In Matter of Pro-Snax Distributors, Inc., 157 F.3d 414 (5th Cir. 1998), a panel of the Fifth Circuit made the uncontroversial ruling that a chapter 11 debtor’s attorney could not recover attorney’s fees from the bankruptcy estate after appointment of a trustee. However, the court went one step further and stated that in order to recover fees for the period prior to appointment of the trustee, the applicant must demonstrate an “identifiable, tangible and material benefit to the estate” in order to be compensated. Most courts to consider this standard have concluded that when a case does not generate results notwithstanding the best professional efforts of the attorney that compensation may not be allowed except for certain mandatory services. That consensus was broken when Judge Michael Lynn ruled that an “identifiable, tangible and material result to the estate” means that an attorney acted at the behest of his client acting in the exercise of its business judgment. In re Broughton Ltd. Partnership, No. 10-42327 (Bankr. N.D. Tex. 4/25/12), a copy of which can be found here. Judge Lynn’s ruling transforms the standard for compensation from a one-sided contingency fee to a professional judgment standard and is consistent with the text of 11 U.S.C. §330. (Disclosure: I am currently appealing a Pro-Snax ruling and will be relying upon the Broughton Ltd. Partnership case.).
The facts are straightforward. The debtors’ business was “the development of high-end residential subdivisions and sales of the developed lots.” Special counsel was retained to negotiate the sale of 22 lots to a specific purchaser. The purchaser required that a homeowners association waive certain rights. When the homeowners association refused, the contract fell through notwithstanding counsel's efforts. When the sale fell through, the case ultimately converted. When special counsel applied for its fees, the U.S. Trustee objected based upon Pro-Snax.
The Court noted that bankruptcy courts within the Fifth Circuit following Pro-Snax had required that fees be reasonable on both a prospective basis and based on a retrospective review. The prospective test is based on section 330(a)(3)(C) which provides that “the services (be) necessary to the administration of, or beneficial at the time at which the service was rendered toward the completion of, [the bankruptcy case].” The retrospective or hindsight test incorporates the Pro-Snax requirement that the services actually result in an “identifiable, tangible and material benefit to the estate.”
The U.S. Trustee argued that it was not even necessary to apply the retrospective test since the attorney should have realized early on that the proposed transaction would not result in a benefit to the estate. The Court disagreed, noting that “(t)he proposed sale to SPOT was viewed in late 2010, not only by the court, but by the various parties, as the keystone of Debtors’ potential reorganization.” Opinion, p. 5. The Court went on to state that:
That the transaction was a difficult one to put together and that the idiosyncrasies of the parties might frustrate the efforts of counsel does not mean that counsel was required to cease work and give up. Rather, so long as a professional is doing its principal’s bidding and there is a reasonable prospect of success, the professional is entitled to work in the expectation of being paid.
Opinion, p. 6. It is nice to see that the Court did not adopt the position that when the going gets tough, those who want to get paid give up.
The Court approached the question of what constituted an “identifiable, tangible and material benefit to the estate” from several angles. First, the Court noted that a literal application of the phrase could result in absurd results.
The problem posed by Pro-Snax is that use of the word “benefit” suggests a positive contribution is required. An “identifiable, tangible, and material” benefit to the estate at first blush would appear to be something that augments the estate. Yet it seems clear that professionals serving a debtor or other fiduciary in a chapter 11 case cannot be limited in their compensation to those activities that actually add to the estate. First, such a determination would exclude from compensation many critical functions performed by professionals in the course of a chapter 11 case. Administrative matters, operational oversight, disputes respecting control, steps in the plan process such as extensions of exclusivity and many other matters dealt with by professionals covered by Pro-Snax do not increase the debtor’s estate or reduce the claims against it – yet the chapter 11 case could not work if professionals did not perform services in connection with these functions.Second, as with the Firm’s work, that work which a professional undertakes doesn’t always lead to success.16 Deals – as with SPOT – fall through. Litigation on behalf of the estate may offer the prospect of substantial recoveries, but will not necessarily be won. It may be that counsel representing Stern, the estate representative in Stern v. Marshall, --- U.S. ----, 131 S.Ct. 2594, 180 L.Ed.2d 475 (2011), was unsuccessful, ultimately losing the estate’s case in the United States Supreme Court in a 5-4 decision. It is unthinkable that that counsel’s work leading to that result should be uncompensated. The very fact that section 328(b) permits (but does not require) retention of professionals on, inter alia, a contingency basis demonstrates that Congress did not intend all professional services to be compensable only on that basis. Yet, as some courts have noted, to apply Pro-Snax as requiring estate augmentation would be tantamount to doing so.
Opinion, pp. 10-11.
