Two recent appeals court decisions address important ethical and professional compensation issues: In re Federal Mogul-Global Inc.² and In re Financial Federated Title Trust Inc.³

We All Have Our Limitations: In re Federal Mogul-Global Inc.

Federal Mogul and its related debtors are auto-part manufacturers and distributors that have significant exposure to asbestos liability. An equity committee was appointed in this case, and it applied under 11 U.S.C. §§328(a) and 1103 to employ a financial advisor on an hourly basis with a cap of $200,000 per month on the financial advisor's fees for the first five months of their employment and $125,000 for each month thereafter.

The unsecured creditors' committee objected to the application on the ground the equity committee members had no chance to receive any distribution from the chapter 11 as the debtor was insolvent.⁴ The bankruptcy court ultimately approved the financial advisor's retention, but capped the advisor's compensation at $30,000 per month on the grounds that (1) the debtor was probably insolvent, and (2) the equity committee's financial advisor could rely on the financial data compiled by the debtor's financial advisor so they would not have to duplicate the bulk of the debtors' financial advisor's work. The equity committee appealed, and the decision was affirmed by the district court.

On appeal, the Third Circuit, in an opinion that ultimately vacated the lower court opinions due to the lack of an adequate record, made four important rulings.

First, the Third Circuit held that it was permissible for bankruptcy courts to impose compensation caps on professionals. The Third Circuit found that such caps were not prohibited by either 11 U.S.C. §328 or any other Code provision. The court found that capping fees was appropriate under the provisions of 11 U.S.C. §328(a), which permits a court to approve professional employment under reasonable terms and conditions.⁵

Second, the Third Circuit ruled that while compensation on a lodestar, or hourly rate basis, was reasonable, courts were not bound to accept any hourly fee arrangement proposed by a professional or only to reduce those fees under 11 U.S.C. §330. Therefore, courts could impose caps on hourly fee arrangements, as part of approving the professional's employment, even if the concept of hourly fee arrangements was generally reasonable.⁶

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While Federal Mogul is clearly not a wholesale return to the old notions of economy of the estate, it is an opinion that should be carefully monitored.

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Third, the Federal Mogul court held that it was permissible, under appropriate facts⁷ for a bankruptcy court, to consider whether a committee's constituency could receive value from a bankruptcy case in determining whether to appoint or limit compensation to a professional.

Finally, the court held that a bankruptcy court could consider and, by implication, direct the sharing of financial information generated by financial professionals in a case to prevent costly duplication of effort.⁸ The Third Circuit held that sharing this information did not violate any duties owed by the debtors' financial professional to the estate, especially in light of the debtors' willingness to share the information.

In summary, the Federal Mogul opinion indicates an increased willingness of courts, especially appellate courts, to carefully review the terms of professional fee arrangements in chapter 11 cases.

Home May Not Be a Sweet Homestead: Financial Federated

The second case comes from the Eleventh Circuit and involves the ever-popular topic of the extent of Florida homestead protections.⁹ In Financial Federated, the Eleventh Circuit affirmed and adopted a bankruptcy court's ruling that property constituting a homestead under Florida law could be subject to the imposition of an equitable lien or constructive trust where a creditor or trustee could demonstrate the homestead was acquired with funds that were fraudulently or improperly acquired by the debtor claiming the homestead.

The facts underlying Financial Federated are fairly straightforward. One of the owners of the homestead in question was involved in a ghoulish ponzi scheme involving the alleged purchasing of and obtaining investments in life insurance policies on terminally ill people.¹⁰ The owner took nearly $1 million of the illegal ponzi scheme profits¹¹ and invested them in his homestead. Shortly thereafter, the trustee of the entity from which the ponzi scheme was operated filed suit to have a constructive trust or equitable lien placed on the owner's homestead. The bankruptcy court imposed the lien, and the district court affirmed.

In an opinion by the Eleventh Circuit,¹² which adopted the bankruptcy court's opinion in this matter, the appeals court stated that while Florida homestead law protected homesteads against criminal forfeiture actions under state law and fraudulent conveyance actions where non-exempt assets were fraudulently converted into homesteads, homesteads acquired by the use of fraudulently or improperly acquired assets could be subject to constructive trusts or equitable liens.

Relying on an old line of Florida cases,¹³ the Federated Financial court ruled that the owner directly used fraudulently obtained funds to directly purchase¹⁴ his homestead rather than using funds that were obtained from his employer, which defrauded the ponzi scheme victims and converted those funds to exempt assets. Indeed, the most serious challenge to the trustee in this case by the owner was the owner's contention that he had "earned" the funds as commissions from the ponzi scheme and merely defrauded his creditors by converting the non-exempt assets to exempt assets under the Havoco doctrine. The court rejected that argument, finding that the owner gave no value to the companies involved for the ponzi scheme proceeds by his services.

The importance of this case is fairly clear. Now, a Florida homestead can be defeated through an equitable lien/constructive trust theory if the creditor or trustee can demonstrate some degree of tracing of the fraudulently obtained assets to the homestead. The court in Financial Federated did not articulate how strict the tracing requirement would be, but in ponzi and similar fraud schemes, it appears that it could be argued that any funds generated directly or indirectly from that scheme are proceeds of a fraud and an equitable lien can be imposed on a Florida homestead under such a theory.

