Some, but not all, lawyers in a bankruptcy case need court approval before they can represent their client and get paid for doing so. We begin by noting a few who do not need court approval. Then we move on to those who do.

First, if you are going to represent a chapter 7 debtor (filing the petition and schedules, showing up at the meeting of creditors and whatever else) you don't need court approval to take on the case or to take a fee. This is conceptually intuitive once you recall that a lawyer who represents a chapter 7 debtor represents only the debtor and not the estate,¹ whereas, a chapter 11 debtor's attorney represents the debtor company and its estate. The court can, however, second-guess your fees and make you disgorge money later if it thinks your fee was too high. In just about every district there is a "rack rate," and if you come in at or below that rate, you won't run into much trouble.

Second, if you represent a creditor in a bankruptcy case, then for the most part your retention and compensation is a matter between you and your client—unless you are seeking payment from the estate. Examples of a creditor's counsel seeking payment from the estate include (1) where the creditor asserts that it made a "substantial contribution" under Bankruptcy Code §503(b)(3)(D) (we say a bit more about this topic below) or (2) where an oversecured creditor seeks attorneys' fees under §506(b). If you represent another party that is not going to be paid from estate funds (such as an investor or asset purchaser, a trade vendor, an employee, etc.), you are free—subject to the ordinary ethics rules—to make your deal with the client, without court involvement. Note, however, that if you represent more than one creditor, you must disclose that fact and provide the information required by Bankruptcy Rule 2019.

But none of these is our primary concern. Rather, we consider here those cases where you want to get your fees directly out of the bankruptcy estate. Here, you are very much under court control.

Debtors' Bankruptcy Counsel

Code §327(a) says that "the trustee, with the court's approval, may employ one or more attorneys...to represent or assist the trustee in carrying out the trustee's duties under this title."²

In practice, it works like this: Among the papers that prospective debtors' counsel prepares at the beginning of the case is an "Application to Employ Counsel." It is filed not in your name, but in the name of the client. It says (e.g.,) that "Dawson Debtor, the debtor and debtor-in-possession (DIP) in this case, hereby requests authorization to employ the firm of Ayer, Bernstein & Friedland to represent it as debtor's counsel in this case."

Conflicts Basics

Now, let's go back and take a second look at §327(a). It provides that "the trustee...may employ one or more attorneys," but it imposes two limitations. One, the attorney must not "hold or represent an interest adverse to the estate." And two, she must be a "disinterested person."

No Adverse Interest

"Adverse interest" is not defined in the Code. In our view, to understand it, you start with what you know about conflicts outside of bankruptcy. For starters, you can't represent both plaintiff and defendant in a (non-bankruptcy) lawsuit; consequently, you can't represent both creditor and DIP in the bankruptcy case. So far, so good.

The trouble is that bankruptcy isn't quite like non-bankruptcy litigation, and there are problems for which non-bankruptcy principles offer no analog—most importantly, how aggressively may you support the interests of the old equity owners in fighting off the depredations of creditors? There is no easy answer to this one; the best we can do is to say you can represent them some, but not too much. As DIP counsel, one of our favorite cases would be Casco Northern Bank v. DN Associates, 3 F.3d 512 (1st Cir. 1993), where the court allowed payment for a DIP counsel whose main contribution to the case appears to be that he induced senior creditors to pay the juniors. Among our least-favorite cases would be In re Kendavis Industries Intern. Inc., 91 B.R. 742 (Bankr. N.D. Tex. 1988), where the court comes close to saying that anything you do other than simply pay off creditors is improper. Then again, the facts in Kendavis were extreme: The old equity owners seem to have taken the position that if they were going down, then they would be perfectly happy to take the creditors down with them—and whatever the law allows, we would concede it's probably not that.

Disinterestedness Requirement

So much for "adverse interest." But recall that the court must also find that counsel is a "disinterested person." Unlike "adverse interest," it turns out that "disinterested person" is a defined term, and the definition is stringent. See Code §101(14). It provides (among other things) that a "disinterested person" is one who "is not an equity security-holder" and "is not...a director, officer or employee of the debtor...." If the debtor's pre-bankruptcy corporate counsel is (a) a two percent stockholder and/or (b) the corporate secretary, he may be the person best equipped to represent the estate; yet on the face of things, he is disqualified.

