Getting Paid: Retention and Compensation of Special Counsel in Bankruptcy

This article was originally published by The Alabama Lawyer on Jan. 30, 2023 and was expanded for additional publication by Law360 under the title Navigating Compensation Of Special Counsel in Bankruptcy.

Ignorance of the law is no excuse. We all learned that.

Still, you don't know what you don't know. And when it comes to bankruptcy law, too many of us just don't know some basics, like how to protect your fee.

Nonbankruptcy lawyers routinely represent debtors or their litigation opponents in nonbankruptcy disputes, such as personal injury claims. To comply with your duty to competently represent clients who are in bankruptcy or litigating against a debtor, and to protect your fee, know these fundamentals.

The filing of a voluntary petition creates an estate consisting of "all legal or equitable interests of the debtor in property."[1] Claims of the debtor arising prepetition are property of the estate.[2]

In a case under Chapter 12 or 13, or an individual case under Chapter 11, claims arising after the petition date, but before the case is closed, dismissed, or converted are also estate property.[3] Proceeds of estate claims — i.e., settlement funds — are, similarly, estate property.[4]

In a Chapter 7 case, the Chapter 7 trustee, as the real party in interest, has authority and responsibility for prosecuting and resolving prepetition claims.[5]

In Chapters 11 and 12, the debtor-in-possession has all rights and powers of a trustee, including the right and power to prosecute and resolve estate claims.[6]

In Chapter 13, the debtor has authority and responsibility for prosecuting and resolving estate claims.[7]

During the 2022 annual meeting of the bankruptcy section of the Alabama State Bar, bankruptcy judges warned: Lawyers who fail to follow the law — i.e., the U.S. Bankruptcy Code, the Federal Rules of Bankruptcy Procedure and case law construing each — not only put their fees in peril, they run a real risk of being sanctioned.

As illustrated by the recent In re: McLemore case in the U.S. Bankruptcy Court for the Middle District of Alabama, to competently represent clients, nonbankruptcy lawyers must know how to determine if a party is in bankruptcy, when to make such determinations, and what to do if a party, particularly your client, is in bankruptcy.

With professional liability litigation and disputes over lawyer fees on the rise, it is vital that lawyers follow the law to protect both their clients and their own fees in the following ways.

Before representing an estate fiduciary, have your employment approved by the bankruptcy court.

Before an lawyer may represent an estate fiduciary, such as a trustee or debtor-in-possession, the fiduciary must obtain court approval of the terms of the professional's engagement.

Section 327(a) of the U.S. Bankruptcy Code provides that only lawyers "that do not hold or represent an interest adverse to the estate, and that are disinterested persons" may be employed to assist the estate fiduciary in carrying out his or her duties under the code.

Section 101(14) defines "disinterested person" as a person that:

• • Is not a creditor, an equity security holder or an insider;
    
    
  • Is not and was not, within two years before the date of the filing of the petition, a director, officer or employee of the debtor; and
    
    
  • Does not have an interest materially adverse to the interest of the estate or of any class of creditors or equity security holders, by reason of any direct or indirect relationship to, connection with, or interest in, the debtor, or for any other reason.

With court approval, pursuant to Section 327(e), an estate fiduciary may employ an lawyer that has represented the debtor, for a "specified special purpose," if the lawyer "does not represent or hold any interest adverse to the debtor or to the estate with respect to the matter on which such lawyer is to be employed."[8]

Rule 2014 of the Federal Rules of Bankruptcy Procedure sets out the information that must be included in an employment application. It provides that such application must set forth specific facts showing:

• • The necessity for the employment;
    
    
  • The name of the person to be employed;
    
    
  • The reasons for the selection;
    
    
  • The professional services to be rendered, any proposed arrangement for compensation; and
    
    
  • To the best of the applicant's knowledge, all of the person's connections with the debtor, creditors, any other party in interest, their respective lawyers and accountants, the U.S. trustee[9] or any person employed in the U.S. Trustee's Office.

According to Rule 2014, the application must be accompanied by a verified statement of the person to be employed setting forth the person's connections with the debtor, creditors, any other party in interest, their respective lawyers and accountants, the United States trustee or any person employed in the office of the United States trustee.

Special counsel should communicate with bankruptcy counsel or the trustee at the beginning of the representation or commencement of the bankruptcy about having his or her employment and terms of engagement approved by the court.