This Just In—Do Not Ignore the Code, Do Not Collect Your Unpaid Pre-petition Fees in Chapter 7 Cases: Bethea v. Robert Adams & Associates

In Bethea v. Robert Adams & Associates, 2003 WL 22961377 (7th Cir. Dec. 17, 2003), three debtors contracted pre-petition with chapter 7 bankruptcy attorneys to represent them in chapter 7 cases. The chapter 7 attorneys were not paid their full fees as retainers prior to filing their clients' chapter 7 cases. Rather, each chapter 7 attorney agreed to accept payments of their fees over time, including after their clients' bankruptcies were filed. After the debtors received their discharges, they sued (with new counsel as noted by Judge Easterbrook) their chapter 7 attorneys, seeking a refund of their post-petition payments and holding their chapter 7 attorneys in contempt. The bankruptcy court overruled their adversary proceedings, finding that the fees paid by the debtors were reasonable under 11 U.S.C. §329 and that 11 U.S.C. §329 was an implied exception to the discharge provisions of 11 U.S.C. §329. In re Bethea, 275 B.R. 284 (Bankr. N.D. Ill. 2002). The bankruptcy court's decision was affirmed by the district court, 287 B.R. 906 (N.D. Ill. 2003).

The Seventh Circuit overruled the lower court's decisions and rejected their rationale that 11 U.S.C. §329 was an exception to the discharge provisions of 11 U.S.C. §727. The Seventh Circuit held that all legal fees owed by chapter 7 debtors at the time of their petition are discharged by 11 U.S.C. §727 (unless otherwise excepted from discharge), including any legal fees owed under a pre-petition agreement with their chapter 7 attorney.

While the lower-court Bethea decisions only dealt with fees owed for legal services performed pre-petition,¹⁵ the Seventh Circuit held that the 11 U.S.C. §727 discharge also discharged the debtor's liability for all fees contracted for pre-petition, whether or not the services were performed pre- or post-petition, rejecting the rationale of the Ninth Circuit in In re Hines, 147 F.3d 1180 (9th Cir. 1998), which held that the legal fees contracted for pre-petition, but which were performed post-petition, were not discharged under 11 U.S.C. §727.

The importance of Bethea is multifold. First, under Bethea, it means that a "no-money-down" chapter 7 is impermissible (or, more exactly, the lawyer's fee will be at serious risk) as a matter of law. Second, it raises the questions in chapter 13 cases as to how contracted-for pre-petition attorney fees are to be treated under such a strict reading of the Code. Are contracted-for but unpaid chapter 13 debtor's counsel fees administrative claims or executory contracts, or will they require some other form of court approval to avoid the chapter 13 discharge provisions? Finally, other than recommending having Congress fix the problem of chapter 7 attorney fees, the Bethea court offered no guidance on this issue, other than an implicit suggestion that a post-petition contract for post-petition services, rather than a pre-petition contract with a debtor, might survive discharge. Therefore, consumer bankruptcy attorneys must reexamine their employment agreements with their clients so as to not run afoul of Bethea.

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Footnotes

¹ Board-certified in business bankruptcy by the American Board of Certification. Return to article

² 348 F.3d 390 (3rd Cir. 2003). Return to article

³ 347 F.3d 880 (11th Cir. 2003). Return to article

⁴ The unsecured creditors' committee also objected on the grounds the financial advisor had a conflict of interest, which was apparently resolved as it is not discussed in this opinion. Return to article

⁵ 348 F.3d at 401. Return to article

⁶ Id. at 400. Return to article

⁷ In this case, the circuit court held that there was an insufficient record to determine whether the Federal Mogul equity was out of the money and whether the caps were appropriate. Return to article

⁸ Id. at 403-405. Return to article

⁹ See, generally, Tramel v. Stewart, 697 So.2d 821 (Fla. 1997) (homestead protected from criminal forfeiture under Florida law); Havoco of America Ltd. v. Hill, 790 So.2d 1018 (Fla. 2001) (homestead obtained or augmented by fraudulent conversation of non-exempt assets to homestead protected under Florida law). Return to article

¹⁰ See 347 F.3d at 882 n.1. Return to article

¹¹ Through a highly complex set of transactions. See Id. at 880-885. Return to article

¹² It is interesting to note the Eleventh Circuit did not certify this case to the Florida Supreme Court for their interpretation of Florida homestead law as they did in the case of Havoco of America Ltd. v. Hill, 790 So.2d at 1018. Return to article

¹³ See Milton v. Milton, 106 So. 718 (Fla. 1912), and Jones v. Carpenter, 106 So. 127 (Fla. 1925). Return to article

¹⁴ The Eleventh Circuit found that the analysis would be the same if the owner used fraudulently obtained proceeds to increase equity in his homestead. Return to article

¹⁵ See Judge Cudaly concurring in part and dissenting in part at 2003 WL 22961377 *4-*7. Return to article