The Ninth Circuit tackled a particularly cerebral question at the intersection of the Full Faith and Credit Act and Section 502(b)(4), the section of the Bankruptcy Code that puts a “reasonable value” cap on a prepetition claim for services by a debtor’s attorneys.
Without saying so explicitly, the Sept. 14 opinion by Circuit Judge Andrew J. Kleinfeld seems to stand for the proposition that a prepetition judgment or arbitration awarding contingency fees to a debtor’s counsel is not likely to be reduced under Section 502(b)(4) absent evidence that the fees were inflated by collusion. Arguably, the holding is equally applicable if the attorney does not have a judgment for contingency fees, only a claim based on a prepetition retention agreement.
The Tangled Facts
Hacking through a jungle of facts, Judge Kleinfeld explained how the appeal involved an individual debtor with a proclivity for hiring multiple lawyers, firing them, refusing to pay them, and suing them for malpractice. Among the lawyers not paid was a firm with a contingent fee arrangement including an arbitration clause. Serving as advisors to the debtor’s trial counsel, the firm was to receive 8% of any judgment or settlement.
The lawyers won a difficult suit that consumed their time for several years. At 8%, the firm was entitled to a contingency fee of about $2.5 million, but the debtor refused to pay. The firm commenced an arbitration that the debtor attempted unsuccessfully to derail. Eventually, the arbitrator upheld the $2.5 million contingency fee, rejecting the debtor’s argument that the contingency fees were excessive given the time devoted to the case and should not exceed the firm’s hourly rate multiplied by time expended on the successful case.
The arbitration award was confirmed by the state court that entered a money judgment. Rather than pay the judgment, the debtor filed a chapter 11 petition.
The debtor objected to the firm’s $2.5 million proof of claim. Invoking Section 502(b)(4), the bankruptcy judge sustained the objection and reduced the fee to $440,000, equal to 1,760 hours multiplied by the firm’s $250 hourly rate.
The district court reversed and reinstated the arbitration award. At the end of a 31-page opinion, Circuit Judge Kleinfeld upheld the result from district court.
The Section 502(b)(4) Analysis
Judge Kleinfeld said that the Tenth Circuit in 1990 had written the only appeals court precedent interpreting Section 502(b)(4). He said that case, Landsing Diversified Properties v. First National Bank and Trust Co. (In re Western Real Estate Fund, Inc.), 922 F.2d 592 (10th Cir. 1990), modified sub nom. Abel v. West, 932 F.2d 898 (10th Cir. 1991), stands for the proposition that “the source of allowable contract damages for a breached attorney’s fee agreement is state law.” The Tenth Circuit, he said, rejected the idea that the bankruptcy court can “establish the reasonableness of an attorney’s fee in the first instance, independently of state law.”
Adopting the holding of the Tenth Circuit, Judge Kleinfeld said that “Section 504(b)(4) works as a federal cap on a fee already determined pursuant to state law.”
Following Western Real Estate, Judge Kleinfeld said it was error for the bankruptcy court to “determine for itself in the first instance a reasonable contingent fee using the lodestar method.”
Judge Kleinfeld also adopted the Tenth Circuit’s holding that contingency fees are a reasonable alternative to an hourly retainer even though they can generate fees substantially in excess of lodestar fees, because “the contingent and therefore risky nature of a contingent fee is itself an element off the reasonableness analysis.”
Full Faith and Credit Act and Res Judicata
Next, Judge Kleinfeld analyzed whether fees allowed in a state court judgment can ever be reduced by the reasonableness cap under Section 502(b)(4) in the face of res judicata and the federal Full Faith and Credit Act, 28 U.S.C. § 1738.
Even though the Full Faith and Credit Act applies in bankruptcy court, Judge Kleinfeld followed the Tenth Circuit, and also the Third, by holding that the reasonableness cap in Section 502(b)(4) can reduce “a pre-petition obligation for a debtor’s attorneys’ fees, even if such fees were allowable under state law, and even if such fees had been reduced to a state court judgment.”
In substance, the Supremacy Clause triumphs over automatic full faith and credit because Congress adopted Section 502(b)(4) to ensure that creditors are not harmed by a debtor who is overly generous to his or her attorneys.
Judge Kleinfeld was left with deciding the extent to which Section 1738 applied to the case at bar.
Having already held that a state court judgment does not always have preclusive effect on the reasonableness analysis, Judge Kleinfeld analyzed whether “the state court judgment had preclusive effect on the reasonableness analysis in the particular circumstances of this case.”
In substance, Judge Kleinfeld concluded that the reasonableness analysis undertaken by the arbitrator and explained in his 26-page opinion coincides with the reasonableness analysis under Section 502(b)(4). Although there might be “room for a reduction” in “some cases,” he said there was “no room here” because the case was “difficult and demanding.”
Section 1738, he said, required giving full faith and credit to the state court judgment because the relationship between the contingency fee and the services provided by the lawyers did not make “payment of the fee unreasonable.”