Too often, special counsel waits until settlement has been reached and then seeks to have his or her employment, compensation and the settlement all approved in one go, with the employment approved nunc pro tunc to the date of engagement.

This practice is frowned upon and, considering the U.S. Supreme Court's ruling in Roman Catholic Archdiocese of San Juan v. Feliciano in 2020, arguably impermissible.[10]

Before settling an estate claim, have the settlement approved by the bankruptcy court.

In order to be enforceable, any settlement of estate claims must be approved by the bankruptcy court after notice and a hearing under Rule 9019 of the Federal Rules of Bankruptcy Procedure.[11]

In other words, the compromise of estate claims has no effect until approved by the bankruptcy court. Rule 9019 provides that [o]n motion by the trustee and after notice and a hearing, the court may approve a compromise or settlement. Notice shall be given to creditors, the United States trustee, the debtor and indenture trustees as provided in Rule 2002 and to any other entity as the court may direct.

Rule 9019 gives bankruptcy courts broad discretion in approving compromises.[12] In the Eleventh Circuit, courts consider the following factors in determining whether to approve a settlement of estate claims:

• • The probability of success in the litigation;
    
    
  • The difficulties, if any, to be encountered in the matter of collection;
    
    
  • The complexity of the litigation involved, and the expense, inconvenience and delay necessarily attending it; and
    
    
  • The paramount interest of the creditors and a proper deference to their reasonable views in the premises.[13]

Like other courts, bankruptcy courts typically favor the consensual resolution of claims. They are not out to blow up your settlement agreement, but they do require a record upon which to base findings of fact and conclusions of law approving your settlement. Give it to them.

Before taking your fee, have your fees and expenses approved by the bankruptcy court.

For professionals employed pursuant to Title 11 of the U.S. Code, Section 327, Section 330 governs the award of compensation and reimbursement.[14]

Compensation awarded under Section 330 is entitled to administrative expense priority,[15] which is paid ahead of general unsecured creditors.

In pertinent part, Section 330(a) provides that after notice to parties in interest and the U.S. trustee and a hearing, the court may award to a professional person employed under Section 327 or 1103 reasonable compensation for:

• • Actual, necessary services rendered by the trustee, examiner, ombudsman, professional person or lawyer, and by any paraprofessional person employed by any such person; and
    
    
  • Reimbursement for actual, necessary expenses.

The court may, on its own motion or on the motion of the U.S. trustee, the U.S. trustee for the district or region, the trustee for the estate, or any other party in interest, award compensation that is less than the amount of compensation that is requested.

In determining the amount of reasonable compensation to be awarded to an examiner, trustee under Chapter 11, or professional person, the court shall consider the nature, the extent, and the value of such services, taking into account all relevant factors, including:

• • The time spent on such services;
    
    
  • The rates charged for such services;
    
    
  • Whether the services were necessary to the administration of, or beneficial at the time at which the service was rendered toward the completion of, a case under Title 11;
    
    
  • Whether the services were performed within a reasonable amount of time commensurate with the complexity, importance, and nature of the problem, issue or task addressed;
    
    
  • With respect to a professional person, whether the person is board certified or otherwise has demonstrated skill and experience in the bankruptcy field; and
    
    
  • Whether the compensation is reasonable based on the customary compensation charged by comparably skilled practitioners in cases other than cases under this Title 11.

As the statute makes plain, the bankruptcy court has discretion to determine reasonable lawyer fees and expenses and an independent duty to satisfy itself that the fees and expenses requested are reasonable and necessary.[16]

To enable the bankruptcy court to award the fees and expenses requested, the applicant must provide the court with evidence of the time spent, fees charged, substance of the work performed, complexity of work performed, lawyer's skills, and expertise and market rates for comparable work.

Rule 2016 of the Federal Rules of Bankruptcy Procedure sets forth the procedure for applying to the court for approval of compensation for services rendered and reimbursement of expenses incurred.

The application for compensation must include a detailed statement of "(1) the services rendered, time expended and expenses incurred and (2) the amounts requested."[17] It must also disclose any payments made or promised to the applicant in connection with the case, including details about the source of any such payments.

Crucially, the application must also state whether any payments previously received by the lawyer have been shared and whether any agreement exists for the sharing of compensation received in connection with the case.

Do not share fees.

Disclosure of the particulars of any agreement to share fees approved in connection with the case is crucial because Title 11 of the U.S. Code, Section 504, strictly prohibits fee sharing in bankruptcy cases.