The same is true of the law firm that is owed $1,000 for pre-bankruptcy work. It is a creditor and therefore not a "disinterested person" under §101(14). These are difficult waters to navigate. The usual approach is to get pre-paid for your work during the 90 days before bankruptcy so that you are not a preference recipient and also not a creditor as of the petition date. Unfortunately, filings cannot always be timed that well, the debtor does not always have the ability to pay in advance, and the amount of fees cannot always be predicted—so it is worth careful planning, but it doesn't always work.

Some courts have cooked up "de minimis" exceptions and such to get around the disinterestedness rule, which is often viewed as unduly restrictive. We are happy to be on the receiving end of such largesse, but would not recommend relying on it.

Pillowtex

The Third Circuit in In re Pillowtex, 304 F.3d 246 (3d Cir. 2002), has provided a fair amount of guidance on steps that a debtor's counsel should take (from early on) to avoid disqualification for allegedly holding an interest adverse to the debtor as a result of being a pre-petition creditor. In Pillowtex, the company paid $1 million in fees to its law firm in the 90-day period preceding its chapter 11 filing (thus constituting an avoidable preferential transfer). As a potential defendant to an avoidance action, the law firm was a potential creditor and thus did not meet §327(a)'s distinterestedness requirement. As a result, the law firm was disqualified from the case, and all of the fees it had earned became subject to disgorgement.

We offer a couple of guidance points here. First, do not allow accounts receivable to get past due. Pillowtex suggests that a law 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 account of antecedent debt. Bringing a past-due account current certainly poses far less risk when done more than 90 days before the petition date. However, as noted above, the timing of a chapter 11 petition is not entirely predictable.

The best solution is this: Obtain a sufficient pre-petition advance payment retainer before commencing bankruptcy work. It appears 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 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.

Approval of Retention Application

Absent conflict issues, approval of an employment application is usually pretty routine. This approval comes in the form of an order authorizing employment of counsel. Strictly speaking, only then are you allowed to technically represent the DIP in the case—but everybody recognizes there is a bit of slippage in the early hours or days, and you are likely to get paid for the work that you do prior to entry of the approval order, so long as your application is timely filed and does in fact get approved in due course. To facilitate this, employment orders are typically entered to be effective as of the petition date or the date on which the employment application was filed. Some judges will enter an interim order approving the employment application, and then set the matter for a final hearing a few weeks later to give parties more time to review and address any concerns (including, potentially, those of a committee, which may not have been appointed until several weeks after the case). This approach allows a more careful review of an employment application, while protecting the professionals for necessary work that is done while that review is ongoing.

Disclose, Disclose, Disclose

The application must be accompanied by an affidavit signed by the professional, in accordance with Bankruptcy Rule 2014, setting forth, among other things, all of the professional's connections with the debtor, creditors, other parties-in-interest, their attorneys and accountants, and the U.S. Trustee's office. This disclosure is made so that other parties, and the court, can evaluate whether there are disqualifying conflicts. Although the Bankruptcy Rules do not prescribe the exact form that the affidavit should take, the affidavits all tend to look fairly similar.

In a large case, preparing the disclosures can entail a lot of work. It is worthwhile to do this work carefully to make sure your disclosures are complete and to err on the side of over-disclosure. The consequences for incomplete or misleading disclosures may include disqualification, loss of compensation and sometimes worse.

Conducting the Conflicts Search

We've seen that you can't represent the DIP if you have certain kinds of conflicts. But you can't deal with conflicts if you don't know about them. In a big case (or a big firm—or both), just identifying conflicts can be a major undertaking. Here, we offer a protocol designed to make sure you identify conflict problems.

At the outset of the representation, you should obtain lists from the company of its top creditors and other conventionally adverse parties. The scope of the search categories can be narrowed, within reason, by using parameters such as "Top 50" or "in the last three years," depending on the circumstances. These categories may include, but are not limited to, any or all of the following: (a) former directors and officers, (b) landlords and tenants, (c) key customers, (d) primary vendors, (e) largest 50 unsecured creditors, (f) secured creditors and lienholders, (g) other professional services firms, (h) insurers, (i) securities holders, (k) litigation counterparties and (l) parties to key contracts. As the data comes in from the company, you'll then need to cross-reference it against your client database and generate a report that reflects your search results.

When a name is identified as a current client of your firm, the usual course of action is to disclose the client relationship in general terms on the disclosure exhibit to your retention affidavit. The disclosure usually goes something like "Ayer, Bernstein & Friedland represents Acme Tire Co., a key vendor of the debtor, in corporate and transactional matters unrelated to the debtor."

