Professional compensation is always subject to approval, reexamination and adjustment for unreasonableness or excessiveness under 11 U.S.C. §§329 and 330. However, in recent years, some courts appear to have broadened the scope of this reexamination and adjustment when an estate becomes administratively insolvent.

In Specker Motor Sales Co. v. Eisen, 393 F.3d 659 (6th Cir. 2004), the Sixth Circuit Court of Appeals ordered a debtor's attorney to disgorge his post-petition retainer for pro rata distribution among administrative claimants after the administratively insolvent case was converted to a chapter 7. In so ruling, however, the court did not consider (a) the impact of an attorney being paid from a carve-out or by a third party, or (b) other actions an attorney may take to protect the integrity of the retainer or fees previously approved by the court and paid by the debtor prior to an estate being rendered administratively insolvent.

Recently, in In re U.S. Flow, 332 B.R. 792 (Bankr. W.D. Mich. 2005), Judge James Gregg of the U.S. Bankruptcy Court for the Western District of Michigan allowed professionals appointed under the Bankruptcy Code to retain fees paid during the course of a chapter 11 case, over the objection of the U.S. Trustee, when the estate subsequently became administratively insolvent. The primary fact upon which Judge Gregg justified retention of the fees paid to the professionals was that they had been derived from a carve-out previously approved by the bankruptcy court and consented to by the secured creditor. His ruling, however, makes clear that the facts upon which the bankruptcy court relied in making its ruling (i.e., those specifically set forth in a previously approved financing order) justified the holding that such fees would not be subject to disgorgement to the trustee for payment of chapter 7 administrative claims and thereafter for pro rata distribution to holders of chapter 11 administrative expense claims—the result that otherwise would have been dictated by the Specker decision.

Thus, in order to "Get What You Earn and Keep What You Got," it is important that a professional consider, at the onset of a case, the options that may arise if the estate subsequently becomes administratively insolvent. Failure to consider and take appropriate action to protect retainers received and fees paid may otherwise result in the professional having to disgorge amounts earned, approved and received.

The Facts Underlying the Specker Decision

In Specker, Counsel Donald Bays was authorized to be employed as counsel for the chapter 11 debtor and received a $10,000 retainer from the debtor shortly after commencement of the chapter 11 case.² A few months later, the case was converted to chapter 7 liquidation, a trustee was appointed and the estate was found to be administratively insolvent. Thereafter, the bankruptcy court approved counsel's final fee application and allowed him to keep the retainer as interim compensation. However, upon final administration, because the estate was administratively insolvent, counsel was ordered by the bankruptcy court to disgorge more than 90 percent of his retainer to share pro rata with the four other administrative claimants of the debtor. The bankruptcy court found that "the plain language of 11 U.S.C. §726(b) mandates disgorgement when necessary to achieve pro rata distribution among similarly situated claimants."³ Counsel appealed.

The district court affirmed the bankruptcy court's decision, reasoning that §726(b), governing distribution of property of the estate in a chapter 7 case, mandated a pro rata distribution of assets among creditors in the same statutory class. Section 726(b) states, in relevant part, as follows:

Payment on claims of a kind specified in paragraphs (1), (2), (3), (4), (5), (6), (7) or (8) of §507(a) of this title, or in paragraph (2), (3) (4) or (5) of this section, shall be made pro rata among claims of the kind specified in each such particular paragraph, except that in a case that has been converted to this chapter under §1112, 1208 or 1307 of this title, a claim allowed under §503(b) of this title incurred under this chapter after such conversion has priority over a claim allowed under §503(b) of this title incurred under any other chapter of this title or under this chapter before such conversion and over any expenses of a custodian superseded under §543 of this title.⁴

Section 507(a) establishes a payment scheme based on a hierarchy of creditors and describes the order in which such claimants may lay claim to, and be paid from, the assets of a bankruptcy estate. Administrative claims, including professional fees awarded under §330(a)(1), are treated as administrative expenses allowed under §503(b)(1).⁵ The court found that in addition to the professionals that had been awarded compensation, four creditors also held administrative claims, and therefore, each was entitled to share pro rata with the professionals in receiving a distribution from the estate. Thus, the district court ruled that counsel was required to disgorge almost all of the retainer that he had previously been authorized to use to pay interim compensation—i.e., fees and expenses that were in excess of the pro rata share of the estate that he would have received—in order to share it with the other administrative claimants. In making this ruling, the district court found that "mandatory disgorgement is the only reasonable and logical result if 11 U.S.C. §726(b) is to be given any effect."⁶ Counsel appealed to the Sixth Circuit.

