Gadzooks Update

This blog previously reported on an opinion by Judge Harlin Hale of the Northern District of Texas which limited the effect of the Fifth Circuit's opinion in Matter of Pro-Snax Distributors, Inc., 157 F.3d 414 (5th Cir. 1998). http://stevesathersbankruptcynews.blogspot.com/2006_10_01_archive.html. U.S. District Judge Jane Boyle has now reversed the Bankruptcy Court opinion. William Kaye vs. Hughes & Luce, LLP, No. 3:06-CV-01863-B (N.D. Tex. 7/13/07).

Judge Boyle found that although the Fifth Circuit's Pro-Snax discussion of the correct standard to apply in awarding attorney's fees under Sec. 330 was dicta, that it was judicial dicta rather than obiter dicta. Judical dicta is defined as an opinion on an issue which was directly briefed and argued by the parties, but which was not essential to the decision. Judge Boyle found that judicial dicta should not be lightly disregarded. The Court also questioned whether the Circuit's instructions on the test to be applied on remand was really dicta at all.

The District Court engaged in a curious discussion of whether Pro-Snax was inconsistent with the language of Sec. 330. On the one hand, the District Court noted that it was bound to apply Pro-Snax regardless of whether it was correct. It also noted that many courts had disagreed with its logic. It then engaged in a rather tortured analysis of how Pro-Snax could be reconciled with the language of Sec. 330. Thus, the District Court fulfilled its obligation to follow binding precedent and did so with a straight face.

Finally, the District Court rejected the Bankruptcy Court's attempt to limit Pro-Snax to its original context of awarding fees to debtor's counsel. The District Court found that the language of Sec. 330 did not distinguish between different types of professionals.

The District Court ruling has been appealed to the Fifth Circuit. This may set the stage for the en banc Fifth Circuit to reconsider Pro-Snax.

Gadzooks! Northern District Judge Limits Impact of Pro-Snax

Judge Harlin Hale was just written an important opinion on attorney's fees in chapter 11. In re Gadzooks, Inc., No. 04-31486 (Bankr. N.D. Tex. 10/5/06). Judge Hale questions the applicability of the Fifth Circuit's Pro-Snax dicta in light of subsequent Supreme court precedent. Alternatively, he would limit the opinion to debtor's counsel in doomed cases.

A Little Background

Since the Bankruptcy Reform Act of 1978, bankruptcy has become big business. Large firms which once shunned bankruptcy as being beneath them now have large departments. As a result, issues relating to employing and compensating professionals are of keen interest to those who make their living in the bankruptcy world.

In 1998, the Fifth Circuit decided the narrow issue of whether the statutory language of 11 U.S.C. Section 330(a) allowed debtor's counsel to be compensated subsequent to appointment of a trustee. The Fifth Circuit followed the statutory language and said no. Matter of Pro-Snax Distributors, Inc., 157 F.3d 414 (5th Cir. 1998). That result was subsequently upheld by the Supreme Court in another case. Lamie v. U.S. Trustee, 540 U.S. 526, 124 S.Ct. 1023 (2004). Not surprisingly, the Supreme Court said that courts should follow statute as written.

However, Pro-Snax had a second component to it. Because the firm was going to be able to receive some compensation, the Fifth Circuit gave instructions on how that compensation should be determined. The Court stated that in order to be compensable, services must result in an "identifiable, tangible and material benefit to the estate." The Court rejected the argument that services "need only be reasonable to be compensable." This holding arguably re-wrote the statute. Section 330(a)(4)(A) states that services may not be compensable if they "were not … reasonably likely to benefit the debtor’s estate or …necessary to the administration of the estate.” Since services "not ...reasonably likely" to benefit the estate could not be compensated, by negative implication, services which were reasonably likely to benefit the estate should be compensated even if they did not ultimately turn out to yield a benefit. It could be argued that while Pro-Snax was uniformly harsh toward debtors' counsel, it was schizophrenic when it came to statutory language; the primary holding was based on a strict reading of the statute, while the dicta edited out part of the text.

At least one court has held that, regardless of whether Pro-Snax properly read the statute, that it was still the law in the Fifth Circuit and should be followed. In re Weaver, 336 B.R. 115 (Bankr. W.D. Tex. 2005).

