Revisiting Retentions for Professional Preferences

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Dec/Jan 2002

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If the Greater Wilmington Convention and Visitors Bureau has it right, Greater
Wilmington, Del., and the Brandywine Valley "offers something for everyone—history,
culture, fine dining, shopping and more." Visitors to visitwilmingtonde.com are
admonished to "Come spend the night! One day isn't enough!" While heartily
recommending a visit to the Mushroom Festival (which is not in Wilmington—or in
Delaware, for that matter), the web site leaves unanswered the question of whether
a visit to the U.S. Bankruptcy Court for the District of Delaware falls within
the category of, say, "culture" or "shopping" (insert your favorite forum-related quip
here).

Whatever Delaware may once have offered the bankruptcy world, a smooth ride through
a chapter 11 mega-case is no longer so commonplace as it once was. (Maybe this
is some of the "history" that the Brandywine Valley now offers.) The Third Circuit's
recent jurisprudence has signaled an intended sea of change in the way large chapter
11 cases proceed in Wilmington, and very little of it looks good to debtors or to
general unsecured creditors. Looking back on the Third Circuit's contributions to
bankruptcy law in the last year and half alone has caused at least one prominent
restructuring lawyer to suggest, not for attribution, that "the bloom is off the rose
in Delaware." For unsecured creditors, this may have already been true for some
time—but the last 14 months or so have been particularly bad.

Last October, the Third Circuit issued its ruling in Official Committee of
Unsecured Creditors v. R.F. Lafferty & Co.,<a href="#1" name="1a">1</a> holding that despite utter
innocence of any wrongdoing, the unsecured creditors' committee was unable to proceed
against the operators of a Ponzi scheme because the estate inherited the debtor's cause
of action subject to the equitable defense of in pari delicto. Because the debtor
could not itself overcome the defense (the debtor's principals were direct wrongdoers),
the estate (now represented by the committee) could not, either. By invoking what
the dissenting judge called a "pointless technicality," the Third Circuit all but
ensured that the unsecured creditors in that case (the Ponzi scheme's victims) would
be unable to obtain any recovery from the Ponzi scheme's perpetrators.<a href="#2" name="2a">2</a>

The very next day, in Centerpoint Properties v. Montgomery Ward Holding Corp,<a href="#3" name="3a">3</a>
the Third Circuit bucked well-established (although not uniform) practice and held
that the estate is liable to a commercial landlord, as part of its administrative rent
obligations under Bankruptcy Code §365(d)(3), for real property taxes charged
post-petition to the debtor-tenant under a "pass-through" lease provision, irrespective
of when the taxes were actually assessed by the taxing authority or charged against
the property. By refusing to follow the majority approach of prorating actual tax
obligations between the pre- and post-petition periods (conferring general unsecured
status to taxes accrued in the pre-petition period), the Third Circuit elevated what
could be hundreds of thousands (or millions) of dollars in taxes to administrative
expense priority, at the direct expense of unsecured creditors.<a href="#4" name="4a">4</a> There is now a
direct split among circuit courts on this point.

A few months later, the Third Circuit ruled in Official Committee of Unsecured
Creditors v. Chinery<a href="#5" name="5a">5</a> that, because the Supreme Court in Hartford Underwriters<a href="#6" name="6a">6</a>
instructed courts to read the Bankruptcy Code literally and strictly, the plain
language of Bankruptcy Code §544 excludes all parties other than the trustee (or
debtor-in-possession (DIP)) from asserting avoidance actions such as the would-be
fraudulent transfer claim in that case. This deprived unsecured creditors—who would have
been the beneficiaries of any recovery in that action—of even the standing needed to
bring a claim that the DIP expressly refused to bring. Another decision, another
split with other circuits, and another bad result for those who stand last in line.

