In a long-awaited opinion, the Fifth Circuit Court of Appeals recently reversed its ruling in Pro-Snax Distributors, Inc., 157 F.3d 414, 426 (5th Cir. 1998), providing that a bankruptcy professional can only collect fees for services provided to a bankrupt debtor that “resulted in an identifiable, tangible, and material benefit to the bankruptcy estate.” See Baron & Newburger, P.C. v. Texas Skyline, Limited (In re Woerner), Case No. 13-50075 (5th Cir. April 9, 2015). This prior holding often lead to a hindsight approach, where professional fees could be challenged and denied based–not on the hard work performed by a professional–but rather on the actual results of the case. In the recent opinion, the Fifth Circuit reversed course and adopted a more reasonable, prospective approach, which focuses on whether the professional services were objectively beneficial towards the completion of a bankruptcy case at the time the services were performed. This holding adopts the view of most of the sister federal circuit courts of appeal and is consistent with the text and legislative history of the Bankruptcy Code. It also spells a sigh of relief to all bankruptcy practitioners within this jurisdiction.
As is well-known, there are different types of bankruptcy relief that a financially distressed company or individual can seek. For most companies, the choices are generally limited to liquidating the company in chapter 7 or reorganizing under chapter 11. The first choice, which requires the appointment of a trustee to manage and liquidate the company, usually results in a short-term existence, while the latter, which allows existing management to stay in place and formulate a reorganization plan, contemplates the continuation of the company on a long-term basis.
Due to miscalculation, unwarranted optimism, misfortune or fear, companies often pursue a reorganization under chapter 11, when there is not a high chance of success. In doing so, they hire professionals to engage in an expensive chapter 11 process, and the professionals, who owe a duty to the company, often do their best to keep the optimism alive.
The bubble finally bursts, however, when the bankruptcy court loses optimism in the debtor’s ability to reorganize on its own. That realization may occur 30 days, 90 days, 6 months, a year or two years after the bankruptcy case is commenced. Between that time, the debtor’s professionals often provide significant services either trying to convince the company to re-evaluate its approach or litigating with creditors and other parties that are throwing stones at the debtor.
What happens then to the professionals when the bankruptcy court finally loses hope? Are they guilty by association for delaying a case? Are these professionals who waited to be paid because of the Bankruptcy Code’s intricate compensation procedures ultimately entitled to recover their unpaid fees once the bankruptcy court decides to appoint a trustee to take over the management of the debtor?
This unfortunate situation often leaves the bankruptcy professional in an uphill battle to collect its earned but unpaid fees. It is hard for such a professional to demonstrate that–despite its best efforts–its services actually provided a material benefit to an estate whose prognosis has turned for the worse. In such situations, it becomes easier for creditors to argue that all of the professional’s efforts merely delayed the process and added an extra layer of administrative expenses to the detriment of the bankruptcy estate.
This common scenario became a reality in the Woerner case.
In Woerner, the debtor filed for chapter 11 relief on the eve of a state court entering a major judgment against him. The state lawsuit alleged that the debtor had breached a partnership agreement and his fiduciary duties to an investor, by misappropriating funds belonging to the partnership. The state court had already ruled against the debtor on liability and was scheduled to rule on the damages incurred by the investor, when the debtor filed bankruptcy to avail himself of the automatic stay, which would prevent the lawsuit from moving forward.
After commencing the bankruptcy case, the debtor mistakenly believed that the plaintiff in the lawsuit would stop litigating against him. The plaintiff did not, initiating an adversary proceeding to determine that its debt was non-dischargeable and moving for relief from the automatic stay so that the state court lawsuit could proceed to final judgment. In addition, another active creditor commenced a separate adversary proceeding against the debtor.
During the chapter 11 proceeding, the law firm of Barron and Newburger, as bankruptcy counsel, assisted the debtor in complying with its numerous obligations under the Bankruptcy Code and in vigorously defending against the multiple allegations being made against the him by multiple parties. This fighting continued for approximately 11 months until the bankruptcy court finally decided, upon motion by one of the debtor’s adversaries, that the debtor had inappropriately attempted to conceal assets from the bankruptcy estate. The court then converted the case to chapter 7 and appointed a chapter 7 trustee.
Once the case was converted and a trustee was appointed, the debtor no longer managed the administration of the case and the law firm was dismissed of any further duties to continue representing the debtor in the bankruptcy case. However, the law firm was still owed approximately $134,000.00 for all the services it had provided the debtor during the course of 11 months. As is normally the case, the law firm filed a fee application with the bankruptcy court to collect all of its fees, but this application met with firm opposition by the United States Trustee (an oversight official) and the debtor’s adversaries. The latter claimed that the requested fees were unreasonable because (a) the debtor never held sufficient funds to proceed under chapter 11 and (b) the law firm’s assistance was dilatory and added an extra layer of administrative expense to the already nimble bankruptcy estate.
