There appears to be a recent trend of creditors using involuntary bankruptcies to resolve their disputes with debtors. This increase in involuntary bankruptcies has given rise to a large number of problems for both debtor and creditor attorneys. In the first of what hopefully will be a three-part series discussing the ethics of representing parties in involuntary bankruptcy proceedings, this article addresses fee problems faced by professionals representing parties faced with an involuntary bankruptcy petition between the involuntary petition's filing and the adjudication or consent to the entry of the Order of Relief (gap period).¹ These fee issues related to representing parties subject to involuntary bankruptcy proceedings (potential debtors) arise from the lack of certainty as to how professional fees accrued and/or paid during the gap period are treated in the subsequent bankruptcy.

Can Anyone Tell Me What the Ordinary Course of Business Is?

In a voluntary bankruptcy proceeding, the Bankruptcy Code offers a clear, if not particularly precise, statutory framework as to how and when the debtor's professional can be hired to represent the bankruptcy estate.² In involuntary bankruptcies, 11 U.S.C. §327 does not govern professionals' employment during the gap period.³ Instead, the process for being paid while representing an alleged debtor in an involuntary bankruptcy petition is indirectly governed by four separate statutes: 11 U.S.C. §§303(f), 502(f), 507(a)(2) and 549.

The primary Bankruptcy Code section addressing how a debtor may hire and pay professionals during the gap period is 11 U.S.C. §303(f), which authorizes an alleged debtor to operate its business and use, acquire and dispose of its property as if an involuntary case had not been commenced, unless a court orders otherwise.⁴ This provision generally permits a debtor to continue to operate in the ordinary course of its business under the restrictions of 11 U.S.C. §363, which requires court authorization for the sale, use or lease of property of the debtor other than in the ordinary course of its business.⁵

However, a debtor's ability to operate its business and pay its gap period creditors is also limited by 11 U.S.C. §§502(f) and 507(a)(2), which govern the allowance of claims during the gap period.⁶ Section 502(f) allows claims "arising out of the ordinary course of the debtor's business or financial affairs" during the gap period to be allowed as a pre-petition claim in a bankruptcy case. 11 U.S.C. §507(a)(2) grants claims allowed under §502(f) a second priority status, behind administrative expenses. Read together, §§502(f) and 507(a)(2) mean that unsecured claims that arise in the ordinary course of the debtors' business during the gap period are entitled to a second priority status. Unsecured claims, which do not arise in the ordinary course of the debtor's business during the gap period, if allowed at all, will be treated only as general unsecured claims.⁷

Finally, 11 U.S.C. §549 provides a final limitation on paying professional fees during the gap period.⁸ It also provides that the trustee may avoid the property transfers that occur after the commencement of a bankruptcy case, including an involuntary proceeding if the transfer is only authorized under §303(f), unless said transfer is (1) made after the commencement of the involuntary case, (2) before the entry of an Order of Relief and (3) made to the extent of any value of goods or services rendered to a debtor after the commencement of the case.⁹ The "safe harbor" provisions of 11 U.S.C. §549(b) do not include providing security or paying any debt that arose before the commencement of the case.

Based on this patchwork quilt of statutes, it appears that if a potential debtor ultimately files bankruptcy, any professional fees earned or paid during the gap period are at risk. Unless a court is willing to approve the application of a chapter 11 debtor's professionals on a nunc pro tunc basis, then that professional will be entitled to at best a second-level priority claim under 11 U.S.C. §507(a)(2) for any services rendered "in the ordinary course of the debtor's business." However, even entitlement to that second-tier priority claim is uncertain as courts are generally split as to whether these gap period professional fees arise "in the ordinary course" of a debtor's business.

Since When Is an Involuntary Bankruptcy Ordinary?

Although there is little direct case law on the subject, courts have still managed to split on the issue of whether payments or accrual of gap period professional fees arise in the ordinary course of a potential debtor's business for purposes of 11 U.S.C. §§303(f) and 507(a)(2).

One line of bankruptcy cases, a minority view, holds that generally the professional fees accrued or paid by a debtor during the gap period do not arise in the ordinary course of business and are not entitled to priority under 11 U.S.C. §507(a)(2).

