We hold that when there has been a facially plausible claim of a substantial preference, the district court and/or the bankruptcy court cannot avoid the clear mandate of the statute by the mere expedient of approving retention conditional on a later determination of the preference issue.

Bankruptcy attorneys should review Pillowtex closely for the guidance it provides on steps debtor's counsel may undertake to avoid disqualification based on allegedly holding an adverse interest to the debtor as a result of being a contingent pre-petition creditor. A close review is also warranted by the significant number of questions raised, but not answered. For example, what constitutes a facially plausible claim? What is a substantial preference? And what should practitioners make of the Third Circuit's clear implication that the district court, on remand, has the latitude to find a preference, yet also conclude that such a finding does not necessarily warrant disqualification?

The Facts of Pillowtex

Jones, Day, Reavis and Pogue (Jones Day) had represented Pillowtex since 1996 and assisted Pillowtex in preparing for its Nov. 14, 2000, chapter 11 filing. Jones Day made certain disclosures, as required under applicable bankruptcy rules. One such disclosure was that Pillowtex paid Jones Day approximately $1 million in fees during the 90-day period preceding the filing. The U.S. Trustee objected to Jones Day's retention on the basis that these payments were voidable preferences, and thus Jones Day was not a disinterested person as required by §327.

The district court (sitting in bankruptcy) avoided ruling on the preference issue by approving Jones Day's retention subject to the conditions that (1) Jones Day return any preference it might be determined to have received, and (2) Jones Day waive any claim resulting from the preference.¹

The U.S. Trustee appealed, and the Third Circuit "agree[d] with the U.S. Trustee that the court's order incorporating the two conditions does not resolve the question of whether Jones Day received an avoidable preference and was therefore not disinterested and whether it should have been disqualified." Pillowtex, 304 F.3d at 253. The Third Circuit remanded the case to the district court for a hearing on whether a preference existed. As a result, all of Jones Day's fees accrued during the course of the case (approximately $6 million), and the alleged preference amount, are at risk.

How Does Pillowtex Change the Law?

In In re First Jersey Securities Inc., 180 F.3d 504 (3rd Cir. 1999), the Third Circuit found a transfer of restricted securities to counsel on the eve of bankruptcy to be a preference and not within the ordinary course of business. The Third Circuit stated that a "preferential transfer to [debtor's counsel] would constitute an actual conflict of interest between counsel and the debtor, and would require the firm's disqualification." Id. at 509. Therefore, the Third Circuit directed the district court to "remand to the bankruptcy court with instructions to disqualify [counsel]..." Id. at 514.

In light of First Jersey, the fact that Jones Day could be found not to be a disinterested person based on receiving a preference is not totally surprising. The real impact of Pillowtex is that it will prevent lower courts in the Third Circuit from continuing to approve the retention of professionals subject to conditions similar to those proposed by Jones Day.²

Enron

A recent bench decision in In re Enron Corp., No. 01-16034 (Bankr. S.D.N.Y. May 23, 2002), provides an interesting comparison to Pillowtex. There, Bankruptcy Judge Gonzalez was presented with a motion that sought to disqualify Milbank, Tweed, Hadley & McCloy LLP from continuing to represent the official committee of unsecured creditors. There are a number of significant differences between the two cases.³ For example, in Enron the disqualification motion was filed two months into the case and was not supported by the U.S. Trustee (who assessed disqualification as inappropriate). Still, despite the differences, the heart of the issue in Pillowtex was also present in Enron: Milbank had received potential preferences, the bankruptcy court made no factual finding as to whether the payments at issue constituted actual preferences that required disqualification, and Milbank neither returned the money at issue nor waived any claim it may have in the event the money had to be returned as a preference.⁴ A crucial distinction may be that in Enron, an examiner was charged with investigating the potential preference, and Milbank agreed to abide by whatever the examiner's conclusion was without contest, and waive any related claim if the examiner found it to be a preference.⁵ Certainly, Judge Gonzalez thought it important:

