A bankruptcy judge on Long Island, N.Y., interpreted Section 502(b)(4) to mean that a debt-reduction service provider ordinarily will not have an allowable claim based on the client’s outstanding debt when the client files bankruptcy.
Bankruptcy Judge Robert E. Grossman of Central Islip, N.Y., described the debt-reduction service business as a “rapidly growing” industry “with little to no regulation” that serves clients who are “often unsophisticated, have limited means, and are facing severe financial hardship.”
The service provider filing a claim in the case before him was a licensed attorney who, according to Judge Grossman, was “operating in a professional manner.”
The husband and wife clients, who later filed a chapter 13 petition, came to the service provider with about $125,000 in unsecured debt. Among other things, the written agreement called for the clients to pay 39% of any negotiated debt reductions and a 20% flat fee based on total outstanding debt if the agreement were terminated.
Over 13 months before bankruptcy, the service provider took $1,450 a month from the debtors’ bank account. The payments, totaling $18,850, covered the $2,900 flat fee for setting up the account plus a 39% contingency fee of $5,339 for debt reductions that were negotiated before bankruptcy. The service provider had applied the remainder toward the payment of claims that were settled.
The clients filed bankruptcy a month after terminating the agreement. The service provider filed a claim for about $17,250, representing the 20% contingency fee that was due on termination based on outstanding debt. The service provider conceded that he had been paid in full for the negotiated debt reductions.
The debtors objected to the claim because they were proposing a 100% plan. Judge Grossman sustained the objection in his May 18 opinion and expunged the claim in its entirety, nonetheless recognizing that the court must be “sensitive to the rights attorneys have to enter into a written agreement.”
Judge Grossman did not reach the issue of whether the fee arrangement was enforceable under state law or whether it was an unenforceable penalty.
Instead, he said the controversy was governed by Section 502(b)(4), which disallows a claim “for services of an . . . attorney of the debtor, [if] such claim exceeds the reasonable value of such services.”
Judge Grossman reasoned that the “reasonable value” of service in Section 502(b)(4) should be measured “under both a federal standard and under state rules of professional conduct.” Because the debtors had filed a legally sufficient claim objection, he said the burden shifted to the creditor to prove that the amount of the claim was reasonable.
Since the creditor had been fully compensated for services provided to the debtors before filing, Judge Grossman said he could “think of no scenario where a $17,248.03 flat fee for termination, in addition to the guaranteed minimum fee already paid, would constitute reasonable value for debt reduction services for unsettled debts.”
Judge Grossman said his conclusion “furthers the stated purpose” of Section 502(b)(4) “to prevent overreaching by attorneys to the detriment of unsecured creditors in bankruptcy.” The result, he said, “also protects the unsophisticated debtor facing severe financial hardship.”