The leading case in this line of authority is In re Hanson Industries Inc.¹⁰ In Hanson, counsel for the alleged debtor applied in the potential debtor's bankruptcy for an award of attorney's fees, both as an administrative expense under 11 U.S.C. §507(a)(1) or as a second priority administrative expense under 11 U.S.C. §507(a)(2). The services for which the attorney sought reimbursement primarily were related to "virtually every possible defense for filing an involuntary petition."¹¹ In reviewing the fee application, the court ultimately found that the debtor's counsel actions were at best of extremely doubtful value to the bankruptcy estate, and at worst, an obstruction to the bankruptcy trustee's efforts to administer the estate. The bankruptcy court ultimately determined that most of the debtor's counsel's work was not beneficial to the estate and denied $48,000 of the $60,000 fee application. The court noted that "creditors would not ordinarily and reasonably expect a company with virtually no assets and no business to expend more than $60,000 over a period of 11 weeks in litigation of any sort. Thus, while some reasonable amount of attorney's fees might be expected to minimally keep certain of the claims of the company alive, sums in the amount and of the nature involved, and efforts as zealous and determined as these, are not reasonably justified."¹² The court went on to find that where a debtor failed to convert its involuntary to a voluntary chapter 11, or agree to an adjudication of bankruptcy and ultimately had an order of relief entered against it, that the gap period professional fees and expenses did not arise in the ordinary course of the debtor's business.¹³

Perhaps the most troubling portion of the Hanson decision is its discussion of why Hanson was distinguishable from the case of In re Sun Spec Industries,¹⁴ which found professional fees earned during the gap period arose in the debtor's ordinary course of business and were entitled to priority status. The Hanson court distinguished Sun Spec by noting that "the debtor chose to voluntarily convert to a chapter 11, an option this debtor rejected." This dicta is problematic as it seems to indicate that professionals are more likely to get paid if a potential debtor voluntarily enters bankruptcy than if it fights the petition.

Hanson was based on a group of somewhat similar rulings, including In re Rocanville Marketing Corp.¹⁵ and In re JV Knitting Service Inc.,¹⁶ both of which held that professionals working for potential debtors that opposed an involuntary petition would not be awarded either an administrative expense under 11 U.S.C. §507(a)(1) or an administrative expense under 11 U.S.C. §507(a)(2) for their work during the gap period. Hanson based its decision on the cases of Kallen v. Litas¹⁷ and In re Peninsula Roofing & Sheet Metal Inc.¹⁸ The court also ruled against professionals on preference actions for fees paid prior to a bankruptcy filing that were found not to have been paid in the ordinary course of a debtor's business.

The rationale behind the Hanson line of cases is that payments made to professionals during the gap period, especially payments made to contest an involuntary bankruptcy petition, rarely arise in the ordinary course of business and that such services are not valuable to the debtor's bankruptcy estate. These cases take a rather strict approach as to the concept of the ordinary course of business and make it difficult for an attorney representing a potential debtor to be assured of being paid or even having a priority claim for fees earned during the gap period, unless the potential debtor agrees to convert to a chapter 11 or is successful in opposing the involuntary bankruptcy petition.

Since When Is It Not Ordinary to Hire an Attorney to Fight a Lawsuit?

Other bankruptcy courts have rejected the reasoning of Hanson and have allowed professionals to be paid, or at least be awarded a priority claim, for their services during the gap period. Perhaps the most liberal position on this matter is taken by the court in In re Rundlett.¹⁹ In Rundlett, the law firm was paid $50,000 during the gap period to represent the potential debtor in the involuntary chapter 7 petition filed against her. Approximately three weeks after they were retained, the debtor converted her case to a chapter 11 proceeding and moved to employ the law firm as her chapter 11 counsel. The proposed employment application permitted the law firm to retain the $50,000 retainer paid to them during the gap period.

Shortly after the employment application was filed, the involuntary chapter 11 was converted to a chapter 7 proceeding, and the debtor's estate was liquidated. The chapter 11 employment application was never ruled upon by the bankruptcy court before the case was converted back to a chapter 7 proceeding. Certain bank creditors objected to the $50,000 retainer and moved that it be returned to the bankruptcy estate for distribution to creditors. The bankruptcy court rejected this motion, holding that the retainer was authorized under 11 U.S.C. §§303(f) and 329 and was subject only to a review for the reasonableness of the retainer, and any fees charged by debtor's counsel during the gap period under the provisions of 11 U.S.C. §329(b). The court held that it had no other duty or authority to regulate the payment to professionals during the gap period. The Rundlett court ultimately ruled against the creditors, finding that they had not proven that either the retainer or the fees were excessive or improper under the provisions of 11 U.S.C. §329(b).²⁰ The court did not discuss the fees' priority under 11 U.S.C. §507(a)(2) nor the possibility of having any of the retainer avoided under the provisions of 11 U.S.C. §549.

