No Super-Priority for Professional Compensation Claims - - PDF document

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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

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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.

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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.

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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

• perations, 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

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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.

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The Court of Appeals affirmed. Reasoning in an unpublished opinion that section 726(b) plainly states that payments on priority claims "shall be made pro rata" among the claimants in each category of priority, the Sixth Circuit concluded that the $10,000 received by Bays as interim compensation was always subject to disgorgement to achieve that end. The Court rejected Bays' contention that the retainer should not be subject to mandatory pro rata distribution because the money had already been paid out of the estate. According to the Sixth Circuit, a retainer is held in trust for the estate and remains property of the estate, such that it can be recovered where circumstances call for recovery. The Court of Appeals distanced itself from the bankruptcy appellate panel's ruling in In re Unitcast, Inc. and decisions of other courts that have characterized as "discretionary" disgorgement of payments made to administrative claimants to achieve pro rata distribution under section 726(b). It was critical of Unitcast's emphasis on the harshness of disgorgement and its effect of subordinating interim awards of professional fees. Acknowledging that only professionals can be asked to disgorge interim payments, the Court emphasized that insulating such payments from the rule of section 726(b) confers a super-priority status on them that exists nowhere in the Bankruptcy Code. Instead, the Sixth Circuit chose to side with those courts ― representing the majority rule ― that find disgorgement to achieve parity mandatory in keeping with the unambiguous language of the statute. Analysis The administrative priority granted to professional fee and expense claims is an important and necessary feature of federal bankruptcy law. Still, it is not a guarantee. Professionals, other

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administrative claimants and creditors as a whole collectively lose if a chapter 11 reorganization spirals out of control. Professionals, as a general rule, get no better treatment than other administrative claimants in a reorganization meltdown. For this reason, it is incumbent upon the professionals involved in a reorganization to monitor closely the developments in the case to ensure that administrative costs are reasonable based upon the circumstances and overall strategy

• f the bankruptcy case. Although unforeseeable developments sometimes lead to a disaster that

no one can control, most chapter 11 cases that are brought to a successful conclusion involve careful management of administrative costs as part of an overall reorganization strategy. Specker Motor Sales also sends a clear message concerning "interim" compensation awards in a bankruptcy case: the bankruptcy court only grants such interim awards as an accommodation to professionals who perform ongoing services but would otherwise be forced to wait until confirmation of a plan to get paid. The court can revise its decision to allow interim compensation at any time during the bankruptcy case, due to changed circumstances or reconsideration of its initial decision that the professional services or fees involved were necessary and/or reasonable. Finally, the court's conclusion that the $10,000 paid to Bays as a retainer was still property of Specker's bankruptcy estate is noteworthy. The purpose of a retainer is generally to ensure payment for services rendered by an attorney. For this reason, most courts find that a retainer paid to a lawyer, even if paid pre-bankruptcy in anticipation of services to be rendered during a bankruptcy case, acts as security for the lawyer's compensation claims. The Sixth Circuit's conclusion to the contrary may have been motivated by the fact that Bays received his retainer

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after Specker filed for bankruptcy, but the opinion does not appear to make any distinction between pre- and post-petition retainers. __________________________________________ Specker Motor Sales Co. v. Eisen, 2004 WL 2921971 (6th Cir. Dec. 17, 2004). United States v. Schottenstein, Zox & Dunn (In re Unitcast), 219 B.R. 741 (B.A.P. 6th Cir. 1998). In re Kids Creek Partners, L.P., 220 B.R. 963 (Bankr. N.D. Ill. 1998). In re Anolik, 207 B.R. 34 (Bankr. D. Mass. 1997). Matz v. Hoseman, 197 B.R. 635 (Bankr. N.D. Ill. 1996). In re Lochmiller Industries, Inc., 178 B.R. 241 (Bankr. S.D. Cal. 1995). In re Kingston Turf Farms, Inc., 176 B.R. 308 (Bankr. D.R.I. 1995). U.S. Trustee v. Johnston, 189 B.R. 676 (N.D. Miss. 1995).