[E]ven assuming that the presumptively preferential payments represent an impermissible holding of an adverse interest, the fact that Milbank has waived any right to challenge the examiner's determination concerning their defenses to the preferential payment and because there is a certainty of any required collection, Milbank under no circumstances will be in a position adverse to the estate either in the determination or collection of any preference. Milbank's agreement to waive any right to challenge the examiner's determination concerning any preference has the same effect as a professional waiver of a claim in order to satisfy the disinterested standard of §101(14) (A)—an accepted practice that has been employed in this case and many other cases. See, e.g., In re Adam Furniture Indus. Inc., 158 B.R. 291, 297 (Bankr. S.D. Ga. 1993).

The Pillowtex Lesson

So what can a firm do to attempt to avoid such a Pillowtex-like situation?

1. Do not allow accounts receivable to get past due. Section 101(14) provides that a creditor cannot be a "disinterested person." Pillowtex suggests that a firm is at risk if it brings a past-due account receivable current during the 90 days prior to the petition date or even if it is simply collecting fees in due course prior to filing, since in either case payments would be made on antecedent debt. Bringing a past-due account current certainly poses far less risk when done more than 90 days before the petition date. However, the timing of a chapter 11 petition is obviously not wholly predictable.⁶ Moreover, absent a retainer, any payment received by a firm within 90 days prior to the petition date could be argued to constitute a preference, requiring the firm to either forego the payment or defend the preference claim in connection with the debtor's application to approve the firm's employment. Pillowtex will force debtors' counsel to be more proactive about maintaining a retainer balance that at all times exceeds all uncollected (whether actually billed or not) time and expenses (or at least collecting past-due receivables well ahead of any bankruptcy filing), or to face the unpleasant prospect of leaving money on the table.

2. Obtain a sizeable retainer for bankruptcy work. Since the issue was not before it in Pillowtex, the Third Circuit explicitly reserved the issue of how debtor's counsel could receive fees for bankruptcy planning "consistently with the provisions of the Code." Pillowtex, 304 F.3d at 255. The U.S. Trustee argued that "professionals entering bankruptcy cases protect themselves from the preference issue by obtaining a retainer, and they...draw down on the retainer during the 90-day period so as to avoid raising the issue of whether or not they received preferential payments." Id. This provides some comfort that the common practice of obtaining, and drawing against, a retainer remains acceptable. Certainly, drawing against a retainer should pose no preference issue because such draws are not "on account of an antecedent debt." Therefore, one method of protection against a Pillowtex-like scenario is to obtain a large retainer, frequently draw earned fees from that retainer, and then simultaneously request that the client replenish the retainer.

3. Be diligent and pro-active. A prima facie (even if not actual) preference may result if a client's account receivable at any time exceeds the amount of the retainer and payment is later made. Therefore, it is critical that all bills plus all internally billed time and expenses (and, for that matter, time and expenses that have been incurred but not yet recorded anywhere) at all times be less than the retainer balance. If a firm is going to draw fees from its retainer and not take in any new cash from a client in the 90 days preceding a filing, then the retainer needs to be estimated at an amount high enough to cover the total burn rate for that period. If a firm chooses to invoice the client for fees as they are incurred and not draw down on the retainer, then the account receivable can be kept low by billing and collecting more frequently. However, this approach might be attacked as involving a payment on account of an antecedent debt.⁷

Conclusion

Unfortunately, Pillowtex raises more questions than it answers. It is, however, a wake-up call for attorneys and their clients. Human nature sometimes causes attorneys to hesitate to ask clients to pay bills and/or replenish retainers. However, clients invest considerable time and money in bringing counsel up to speed, and attorneys do no favor for their clients by creating a situation that may jeopardize a client's ability to continue using its counsel after a bankruptcy filing. Pillowtex should remind bankruptcy attorneys to review their practices regarding retainer and accounts-receivable management. Enron, of course, exemplifies other strategies that may be considered in appropriate circumstances.

