Can This Possibly Be Ethical or Permissible?

On May 18, 2016, the U.S. Bankruptcy Court for the Northern District of Texas issued a 51-page opinion resolving its Order Setting Show Cause Hearing (the “show cause order”) in the chapter 13 case of Netoche Brigham Fair (the debtor, or “Ms. Fair”).[1] In this remarkable opinion, the bankruptcy court rendered a decision about the propriety (or lack thereof) of debtor’s counsel’s practice of (1) using clients’ debit card accounts for the purpose of making chapter 13 plan payments and (2) payment of counsel’s fees by a local car dealer, New Start Auto, with whom counsel had established a referral arrangement. The opinion is directed toward both Ms. Fair’s counsel, as well as the law firm that her counsel shared with another practitioner. Ms. Fair’s counsel and the law firm are referenced in this article as “debtor’s counsel” or “counsel.”

Counsel’s practices were “ethically flawed.”[2] The bankruptcy court ordered disgorgement of $77,175 in fees collected by counsel over the course of at least 106 bankruptcy cases, and invited the U.S. Trustee’s office to file a fee application for reimbursement of reasonable and necessary fees and expenses incurred in the matter, with any remaining disgorged fees to be paid to the Texas Access to Justice Foundation. The court also ordered counsel to file Bankruptcy Rule 2016 statements in the 106 bankruptcy cases in which counsel received compensation from New Start Auto. To the extent that any of the cases were closed, the bankruptcy court ordered counsel to pay the requisite fee to reopen them in order to file the appropriate disclosures.

Counsel’s Use of Its Client’s Debit Cards to Pay Plan Payments Is Improper and Unwise

The bankruptcy court found counsel’s practice of using its clients’ debit cards to make plan payments to be “ethically flawed.”[3] With a client’s permission, counsel would make a withdrawal using the client’s debit card each month and use the money to make chapter 13 plan payments. The money withdrawn from each client’s bank account was placed into a general business banking account, and co-mingled with money from other clients. The business banking account was not labeled as a trust or IOLTA account. A paralegal at the counsel’s office would go to the bank and obtain cashier’s checks from the account and make chapter 13 plan payments on behalf of each client.

The bankruptcy court noted that the practice was likely designed to ensure that each client’s chapter 13 plan was funded enough to pay counsel’s fees. The bankruptcy court determined that the practice violated counsel’s ethical duties, including, but not limited to, safekeeping property and maintaining client property in a trust account or IOLTA account. The bankruptcy court further held that such practice “should not be used by any counsel henceforth in cases before this court.”[4] However, the bankruptcy court did not find that any funds were mishandled, and counsel advised the court that it had discontinued the practice. Therefore, the bankruptcy court made no further rulings regarding the practice, but noted that its decision was without prejudice to any actions that the Texas State Bar may take against counsel.

Fresh Start Auto May Not Pay Counsel’s Fees Associated with Debtor’s Fresh Start — at Least, Not Without Disclosure

In the course of the debtor’s bankruptcy case, it came to the attention of the bankruptcy court that counsel had advised the debtor to take the following steps in her chapter 13 case. Step 1: Turn in the debtor’s old car. Step 2: Counsel would seek a conversion of the debtor’s chapter 13 case to a chapter 7 case. Step 3: After conversion was complete, the debtor could obtain a new (or newer) car from Fresh Start Auto. Step 4: Fresh Start Auto would pay the debtor’s legal fees in connection with the transaction. Under this plan, the debtor could obtain a new car and discharge unpaid debt owed on the old car, and New Start Auto would pay the legal fees in the bankruptcy case to facilitate the new car purchase.

Upon investigation, the bankruptcy court learned that debtor’s counsel had established a practice of advising chapter 13 clients to obtain a new car from Fresh Start Auto during their bankruptcy cases. Under other circumstances, counsel had also advised clients to surrender their vehicles prior to a chapter 7 filing and to obtain a vehicle from New Start Auto after a chapter 7 petition had been filed. Finally, counsel had also advised clients who stayed in chapter 13 and wanted or needed a new car to purchase a car from New Start Auto. New Start Auto paid counsel $400 for chapter 13 motions to incur debt, and $525 for fees associated with conversion from a chapter 13 to chapter 7. In a simple chapter 7 filing scenario, New Start Auto paid counsel between $700 to $1,000 per case.

Counsel and New Start Auto had no written agreement, only an oral understanding. Nevertheless, the understanding between the parties must have been quite strong. In the course of an 18-month period examined by the bankruptcy court, counsel received more than $77,000 in fees from New Start Auto.

The bankruptcy court examined the New Start Auto payments and determined whether they were permissible under §§ 504, 329(a) and 526(a)(4) of the Bankruptcy Code. In addition, the bankruptcy court examined whether counsel complied with Bankruptcy Rule 2016.

Fee-Sharing Under § 504 of the Bankruptcy Code

Generally, § 504 of the Bankruptcy Code prohibits fee-sharing in bankruptcy cases. It provides:

(a)    Except as provided in subsection (b) of this section, a person receiving compensation or reimbursement under section 503(b)(2) or 503(b)(4) of this title may not share or agree to share –

(1)   Any such compensation or reimbursement with another person; or

(2)  Any compensation or reimbursement received by another person under such sections.[5]

Thus, under the statute, fee-sharing is prohibited when three requirements are met. First, a “person” within the meaning of the Bankruptcy Code must receive compensation or reimbursement. Second, the compensation or reimbursement must be received by the person pursuant to § 503(b)(2) or 503(b)(4) of the Bankruptcy Code. Third, the person who received compensation or reimbursement must not share it with another person.