The Gadzooks Case

The recent opinion by Judge Hale addresses the situation where an Equity Security Holders Committee performed services which were objectively reasonable at the time they were performed, but did not yield a benefit to the equity holders for reasons beyond the committee's control. Gadzooks was a publicly traded company which catered to women between the ages of 14-22. At the time that it filed, equity was still in the money and the U.S. Trustee appointed an equity committee. The equity committee proposed a plan which could have paid unsecured creditors as much as 75% on their claims and would have allowed equity to buy back in. Unfortunately, the Debtor's sales tanked over the 2004 holiday season. As a result, the Debtor defaulted on its DIP financing, the proposed investment transaction was canceled and the equity committee was dissolved.

Hughes & Luce, the counsel to the equity committee, filed a fee application for approximately one million dollars. Both the creditors' committee and the liquidating trustee under the subsequently confirmed plan objected based on Pro-Snax. The case set up a perfect opportunity to examine the apparent conflict between Pro-Snax and Section 330(a). First, all parties stipulated that the services were reasonably calculated to provide a benefit up through the point that the Debtor's performance crashed. Second, the failure to achieve results was a result of factors the committee could not control. Third, the party making the request was not the debtor.

The Ruling

After a lengthy analysis, Judge Hale allowed compensation up until the point of futility for two independent reasons. First, Judge Hale applied the traditional lodestar analysis used by the Fifth Circuit prior to Pro-Snax to determine how much compensation was allowable. This conclusion was based on the preceeding analysis which rejected hindsight as a basis for denying fees. Judge Hale quoted the following language from the Supreme Court's Lamie opinion: "It is well established that 'when the statute's language is plain, the sole function of the courts--at least where the disposition required by the text is not absurd--is to enforce it according to its terms." Judge Hale added his own conclusion that, "This Court finds that, based on the wording in Section 330(a)(3) and (4), professional fees are not to be judged in hindsight."

Judge Hale relied on the intervening Supreme Court decision overturn the inconsistency in Pro-Snax.The Supreme Court said to follow the text of Section 330(a). The Pro-Snax dicta strayed from the text. Thus, while the Supreme Court upheld the holding in Pro-Snax, it implicitly rejected the dicta.

Judge Hale acknowledged that his ruling might be a little bold. He stated, "This Court realizes that its understanding of Pro-Snax may be misplaced. Certainly, other courts in Texas have constured the decision as requiring a hindsight analysis for professionals." Consequently, he offered a second rationale, finding that "Nevertheless, the Pro-Snax opinion is directed at a debtor's professionals, for obvious reasons--usually they have far more control over the reorganization efforts and strategy in a bankruptcy case. At least in Pro-Snax, they controlled the conversion to chapter 11 and the failed plan process." In his concluding paragraph, Judge Hale characterized Pro-Snax as "directed to professionals for the debtor who knew that their efforts were futile."

Judge Hale's order (which preceded the opinion) has already been appealed. Therefore it is likely that the Fifth Circuit will have the opportunity to revisit Pro-Snax in light of a decision squarely on point. If Gadzooks holds up, it will mean that professionals in bankruptcy will be less likely to have their fees denied based on factors beyond their control, such as poor holiday shopping sales. Of course, Gadzooks can't fix the largest problem in professional compensation--estates with no cash to pay professionals. However, it does remove an artificial roadblock.

Update:

On appeal, U.S. District Judge Jane Boyle reversed the Bankruptcy Court's opinion in Gadzooks. William Kaye vs. Hughes & Luce, LLP, No. 3:06-CV-01863-B (N.D. Tex. 7/13/07). Judge Boyle found that although the Fifth Circuit's Pro-Snax discussion of the correct standard to apply in awarding attorney's fees under Sec. 330 was dicta, that it was judicial dicta rather than obiter dicta. Judical dicta is defined as an opinion on an issue which was directly briefed and argued by the parties, but which was not essential to the decision. Judge Boyle found that judicial dicta should not be lightly disregarded. The Court also questioned whether the Circuit's instructions on the test to be applied on remand was really dicta at all.

The District Court engaged in a curious discussion of whether Pro-Snax was inconsistent with the language of Sec. 330. On the one hand, the District Court noted that it was bound to apply Pro-Snax regardless of whether it was correct and that many courts had disagreed with its logic. On the other hand, the District Court found that Sec. 330 could possibly be construed consistently with Pro-Snax.

