Good Faith v. Blind Faith: Duty to Investigate Source of Funds for Pre-Petition Payment

When a client is willing and able to pay a hefty retainer up front, it is difficult to question the source. To keep that retainer, one must investigate any fact that could cause a reasonable person to question the client’s right to use the funds. Blindly accepting funds could lead to disgorgement, so inquire as to the source of the funds before accepting them in good faith. This duty to investigate is illustrated by In re Parklex Associates Inc. [1]

Following the trend of civil decisions nationwide, [2] the Bankruptcy Court for the Southern District of New York ruled that an attorney “has a duty to investigate the source of the retainer where there is a reasonable suspicion that the funds derived from a fraudulent transfer.” [3] This duty arises whenever a reasonable lawyer would question the client’s intent in paying the fees.

Pre-Bankruptcy Events
In Parklex a bankruptcy lawyer, Nutovic, was hired to file chapter 11 petitions for 12 entities controlled by individual debtor Fred Deutsch. Prior to the bankruptcies, a dispute arose out of the closing of one of the company’s real estate deals when Deutsch directed a transfer of $23 million of proceeds to a newly formed limited partnership. One of Deutsch’s investors filed suit and got a restraining order prohibiting the use of funds from any of the Parklex accounts.

Despite the restraining order, Deutsch transferred $20 million from the limited partnership to a limited liability company (LLC) that he controlled. Deutsch and the limited partnership settled the matter by agreeing to make a series of payments and provide a confession of judgment, but Deutsch promptly defaulted and the confession of judgment was entered. Presumably, to avoid paying the judgment and to stay a pending state court action, Deutsch retained Nutovic to file for bankruptcy and the LLC paid a $100,000 retainer.

Nutovic’s Employment & Payment
Nutovic disclosed the retainer, attributing it to a non-debtor entity as part of his application for employment. Nutovic made only a cursory inquiry of his client as to the origin of the funds, even though he knew that the state court action alleged a misappropriation of funds. At the initial hearing on Nutovic’s application employment, both the court and the U.S. trustee questioned his ability to represent all of the related entities simultaneously and noted the possibility that the retainer might be the result of a fraudulent transfer. [4] Accordingly, the court granted the application on an interim basis only.

The bankruptcies were dismissed less than two months after they were filed. Nutovic sought no further clarification and received only an interim retention order, so he was not entitled to spend the retainer. Following the dismissal, in a related case, a state court judge immediately entered a restraining order prohibiting Nutovic from spending any remaining retainer funds. Yet, merely one week later, Nutovic claimed to have already spent the retainer. A turnover action followed.

A year after the bankruptcy cases were dismissed, Nutovic sought retroactive approval of professional employment and a fee award in the dismissed bankruptcies. Due to his failure to investigate the source of the funds, Nutovic’s fee award was denied. Disgorgement was left to determination in the state action to avoid the underlying fraudulent transfers.

Impact of Attorney’s Knowledge of Fraudulent Transfers
Nutovic “admitted that he was aware that several fraudulent conveyance claims were being asserted against Deutsch,” [5] yet, he did not investigate, which implicated him in his client’s fraud:

Outside of the bankruptcy context, courts in this district have determined that “lawyers who receive a conveyance under circumstances that should cause them to inquire into the reasons behind the conveyance must diligently do so, lest they be charged with knowledge of any intent on the part of the transferor to hinder, delay or defraud. A lawyer who blindly accepts fees from a client under circumstances that would cause a reasonable lawyer to question the client’s intent in paying the fees accepts the fees at his peril. [6]

He cannot be protected by asserting that he acted in good faith.

Practical Application and Conclusion
This opinion underscores that the duty to inquire as to the source of funds is applicable to civil as well as criminal matters whenever the circumstances would cause a reasonable attorney to suspect that a fraudulent transfer may have taken place. Other courts have concluded that proper disclosure and analysis of attorney compensation is particularly important because financially distressed debtors tend to rely on—and prefer—their attorneys. [7] “Thus, courts are authorized to scrutinize all payments made to attorneys while bankruptcy is imminent for signs of preference, collusion, overreaching or concealment.” [8] A court may raise this issue sua sponte and seek disgorgement; the trustee and opposing counsel may raise the issue as well.

Disgorgement of attorney fees is not an uncommon remedy when third parties receive ill-gotten gains. While disgorgement for failure to inquire has received increased attention in the past several years, this line of reasoning has been acknowledged since U.S. Supreme Court case Caplin & Drysdale. [9] In this case, the Court stated that “[n]o lawyer, in any case, has the right to accept stolen property or ransom money in payment of a fee. The privilege to practice law is not a license to steal.”

The lesson here is that under certain circumstances, an attorney must inquire why and how a client can pay. A vague or convoluted answer or a history or accusation of fraud will likely give rise to the duty to investigate. A good-faith investigation could protect an attorney from fee disgorgement.