Of course, the appropriate level of detail for each disclosure will vary based on the circumstances. For instance, where a particular client relationship is more suspect and more likely to become adversarial (e.g., where the law firm represents the non-debtor parent or significant equity-holder), it is a good idea to address the issue in detail in the actual text of the affidavit (as opposed to a two-line cursory statement in an exhibit).

As the bankruptcy case progresses, it is important to remember that as debtor's counsel, you'll still have a duty of continuing disclosure. This means that if a potentially adverse relationship between the debtor and another client was either unknown to you at the time you submitted the original retention affidavit or later developed as a result of unforeseen events, you should file a supplemental affidavit that discloses the existence of such relationship. As with the initial disclosures, this supplemental disclosure shouldn't be viewed as a burden, but rather as the opportunity to get everything out on the table and avoid the appearance of impropriety that would otherwise likely arise if the relationship was uncovered by another party.

Handling Actual Conflicts of Interest

With that said, it is important to understand that debtor's counsel's ongoing representation of key parties in interest is not prohibited. What is prohibited is representing such parties in matters adverse to the debtor (e.g., filing a proof of claim in the debtor's bankruptcy case).

In these situations, one common fix is to retain conflicts counsel to represent the DIP in matters where the actual conflict of interest exists between the DIP and one of your firm's other current clients. Conflicts counsel is then available to handle one-off matters (e.g., claims objections, avoidance actions) that will be brought against your other clients by the debtors. If local counsel has been retained in the case, such a firm often serves this dual capacity as well. When you're drafting your retention affidavit, it is usually best to expressly note that your firm will not represent such clients in any matters adverse to the DIP (and vice versa) and that, should such matters arise, conflicts counsel will represent the DIP in such regard.

An additional point of note is that often when a holding company files for chapter 11, some of its subsidiaries and affiliates will file along with it. In such cases, retention applications often contemplate that the professionals will be representing all of the debtors, not just one. This raises obvious questions as to conflicts of interest (e.g., holding company debtor is largest creditor of subsidiary debtor). We don't have the space here to give this issue its due, but the bottom line is that most courts understand that in the absence of an actual conflict, a single firm can adequately represent multiple debtors. This is also the logical result when one thinks about the expense that would be involved if the baseline rule were that each debtor in a multi-debtor enterprise be represented by separate counsel. However, where there is an important actual or potential conflict between affiliated debtors, it may be appropriate to seek separate counsel.

Getting Paid

Obtaining approval of the employment application is a good start; but it is not the end. There is still the matter of fees. The statute allows "(A) reasonable compensation for actual, necessary services rendered...and (B) reimbursement for actual, necessary expenses." See Code §330(a)(1). So even though authorized to represent the estate, you need to make a separate application to get paid. The statute specifies that "the court may...award compensation that is less than the amount of the compensation requested." Code §327(a)(2); see, also, §503.

Fee Applications

Given these constraints, getting a fee award is far from automatic. We all know about the public complaints against allegedly excessive bankruptcy fees. We are acquainted also with the defense from lawyers who argue that they add value and should be well compensated, in order to attract talented professionals to the bankruptcy practice. We won't get into that mare's nest here. Suffice it to say that anyone who wants to get paid for representing the DIP had better be prepared to keep full and accurate time records (usually in tenth-of-an-hour increments), and to be able tell a plausible story as to why his services are in fact worthy of reward.

In filing a fee application, you should review the court's local rules and U.S. Trustee's guidelines to make sure you provide the information the court requires in the proper format and that you don't seek fees or expenses of a kind that the court does not permit.³ See http://www.usdoj.gov/ust/guidlins.htm (providing downloadable access to the official U.S. Trustee fee guidelines, including suggested billing categories and sample summary sheet).

In §330(a)(3), there is a list of "factors" that the court may consider in setting fees. The statute lists five factors and specifies that list is not exclusive. Some court decisions have listed more factors. See, e.g., Johnson v. Georgia Highway Exp. Inc., 488 F.2d 714, 717 (5th Cir. 1974). It is often a good idea to address these factors in your fee application, although the list of factors should not constrain you from telling the story of how your work benefited the estate.

Any party in interest can object to an interim or final fee application. The U.S. Trustees tend to be particularly active in this area, perhaps believing that other lawyers in the case may not be sufficiently vigilant in policing each other's fees. Even without objections, judges may raise issues and concerns of their own.