The Rundlett standard has not been fully adopted by other courts. Instead, a majority finding that gap period professional fees should be entitled to priority treatment have adopted a "flexible standard"²¹ for determining whether gap period fees are entitled to priority treatment under 11 U.S.C. §507(a)(2). The cases of In re May Lumber Co.,²² In re Shah International Inc.²³ and In re McNair Inc.²⁴ held that professionals were entitled to retain compensation earned and/or retainers received²⁵ from the alleged debtors during the gap period. These courts, however, held that all fees billed and paid during the gap period were subject to review by the bankruptcy court in the event a debtor "wound up" in bankruptcy.²⁶ These courts recognize the importance of an alleged debtor being allowed to hire competent counsel to either defend itself against an involuntary petition or, ultimately, to guide it through a chapter 11 proceeding. As noted by the Shah International court:

For a debtor to be successful in chapter 11, it is imperative that the debtor have skilled legal counsel. As was stated in In re Martin, 817 F.2d 175, 181, "It will sometimes be difficult to obtain competent counsel in anticipation of a bankruptcy proceeding unless the lawyer's financial well-being can be assured to some extent." Equitable principles govern the exercise of bankruptcy jurisdiction (Bank of Marin v. England, 385 U.S. 99, 103, 87 S.Ct. 274, 277, 17 L.Ed.2d 197 (1966)), and legal counsel have rights, as do other persons in the case. One right is a reasonable opportunity to be paid in a bona fide case, whether commenced by a voluntary or an involuntary petition. A putative debtor should not be prevented from obtaining skilled counsel solely because the debtor is in bankruptcy only because creditors succeeded in filing an involuntary petition prior to the time the debtor filed a voluntary petition.²⁷

The May Lumber line of cases represents the middle ground between the strict limitations on employment of counsel in Hanson and the virtually unfettered discretion of potential debtors enjoyed under the Rundlett case. May Lumber places reasonable limits on a potential debtor's ability to direct professionals to guard against the overzealous advocacy decried in Hanson, yet still permits the potential debtor the right to seek competent counsel to defend itself or guide it through a bankruptcy in the event it must enter a chapter 11.

Conclusion: What's a Poor Debtor's Attorney to Do?

Given the wide divergence of case law, professionals for an alleged debtor must carefully weigh their options before accepting the representation. The best of all worlds would be to receive a fair retainer from the alleged debtor and apply that retainer against all fees earned during the gap period before entering bankruptcy. Even the Hanson line of cases does not discuss requiring the return of professional fees or a retainer, except in the context of preference litigation. However, this course of action does have the drawback of possibly presenting an alleged debtor's bankruptcy counsel with an adverse interest to the debtor should the case ultimately be converted to a chapter 11, unless counsel seeks specific approval of payments as part of the employment application. However, this risk is not very different from the risk all chapter 11 attorneys run every day by accepting any fee payment in the 90 days prior to the bankruptcy filing, which could be challenged in any chapter 11 proceeding that bankruptcy attorneys routinely defend as being made in the ordinary course of business.

Second, in a hotly contested case, the alleged debtor's counsel could move for approval of their fees under the provisions of §363 of the Bankruptcy Code. Under 11 U.S.C. §303(f), in unadjudicated involuntary cases 11 U.S.C. §363 still prohibits the sale, use or transfer of a debtor's assets outside the ordinary course of business without court approval. If there is a question about paying a retainer or fees during the gap period, a bankruptcy court could authorize the payment to the debtor's counsel under 11 U.S.C. §363 during this gap period, thereby giving some assurance of being paid for its work during the gap period. Unfortunately, this is a rather cumbersome and untried procedure that, given the nature of a hotly contested involuntary proceeding, may get lost in the shuffle and become just another bargaining chip concerning the fate of the entire involuntary case.

Finally, in the event that the involuntary case ultimately becomes a chapter 11 proceeding, debtor's counsel can petition the bankruptcy court for approval of employment nunc pro tunc to the date the involuntary petition was actually filed, thereby converting the gap period fees to ordinary professional fees under 11 U.S.C. §§330 and 331. Alternatively, professionals could also seek implicit approval of all payments made during the gap period by full disclosure in their employment application. This final option is apparently one of the most often used by counsel in involuntary cases, and offers a fair degree of protection. The bankruptcy court will be apprised of all payments of gap period fees when the application is made for employment, thereby fulfilling a professional disclosure requirement. The bankruptcy court and all creditors-in-interest can object to those payments as part of the employment application, and if they fail to do so, they could be estopped from contesting the payment at a later date. However, absent a specific finding in a bankruptcy court's order employing counsel that the payments made during the gap period were made in the ordinary course of a debtor's business and are entitled to priority under 11 U.S.C. §507(a)(2), the issue of any gap period retainer or payments will still remain in doubt despite the implied approval.