Finally, the District Court rejected the Bankruptcy Court's attempt to limit Pro-Snax to its original context of awarding fees to debtor's counsel. The District Court found that the language of Sec. 330 did not distinguish between different types of professionals.

The District Court ruling has been appealed to the Fifth Circuit.

The Other Shoe Drops on Pro-Snax

Here is an article which I wrote that was recently published in the Bankruptcy Law Section Newsletter published by the Bankruptcy Law Section of the State Bar of Texas.

When the Fifth Circuit decided Matter of Pro-Snax Distributors, Inc[1].,the court devoted most of its analysis to the issue of whether debtor’s counsel could be compensated from the estate after appointment of a chapter 11 trustee. The Fifth Circuit ruled that the statutory language of 11 U.S.C. §330(a) prohibited such compensation and the Supreme Court subsequently adopted the same position.[2] However, the Fifth Circuit also addressed the broader issue of the proper standard to be used in awarding compensation. In a few short paragraphs, the Fifth Circuit rejected a standard of objective reasonableness and required that legal services result in “an identifiable, tangible and material benefit to the bankruptcy estate.”[3] Courts are only just now starting to focus on the meaning of this second holding.

The Pro-Snax Holding

In addressing the proper standard for awarding compensation, the court stated:

The other task to which this appeal commends us it deciding which standard we must apply to A & K’s services rendered before the appointment of the trustee. A & K argues that a reasonableness test is appropriate—whether the services were objectively beneficial toward the completion of the case at the time they were performed. The Petitioning Creditors, by contrast, advocate a more stringent test—whether A & K’s services resulted in an identifiable, tangible and material benefit to the bankruptcy estate. We determine today that the stricter test is the appropriate measure.[4]

The court went on to state that “we are disinclined to hold that any service performed at any time need only be reasonable to be compensable[5]” and added that “we believe it is important to stress that any work performed by legal counsel on behalf of a debtor must be of material benefit to the estate.[6]”

Thus, the court appears to have held that:

1. Services must result in an identifiable, tangible and material benefit to the estate to be compensable; and
2. Services which were objectively reasonable at the time they were performed, but did not result in an identifiable, tangible and material benefit are not compensable.

These holdings are problematic because they appear to contradict the language of 11 U.S.C. §330(a). The statute provides that courts shall not allow compensation for “services that were not … reasonably likely to benefit the debtor’s estate or …necessary to the administration of the estate.[7]” Because Congress prohibited payment for services not “reasonably likely to benefit the debtor’s estate,” it seems that they approved payment for services which were reasonably likely to benefit the estate. However, Pro-Snax would amend the statute to require that the services rendered an actual, material benefit as judged in hindsight. Congress also stated that courts should consider “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.”[8] How can Pro-Snax be reconciled with a requirement to look at whether services necessary or beneficial at the time at which they were rendered?

The Pro-Snax ruling is also difficult because it fails to address services, which are necessary to the administration of the case, but do not result in an identifiable, tangible and material benefit. For example, the bankruptcy estate does not receive a direct benefit from filing schedules, attending the first meeting of creditors or filing monthly operating report. However, each of these functions is required by Title 11. While these services do not render a direct benefit, they avoid a direct detriment, that is, having the case dismissed or converted.

Applying Pro-Snax in Chapter 11

While the Pro-Snax material benefit standard has been rejected by some courts in other circuits,[9] it has been applied in a handful of cases within the Fifth Circuit.[10] The most extensive discussion is found in the recent Evans Weaver [11]case from the Western District of Texas. Weaver involved representation of an individual in a failed chapter 11 case described by the judge as “one of the most contentious cases that the Court has involved with since being licensed as a lawyer in 1969.[12]” The case was precarious for debtor’s counsel due to the nastiness of the case, the ultimate conversion to chapter 7 and the inherent conflict present in representing an individual as both debtor and debtor-in-possession.[13]

The Court followed Pro-Snax despite an argument that it was contrary to clear statutory authority.[14] The court separately analyzed each project that the debtor’s counsel and special counsel worked upon to see whether it was compensable.[15] The Court generally divided the fee requests into several categories: those which represented mandatory duties for Debtor’s counsel, which would be allowed subject to reasonableness; those which were for the benefit of the individual debtor, which would not be allowed; those which were not mandatory and did not benefit the estate, for which no compensation would be allowed; and those which were not mandatory but did benefit the estate, for which compensation would be allowed based on reasonableness and the results obtained.