Three days after Chinery, the Third Circuit issued its latest word on attorney
retentions under Bankruptcy Code §327(a) in In re Pillowtex Inc.<a href="#7" name="7a">7</a> Among other
things, Pillowtex stands for the unremarkable propositions that (a) attorneys who are
not "disinterested" cannot be retained as counsel for the debtor, (b) being a
creditor of the estate renders an attorney not disinterested and (c) if an attorney
is adjudicated to have received a preference (without an adequate defense under
Bankruptcy Code §547), the attorney is liable to the estate for return of the
preference, is not disinterested, and is ineligible to be retained as counsel for the
debtor under Bankruptcy Code §327. The critical issue in Pillowtex, however, was
one of timing: When does the bankruptcy court have to adjudicate the issue of a
proposed counsel's receipt of a preference? The Third Circuit used Pillowtex to require
bankruptcy courts to determine a proposed counsel's preference exposure before approving
counsel's retention under §327(a), saying that a bankruptcy court cannot rule that
counsel is "disinterested" unless and until it resolves the issue of whether counsel
received a recoverable preference.

Counsel for Pillowtex, Jones Day, had represented the debtor for some four
years pre-petition. Like all experienced restructuring counsel, Jones Day arranged
for Pillowtex to bring Jones Day current on its pre-petition invoices before
Pillowtex's chapter 11 filing. As the Third Circuit correctly pointed out,
Jones Day could not permit itself to be a creditor on account of pre-petition
services as of the petition date, lest it be disqualified to serve as debtor's
counsel. Pillowtex made a series of payments to Jones Day (one, of some
$778,000, four days before the petition date) to bring Jones Day current
before the filing. In this fashion, Pillowtex did what large soon-to-be debtors
do all the time—make often substantial payments to counsel to avoid the unpleasant
choice of either counsel's waiving what could be a substantial claim for pre-petition
services or the company's having to hire brand-new counsel wholly unfamiliar with
the company and its nascent bankruptcy case.

This practice is pervasive, certainly in large bankruptcy cases, and rarely is the
subject of real discussion, much less a circuit-level decision. Creditors—those with
the most at stake in any bankruptcy case—are usually disinclined to challenge such
pre-bankruptcy payments to debtor's counsel as preferences. The reasons are obvious.
An attempt by creditors to disqualify debtor's counsel could thrust a complex chapter
11 case into chaos almost immediately. Without counsel fully engaged, the debtor
would be unable to obtain critical "first-day" relief, secure use of cash collateral
or gain approval of DIP financing. An operating debtor would be running the real
risk of a complete shutdown at or shortly after filing—and creditors know that is
almost never in their best interests. At bottom, there is an understanding between
creditors and the debtor that capable, informed and motivated debtor's counsel is
critical to ensure at the very least that the chapter 11 case gets off to the right
start. This is why creditors seldom oppose the retention application for debtor's
counsel and why they almost never raise the specter of preference liability for
counsel's receipt of pre-filing fees.

So then what was different in Pillowtex? From the creditors' perspective, nothing.
No creditor opposed Jones Day's retention as debtor's counsel, but The U.S. Trustee
did, claiming that Jones Day was not "disinterested" because it had been the recipient
of preferential payments of fees before the petition date. Jones Day argued that
spending time litigating an alleged preference—particularly at the critical early stages
of Pillowtex's reorganization case—was a waste of time and money.<a href="#8" name="8a">8</a> There is no mention
that any of the creditors in the case disagreed with Jones Day's assessment, yet the
U.S. Trustee persisted. In response, Jones Day proposed that the court approve its
retention and that "if a preference action against the firm is initiated and a final
order is entered determining that Jones Day in fact received a preference, Jones Day
will return to the debtors' estates the full amount of the preferential payment and
waive any related claim."<a href="#9" name="9a">9</a> The district court (sitting as the bankruptcy court)
adopted Jones Day's suggestion and approved the retention, finding that "subject to"
Jones Day's promise to return an adjudicated preference and waive the resulting claim,
Jones Day was disinterested.<a href="#10" name="10a">10</a>

