second, it creates "hidden" administrative expenses. Bradford's request to be reimbursed for
professional fees apparently took both the debtor and the committee by surprise. When a debtor is
attempting to do feasibility analyses and otherwise determine its cash needs to have a plan go effective, it
needs to have an idea as to what the professional fees will be. FMAC's committee was an eight-member
committee. Under the Third Circuit analysis, presumably all eight members could have retained their own
lawyers and accountants to advise them in the discharge of their duties and every one of them could have
submitted a fee application.

</p><p>The Third Circuit states that the bankruptcy court can, of course, always determine
reasonableness. That is really not the point. It is not beyond the pale that a creditors' committee and
equity committee could each have their own set of attorneys and accountants, and each member of
those committees have their own attorney and accountant. The cumulative effect of these fees can
be devastating on an estate.

</p><p>Third, the irony of the Third Circuit's decision is also noteworthy. A creditors' committee has
a fiduciary duty to maximize return to creditors. The Third Circuit's decision in <i>FMAC</i> will open
a virtual Pandora's box of potential administrative claims that the parties may not know are even in
existence until the end of the case, thereby reducing recovery to unsecured creditors.

</p><hr>
<h3>Footnotes</h3>

<p>^{<small><a name="1">1</a></small>}The House Report involving the amendment to §503(b)(3) provided in pertinent part as follows:
</p><blockquote>
This section of the bill amends §503(b) of the Bankruptcy Code to specifically permit members of chapter 11 committees
to receive court-approved reimbursement of their actual and necessary out-of-pocket expenses. <i>The new provision would not allow
the payment of compensation for services rendered by or to committee members.</i>
</blockquote>

H.R. Rep. No. 103-385, at 39 (1994), <i>reprinted in</i> 1994 U.S.C.C.A.N. 3340, 3348 (emphasis
added). <a href="#1a">Return to article</a>