Mandatory Services

The Court found that benefit must be presumed on those matters “necessary to the administration of the case.[16]” Judge Monroe stated that, “The Court believes that is the only exception to the Pro-Snax pronouncement that all services rendered by persons representing the estate have the ability to show the identifiable, tangible and material benefit that has come from their efforts. With regard to ‘mandatory’ work, the benefit must be presumed and the inquiry is one of the reasonableness of the fees charged on such mandatory matters.[17]” Mandatory services were found to include such items as preparing the initial filing, matters related to case administration such as filing schedules and attending the creditors’ meeting[18] and “investigating whether property of the estate has value.[19]” There were also a number of small items which arguably fell into this category.

Services for Debtor’s Benefit

This category illustrates the perils of representing an individual debtor. While the debtor was in chapter 11, he was a party to a pending divorce action and was sued by several creditors to determine dischargeability of debts. These are both areas where the debtor required counsel and which could impact the reorganization case. For example, the divorce action could create new obligations for maintenance or support which would limit the debtor’s funds to pay creditors and could attempt to divide or dispose of property of the estate. Similarly, it would be difficult to negotiate a plan with a creditor without addressing the dischargeability of that creditor’s claim.

However, the court denied or substantially reduced fees in this area reasoning that they were for the benefit of the individual debtor and not the estate. The court completely denied fees with regard to the dischargeability actions. The court was more generous with regard to the divorce action. The court allowed a small portion of special counsel’s fees which brought an asset into the estate which was later bought back from the chapter 7 trustee by the individual debtor. The court also allowed bankruptcy counsel to recover for fees incurred in connection with the motion to lift stay to allow the divorce to go forward and allowed reduced fees for matters relating to coordination between the divorce and bankruptcy.

These rulings, while true to Pro-Snax, raise difficult practical problems. If debtor must have counsel for a dispute, but is not allowed to pay counsel out of the estate, how will debtor obtain qualified counsel? The choices are limited. A debtor can liquidate exempt property, can use funds which are not property of the estate or can borrow funds from outside the estate. However, under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, the debtor’s post-petition earnings in a chapter 11 case are now property of the estate.[20] Therefore, these funds are no longer available to pay counsel for matters which can’t be paid out of the estate.

Non-Mandatory Services Without Benefit

This category resulted in denial of a substantial amount of fees. A non-mandatory service is one that debtor’s counsel is not required to perform under the code. Debtor’s counsel does not have to propose a plan or respond to respond to a motion to dismiss or convert the case. As a practical matter, counsel must perform these duties if the debtor is to emerge from bankruptcy with a confirmed plan. However, these are areas which might not be appropriate in a specific case. As a result, counsel is subject to being second-guessed at fee application time.

The two main areas where the court denied fees for this reason related to the plan and the motion to convert. The court found that the facts relating to the plan were very close to those of Pro Snax in that the debtor was attempting to propose a plan over the vehement objection of his main creditors. However, the court also stated that it could not understand why the creditors would prefer trying to seek a non-dischargeable judgment in chapter 7 to the debtor’s plan. Thus, even though the debtor was objectively trying to benefit his creditors, the fact that they did not want to be benefited meant that these services were not compensable.[21] With regard to the motion to convert, the court found that the debtor’s resistance was simply an attempt to keep the debtor in control at a point where the case had become hopeless.[22]

Non-Mandatory Services With Benefit

In an unsuccessful case, this category is likely to be slim. However, in the Weaver case, the debtor’s counsel pursued a preference claim against the major creditor in the case which the trustee successfully settled for a large sum. The court allowed these fees after noting that it had to prod the debtor to pursue the action in the first place.

