A critical issue for all attorneys who represent debtors in bankruptcy is how to ensure payment for services performed both prior to and after a bankruptcy filing. One way that attorneys seek to secure payment for post-petition services is by obtaining an “advance fee retainer” that is earned in full upon receipt and thus arguably never becomes property of the debtor’s estate and can be used to fund post-petition services.
However, in Ulrich v. Schian Walker, P.C. (In re Boates),[1] the Ninth Circuit Bankruptcy Appellate Panel (BAP) held that a flat-fee, advance-payment retainer, fully paid pre-petition, was an executory contract that could be rejected by a chapter 7 trustee. In addition, the court found that upon rejection, the trustee could exercise the debtor’s pre-petition right to terminate the contract and obtain a refund of any portion of the retainer that is unused at the time of termination.
Facts
The debtor was a defendant in state court litigation commenced by a bank against the debtor. In the suit, the bank asserted claims against the debtor for negligence, misrepresentation and fraud. After communicating his intent to file for bankruptcy, the bank told the debtor that it would file a nondischargeability adversary proceeding in his bankruptcy case. In response, the debtor retained the services of a law firm to defend him in the anticipated nondischargeability action.
The debtor and law firm entered into an advance payment retainer (retainer agreement) that provided the following:
The Flat Fee ($60,000) will cover the value of all work we will perform through the conclusion of the Adversary Proceeding. The Flat Fee will be paid by you directly to us, and will be deposited in our business account. The Flat Fee is not an advance against any hourly rate, and the Flat Fee will not be billed against an hourly rate. You agree that the Flat Fee becomes the property of our firm upon receipt, and will be deposited into our business account.
Days before he filed for bankruptcy, the debtor signed the retainer agreement and paid the $60,000 retainer to the law firm. Thereafter, the debtor filed.
Post-petition, the chapter 7 trustee sued the law firm seeking the return of the $60,000 retainer. In the complaint, the trustee asserted that the retainer should be returned because the retainer agreement had been rejected by operation of law under § 365(d)(1) of the Code. The trustee also alleged that he had demanded the return of the retainer from the law firm prior to any litigation in the nondischargeability action. The trustee premised his argument on a previous BAP decision that stated that a “trustee can liquidate the debtor’s [prepaid] right to legal services by rejecting the contract with the attorney and demanding a refund of the unearned fees.”[2]
Notwithstanding the BAP’s previous decision, the bankruptcy court granted the law firm’s motion for summary judgment based on a finding that, among other things, the retainer agreement was not an executory contract because the debtor’s pre-petition payment of the flat-fee retainer constituted substantial performance of the debtor’s obligations. The trustee appealed.
The Decision
The BAP determined that a threshold issue was whether the retainer agreement was an executory contract subject to rejection under § 365 of the Code. In evaluating the retainer agreement, the court rejected the trustee’s argument that the debtor’s agreement to cooperate in his own defense created an executory contract. If anything, “the [debtor’s] cooperation was a mere condition to [the law firm’s] performance,” the breach of which would not result in breach of the contract.[3] Nonetheless, the court held that the retainer agreement was executory based on the debtor’s continuing obligation to pay out-of-pocket costs incurred by the law firm in the process of defending the debtor. As the court stated, the debtor’s “obligation to pay [the law firm’s] costs was a material contractual duty that could result in breach and could excuse the [law firm] from further performance.”[4]
The court went on to explain that the rejection of the retainer agreement did not terminate, rescind or relinquish any rights of the debtor in the contract as of the petition date. “[T]he real issue the bankruptcy court [] needed to resolve was the nature and extent of the [debtor’s] contract rights on the date of the bankruptcy filing if [the debtor] were considered to have breached the contract on that date.”[5] As a matter of Arizona law (the applicable law), the debtor’s “Retainer Agreement rights on the date of bankruptcy filing necessarily included a right to terminate [the law firm] and a right to a refund of the fees previously prepaid based on the value of services provided before termination.”[6] The court remanded the case back to the bankruptcy court with instructions to determine when the trustee exercised his right to terminate the law firm,[7] as the summary judgment record presented no evidence on this issue.
Takeaway
With its holding, the Ninth Circuit BAP makes advance payment retainers a risky option for counsel attempting to secure funding for post-petition services to debtors. In light of this, attorneys should consider the three forms of retainers — classic, advance payment and security — and the relative rights afforded to an attorney under applicable state law. If an advance fee retainer is used, counsel should be careful to ensure that the agreement does not include any term that could cause the agreement to be executory, including any provision regarding the debtor/client’s payment of out-of-pocket costs and expenses. Attorneys should also review a client’s rights under applicable state law to obtain the return of an advance-payment retainer to assess potential liability if the retainer agreement is later determined to be executory.
From a trustee’s perspective, the Boates decision serves as a cautionary tale that rejection of an executory advance-payment retainer agreement, in and of itself, may not be enough to enable the trustee to obtain a return of the retainer. An explicit termination letter may also be required to trigger a right to the return of any unused advance-payment retainer.
[1] --- B.R. ----, 2016 WL 3213665 (B.A.P. 9th Cir. June 9, 2016).
[2] Gordon v. Hines (In re Hines), 147 F.3d 1185, 1189 (B.A.P. 9th Cir. 1998).
[3] Boates, 2016 WL 3213665 at *5.
[4] Id.
[5] Id. at *6.
[6] Id. at *7.
[7] Also notable is the court’s rejection of the trustee’s argument that he never retained the law firm under §§ 327 and 330 of the Code and therefore the firm had no right to any of the retainer. The court explained that the advance-payment retainer never became property of the estate because under the terms of the retainer agreement, the entire retainer was earned pre-petition upon receipt. Rather, the question is when the trustee gave notice of termination to the law firm, which triggered the right to a refund of the unused portion of the retainer.