Beware the Bankruptcy Conversion in Fee Collections

 When seeking to collect post-petition fees from a chapter 7 debtor, beware of the conversion. If former counsel files a collection action against a debtor for post-petition fees in state court, failing to stay the action after a conversion to a chapter 13 case will result in a stay violation. The bankruptcy court in the Northern District of Illinois held the debtor’s former counsel liable for actual damages, pursuant to 11 U.S.C. § 362(k), for failing to stay a state court collection action after the debtor converted his case from a chapter 7 bankruptcy to a chapter 13 bankruptcy.[1]

Background

            The debtor filed his chapter 7 bankruptcy petition on March 18, 2016, and was represented by Wendy Morgan at the time. Morgan also represented the debtor in several contested matters before she moved to withdraw. On Jan. 10, 2017, the bankruptcy court granted Morgan’s motion to withdraw as counsel. With new counsel, the debtor filed a motion to convert his case to a chapter 13 on May 11, 2017. Due to objections by a creditor and the chapter 7 trustee, the bankruptcy court did not grant the conversion until Nov. 15, 2017.

Between the date the debtor filed the motion to convert and the actual conversion, Morgan filed a collection lawsuit against the debtor in state court on July 25, 2017. The collection action was based on a post-petition retainer agreement and was limited to unpaid post-petition fees.

Analysis

            The bankruptcy court broke down its analysis into three questions. Does a chapter 7 debtor’s attorney violate the automatic stay by suing the debtor in state court during the pendency of the case for unpaid post-petition fees? Does the analysis change if the post-petition obligation is for debtor’s attorneys’ fees? Does the conversion from a chapter 7 to a chapter 13 change the analysis?

            In deciding whether a state court collection action for post-petition fees during a bankruptcy case violated the stay, the bankruptcy court looked at in personam and in rem protections provided by § 362(a). The bankruptcy court concluded that both the in personam and in rem protections only provided protection against claims and actions that arose pre-petition.[2] The in personam protections did not prevent actions based on post-petition obligations. Moreover, the in rem protections did not prevent an attempt to collect on the post-petition services from non-estate assets, which include the chapter 7 debtor’s post-petition income.

            Next, the bankruptcy court looked at whether the fact that the collection action was for a debtor’s attorneys’ fees made a difference. The bankruptcy court reasoned that chapter 7 attorneys are not retained and paid in the same manner as chapter 11 and chapter 13 counsel. While chapter 7 counsel is required to disclose compensation to the bankruptcy court, such counsel does not need approval for post-petition fees. Thus, chapter 7 counsel’s relationship with their debtor is comparable to the attorney/client relationship in other areas of the law. The import is that counsel can pursue its claim in state court, so long as counsel does not seek recovery of post-petition fees from estate assets.

            Finally, the bankruptcy court looked at conversion and the interplay among 11 U.S.C. §§ 348, 541 and 1306. In a chapter 13 case, property of the estate expands to include more than the property included in § 541. Section 1306(a) expands property of the estate to include post-petition income and assets that are acquired post-petition but before the case closes.[3] Thus, the assets that could be used to satisfy any collection action are limited.

Not only may the creditor have no assets to recover, the automatic stay springs up to protect the debtor. Section 348(d) states in part:

[A] claim against the estate or the debtor that arises after the order for relief but before the conversion in a case that is converted under section … 1307 of this title … shall be treated for all purposes as if such claim had arisen immediately before the date of the filing of the petition.[4]

            Thus, the bankruptcy court held that once the conversion occurred, Morgan’s claim went from a post-petition claim to a pre-petition claim. Therefore, Morgan violated the in personam stay under § 362(a), when she continued to pursue the collection action after the conversion date.

            After the bankruptcy court determined that Morgan violated the stay, it looked at whether the debtor was entitled to damages. The bankruptcy court found that Morgan intentionally (intending to prosecute) and with knowledge of the bankruptcy case continued her collection action and therefore acted willfully. Thus, Morgan willfully violated the automatic stay, and the debtor, as an individual, was entitled to actual damages pursuant to § 362(k).[5]

            The debtor sought both actual damages for fees and costs and punitive damages. The bankruptcy court broke the fees and costs into three parts: (1) pre-conversion damages; (2) post-conversion proactive damages; and (3) post-conversion reactive damages. The pre-conversion damages consisted of fees and costs incurred prior to the conversion date. The post-conversion proactive damages consisted of fees and costs incurred after the conversion date when the debtor sought to stay or dismiss the collection action. The post-conversion reactive damages consisted of fees and costs incurred when Morgan opposed the debtor’s attempts to stay or dismiss the action.

The bankruptcy court concluded that the pre-conversion damages would fall into the category of punitive damages, not actual damages, because they arose before the automatic stay applied to the collection action. The post-conversion reactive damages, however, were actual damages as they resulted from Morgan’s failure to affirmatively stay the action or her fight against the debtor’s attempts to stay or dismiss the action. The post-conversion proactive damages were also actual damages due to Morgan’s failure to stay the collection action. Accordingly, the bankruptcy court held that the debtor was entitled to actual damages consisting of post-conversion proactive and reactive damages.

            The bankruptcy court further held that because punitive damages are discretionary, the circumstances did not warrant such an award. The bankruptcy court stated that while Morgan’s conduct was imprudent, it was not outrageous due to some confusion initially about the extent of the stay after the conversion and the state court’s insistence on dismissing the collection action rather than stay the matter.

Conclusion

            The Ludkowski case shows that while it is possible to pursue state court collection of unpaid post-petition attorneys’ fees while a chapter 7 is pending, practitioners should be wary of a conversion. Once a conversion occurs, any collection litigation must be stayed.