Applying Pro-Snax Beyond Chapter 11 Debtor’s Counsel

Nearly all of the cases applying Pro-Snax have involved compensation of debtor’s counsel in a chapter 11 case. However, the statute being interpreted, 11 U.S.C. §330(a), also applies to compensation of a chapter 11 trustee, an ombudsman, an examiner and counsel for a trustee. If the identifiable, tangible material benefit standard is part of the statute, then it must apply to these parties as well. How exactly does an examiner benefit the estate? If an examiner is appointed to investigate the debtor’s transactions with insiders and concludes that no wrongdoing occurred, should compensation be denied on the basis that no benefit was received? If trustee’s counsel investigates 100 potential preference actions, chooses to pursue ten and is successful on five, should compensation be limited to the time spent on the five successful actions or should compensation be allowed for the entire project on the theory that it was necessary to wade through 95 potential claims to find the five meritorious ones?

The second Pro-Snax holding is difficult to reconcile with the statute it sought to interpret. Perhaps the Fifth Circuit was reacting to the specific facts before it and would not apply the same standard to a consumer privacy ombudsman (a position which did not exist at the time of the opinion) or an examiner. It also may be that the Fifth Circuit, like Judge Monroe, would find an exception for “mandatory” services which would mitigate the potential harshness of its ruling. In the alternative, all professionals employed by bankruptcy estates may find themselves under a one-sided contingent fee arrangement[23] and should negotiate their fees accordingly.

End-Notes:
[1] 125 F.3d 414 (5th Cir. 1998).
[2] Lamie v. United States Trustee, 540 U.S. 526, 124 S.Ct. 1023, 157 L.Ed.2d 1024 (2004).
[3] 157 F.3d at 426.
[4] Id.
[5] Id.
[6] Id.
[7] 11 U.S.C. §330(a)(4)(A).
[8] 11 U.S.C. §330(a)(3)(C).
[9] In re Ames Department Stores, Inc., 76 F.3d 66 (2nd Cir. 1996)(while this opinion pre-dates Pro-Snax, it adopts the position rejected by the Fifth Circuit); In re Mednet, 251 B.R. 103 (9th Cir. BAP 2000).
[10] In re Condit, 2003 Bankr. LEXIS 601 (Bankr. N.D. Tex. 2003); In re Needham, 279 B.R. 519 (Bankr. W.D. La. 2001).
[11] In re Evans Weaver, 336 B.R. 115 (Bankr. W.D. Tex. 2005).
[12] In re Evans Weaver, 336 B.R. at 118.
[13] Representation of an individual chapter 11 debtor requires counsel to represent a single individual who is both the individual debtor and the representative of the estate. Some matters, such as exemption disputes, place counsel in a conflict between duties to the debtor and to the estate. Other areas, such as objections to discharge and determination of dischargeability, benefit the debtor without affecting the estate. The state disciplinary rules require counsel to sealously represent both interests. This is less of a problem in chapter 12 and 13 cases because the statute allows compensation for services reasonably benefiting the debtor. 11 U.S.C. §330(a)(4)(B).
[14] “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” (citation omitted) as well as services that are ‘reasonably likely to benefit the debtor’s estate.” (citation omitted). Even if such be true, this Court is constrained to follow the 5th Circuit’s interpretation.” 336 B.R. at 119.
[15] The Local Rules of the Western District require that fee applications contain a description of the categories of services rendered stating the nature and purpose of each category and the results obtained. W. D. Tex. Local Bankr. R. 2016(a)(1).
[16] 11 U.S.C. §330(a)(4)(A)(ii)(II).
[17] In re Evans Weaver, 336 B.R. at 122.
[18] The Condit court approached this area somewhat differently, finding that items such as preparation of schedules and attendance at the first meeting of creditors “inures to the estate’s benefit” and “may confer an actual benefit on the estate” and were therefore compensable. In re Condit, at 8.
[19] “(I)t is mandatory that counsel should spend some time investigating whether property of the estate has value. He should not be required to simply roll over.” 336 B.R. at 123.
[20] 11 U.S.C. §1115.
[21] Other courts have fudged on this issue and have allowed partial compensation for unsuccessful attempts to propose a plan. In re Condit, supra (50% of requested fees allowed); In re Needham, supra (20 hours out of 98.25 allowed).
[22] In contrast, the court allowed fees for resisting a motion to appoint trustee which was “wholly without merit.” It is unclear whether this was allowed as a mandatory item or whether preventing something bad from happening counts as an identifiable, tangible and material benefit.
[23] A one-sided contingent fee arrangement is one where the hourly rate is paid if counsel is successful and no compensation is paid if counsel is unsuccessful. It lacks the upside potential of a traditional contingent fee contract.