Rather than actually file a complaint to recover a preference, the U.S. Trustee
appealed to the Third Circuit, and the bankruptcy case proceeded unabated. As the
Third Circuit pointed out, "in the interim, no party has brought a preference action
against Jones Day." A reorganization plan was confirmed in May 2002. Despite
"only receiv[ing] pennies on the dollar for their claims," unsecured creditors never
brought a preference action against Jones Day.<a href="#11" name="11a">11</a> While the U.S. Trustee—the only
party in that bankruptcy case without a pecuniary interest in the outcome—pursued an
appeal to the Third Circuit that sought to disqualify Jones Day after 18 months
of extensive work as debtor's counsel that resulted in a confirmed plan, unsecured
creditors (through their official committee or otherwise) declined to commence a
preference action against Jones Day. Suing Jones Day on a preference was obviously
not something that creditors wanted to spend their own money to do—so the U.S.
Trustee decided to spend it for them.

<blockquote><blockquote>
<hr>
<big><center>
[B]ecause Jones Day never attempted to address the
merits of the U.S. Trustee's preference allegations,
it is just a bit easier to understand why the Third
Circuit felt it had to remand the issue back to
the district court for a determination of whether
Jones Day received a preference.
</center></big>
<hr>
</blockquote></blockquote>

Incredibly, the Third Circuit vindicated the U.S. Trustee's efforts by conferring
standing to the U.S. Trustee to assert an avoidance action against Jones Day when
only days earlier it had denied such standing to a creditors' committee in Chinery.
Right after noting that Pillowtex's creditors have never sued Jones Day for a
preference, the Third Circuit cited legislative history for the proposition that the
U.S. Trustee "retains discretion to decide when a matter of concern to the proper
administration of the bankruptcy laws should be raised."<a href="#12" name="12a">12</a> The U.S. Trustee spent
estate assets to pursue an objection to Jones Day's retention and a preference
allegation that no creditor wanted pursued. In doing so, the U.S. Trustee exercised
its "discretion" by telling creditors that even though the U.S. Trustee had no
pecuniary interest in the case, it knew better than creditors what was in those
creditors' best interests.

At bottom, the Third Circuit held that the lower court could not "avoid the clear
mandate of the [Bankruptcy Code] by the mere expedient of approving retention
conditional on a later determination of the preference issue." In this manner, the
district court could not properly find Jones Day to be disinterested "when there has
been a facially plausible claim of a substantial preference" and where Jones Day had
not made an effort to address the claim on the merits before its retention had been
approved.

The Third Circuit intimated that Jones Day may have been better off mounting a
defense to the preference allegation on the merits rather than trying to avoid the
issue altogether by arguing that conducting a hearing on preference liability was
needless.<a href="#13" name="13a">13</a> The court noted that Jones Day did not "make a proffer" of information
such as "how much of the fee Jones Day received within the 90 days before
bankruptcy was for bankruptcy preparation, how much was for legal work done years
earlier and what the ordinary practice was in Jones Day's billings to Pillowtex and
Pillowtex's payments."<a href="#14" name="14a">14</a> In this context, because Jones Day never attempted to
address the merits of the U.S. Trustee's preference allegations, it is just a bit
easier to understand why the Third Circuit felt it had to remand the issue back to
the district court for a determination of whether Jones Day received a
preference.<a href="#15" name="15a">15</a>

In remanding for this purpose, the Third Circuit suggested that "some
accommodation can undoubtedly be made between the need of counsel for payment of
appropriate fees and the explicit provisions of the Code."<a href="#16" name="16a">16</a> While the Third
Circuit's decision declines to answer the obvious next question of "what kind of
accommodation?" consider this: Bankruptcy judges, who know that critical first-day
issues such as cash collateral use and DIP financing can almost never await a full
trial of a preference action, will bring a practical solution to the Third Circuit's
theory of "some accommodation." The court will have proposed that debtor's counsel
submit declarations and supporting briefs to substantiate and support whatever preference
defense counsel has in connection with the pre-bankruptcy payment of fees. Counsel
will likely assert that payments were made in the ordinary course of business under
§547(c)(2) and that counsel received such payments in exchange for an agreement
to provide subsequent new value (representation of a financially distressed client in
the uncertain realm of chapter 11) under §547(c)(4). There may be other
applicable defenses, as well. After the submission of counsel's declarations, the
court will set an evidentiary hearing on the second day of the case (right before
the judge approves first-day orders), take counsel's declarations into evidence (with
counsel remaining available for cross examination at the hearing), and invite the
U.S. Trustee to call its first witness. It will surprise no one that the U.S.
Trustee will be ill-prepared to proceed in this fashion, and the U.S. Trustee will
argue a lack of due process. Under this circumstance, given that the retention of
debtor's counsel is usually regarded as an emergency matter, and given that local rules
in an increasing number of jurisdictions require pre-filing advance notice of first-day
orders (including counsel retentions) to the U.S. Trustee, this type of expedited
hearing should comply with Bankruptcy Code §102(1)(A)'s definition of "notice
and a hearing." Even if the court decided to treat this type of expedited evidentiary
hearing as a preliminary hearing and set a final hearing on regular notice for some
time in the future, the court would still be within its discretion under Pillowtex