The court found that the first element of the test was clearly met because counsel is a “person” within the meaning of the Bankruptcy Code.

As to the second requirement, the bankruptcy court determined that in chapter 13 cases, § 503(b)(2), referenced in § 504(a), affords administrative expense status to compensation awarded under § 330(a). Specifically, § 330(a)(4)(B) of the Bankruptcy Code permits bankruptcy courts to award reasonable compensation to a debtor’s attorney for representing the debtor, and in chapter 13 cases compensation is so awarded.

The bankruptcy court questioned whether or not the second requirement was met in chapter 7 cases. The court referenced bankruptcy court decisions from the Eastern District of Virginia and the Northern District of New York that found that § 503(b)(2)’s reference to § 330(a) of the Bankruptcy Code allowed for review of fee-sharing arrangements in chapter 7 cases when they are made pre-petition.[6] In contrast, the bankruptcy court also cited other bankruptcy courts in the Eastern District of Louisiana and the Western District of Michigan that opined that § 504 was not applicable in chapter 7 cases.[7]

Ultimately, the bankruptcy court determined that it need not weigh in on the split of authority because the third element of the test was not met. Section 504 prohibits bankruptcy counsel from sharing compensation with another person. Here, New Start Auto, a third party, was paying a portion of debtor’s counsel’s fees on behalf of the debtor. Counsel was not sharing the fees with another person. Thus, the bankruptcy court determined that it could not find that a violation of § 504.

Section 329 of the Bankruptcy Code and Bankruptcy Rule 2016 Require Full Disclosure of All Fees Paid to Counsel

Finding that counsel did not run afoul of § 504, the bankruptcy court cited the disclosure requirements of § 329 of the Bankruptcy Code and Bankruptcy Rule 2016 and found that counsel’s practice failed to comply. Section 329(a) of the Bankruptcy Code states:

Any attorney representing a debtor in a case under this title, or in connection with such a case, whether or not such attorney applies for compensation under this title, shall file with the court a statement of the compensation paid or agreed to be paid, if such payment or agreement was made after one year before the date of the filing of the petition, for services rendered or to be rendered in contemplation of or in connection with the case by such attorney, and the source of such compensation.[8]

Bankruptcy Rule 2016 implements § 329 of the Bankruptcy Code. It is entitled “Disclosure of Compensation Paid or Promised to Attorney for Debtor” and is encapsulated in Official Form B203.

The bankruptcy court found that counsel never disclosed payments it received from New Start Auto, and that “failure to disclose is a breach of the duty of candor to the tribunal” and implicated Bankruptcy Rule 9011, various sections of the Texas Disciplinary Rules of Professional Conduct, and possibly other authority as well.[9] For these reasons, the bankruptcy court ordered the disgorgement of $77,175 in fees paid to counsel by New Start Auto and directed counsel to file the appropriate disclosures in all bankruptcy cases where compensation was paid by New Start Auto.

Counsel May Have Violated § 526 of the Bankruptcy Code, but Not Enough Evidence in the Record to Conclude that a Violation Occurred

The U.S. Supreme Court in Milavetz, Gallop & Milavetz, P.A. v. United States held that attorneys who provide bankruptcy assistance to assisted persons in return for consideration are “debt relief agencies” and subject to § 526 of the Bankruptcy Code. Section 526 states:

(a)    A debt relief agency shall not - …

            (4) advise an assisted person or prospective assisted person to incur more debt in contemplation of such person filing a case under this title or to pay an attorney or bankruptcy petition preparer fee or charge for services performed as part of preparing for or representing a debtor in a case under this title.[10]

As chapter 13 counsel to Ms. Fair, counsel qualifies as a debt-relief agency and is subject to § 526. In Milavetz, the Supreme Court explained that an attorney may not advise a client to “load up” on debt prior to filing a bankruptcy case with the expectation of obtaining a discharge in bankruptcy. To do so would violate § 526(a)(4). In In re Fair, because counsel advised clients to take on new debt after a bankruptcy filing, the bankruptcy court stated that it did not believe § 526(a)(4) of the Bankruptcy Code applied.

Reviewing § 526 further, the bankruptcy court raised the possibility that § 526(a)(2) of the Bankruptcy Code was possibly violated. Section 526(a)(2) prohibits a debt-relief agency from making a statement or giving advice to an assisted person that is misleading, untrue or should reasonably be known to be untrue. In each case, counsel failed to reflect that the debtor expected an increase in expenses on the debtor’s Schedule J and failed to disclose the New Start Auto payments on Question 16 of the debtor’s Statement of Financial Affairs.

Despite these factors, there was not enough evidence in the record for the bankruptcy court to determine whether counsel had violated § 526(a)(2). Nevertheless, the court was “extremely troubled by what it has heard and knows that [the] Show Cause Matter has likely only scratched the surface of undisclosed transactions in this District involving New Start Auto.”[11]

Conclusion

Without question, the bankruptcy court clearly spent a great deal of time, effort and resources to investigate counsel’s practices and draft the In re Fair opinion in such a thorough and thoughtful manner. It is regrettable that the issues arose in the first place. However, the Fair opinion will hopefully educate practitioners and potentially deter such questionable practices in the future. The Fair opinion sends the message that the bankruptcy court will not tolerate careless and harmful legal practice and that the Bankruptcy Code must, and will, be enforced.