No Super-Priority for Professional Compensation Claims - PDF document

No Super-Priority for Professional Compensation Claims January/February 2005 Mark G. Douglas Fees paid to lawyers and other professionals hired during the course of highly visible bankruptcy "mega-cases" involving troubled corporate giants such as Enron, U.S. Airways and Mirant are inevitably a magnet for criticism, given the substantial amounts involved compared to the payments generally made to other creditors at the conclusion of a chapter 11 case. What is ignored more often than not in coverage maligning the substantial fees paid to such professionals is at least grudging recognition that successful chapter 11 reorganizations would be impossible without their participation. Federal bankruptcy law and practice encourage the finest lawyers, accountants and investment bankers to offer their services in bankruptcy cases in several ways. Among these are the assurance that court-approved professionals will be compensated at market rates, and elevated priority of payment for professional fees and expenses. Still, these incentives do not insulate professionals from the risks associated with a chapter 11 case. One such risk ― administrative insolvency, or the absence of sufficient estate assets to pay administrative claims ― was the subject of a ruling recently handed down by the Sixth Circuit Court of Appeals. In Specker Motor Sales Co. v. Eisen , the Court held that a chapter 11 debtor's attorney had to disgorge some of the fees awarded to him before the case was converted to a chapter 7 liquidation because the estate lacked sufficient funds to pay all administrative claims in full. Retention and Compensation of Professionals NYI-2182016v1

Bankruptcy trustees, chapter 11 debtors-in-possession and committees are permitted to retain a wide variety of professionals, including lawyers, accountants, auctioneers and investment bankers, to represent their interests during a bankruptcy case. Sections 327 and 1103 of the Bankruptcy Code authorize these entities, subject to bankruptcy court approval, to employ "disinterested" professionals to represent them during the course of the bankruptcy. Retained professionals are generally paid in accordance with the interim and final compensation procedures delineated in sections 330 and 331 of the Bankruptcy Code. Those procedures contemplate court scrutiny of services for which compensation is sought, and the discretion to reduce, or in some rare cases augment, the allowed amount of fees based upon the court's determination of what is reasonable and necessary under the circumstances. Elevated Priority of Compensation Claims The Bankruptcy Code classifies all kinds of "claims" against a debtor and prioritizes them according to specific rules depending upon, among other things, when the claim arose, whether it is secured or unsecured and whether it should be entitled to some specially elevated status of payment in accordance with various policy considerations and special interest concerns identified by Congress. Secured claims have the highest priority. So long as the value of collateral securing a claim is greater than the face amount of the obligation, the secured creditor's rights will be relatively unaffected by a bankruptcy case. Unsecured claims fare less well. Except in rare circumstances, unsecured creditors receive a pro rata distribution from a bankruptcy estate that contains insufficient assets to satisfy all creditor claims. NYI-2182016v1

Not all unsecured claims are created equal. Bankruptcy Code section 507(a) establishes nine separate categories of claims that must be paid before the holder of any other unsecured claim can receive a distribution from the estate. Foremost among these unsecured priorities are the post-petition expenses of administering the bankruptcy estate. Bankruptcy Code section 503(b)(1) provides that "administrative expenses" include "the actual, necessary costs and expenses of preserving the estate, including wages, salaries, or commissions for services rendered after the commencement of the case." Most obligations incurred by a trustee or chapter 11 debtor-in-possession during the course of a bankruptcy case are conferred with special priority entitling them to payment prior to all pre-bankruptcy unsecured obligations. The enhanced priority was intended, in part, to encourage vendors and other creditors to do business with, or extend credit to, a bankruptcy trustee or chapter 11 debtor. It was also designed to provide an incentive for qualified lawyers, accountants, financial advisors and other professionals to provide their services in connection with a chapter 11 reorganization. Certain kinds of administrative claims can even be conferred with "super-priority" status. These "uber" claims can include a lender's claim for repayment of unsecured post-petition financing or credit under certain circumstances and any claims arising from the debtor's failure to provide "adequate protection" of a secured creditor's interest in estate assets. Super-priority administrative claims take precedence over all other administrative claims. Except in connection with post-petition financing, bankruptcy courts sparingly grant super-priority status to a claim, largely because it runs afoul of the basic bankruptcy principal favoring equal treatment of similarly situated creditors. NYI-2182016v1

Unlike unsecured and lesser priority claims, administrative claims, such as debts to vendors and suppliers that arise in the ordinary course of a chapter 11 debtor-in-possession's business operations, are typically paid on a current basis. Court-approved professionals similarly enjoy periodic payment of their fees and expenses according to the interim compensation procedures contained in the Bankruptcy Code. However, the court retains the discretion to revisit the propriety of its interim fee awards until the very end of the case. Meltdown ― the Specter of Administrative Insolvency If a restructuring strategy fails and the company approaches (or oversteps) the brink of administrative insolvency, administrative priority (even super-priority) may not insulate a claimant from the ramifications of the meltdown. Administrative claims must be paid in full as a condition to confirmation of a chapter 11 plan, unless administrative creditors agree to less than full payment. Where no agreement is possible, the most likely upshot will be conversion of the case to a chapter 7 liquidation. Alternatively, the case could be dismissed altogether, in which case administrative claimants would have no greater standing than all of the debtor's other unsecured creditors. Upon conversion to chapter 7, the priority scheme that governed in chapter 11 changes. The Bankruptcy Code reorders the hierarchy of claims to account for an added layer of administrative costs associated with the chapter 7 trustee's liquidation of the debtor's bankruptcy estate. Such post-conversion administrative claims are afforded the highest priority among unsecured claims pursuant to section 726(b) of the Bankruptcy Code. Pre-conversion administrative claims fall to second priority and holders of such claims are entitled to no more than a pro rata share of estate NYI-2182016v1

assets remaining after the payment of post-conversion admin claims. The impact of reorganization meltdown on certain administrative claimants was the subject of the Sixth Circuit's ruling in Specker Motor Sales . The Sixth Circuit's Ruling After Specker Motor Sales, Inc. filed for chapter 11 in 1997, it obtained court authority to retain Donald Bays as its bankruptcy counsel. Bays received a $10,000 retainer in connection with the representation. Specker auctioned off all its assets and neglected to submit required reports and payments, all of which resulted in conversion of the case to a chapter 7 liquidation. Bays submitted his final fee application, requesting a total of approximately $17,000. The bankruptcy court approved the application and permitted Bays to keep the $10,000 retainer as interim compensation. Unfortunately, Specker was administratively insolvent. Administrative claims, including Bays', totaled nearly $205,000, while Specker's assets were valued at no more than approximately $11,000. Bays' pro rata share of the estate was less than $1,000. However, because he had already been paid $10,000 (in the form of his retainer), the bankruptcy court ordered Bays to disgorge that portion of the retainer in excess of the pro rata distribution mandated by section 726(b) of the Bankruptcy Code. Bays appealed to the district court, which affirmed, remarking that "counsel is a gambler in [bankruptcy] proceedings like every other administrative creditor." Bays brought his appeal to the Sixth Circuit. NYI-2182016v1