to find counsel's asserted defenses valid and enter a finding that counsel is
disinterested for purposes of retention under §327(a). Counsel's fees would be
protected pending the final hearing because those fees would have been earned under a
valid retention order that contained a finding of disinterestedness.

This procedure permits the U.S. Trustee an opportunity to assert preference
allegations at the very beginning of the case before a creditor's committee is
organized. Once the committee is organized, it can determine whether its constituency
is best served by pursuing a preference claim against debtor's counsel, and the U.S.
Trustee should feel comfortable reserving its discretion for another day. What is more,
Chinery and Pillowtex taken together seem to compel the conclusion that creditors who
do want to pursue a preference action—against debtor's counsel or any other creditor—may
have to do so through the U.S. Trustee, since Chinery denies creditors standing to
bring avoidance actions, and Pillowtex confers such standing on the U.S. Trustee.
If the U.S. Trustee really wants to be in the business of bringing preference
actions, the Third Circuit may have granted the U.S. Trustee its Delaware dreams.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d 340 (3d Cir. 2001)</a>. <a href="#1a">Return to article</a>

<a name="2">2</a> See Kroop, Jordan, "A Ponzi Scheme and a 'Pointless Technicality,'" ABI Journal, Vol. XXI, No. 2 at 26. <a href="#2a">Return to article</a>

<a name="3">3</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d 205 (3d Cir. 2001)</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> In Montgomery Ward, although it is difficult to ascertain, the Third Circuit's ruling looks as though it cost unsecured creditors
well in excess of $1 million in administrative expense claims. <a href="#4a">Return to article</a>

<a name="5">5</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d 316 (3d Cir. 2002)</a>. <a href="#5a">Return to article</a>

<a name="6">6</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Underwriters Ins. Co. v. Union Planters Bank N.A., 530 U.S. 1 (2000)</a>. <a href="#6a">Return to article</a>

<a name="7">7</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d 246 (3d Cir. 2002)</a>. <a href="#7a">Return to article</a>

<a name="8">8</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d at 249</a>. <a href="#8a">Return to article</a>

<a name="9">9</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; Presumably, even a firm of Jones Day's size would be unwilling to turn over more than $1 million and waive the resulting
claim, so one can assume that Jones Day remained rather sanguine that either no preference action would be brought or that it would be able
to successfully defend against such an action. <a href="#9a">Return to article</a>

<a name="10">10</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; <a href="#10a">Return to article</a>

<a name="11">11</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; <a href="#11a">Return to article</a>

<a name="12">12</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 250</a>. <a href="#12a">Return to article</a>

<a name="13">13</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 253</a>. <a href="#13a">Return to article</a>

<a name="14">14</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; <a href="#14a">Return to article</a>

<a name="15">15</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 255</a>. Actually, the decision says that "the district court must hold a hearing on whether Pillowtex received a
preference," but it can be assumed that the Third Circuit was referring to Jones Day. <a href="#15a">Return to article</a>

<a name="16">16</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; <a href="#16a">Return to article</a>

Journal Authors

Jordan A. Kroop

Thomas J. Salerno

Journal Date

Sunday, December 1, 2002 - 12:00

Bankruptcy Rule

2002