Footnotes

¹ These conditions were proposed by Jones Day. The U.S. Trustee agreed to identical conditions with respect to the retention of at least one other professional in Pillowtex. Return to article

² In re Midland Food Servs. L.L.C., No. 00-4036 (Bankr. D. Del. Dec. 14, 2000), was one of the cases that Jones Day presented to support its position. That case featured a "conditional waiver similar to" that offered by Jones Day. Pillowtex, 304 F.3d at 253-54 . In Midland, the "bankruptcy court permitted retention based on the court's conclusion that a conflict was only potential until the preference was definitively adjudicated." Id. at 254. However, the Third Circuit in Pillowtex stated, "[t]hat decision was not appealed to this court and appears to be inconsistent with the decision we reach today." Id. Jones Day argued that "historically, bankruptcy courts have been accorded wide discretion in connection with...the terms and conditions of the employment of professionals." Pillowtex, 304 F.3d at 254. The Third Circuit accepted that proposition, but pointed out that such discretion in determining conflicts is not "limitless" and a "bankruptcy court does not enjoy the discretion to bypass the requirements of the Bankruptcy Code." Id. Return to article

³ As noted in dicta by the Enron court, committees employ their professionals under §1103, which does not require disinterestedness as does §327. Return to article

⁴ Alleged preference receipt was just one of several objections in Enron. Return to article

⁵ A similar arrangement could have been made even if there were no examiner because a second law firm had been retained as "conflicts counsel" to investigate claims and handle matters in which Milbank might have a conflict. Return to article

⁶ Moreover, every potential debtor does not become a debtor. A blanket policy of prohibiting the collection of a past due account receivable within 90 days of the expected petition date is not advocated here. It may be advisable to bring an account receivable current, even if a potential preference. Also, while 90 days is ordinarily thought of as the benchmark, it is always possible that a court may find counsel to be an "insider," extending the look-back period to extend one year. While attorneys are not "insiders" (as defined in the Bankruptcy Code) per se, courts have found attorneys to be insiders if they exercise "such control or influence over the debtor as to render their transactions not arms-length." Kepler v. Schmalbach (In re Lemanski), 56 B.R. 981, 983 (W.D. Wis. 1986). See, also, Wake Forest Inc. v. Transamerican Title Ins. Co. (In re Greer West Investment Limited Partnership), 81 F.3d 168 (9th Cir. 1996) (in considering whether firm's vote on plan constituted approval of impaired class under §1129(a)(10), found "that these facts—the debtor's lawyers acting at the debtor's behest in such a way as to influence the disposition of the bankruptcy estate—constitute 'indicia of control [that are] very similar to the control relationships which are expressly defined to be insiders in §101(31)'"); Winick v. Daddy's Money of Clearwater Inc. (In re Daddy's Money of Clearwater Inc.), 187 B.R. 750 (M.D. Fla. 1995) (finding attorney to be insider for preference purposes); Barnhill v. Vaudreuil (In re Busconi), 177 B.R. 153, 158 (D. Mass. 1995) (noting that a debtor's lawyer is "not considered an insider merely because of the lawyer-client relationship, but only if the relationship is such that the lawyer is likely to have actually exercised influence over the debtor to obtain the transfer"). Return to article

⁷ Which, of course, does not necessarily create preference liability. A host of defenses, including the "ordinary course" defense, may apply. Moreover, the retainer should be viewed as security. Therefore, as long as the amounts paid are less than the retainer, there should be no preference because the firm would not be receiving more than it would in a chapter 7 liquidation. One could also conceivably (but not necessarily colorably) argue that paying bills early may be preferential. In fact, this appears to have been the U.S. Trustee's original position in Pillowtex. This argument was not pursued on appeal. Return to article