Digging deeper, the Court looked at the Pro-Snax case itself. The only clue that the Fifth Circuit gave as to the meaning of “identifiable, tangible and material” was a citation to In re Melp, Ltd., 179 B.R. 636 (E.D. Mo. 1995). That case in turn referred to:
In undertaking a “benefit analysis,” a court should consider: (1) whether the debtor’s attorney’s actions duplicated the duties of the trustee or the trustee’s counsel under 11 U.S.C. § 1106; (2) whether the services have in fact, obstructed or impeded the administration of the estate; and (3) whether the debtor’s attorney’s actions are consistent with the debtor’s duties under 11 U.S.C. § 521.
In re Melp, 179 B.R. at 640. Since the Fifth Circuit relied on Melp in formulating its test, it is only reasonable to see what the Melp Court meant.
Judge Lynn also examined the construction given to “identifiable, tangle and material benefit” by District Judge Jane Boyle in Kaye v. Hughes & Luce, LLP, (In re Gadzooks, Inc.), 2007 WL 2059724, at *9 (N.D. Tex. Jul.13, 2007). I have previously written about the Gadzooks case here, here and here.
The Gadzooks court, which applied the benefit test to counsel representing an equity committee, struggled with how to reconcile the Pro-Snax requirement of an “identifiable, tangible, and material benefit” to the estate, including its suggestion of a retrospective review of counsel’s work, with section 330(a)(3)(C) which indicate a professional’s efforts should be assessed prospectively, as of the time they were to be performed. Judge Boyle, in Gadzooks, concluded that the requirement set by the Court of Appeals of a benefit to the estate constituted a gloss on the provision in section 330(a)(1)(A) that counsel be awarded “reasonable compensation for actual, necessary services rendered by the…professional person.” See In re Gadzooks¸ 2007 WL 2059724, at *9. That is, services will benefit the estate if they are actual and necessary.
Opinion, pp. 14-15.
The Court also looked to how similar language in section 503(b)(1) has been interpreted.
As it happens, the term “actual, necessary” is found not only in section 330(a)(1)(A) but as well in section 503(b)(1)(A), where it modifies the words “costs and expenses of preserving the estate” and limits what costs and expenses are entitled to priority payment as administrative claims. As used in section 503(b)(1)(A), “actual, necessary” clearly does not mean administrative expenses are limited to only those that enhance or at least preserve a debtor’s estate. It has been black letter law since the Supreme Court rendered its decision in Reading Co. v. Brown, 391 U.S. 471, 478, 88 S.Ct. 1759, 20 L.Ed.2d 751 (1968), that torts committed by an estate representative in the course of performing his, her or its duties give rise to claims entitled to administrative priority. This is because, as the Court reasoned in Reading, a bankruptcy estate, just like any other participant in the business world, must pay those costs necessarily incident to its operations, including satisfying claims arising from torts attributable to the estate.Similar reasoning can be applied to the efforts of the professionals of a debtor in possession (or other statutory bankruptcy fiduciary). It is the duty of a debtor in possession –like any estate representative – to realize any possible value from assets of the estate. If it eventually proves true that an asset cannot be realized upon, that does not mean it should not be investigated and its liquidation (or other means of realization) pursued, so long as, as the Pro-Snax court observed, “the chances of success…outweigh the costs of pursuing the action.” 157 F.3d at 426. Thus, for example, in Stern v. Marshall, pursuit of Stern’s counterclaim was appropriate and compensable, since the chances of success were good. That the case ultimately was lost 5-4 in the Supreme Court (on the basis of the bankruptcy court’s constitutional inability to enter a final judgment on Stern’s counterclaim) does not change the fact that the estate representative and estate professionals were doing their duty in pursuing it.
Opinion, pp. 15-16.
Having considered all of these factors, the Court reached its ultimate conclusion that a professional confers an identifiable, tangible and material benefit to the estate when it performs services at the direction of the representative of the estate which is acting within its business judgment.
The court today holds that a professional provides an “identifiable, tangible and material benefit” to a bankruptcy estate within the meaning of Pro-Snax through assisting the estate representative in administering an asset of the estate, whether or not the effect of administration of the asset is enhancement of the estate, so long as the professional’s services are performed at the direction of the estate representative and the estate representative is acting in accordance with the Code and its sound business judgment. In doing so, the court focuses on the nature of the benefit provided but also takes account of public policy and an estate representative’s decision making authority in bankruptcy.With regard to the latter, the court relies on an estate representative’s sound business judgment in approving acts outside the ordinary course of business. (citation omtted).Unless the manner in which an estate representative arrives at a decision is seriously flawed, the court will defer to the estate representative. (citation omitted). A professional should similarly be able to rely on its client’s business judgment in acting in accordance with the client’s instructions.As to public policy, professionals are retained by an estate representative to advise and assist the representative in carrying out his, her or its duties under the Code. To burden professionals by making their compensation contingent upon the result of the estate representative’s decisions must necessarily skew the regime intended in the Code and will surely create conflicts where a professional believes its client’s decision, though arrived at through due diligence, is not the right one. Had Congress wished professionals retained under section 327 of the Code to second-guess and perhaps veto decisions of a trustee or debtor in possession, it surely would have said so.