Specker Holding by the Sixth Circuit

The Sixth Circuit affirmed the decision of the district court, holding that §726(b) is clear in its mandate, requiring pro rata distribution among creditors in the same class. Furthermore, the court held that retainers are held in trust for the estate and remain property of the estate. While a retainer may be authorized for application to and payment of interim compensation, interim compensation remains subject to reexamination, adjustment and eventual disgorgement under §726(b).

Specker Analysis

On appeal, the sole issue before the court was one of statutory construction. Counsel argued that (1) nothing in §726(b) requires a trustee to request disgorgement from professionals, and (2) debtor's counsel should not be treated as similarly situated to other administrative claimants based on various public policy grounds. The Sixth Circuit rejected both of these arguments.

Counsel first argued that disgorgement was not mandatory, but rather within the discretion of the court based on United States v. Schottenstein, Zox & Dunn (In re Unitcast Inc.), 219 B.R. 741 (BAP 6th Cir. 1998), which found that there was nothing in §726(b) that compelled the trustee of an administratively insolvent estate to reach back through prior administrative periods to recover payments to professionals. To do so, according to the Unitcast court, would "transform [the payments] into (unpayable) 'administrative expenses.'" Id. at 753. Moreover, to permit disgorgement of professional fees would "subordinate" professionals when an estate's funds are insufficient to cover administrative costs. The Unitcast court ultimately concluded that it was within the sound discretion of the bankruptcy court to order disgorgement to achieve pro rata distribution.

The Sixth Circuit refused to adopt the Unitcast view, finding it to be unpersuasive and inconsistent with the view of the majority of courts that have ruled on this issue. In reaching this determination, the court focused on the language of §726(b), which was found to be clear and unambiguous. According to the Sixth Circuit, by its use of the word "shall" with the pro rata requirement, Congress indicated that such distribution is not discretionary, but rather mandatory, and thus requires pro rata distribution among creditors of the same statutory class. The court also dismissed Unitcast's emphasis on the harshness of disgorgement and its effect of subordinating professionals as being misplaced, noting that only professionals are required to disgorge their interim compensation because only professionals can receive interim compensation under §331(a). Moreover, failure to order disgorgement would give interim compensation superpriority treatment not otherwise authorized under the Code. Finally, the Specker court held that the Code was clear in directing equitable distribution among creditors. Thus, once an estate becomes administratively insolvent, fees previously allowed and paid to professionals as compensation under §330 are subject to disgorgement to be shared pro rata with the other administrative creditors of the estate.

Counsel next suggested that various "considerations of a public policy nature" supported a finding that professionals should not be required to disgorge fees previously paid, but rather should be treated like other administrative claimants. In addition, counsel argued that his fiduciary relationship with the estate created a special ethical relationship with the estate that would be undermined by being treated equally with other administrative creditors or being subjected to uncertainty of payment. Because the statute is unambiguous, the Sixth Circuit held—presumably based on rules of statutory construction—that it "need not reach the merits of these arguments," and ultimately concluded that counsel, like the other administrative creditors in bankruptcy cases, was a gambler.⁷

The court in Specker did not consider, however, the availability of other avenues that professionals may pursue to protect retention of retainers received and fees paid. In the fall of 2005, Judge Gregg issued an opinion in In re U.S. Flow, 2005 WL 2952597 (Bankr. W.D. Mich. 2005), that appears to provide a bypass around Specker. In U.S. Flow, over the objection of the U.S. Trustee, court-appointed professionals were allowed to retain fees paid to them after an estate became administratively insolvent based on such fees having been paid through a carve-out pursuant to a DIP financing order consented to by secured creditors and approved by the court.