The bankruptcy court ultimately denied most of the law firm’s fee request, awarding only 85% (or $19,409.00) of the total fees requested. In doing so, the bankruptcy court relied on the Fifth Circuit’s holding in the Pro-Snax case, where the higher court found that a bankruptcy court could deny compensation of professional fees, pursuant to section 330 of the Bankruptcy Code, if the underlying services provided did not amount to an “identifiable, tangible and material benefit” to the bankruptcy estate. See 157 F.3d at 426. In the Woerner case, finding that most of the services provided by the law firm did not amount to success, the bankruptcy court felt that such services were not compensible, using the standard adopted in Pro-Snax.
Two subsequent appeals ensued until the matter finally stood before the Fifth Circuit Court of Appeals.
Fifth Circuit Decision
On appeal to the Fifth Circuit, the law firm argued that the material benefit standard enunciated in Pro-Snax conflicted with the text of section 330 of the Code and also was at odds with most of the Fifth Circuit’s sister circuits. The Fifth Circuit agreed.
The Court first analyzed the language in the Bankruptcy Code, finding that the plain text of section 330 provides, in relevant part, that a bankruptcy court:
- should “consider the nature, the extent, and the value of” the services, taking into account several factors, including “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 . . .;” and
- cannot award compensation for certain services, including those that were not “reasonably likely to benefit the debtor’s estate.”
(citing 11 U.S.C. § 330(a)(3) and (4)(A)(ii)). Reading these two provisions together, the Court found that section 330 allows compensation for services that are reasonably likely to benefit a bankruptcy estate, determined as of the time the services were rendered; not at a later point in time after the bankruptcy case has tanked. According to the Court:
The statute permits a court to compensate a [professional] no only for activities that were “necessary,” but also for good gambles–that is, services that were objectively reasonable at the time they were made–even when those gambles do not produce an ‘identifiable, tangible, and material benefit.’ What matters is that, prospectively, the choice to pursue a course of action was reasonable.
The Court found support of its position in the legislative history of section 330, which was enacted in 1978 to relax the previously stringent standard used by bankruptcy courts in awarding professional fees. The policy behind the prior stringent standard was that bankruptcy cases should be administered as efficiently as possible and professionals who were retained acted as officers of the court–not as private individuals–and therefore should not expect to be compensated as private individuals. The Court noted that in enacting section 330, Congress moved away from the prior strict regime of awarding fees and intended to compensate professionals commensurate with what other professionals earned outside of bankruptcy. (citing In re UNR Indus., Inc., 986 F.2d 207, 208-209 (7th Cir. 1993) (citing H.R. Rep. No. 95-595, at 329-30 (1978), reprinted in 1978 U.S.C.C.A.N. 5963, 6286.)) Significantly, the Court also reasoned that Congress took additional steps in this direction through the 1994 amendments to the Code, which inserted the new factors found in sections 330(a)(3) and (a)(4) (cited above).
Finally, the Court found that after the 1994 amendments to the Code, the Second, Third and Ninth Circuit Courts of Appeal rejected the actual benefits test set forth in Pro-Snax, in favor of the more reasonable prospective approach. These other Circuits reasoned that the actual benefits test (a) was not consistent with the text in section 330, (b) resulted in fee evaluations by hindsight, and (c) was inconsistent with the legislative history of section 330. Finding more support in the other Circuits’ reasoning than in the Pro-Snax opinion (which relied on antiquated law), the Court adopted the more reasonable prospective approach used by the other Circuits.
Under the new standard adopted in Woerman, “if a fee applicant establishe[s] that its service were ‘necessary to the administration’ of a bankruptcy case or ‘reasonably likely to benefit’ the bankruptcy estate ‘at the time at which [they were] rendered’ . . . ‘then the services are compensable,'” pursuant to sections 330(a)(3) and (a)(4) of the Code.
While the Woerman opinion represents an enormous break from the prior practice within the Fifth Circuit, the opinion still reminds practitioners that not all services provided must be compensated under the new prospective approach. Rather, the “reasonably likely to benefit” the estate standard will still allow bankruptcy courts to consider factor such as
- the probability of success when services were rendered;
- the reasonable costs of pursuing certain actions;
- what services a reasonable professional would have performed under the circumstances;
- whether the professional services could have been rendered by a trustee; and
- the potential benefits of the services to a bankruptcy estate (as opposed to individuals)
Thus, even under the new Fifth Circuit standard, whether services are ultimately successful is still relevant, but not dispositive, of professional compensation. Professionals in failed cases then are still going to be required to justify their actions during the course of a chapter 11 proceeding. And a bankruptcy court is still not prohibited from using some hindsight in evaluating the reasonableness of those services at the time they were performed. But, hopefully everyone will realize the new direction that the Fifth Circuit wants us to take.