Interim Payment

In a simpler time, at least in smaller cases, you had to wait until the end of the case and take your fees out of the final distribution. Maybe that is still true today somewhere, but we know of no such evil place. Courts typically permit some sort of mechanism for "interim fees." This is contemplated by §331, which provides for interim fee applications once every 120 days or more often if the court permits. In large cases, even the 120-day delay can be a burden on professionals. As a result, many courts will enter orders permitting monthly payment of undisputed fees and expenses, subject to a holdback (a typical arrangement might be 80-95 percent of fees and 100 percent of expenses). You still need to file interim and final fee applications, but the monthly compensation orders help with the cash-flow issues.

Local vs. National Rate

In recent years, professional service firms with national reputations and extensive experience representing debtors in large chapter 11 cases have captured a large share of the market. When a bankruptcy case is filed in a city where a local professional typically charges lower hourly rates than national firms charge, an issue arises as to whether such national firms may be compensated at their customary hourly rates. This is known in the business as the "national rate vs. local rate" debate. For the most part, however, this debate appears to be coming to a close, with most bankruptcy courts and U.S. Trustees recognizing that compensation should be based on the customary rates the retained firm typically charges. If you look at the legislative history, you will see that it supports this result.

Nonetheless, it is important to be aware that certain courts to this day will enforce the local rate rule. In addition, if you find yourself considering filing in one such jurisdiction, it would behoove you to be well-versed in the relevant case law and prepare to support your compensation as "reasonable" in the event that such a challenge arises.

Priority of Payment

Ok—now, the bad news is that you have to jump through all of these hoops to get paid. The good news is that when it does come, you go to the head of the queue. The Code provides for a schedule of priorities in distribution; Bankruptcy Code §507(a)(1) specifies that first priority goes to "administrative expenses." Your allowed fees for services in representing the DIP count as an "administrative expense."

Beware of Conversion

But the administrative-expense priority is not necessarily the end to all your troubles. One hundred percent of nothing is still nothing, and you get your priority payment only if there is enough to pay administrative expenses (subject to getting a carve out, as discussed below). Here is a potential nightmare scenario: the chapter 11 collapses into chapter 7. Administrative expenses for the chapter 7 trump the administrative expenses for chapter 11, so you may find that there's not enough money to pay all chapter 11 administrative expenses in full—or sometimes at all. It is typical (and usually quite prudent) for the DIP's counsel to get a pre-petition retainer in order to deal with this risk. This is a good idea, although it usually just limits (rather than eliminates) the risk.

Obtaining the Carve-out

Another risk may be even more common—that the estate's only assets will be encumbered by a secured creditor's (or DIP lender's) first-priority lien. If the secured creditor is undersecured, there will be nothing left to pay professional fees. To deal with this risk, professionals usually negotiate a "carve-out" to provide for the "super-priority" treatment of their allowed fees. The carve-out is essentially an agreement by the secured creditor to subordinate its lien and claim to certain allowed professional fees, permitting such fees to come first in line in terms of payment from the estate's assets.

The carve-out may be subject to a dollar-amount cap and also to restrictions on the services that can be paid from the carve-out (i.e., you usually cannot use the carve-out to sue the secured lender who agreed to it). As a practical matter, the secured lender usually agrees to the carve-out because otherwise nobody will represent the debtor (or committee) and the case will fall apart, further diminishing the overall value of the secured lender's collateral. These carve-outs are very common, but they are not automatic. Make sure you negotiate a carve-out up front, and obtain proper court approval through the applicable first-day financing motion (e.g., motion to approve cash collateral stipulation). Otherwise, you may find at the end of the case that you did a lot of free work, mostly for the benefit of the secured creditor.

Bankruptcy Code §503(a)
and Substantial Contribution

There is another route to compensation in Code §503(a), the section that governs administrative expenses. Section 503 (b)(3)(D) allows compensation to "a creditor" who makes "a substantial contribution" to a chapter 11 case. Section 504(b)(4) allows compensation for its attorney. This rule will occasionally enable a creditor that performs services that are valuable to the entire estate (as opposed to just in its own self interest) to get its fees reimbursed. But we don't think this rule was intended to allow debtor's counsel to circumvent the requirements of §327, and we don't think any debtor's counsel should rely on this as a means to get paid.