U.S. Flow Facts

U.S. Flow and four related corporations (the "debtors") filed for chapter 11 relief on Aug. 12, 2003. The chapter 11 cases were jointly administered. The court appointed two professionals: Kaye Scholer for the debtors and Pepper Hamilton for the unsecured creditors' committee (collectively, the "professionals"). On Aug. 14, 2003, the court entered an interim order authorizing use of cash collateral, which automatically terminated on Aug. 22. Thereafter, the court issued its Second Interim Order (I) Authorizing Debtors' Use of Cash Collateral (II) Granting Adequate Protection and (III) Scheduling Additional Hearing Thereon (the "Second Interim Order"). The Second Interim Order authorized a $55,000 carve-out to benefit chapter 11 court-appointed professionals.

Under the Second Interim Order, "Carve-Out" was defined to mean:

(i) the unpaid fees of the clerk of the bankruptcy court and of the U.S. Trustee pursuant to 28 U.S.C. §1930(a) and (b), and (ii) the aggregate allowed unpaid fees and expenses payable under §§330 and 331 of the Bankruptcy Code to professional persons retained pursuant to an order of the court by the debtor or any statutory committee appointed in this chapter 11 case not to exceed $55,000. [Second Interim Order |16].

The Second Interim Order also expressly recognized that (1) the liens of the secured creditors were found to be valid, perfected and indefeasible in the bankruptcy case; (2) the secured creditor's replacement liens were deemed to be senior to the rights of the debtors and any successor trustee or other estate representative; (3) the carve-out was superior to the secured creditors' interests in the collateral; (4) the rights and obligations of the debtors and the secured creditors would survive any termination of the Second Interim Order; (5) it did not create any rights for the benefit of any third party, creditor or any direct, indirect or incidental beneficiary, other than the professionals; and (6) the court would retain jurisdiction to resolve issues that arose under the Second Interim Order.

Despite negotiations, the debtors were unable to obtain authority for continued use of cash collateral beyond Aug. 22. On Sept. 3, the Second Interim Order expired of its own terms. Thus, only one month after the initial filing, the estate was found to be administratively insolvent and the case was converted to a chapter 7. Following conversion, the U.S. Trustee asked the court to determine that the carve-out was property of the estate and should be distributed pursuant to §726(b) according to the priorities of the Code. The professionals objected and requested that the bankruptcy court order that the carve-out be distributed to them.⁸

U.S. Flow Holding

While the bankruptcy court recognized that, under Specker, interim compensation granted in a chapter 11 case must be disgorged in a converted chapter 7 when necessary to achieve a pro rata distribution among similarly situated creditors, it found that the facts upon which Specker was decided were very limited and did not address the instance where a court-ordered carve-out is established or when court-appointed professionals are paid from collateral of a secured creditor, instead of from property of the estate. After analyzing the carve-out and Specker, Judge Gregg found that the carve-out was not property of the estate and was not recoverable by the estate for the benefit of all creditors because it was specifically set aside for the professionals pursuant to a prior court order.

U.S. Flow Analysis

In making its ruling, the bankruptcy court engaged in a two-step analytical process: (1) Was the carve-out valid and enforceable? and (2) does Specker require disgorgement of the carve-out? The bankruptcy court first analyzed the carve-out. By definition, although not specifically defined in the Code, a carve-out is essentially an agreement pursuant to which a secured creditor allows post-petition proceeds otherwise subject to its secured claim to be exclusively earmarked to pay professionals. The court found that the carve-out was valid and enforceable in this case because (1) the secured creditors consented to the carve-out, (2) the court approved it, (3) the bankruptcy court's order was not appealed and (4) there was no challenge to the validity or priority of the secured creditors' pre-petition or post-petition liens. The bankruptcy court ruled that the liens were not avoidable, and the proceeds transferred to the professionals could not be recovered for the estate. Thus, since the carve-out was derived from the secured creditors' otherwise unassailable collateral, the estate had no right to this collateral.

Second, the bankruptcy court found that Specker did not require disgorgement of the carve-out. Judge Gregg distinguished Specker on the facts—it dealt with a retainer, not a carve-out—which created very different legal results. The crucial difference was that a retainer remains property of the estate, while a carve-out is not property of the estate, but rather the collateral of the secured creditor. Therefore, while a retainer may be assailable, a carve-out is generally unassailable (provided that the secured creditor's liens are valid and enforceable).