In short, the travails of a potential debtor's professionals in an involuntary bankruptcy case are in many instances far worse than those of professionals in a voluntary case. Indeed, given the uncertainty surrounding the payment of gap period fees, 11 U.S.C. §327 may appear to be an "easy" and reasonable standard for debtor's counsel to meet as opposed to the rather threadbare patchwork quilt of statutes governing employing and paying of counsel in gap period cases.

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Footnotes

¹ See 11 U.S.C. §§303 and 502(f). Return to article

² See 11 U.S.C. §327. Return to article

³ See 11 U.S.C. §327; In re McNair Inc., 116 B.R. 746 (Bankr. S.D. Cal. 1990) (order approving employment of counsel for potential debtor not required under either 11 U.S.C. §327 or 329). Return to article

⁴ See 11 U.S.C. §303(f), which provides: "Notwithstanding §363 of this title, except to the extent that the court orders otherwise, and until an order for relief in the case, any business of the debtor may continue to operate, and the debtor may continue to use, acquire or dispose of property as if an involuntary case concerning the debtor had not been commenced." Return to article

⁵ See 11 U.S.C. §363. Return to article

⁶ See 11 U.S.C. §502(f), which provides that in an involuntary case, a claim arising in the ordinary course of the debtor's business or financial affairs after the commencement of the case but before the earlier of the appointment of a trustee and the order for relief shall be determined as of the date such claim arises, and shall be allowed under subsection (a), (b) or (c) of this section or disallowed under subsection (d) or (e) of this section, the same as if such claim had arisen before the date of the filing of the petition. Return to article

⁷ See In re Manufacturer's Supply Co., 132 B.R. 127 (Bankr. N.D. Ohio 1991) (claims that arise in the gap period that do not arise in the ordinary course of a debtor's business are general unsecured claims). Return to article

⁸ See 11 U.S.C. §549(a)(b), which provides: "Except as provided in subsections (b) or (c) of this section, the trustee may avoid a transfer of property of the estate (1) made after the commencement of the case and (2)(a) that is authorized only under §303(f) or 542(c) of this title; or (b) that is not authorized under this title or by the court. In an involuntary case, the trustee may not avoid under subsection (a) of this section a transfer made after the commencement of such case but before the order for relief to the extent any value, including services, but not including satisfaction or securing of a debt that arose before the commencement of the case, is given after the commencement of the case in exchange for such transfer, notwithstanding any notice or knowledge of the case that transferee has." Return to article

⁹ Id. Return to article

¹⁰ 90 B.R. 405 (Bankr. D. Minn. 1988). Return to article

¹¹ Id. at 408. Return to article

¹² Id. at 408 n.2. Return to article

¹³ Id. at 414. Return to article

¹⁴ 3 B.R. 703 (Bankr. S.D.N.Y. 1980). Return to article

¹⁵ 84 B.R. 32 (Bankr. E.D. Pa. 1988). Return to article

¹⁶ 22 B.R. 543 (Bankr. S.D. Fla. 1982). Return to article

¹⁷ 47 B.R. 977 (N.D. Ill. 1985), rev'd. on other grounds, 790 F.2d 574 (7th Cir. 1986). Return to article

¹⁸ 9 B.R. 257 (Bankr. W.D. Mich. 1981). Return to article

¹⁹ 137 B.R. 144 (Bankr. S.D.N.Y 1992). Return to article

²⁰ Id. at 148. Return to article

²¹ See In re May Lumber Co., 135 B.R. 368 (Bankr. W.D. Mo. 1992); In re Shah International Inc., 94 B.R. 136 (Bankr. E.D. Wis. 1988). Return to article

²² 135 B.R. at 368. Return to article

²³ 94 B.R. at 136. Return to article

²⁴ 116 B.R. 746 (Bankr. S.D. Cal. 1990). See, also, In re Matter of Sun Spec Industries, 3 B.R. 703 (Bankr. S.D.N.Y. 1980); In re Labrum & Doals LLP, 1998 WL 34 1933 (Bankr. E.D. Pa. June 25, 1998). Return to article

²⁵ In Shah International, the debtor's counsel were permitted to retain mortgages as a retainer for their fee, although the court held that the mortgages secured all administrative claims in the chapter 11 cases, not just the attorney fees of the debtor's counsel. 94 B.R. at 138-139. Return to article

²⁶ The May Lumber court explained the "flexible standard" as follows:

1. A gap debtor may engage counsel of choice;
2. A gap debtor may pay counsel of choice what is mutually agreeable between debtor and counsel;
3. The aforesaid payment is subject to the test of reasonableness under the circumstances, if the debtor winds up in bankruptcy; and
4. The bankruptcy judge is (hopefully) an expert in the area of reasonableness and thus, all fees are subject to his tender mercies. Return to article

²⁷ 94 B.R. at 137-38. Return to article