The Ninth Circuit Bankruptcy Appellate Panel handed down an opinion possibly meaning that debtors in Arizona, and perhaps elsewhere, cannot pay for post-petition legal services before they file chapter 7 petitions. If the decision is taken to its logical conclusion, consumer debtors in the Ninth Circuit cannot rely on having lawyers to defend objections to discharge or dischargeability and to provide other services after filing.
The B.A.P. could be faulted for misinterpreting a 1998 Ninth Circuit opinion called In re Hines.
Rather than drawing a roadmap for trustees to recover retainers, the appeals court in Hines went out on a limb by creating a judge-made exception to the automatic stay, thereby enabling some chapter 7 debtors to prepay post-petition legal services. The result in the B.A.P. was the opposite of what the Ninth Circuit aimed to accomplish in Hines.
The Facts
When a man filed his chapter 7 petition, a bank was suing him in state court, seeking $3.6 million in damages for fraud. The bank had told him it would challenge the dischargeability of the debt were he to file bankruptcy.
Before filing, the man paid a law firm a $60,000 flat fee to cover all services in connection with dischargeability litigation. The retainer agreement provided that the $60,000 would immediately become the law firm’s property and would go into the firm’s general business account, not an escrow account.
The bank made good on its threat and filed a dischargeability complaint four days after the chapter 7 filing. Six months later, the chapter 7 trustee sued the law firm, contending that the retainer agreement was an executory contract that was automatically rejected under Section 365(d)(1). The trustee demanded that the law firm turn over the $60,000 retainer.
Protecting the debtor’s ability to mount a defense to the bank, the bankruptcy judge dismissed the trustee’s complaint after ruling that the retainer agreement was not an executory contract. The trustee appealed to the B.A.P. and won in an opinion on June 9 by Bankruptcy Judge Frank L. Kurtz, relying in large part on Hines.
The Appellate Panel’s Opinion
The appellate panel focused on language in Hines that said, in the context of prepaid fees, that “the trustee can liquidate the debtor’s right to legal services by rejecting the contract with the attorney and demanding a refund of the unearned fees.”
Applying the so-called Countryman test, the B.A.P. said that the law firm was required to defend while the debtor remained obligated to pay the law firm’s out-of-pocket expenses. Consequently, the B.A.P. held that the agreement remained executory because both sides still had substantial unperformed obligations.
To decide how much in fees the firm was obliged to return, the B.A.P. said the record was inadequate because the bankruptcy judge had not decided when the trustee gave notice of termination to the law firm.
The appellate panel remanded the case to determine when the trustee gave notice of termination so the bankruptcy judge could decide whether the trustee “was entitled to any fee refund based on the value of services provided before termination.”
Scholarly Commentary
“This decision puts the debtor in a very tough position,” Prof. Nancy Rapoport told ABI. According to a message that Prof. Bruce A. Markell sent to ABI, “it seems that Arizona debtors won’t be able to pay prepetition for any possible nondischargeability litigation. That raises real problems.”
In light of the B.A.P. opinion, Prof. Rapoport asked, “What, then, is the best way for the debtor to pay for a defense in an adversary proceeding?”
The answers to the problems identified by the two professors are not immediately apparent, unless the appellate panel misinterpreted Hines, or unless there is no answer absent an amendment to the Bankruptcy Code.
Prof. Rapoport is a professor at the Univ. of Nevada at Las Vegas William S. Boyd School of Law, where she is an expert on legal ethics. Prof. Markell is the Professor of Bankruptcy Law and Practice at Northwestern Univ. Pritzker School of Law. He was a member of the Ninth Circuit B.A.P. before he returned to teaching.
What the Opinion Means
The debtor in the B.A.P. appeal might come out relatively unscathed if the law firm had already performed most of the services in the dischargeability litigation. Other chapter 7 debtors might not be so lucky, especially if trustees begin automatically sending termination notices to consumers’ attorneys immediately after the petitions are filed.
Assuming the B.A.P. correctly interpreted Hines, the trustee could have recovered almost all of the $60,000 had the trustee given notice of termination immediately after the trustee was appointed. The $60,000 would have gone into the estate, leaving the debtor required to pay defense costs out of post-filing income. Although the debtor ultimately might win back some of the $60,000 by claiming exemptions, the allowed exemptions would likely represent only a fraction of defense costs, and the debtor probably would not receive a distribution on account of his exemptions in time to pay legal fees.
The B.A.P.’s opinion discriminates against chapter 7 debtors because individual debtors in chapters 13 and 11 can pay their attorneys from their plans or through interim allowances by using property of the estate that otherwise would go to creditors.
Who Is to Blame?
Blame for the predicament of chapter 7 debtors could be laid at the doorstep of the Countryman definition of executory contracts and its focus on remaining duties. Perhaps the Countryman definition does not work when one side’s remaining duties are miniscule compared to the other’s unperformed obligations.
The Ninth Circuit is hardly to blame for chapter 7 debtors’ dilemma. In the first paragraph of Hines, the appeals court identified the very same problem in personal bankruptcies when the court said that the status of “postpetition services does not fit comfortably within the provisions of the Bankruptcy Code.” The court went on to say that “Congress has been delinquent in failing to deal expressly with the always-present problem of arranging in advance for payment of services to be rendered after the filing in bankruptcy.”
To secure payment of fees before filing, the circuit court said that chapter 7 debtors’ counsel use two constructs, but both “are potentially subject to disruption by the operation of the Code.”
In Hines, the Ninth Circuit recognized that chapter 7 debtors must have a legally enforceable mechanism to prepay for legal services, otherwise, the court said, there could be a “massive breakdown” in the “entire system.”
The Ninth Circuit therefore came up with a judge-made exception to the automatic stay to solve the problem in Hines. That solution, however, does not suit the needs for this year’s case in the B.A.P.
Taking a cue from Hines, the B.A.P. should have felt at liberty under Hines to adopt a construct allowing prepayment for post-petition services.
As the concurring judge said in Hines, Congress, rather than the courts, should level the playing field. Otherwise, the right to file bankruptcy can become illusory.
Taken to its logical conclusion, the B.A.P. opinion is heading in the direction of allowing chapter 7 debtors only to pay counsel in advance for services to be performed before filing. The right to discharge debts will mean little if chapter 7 debtors cannot afford lawyers. Likewise, chapter 7 trustees could compel repayment of fees intended for ordinary post-petition services such as attending creditors’ meetings and filing amended schedules and statements.
Hines in any event is not the solution nationwide. In 2003, the Seventh Circuit rejected Hines in Bethea v. Robert J. Adams & Associates.
Until Congress solves the problem by allowing chapter 7 debtors to pay their lawyers in advance, courts might protect individual bankrupts by ruling that prepaid retainers are fully earned and thus nonrefundable given the lawyers’ promise to provide fixed-fee services. Judges could still police the lawyers by ensuring they gave value for the fees they received. Finding a solution could be more problematic when lawyers charge by the hour with a promise to refund unused retainers.
State legal ethics rules are also a problem because they are designed to protect clients from unscrupulous lawyers who charge up front and provide little later. States could fashion laws specifically for bankruptcy to ensure that individuals will have legal representation, but that would not solve the problem nationwide.