Administrative Insolvency, Professional Responsibility and the Art of Judging

Recently I was involved in a heavily litigated chapter 11 case. The professional fees (which included fees from two sets of debtors’ counsel, a chapter 11 trustee, an examiner, various special counsel and parties claiming substantial contribution fees) threatened to consume the estate until the lawyers agreed to limit their take and leave some funds for the pre-petition creditors. In a remarkable display of good sense, the attorneys then compromised on how the professional fees would be allocated rather than continuing the fight. (I can’t claim any credit here since others did the heavy lifting).

At the hearing to approve the fees, the judge commended the lawyers for their professionalism. However, while everyone was basking in good spirits (or at least as good as you can feel after having agreed to a fee reduction), the court asked what could have been done to stop the bleeding before everything got so expensive. Waxing philosophical, the court questioned whether the traditional ethical rules with regard to professional billing work in the bankruptcy context and whether the court should play a more activist role in managing troublesome cases. The court raised a good question.

In the traditional two-party litigation model, professional responsibility is primarily a matter of consumer protection. Fees are governed by a limitation that they may not be unconscionable, Texas Disciplinary Rules of Professional Conduct 1.04, but beyond that, the rates and amounts charged are largely a function of the client’s ability and willingness to pay. Fee shifting distorts the traditional model, since one party can shift its costs onto the other party. However, there are still some limits since there is no guarantee that the party who is on the receiving end of the fee award will have the ability to pay.

In a complex bankruptcy, the dynamic is far different than the two party litigation model. In this context, a “complex” bankruptcy is one where there is a pot of unencumbered assets worth fighting over and multiple parties with an interest in the pot. In an efficient bankruptcy, the pot is maximized for the benefit of the residual claimants, who are typically the unsecured creditors. On the other hand, in an inefficient bankruptcy, the post-petition claimants (such as professionals, committees, secured lenders and parties claiming a “substantial contribution”) consume the estate at the expense of the residual claimants.

An inefficient bankruptcy poses both an ethical challenge for the professionals and a management challenge for the court. Professionals employed by the estate have a duty to maximize value for the estate (and thus to ultimately benefit the creditors) rather than to simply run up their own fees. The Fifth Circuit has held that professionals may not be compensated unless their efforts result in an “an identifiable, tangible and material benefit to the bankruptcy estate.” Matter of Pro-Snax Distributors, Inc., 125 F.3d 414, 426 (5th Cir. 1998). Thus, there should be a practical deterrent to pursuing inefficient litigation on the part of the estate’s professionals.

However, there are several important limitations on the ability of the estate’s professionals to act efficiently and ethically when it comes to incurring fees. First, contested fee applications are fairly unusual. As a result, the deterrent effect is more theoretical than real. Second, efficiency is much easier to judge in hindsight than in the heat of battle. As a result, decisions which result in unproductive fees may have appeared reasonable at the time. Finally and perhaps most importantly, third parties can impose costs on the estate through their litigation tactics quite independently of the good judgment and ethical decision making of the debtor’s professionals. If a creditor decides to pursue a program of expensive discovery and objects to every action proposed by the debtor, the estate’s professionals will often have little choice but to participate to the same extent, resulting in an escalation of professional fees.

So, since the professionals have an imperfect ability to avoid a train wreck, what can the court do?

1. Watch out for ugly cases. While this sounds fairly trite and self-evident, some cases bear closer watching than others. In some cases, the parties and personalities involved have a greater potential for spiraling out of control. Becky McElroy likes to say that you should watch out for any case with an “ex” in it, whether it is an ex-wife, ex-partner, ex-employee and so on. In the business context, this can apply to a rebuffed purchaser, a competitor or a debt buyer whose strategy is to cause trouble until someone buys them off. Of course, litigiousness can be a management style for the debtor as well. If the court is able to see the warning signs, it can step in sooner to manage the case more closely.

2. Monitor Fees. In a particularly ugly case, the parties may be reluctant to submit fee applications for fear of retaliatory objections. However, in a case where no one is submitting their fees for approval, the court may not be aware that the case is approaching administrative insolvency.

3. Send the Parties to Mediation. Not all problems can be solved through litigation. If the parties are using litigation as a negotiating strategy, the court may be able to save costs by requiring the parties to negotiate directly. Of course, mediation can also be another opportunity for delay and expense if the parties aren’t ready to negotiate.

4. Set Deadlines/Force the Issue. All lawyers want more time and some cases require time to find a business solution. However, time also creates more opportunities for mischief. If the debtor’s lawyers are asking to continue the hearing on the disclosure statement for the fifth time and no creditor is stepping up to propose a plan, then perhaps the case is in a stalemate which won’t be resolved unless the court sets deadlines and forces the parties to litigate, reach an agreement or go away.

5. Appoint a Trustee/Change the Parties. Some cases are basically a two party dispute with the remaining creditors held hostage to the main dispute. While appointing a trustee is normally reserved for situations where the debtor has misbehaved, perhaps it is appropriate to appoint a trustee in cases where the parties’ irrational hatred for each other threatens to consume the estate to the detriment of the third party creditors. By appointing a trustee, the court may deprive one of the factions of its motivation to fight. Of course, the opposite could be true as well. If the non-debtor party has an irrational to inflict its will on others, then appointing a trustee may simply create another opponent for the malevolent party while defunding the former debtor-in-possession (who can no longer bill the estate for its fees).

The suggestions offered here are imperfect and incomplete. Please feel free to use the comments function to offer your own suggestions.