This prohibition encompasses typical referral fee agreements common among the plaintiffs bar, but is much broader than that. It also prohibits an lawyer from contracting out legal work to a professional who is not a regular member of the court-approved lawyer's firm.

What you don't know absolutely can hurt you.

Determining whether an individual or entity is the subject of a pending bankruptcy is free, quick and easy.

The bankruptcy courts expect competent lawyers to know how to determine whether an entity or individual is in bankruptcy, know when to make such a determination and promptly inquire as the circumstances require.

How to Determine Whether a Party is in Bankruptcy

The federal court electronic filing and records database, Pacer, has a case locator function that allows you to locate bankruptcy cases nationwide by Social Security number or employer identification number.

If you do not have this information and cannot obtain it, the advanced bankruptcy search option allows you to search by party name, narrow by date and sort by jurisdiction, among other features. You can train your staff to do this.

Relying on your client or another party's representations about whether he or she is subject to a pending bankruptcy is not sufficient to fulfill your obligation to diligently inquire.

In In re: Fisher in the U.S. Bankruptcy Court for the Southern District of Alabama in 2019, a Chapter 13 debtor listed a claim arising from a prepetition car wreck, which was the subject of a pending lawsuit, on her schedules.

Over a year after the bankruptcy filing, while the bankruptcy case was pending, the debtor's state court lawyer settled her car wreck claim and took his fee from the settlement proceeds. The lawyer's employment, his fee and the settlement itself had not been approved by the court.

After receiving an order from the bankruptcy court to turn over his fee, an order that threatened sanctions and a report to the Alabama State Bar Association if he failed to comply, and then an order to show cause why he should not be sanctioned for failure to comply with the turn over order, the lawyer pled ignorance of the whole bankruptcy situation.

He showed the court a settlement memorandum, signed by the debtor-plaintiff, which said in numerous places

I am not a party to any bankruptcy proceedings and no trustees in bankruptcy or creditor is entitled to or even claims to be entitled to any of the funds paid out of this settlement.

The court found the lawyer's reliance on this statement wholly inadequate, stating that every trial lawyer has or should have a Pacer account with which to check federal court pleadings, including bankruptcy court pleadings. It takes only a few moments to check a client's name on Pacer before distributing settlement proceeds to determine whether that client is in bankruptcy.

To rely on a client's representation that he or she is not in bankruptcy is not enough.

The client may not notice or understand the "not in bankruptcy" language. The client may be confused as to whether he or she is in bankruptcy, and, not surprisingly, sometimes clients will lie, particularly if they think that answering correctly may cause them to get less money.

In this court's view, if a lawyer fails to check Pacer to confirm that a client is not in bankruptcy immediately before distributing settlement proceeds, the lawyer runs the risk of being held liable for the settlement funds that would have otherwise gone into the bankruptcy estate.

Of course, a prudent lawyer should also check Pacer upon initial retention as well, so that his or her employment can be approved by the bankruptcy court on a timely basis.[18]

When to Determine Whether a Party Is in Bankruptcy

The plaintiff's counsel should determine whether his or her client is in a pending bankruptcy at the outset of the representation, as part of the file opening process and before any referral is made or accepted with an expectation of compensation.

The plaintiff's counsel should run a new bankruptcy search on his or her client immediately before finalizing any settlement terms. He or she should run yet another search before disbursing settlement proceeds to his or her client.

Diligent defense counsel should determine whether a plaintiff is in a pending bankruptcy, or has had prior bankruptcies, at the outset of his or her representation, as part of his or her initial investigation of the plaintiff.

Defense counsel should update his or her bankruptcy search before finalizing settlement terms, to confirm plaintiffs' authority to settle and release claims.

Finally, defense counsel should run a search immediately prior to disbursing settlement proceeds to a pro se plaintiff or to plaintiffs' counsel to confirm the settlement, and release, was properly approved by the court and will be enforceable.

What Could Happen if You Fail to Follow These Rules: a Cautionary Tale

In In re: McLemore, a Chapter 13 debtor was involved in a car accident post petition.

His plan, which was confirmed in December 2020, shortly after the accident, provided that nonexempt proceeds of the claim would be paid to the Chapter 13 trustee for the benefit of unsecured creditors.

In July 2021, seven months after the plan was confirmed, and apparently spurred by the Chapter 13 trustee's investigation of the status of the pending claim, the debtor notified his bankruptcy counsel that he had engaged a plaintiffs firm to represent him in the personal injury action.