Special Counsel

For one, §327(e) authorizes the trustee to appoint a firm as special counsel for a particular purpose. The typical example would be the case where debtor's counsel is in the midst of litigation on the debtor's behalf when the chapter 11 begins. The debtor wants to use that same counsel to complete the litigation. The appointment still needs court approval, but the conflict rules are less stringent. Just as before, counsel must have no "adverse interest," but in this case, only "with respect to the matter on which such attorney is to be employed." There is also no "disinterestedness" requirement.

It is thus much easier to qualify under Code §327(e) than under §327(a). But courts have been alert to prevent counsel from using §327(e) as an end run around §327(a): You can't be "special counsel" for the purpose of "generally representing the DIP." By its language, §327(e) also seems only to apply to lawyers and not to, say, accountants who cannot satisfy the disinterestedness standard but may have a special role they are particularly well qualified to play. On occasion, a judge will "bend" this rule to permit a non-lawyer to be retained under §327(e).

Non-lawyers and Bankruptcy Code §327(a)

When lawyers talk about Bankruptcy Code §327(a), the conversation tends to focus on the matter of fees for counsel who represent the DIP. Its scope is broader than that. In fact, §327(a) speaks of "attorneys, accountants, appraisers, auctioneers or other professional persons." Not surprisingly, there is a good deal of activity relating to the employment of these other professionals. Some of this concerns what sort of people are "professionals" who need court approval to be retained. We have seen, for example, real estate brokers end up working for free because nobody told them to seek approval of their retention in advance. A court may sometimes stretch to approve compensation for someone who was not retained in advance, perhaps through retroactive retention order or on a quantum meruit basis—but don't count on it.

In large cases where a debtor employs many professionals, the court will sometimes enter an order authorizing the employment of "ordinary course" professionals in order to avoid having to consider a multitude of employment applications for professionals who perform routine services. Typically these are subject to a monthly compensation cap (both for each individual professional and for all such professionals in the aggregate), to assure that any of the substantial professional retention are approved by the court on an individual basis.

Potential Retention and Fee Payment Alternatives for Financial Advisors and I-Bankers

Another issue with respect to Code §327(a) retention involves investment bankers and financial advisors, who typically don't like to keep records in quarter or tenth of an hour increments and also often charge flat monthly fees plus success fees rather than hourly fees. Some courts resist this, in part because it is difficult for the court to evaluate the work performed and the "value" conferred without time records and in part because the fees are sometimes enormous.

In addition, financial advisors are often employed by distressed companies prior to the bankruptcy filing, sometimes in the capacity of corporate officers. This has caused problems when the filing takes place and the DIP seeks to employ the same advisor via Code §327(a). In such cases, some DIPs will file a motion pursuant to Bankruptcy Code §363 seeking to approve a post-petition engagement agreement with the financial services firm. We will refrain from getting into detail on this, but do know the possibility is out there.

Using Bankruptcy Code §328 for Locking in Approval of Success Fees

Another issue we want to alert you to, but won't get into here, is that some professionals (financial advisors and investment banking firms, in particular) will utilize §328 to obtain up-front approval of lump-sum success or transaction fees. Take a look at Bankruptcy Code §328, and you will understand the basis for this.

Committee Professionals

Paralleling Code §327, §1103 provides that a creditors' committee in a chapter 11 case may appoint counsel and other professionals. Code §§328 and 330 specify that the committee's professional fees also will be a charge against the estate. The same sort of adverse interest rules apply, with a notable exception: The disinterestedness requirement does not apply, just the adverse-interest test. Because the most obvious candidate for committee counsel may be a lawyer who previously represented an individual creditor, §1103 specifies that representation of one or more individual creditors will not be an adverse interest that per se prevents the lawyer from representing the committee. It does, however, provide that he cannot represent the individual creditor at the same time that he is representing the estate.

Footnotes

¹ In these cases, it is the debtor and not the bankruptcy estate that pays the fee; the fee is typically paid in full before the case is filed. Indeed, the Supreme Court's January 2004 decision in Lamie v. US Trustee held that a chapter 7 debtor's counsel ordinarily cannot be paid from estate funds. Return to article

² Recall that the debtor-in-possession (DIP) plays the role of trustee (see §1107) in the majority of chapter 11 cases where no trustee is appointed. Return to article

³ Local rules vary, but some courts have limits on fax charges, meal expenses, billing travel time, compensation for time spent preparing fee applications and other sorts of expenses. Return to article