Judge Gregg also rejected the U.S. Trustee's argument that the result was unfair to other creditors. First, other creditors did not negotiate a carve-out for themselves, object to the Second Interim Order or appeal the order establishing the carve-out. Second, the bankruptcy court found that it would be unfair to require the professionals to lose their entitlement to the carve-out funds after they relied on a final nonappealable court order. Finally, if the terms and conditions of the carve-out were disagreeable, then third parties, including the U.S. Trustee, should have challenged them either (1) before the Second Interim Order was entered or (2) via a timely appeal from the Second Interim Order. However, no such action was taken in this case.

Lessons to Learn on Carve-Outs from U.S. Flow

The result obtained in U.S. Flow was based on certain key facts that prevented disgorgement. These essential facts included (1) the secured creditors' consent to the carve-out, (2) court approval of the carve-out, (3) that no appeal was taken from the court's order, (4) no challenge to the validity or priority of the secured creditors' pre-petition or post-petition liens (thus, the liens were not avoidable and the proceeds transferred by the secured creditors to the professionals could not be recovered for the benefit of the bankruptcy estate) and (5) the monies subject to the carve-out were not property of the estate but rather of the secured creditors. It is therefore important to delineate such findings and incorporate them as conclusions of law in any financing order that creates a carve-out for payment of professionals' fees and expenses.

Second, and as noted above, it is crucial for a carve-out to be approved by the court. Some courts have ruled that purely consensual carve-outs—i.e., those only agreed upon between the secured party and the professionals but not approved by the court—are property of the estate. Therefore, they are subject to disgorgement.⁹

Third, while the liens, claims and interests of the secured creditors were not subject to contest or avoidance in U.S. Flow, in other instances the situation may not be the same. If the secured creditor's claim cannot be validated at the time of the entry of a financing order, a tension is created in two respects: (1) whether the underlying claim will ultimately be allowed as a secured claim, and (2) whether the collateral securing the claim has sufficient value to pay the carve-out. In either case, it is important to carefully craft the carve-out under the financing order to ensure that the first monies paid out from the proceeds of the secured creditor's collateral go to pay the professionals' carve-out. Providing for a "first out" option should protect the professionals and allow them to argue that payment of their fees is protected even if the secured creditor's claims are subsequently attacked (assuming that the secured claim is not invalidated in its entirety) (as will be indicated in Part II of this article, infra), and further provide sufficient value for payment of the carve-out, even if it is ultimately determined that the secured claim is undersecured.

Footnotes

1 The authors give special thanks to Richard M. Meth, Pitney Hardin LLP, for his review and editorial comments of this article.

2 The Specker decision sets forth the facts in this manner, stating that the retainer was received post-petition. However, in the U.S. Flow decision, the bankruptcy court suggests that the Specker retainer was actually received pre-petition. See U.S. Flow, 2005 WL 2952597 at fn. 7. It is unclear whether this factual distinction would have altered the ruling of the court.

3 Specker, 339 F.3d at 661.

4 Id.

5 Under the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), administrative expense claims for compensation and reimbursement awarded under §330 are now treated under (a) §503(b)(2) and subordinated to wages, salaries and commissions for services rendered after the commencement of the case, including the nonpayment of domestic support obligations, and (b) §507(a)(2) and subordinated to domestic support obligations.

6 Id.

7 Id. at 664.

8 The secured creditors that authorized the carve-out did not take a position on this issue.

9 See Bowles, Claude, "Your Retainer: Pocket Aces or a 7-2 Off Suit?," 24 Am. Bankr. Inst. J. 29 (May 2005) (citing In re Ben Franklin Retail Stores Inc., 210 B.R. 315 (Bankr. N.D. Ill. 1997) (holding that proposed agreement between debtor's counsel and secured creditors, which permitted counsel to be compensated directly from secured creditors' collateral, resulted in counsel's payment before other professionals of same priority level were paid, and thus impermissibly re-ordered Code's distribution priorities)).