In August, the plaintiff's lawyer contacted the Chapter 13 trustee. He notified her that the personal injury claim had been settled in June 2021 for $40,000 and that $16,788.26 in settlement proceeds had been disbursed to the debtor.

In response, the trustee filed a motion to examine the debtor's transactions with lawyers, a motion to examine lawyer fees and a motion to dismiss the bankruptcy case.

The debtor amended his schedules to reflect receipt of the settlement proceeds and claim an exemption in a portion of the proceeds and filed a motion to modify a Chapter 13 plan post-confirmation.

In turn, the debtor filed a motion to employ special counsel, a nunc pro tunc, a motion to approve the settlement and an application for approval of lawyer fees and expenses.

The court found that the settlement funds were property of the estate and that disbursement of the funds constituted conversion of estate property.

Finding that the plaintiff's firm had a history of disbursing settlement funds without court approval, the court denied both the motion to employ and the fee application and ordered the plaintiff's counsel not only to disgorge his fees to the trustee, but to turn over the full $40,000 in settlement proceeds to the trustee within 14 days.

In addressing violations of bankruptcy law, bankruptcy courts are not limited to ordering disgorgement of fees and return of converted property. Courts can and do refer counsel to state disciplinary boards, order sanctions and issue show cause orders, among other things.

A client who is found to have converted estate assets may have his or her own complaints to file with the state bar.

Conclusion

When you run that Pacer search and discover your client, or another party, is in bankruptcy, and you aren't certain how that bankruptcy affects your case, there is a whole cast of characters in the bankruptcy world who can and will help you figure it out.

You can find contact information for the debtor's bankruptcy lawyer, the Chapter 13 trustee, the bankruptcy administrator or the Chapter 7 trustee either at the top of the Pacer docket report or on the court's website.

Don't put your engagement, your fee or your settlement in jeopardy. When in doubt, reach out.

[1] 11 U.S.C. § 541(a)(1).

[2] In re Tarrant , 349 B.R. 870, 873 (Bankr. N.D. Ala. 2006).

[3] 11 U.S.C. §§ 1115(a)(1), 1207(a)(1), and 1306(a)(1).

[4] In re McLemore , 2022 WL 362915 (Bankr. M.D. Ala. 2022) (vacated and remanded on appeal with instruction to "determine whether sanctions should be imposed on the Shunnarah firm and, if so, the extent of such sanctions" in Shunnarah Injury Lawyers, P.C. v. Daryl McLemore et al., Civil Action No. 2:22CV134-ECM (N.D. Ala. January 25, 2023).

[5] In re Tarrant, 349 B.R. at 873.

[6] 11 U.S.C. §§ 1107 and 1203.

[7] Crosby v. Monroe County , 394 F.3d 1328, footnote 2 (11th Cir. 2004) (citing with approval In re Mosley, 260 B.R. 590, 595 (Bankr. S.D. Ga. 2000)).

[8] In re Tarrant, 349 B.R. at 875.

[9] Bankruptcy cases are administered by the United States Trustees ("UST"), a division of the U.S. Department of Justice, in all but two states: North Carolina and, you guessed it, Alabama. In Alabama, bankruptcy cases are administered by the Bankruptcy Administrator ("BA"). While UST's and BA's are not a perfect parallel, in Alabama, to construe code sections, cases, and secondary sources that reference the U.S. Trustee, substitute Bankruptcy Administrator.

[10] Cf. In re Osprey Utah, LLC, Case No. 16-2270 (Bankr. S.D. Ala. Mar. 27, 2018) (doc. 295) (noting a circuit split on the permissibility of nunc pro tunc employment orders, adopting a more lenient approach allowing same, but requiring the nunc pro tunc applicant to demonstrate both suitability for employment and excusable neglect in failing to timely seek employment).

[11] 11 U.S.C. § 363(b); see also In re Tarrant, 349 B.R. at 893.

[12] In re Tarrant, 349 B.R. at 893.

[13] Wallis v. Justice Oaks II, Ltd.  (In re Justice Oaks II, Ltd.), 898 F.2d 1544, 1549 (11th Cir. 1990).

[14] In re Tarrant, 349 B.R. at 893.

[15] 11 U.S.C. § 503(b)(2).

[16] In re Tarrant, 349 B.R. at 895.

[17] Fed. R. Bankr. P. 2016(a).

[18] In re Fisher , 2019 WL 1875366, *2 (Bankr. S.D. Ala. 2019).