Last year we wrote about Spiller McProud v. Siller (In re CWS Enterprises Inc.), 870 F.3d 1106 (9th Cir. Sept. 14, 2017), and said the case “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.”
Nine months later, the Ninth Circuit handed down a nonprecedential opinion on Section 502(b)(4) pinpointing a large loophole in CWS allowing bankruptcy courts to reduce claims based on judgments in state court upholding contingency fees. To read ABI’s discussion of CWS, click here.
Section 502(b)(4) allows the court to disallow a claim “for services of an . . . attorney of the debtor [to the extent that] such claim exceeds the reasonable value of such services.”
In view of the Full Faith and Credit Act, 28 U.S.C. § 1738, the Ninth Circuit held last year in CWS that Section 502(b)(4) cannot be invoked to reduce a claim if the prior judgment in state court determined that the contingency fee was “reasonable.”
In the case on appeal, the debtor’s lawyers had a judgment from state court upholding a $237,000 contingency fee. The debtor objected, and the bankruptcy court reduced the claim to less than $44,000. The district court reversed, ruling that the principle of res judicata under California law gave preclusive effect to the judgment for $237,000.
The debtor appealed and won in the nonprecedential, per curiam opinion on June 15.
The Ninth Circuit interpreted CWS to mean that “a state court court’s judgment does not necessarily constrain the bankruptcy court’s obligation to determine the reasonableness of the attorney’s fees in issue.” Significantly, the appeals court said, the arbitrator in CWS had determined that the amount of the contingency fees was reasonable, under the same standard applicable in Section 502(b)(4).
The new case was different because the California court had not decided whether the $237,000 contingency fee was reasonable because the California statute “does not require that the bargained-for fee be reasonable to be enforceable.”
Because the state court made no ruling on the reasonableness of the contingency fees, the Ninth Circuit held that the debtor “was not precluded from challenging the reasonableness of the attorneys’ fees in the bankruptcy proceedings.”