Opinion, pp. 17-18.
What It Means
While I acknowledge my own bias, I think that Broughton Ltd. Partnership should change the way that Courts in the Fifth Circuit interpret Pro-Snax. Judge Lynn’s interpretation allows courts to follow the language used in Pro-Snax without doing violence to the language or the logic of the Code.
Unlocking the Code
Section 330(a) contains several criteria for allowing compensation in bankruptcy, but does not use the words identifiable, tangible and material benefit. In fact, it expressly adopts a prospective analysis.
The statute reads:
§ 330. Compensation of officers
(a) (1) After notice to the parties in interest and the United States Trustee and a hearing, and subject to sections 326, 328, and 329, the court may award to a trustee, a consumer privacy ombudsman appointed under section 332, an examiner, an ombudsman appointed under section 333, or a professional person employed under section 327 or 1103-- (A) reasonable compensation for actual, necessary services rendered by the trustee, examiner, ombudsman, professional person, or attorney and by any paraprofessional person employed by any such person; and (B) reimbursement for actual, necessary expenses.***(3) In determining the amount of reasonable compensation to be awarded to an examiner, trustee under chapter 11, or professional person, the court shall consider the nature, the extent, and the value of such services, taking into account all relevant factors, including-- (A) the time spent on such services; (B) the rates charged for such services; (C) whether the services were necessary to the administration of, or beneficial at the time at which the service was rendered toward the completion of, a case under this title; (D) whether the services were performed within a reasonable amount of time commensurate with the complexity, importance, and nature of the problem, issue, or task addressed; (E) with respect to a professional person, whether the person is board certified or otherwise has demonstrated skill and experience in the bankruptcy field; and (F) whether the compensation is reasonable based on the customary compensation charged by comparably skilled practitioners in cases other than cases under this title. (4) (A) Except as provided in subparagraph (B), the court shall not allow compensation for-- (i) unnecessary duplication of services; or (ii) services that were not-- (I) reasonably likely to benefit the debtor's estate; or (II) necessary to the administration of the case.
***(6) Any compensation awarded for the preparation of a fee application shall be based on the level and skill reasonably required to prepare the application.***
Interpreting Pro-Snax to require a positive result in order to get paid would be to eliminate the words “at the time at which the services were rendered” and “reasonably likely to benefit the debtor’s estate” from section 330(a). Such a view (even though it has been the prevailing one) effectively accuses the panel of negligence at best or judicial activism at worst.
This tension was acknowledged by Judge Frank Monroe in In re Weaver, 336 B.R. 115 (Bankr. W.D. Tex. 2005), when he stated:
Applicant Borsheim argues that Pro-Snax is at odds with the statute and misinterprets it since the statute plainly authorizes fees "for actual, necessary services"-as well as services that are "reasonably likely to benefit the debtor's estate". Even if such be true, this Court is constrained to follow the 5th Circuit's interpretation.
Weaver, at 119.
Judge Lynn, by following Judge Boyle’s conclusion that “identifiable, tangible and material benefit” was merely a gloss upon “actual, necessary services,” has tethered Pro-Snax to the language of the Code and has consistently followed the underlying authority relied upon by the Pro-Snax panel.
With all respect to Judge Monroe (who was a venerable and well-respected judge), it is far better to follow the Fifth Circuit and follow the language of the Code at the same time. Judge Lynn has succeeded in doing both.
(In fairness to Judge Monroe, he had a subsequent opinion in In re Spillman Development Group, Ltd., 376 B.R. 543 (Bankr. W.D. Tex. 2007), in which he which took a more nuanced approach to Pro-Snax.)
When the Going Gets Tough
The Broughton Ltd. Partnership opinion is also good for the system. The English common law system adopted in the United States relies upon an adversarial system in which opposing parties are represented by zealous advocates. Bankruptcy is a multi-party process. If the most aggressive creditor can threaten debtor's counsel with not getting paid, debtor's counsel will have an incentive to placate that party at the expense of everyone else. Moreover, if the court increases the risk of not getting paid, then either lawyers will demand higher fees to compensate for that risk or will forego those representations altogether, leaving them to less qualified lawyers. In order for the system to work, good lawyers need to have a reasonable opportunity to be compensated without being a guarantor of the success of their client's case. While some debtors may be less than deserving scoundrels who use bankruptcy to escape payment of their just debts, the opposite is also true. Some creditors are more interested in using their position to prevent debtors from paying their debts, either so that they can foreclose and reap a windfall or simply to crush another party out of malice and spite. While the bankruptcy court cannot grant equal resources to all parties, it can at least avoid penalizing one side.