Bankruptcy Trustee Can Nix Pre-Paid Legal Fees

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By Daniel Gill

June 13 — The U.S. Bankruptcy Appellate Panel for the Ninth Circuit ruled that a contract for legal services for a debtor could be rejected, even though the fees were paid in full, in advance, and were not property of the bankruptcy estate ( Ulrich v. Schian Walker, P.L.C. (In re Boates), 2016 BL 185297, B.A.P. 9th Cir., No. 2:15-ap-00269-GBN, 6/9/16 ).

The retention agreement was entered pre-petition for services to be rendered after the Chapter 7 case was commenced. The agreement required the debtor to reimburse the firm's future out-of-pocket costs and expenses, and the debtor still had material duties to perform. Because of this, the BAP determined the contract was executory and rejected by operation of law under the Bankruptcy Code.

The court did not discuss the potentially profound effect of its ruling on the debtor, including policy arguments put forth by the debtor's attorneys that an inability to choose—and pay—his own counsel would be highly prejudicial.

Earned on Receipt Retainer Agreement

Craighton Thomas Boates was a defendant in a state court action for negligent misrepresentation and fraud. Plaintiff Metro Phoenix Bank sought more than $3.6 million in damages. When Boates told the plaintiff he intended to file for bankruptcy, the plaintiff advised him that it would file an action seeking to have its claim determined to be non-dischargeable.

In Chapter 7 bankruptcy, a debtor's nonexempt assets are liquidated by a trustee, and the proceeds are distributed to creditors. Subject to certain exceptions, the debtor is awarded a discharge, effectively wiping out dischargeable debts (that is, those debts not subject to an exception). Section 523(a) of the Bankruptcy Code allows creditors to file suit to have their individual debts declared to be non-dischargeable if they can prove that the debts were incurred by fraud or malicious acts of the debtor.

Like any other litigation, dischargeability lawsuits can be expensive to prosecute or defend. Chapter 7 debtors often have insufficient disposable income to fund post-petition litigation. If they did, and depending on the amount of their debts at the time of filing bankruptcy, such individual debtors might not qualify for Chapter 7, instead being required to file Chapter 13 or Chapter 11.

In Chapter 13, the debtor must propose a plan which uses future income to repay all or a portion of his debts over a three to five year period. In Chapter 11, a debtor also seeks to have the court approve a plan for liquidating or restructuring its debts. Typically a Chapter 11 is far more involved and much more expensive than proceedings under Chapters 7 and 13.

Boates tried to fund his dischargeability litigation by paying for his representation in advance of the bankruptcy. The agreement prepared by his attorneys, Schian Walker, P.L.C., provided that the $60,000 fee was earned upon receipt and that the firm could deposit the money directly to its operating bank accounts (instead of into a trust account where firms are required to deposit retainers against which the lawyers would draw for future bills).

Rejecting Executory Contracts

The trustee filed suit in bankruptcy court seeking to recover “the full contract value of Schian Walker's legal services — $60,000 — based on the rejection of the retainer agreement.” The trustee also alleged that the right to legal services under the retention agreement was property of the bankruptcy estate for the trustee to administer for the benefit of creditors.

Section 365 of the Bankruptcy Code (11 U.S.C. §365) provides that certain executory contracts can be “rejected” in bankruptcy court. Although there is significant caselaw discussing what constitutes an “executory contract,” the generally accepted rule is that an agreement is executory if both sides to the agreement still have material obligations to perform. Section 365(d)(1) provides that in Chapter 7, if the trustee does not assume or reject a contract within 60 days of the case filing, it is deemed rejected.

The Trustee relied on Gordon v. Hines (In re Hines), 147 F.3d 1185 (9th Cir. 1998) to support his argument that he could liquidate the debtor's right to legal services by rejecting the contract and demanding a refund of the unearned fees. But first it must be established that the contract was executory as of the bankruptcy filing, the court said.

Schian Walker claimed that the contract was not executory because, since the debtor already paid in full for the services, there were no material obligations left for the debtor to perform. The bankruptcy court agreed and dismissed the trustee's complaint to recover the $60,000 paid to the firm.

Reimbursement of Costs and Expenses

The BAP reviewed the bankruptcy court's finding and came to a different conclusion.

Ultimately it was the provision in the contract that the debtor was required to reimburse the firm's out-of-pocket costs and expenses which proved the debtor's and firm's undoing. The BAP held that the obligation to reimburse costs was a material contractual duty as yet unperformed by the debtor, and noted that the debtor's breach of that provision could excuse the firm's performance under the contract. Therefore, the court concluded, “the retainer agreement qualified as an executory contract” which could be deemed rejected under Section 365(d)(1).

Effect of Rejection

After concluding the contract was executory and could be rejected, the BAP examined the effect of that rejection. The court agreed with the debtor that the $60,000 actually paid to the law firm was not itself property of the estate and could not be recovered by the trustee as such. However, the bankruptcy estate still had rights under the pre-petition contract for post-petition services.

The court noted that rejection acted like a breach of the contract as of the petition date, and not a termination or recision of the agreement. The court cited In re Onecast Media, Inc., 439 F.3d 558 (9th Cir. 2006), when it noted that the key issue is to “resolve the nature and extent of the Boates' contract rights on the date of the bankruptcy filing if Boates were considered to have breached the contract on that date.”

The trustee's “retainer agreement rights on the date of the bankruptcy filing necessarily included a right to terminate Schian Walker and a right to a refund of the fees previously prepaid based on the value of services provided before termination,” the court said. The appellate court found that there was an inadequate record to decide the issue.

Because there was no evidence of when the trustee gave notice of terminating the agreement, “there was no way the bankruptcy court correctly could have determined ... whether [the trustee] was entitled to any fee refund based on the value of services provided before termination,” the court said. Accordingly, the BAP sent back to the bankruptcy court the question of when the trustee “first exercised his right to terminate the firm” and the value of services provided.

What's Left for the Debtor?

The debtor's law firm in its brief to the BAP made the policy arguments that the debtor should be able to hire attorneys to represent him in a $3.6 million dollar lawsuit and that allowing the trustee to terminate the debtor's agreement with his counsel would prejudice him significantly.

The BAP, however, did not discuss in its opinion what the termination of the retention agreement would mean for the debtor who might now be deprived of counsel.

The trustee was represented by Terry A. Dake, Phoenix, Ariz. Schian Walker, P.L.C., represented itself by Mark C. Hudson, Phoenix, Ariz.

To contact the reporter on this story: Daniel Gill in Washington at dgill@bna.com

To contact the editor responsible for this story: Jay Horowitz at jhorowitz@bna.com

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