Telling Clients to “Just Keep Paying” Won’t Cut It – Bankruptcy Court Claws Back Legal Fees as Constructively Fraudulent Transfers

Contributed by Yvanna Custodio
Professionals should be aware of the decision from the United States Bankruptcy Court for the Eastern District of New York in which Judge Robert E. Grossman found certain payments made to two of the debtors’ law firms pursuant to prepetition retainer agreements to be constructively fraudulent.  In Ruffini v. Norton Law Group PLLC (In re Ruffini), the bankruptcy estate of two individual chapter 13 debtors commenced an adversary proceeding against two law firms and their principal to recover prepetition legal fees paid to the defendants on the ground that the services rendered to the debtors did not constitute reasonably equivalent value for such payments.
Pursuant to the first retainer agreement, the debtors paid the lawyers a flat fee of $3,300 for mortgage modification services.  The debtors also agreed to pay an hourly rate for the attorney responsible for the matter, which was “subject to increases ‘from time to time.’”  During the trial in the adversary proceeding, one of the debtors testified that the defendants demanded payment from them every two weeks, threatening to terminate the case and allow the sheriff to foreclose on their home if they did not pay.  When the debtors questioned the progress of the case or asked about invoices, the defendants would respond, “this is office stuff” or “it’s part of your litigation.”  The debtors also alleged that the lawyers advised them to cease paying their mortgage while they were making biweekly payments to the defendants.
Unsurprisingly, the bank commenced a foreclosure action against the debtors.  Surprisingly, the debtors asked the defendants to represent them in defending against the foreclosure action.  This gave rise to a second agreement, which required payment of an upfront $5,000 retainer and that “the retainer would be refreshed in increments of $2,500.”  The debtors said that they did not understand the second agreement and did not understand that they were obligated to pay legal fees on an hourly basis.  In the meantime, the defendants told the debtors to “just keep paying.”
The defendants did not keep the debtors apprised of the foreclosure proceedings.  Eventually, the debtors hired a new attorney who filed their chapter 13 petition and commenced the adversary proceeding to recover the fees paid to the prior counsel based upon constructive fraudulent transfer and preference theories.
In finding that the payments made pursuant to the two retainer agreements were constructively fraudulent under section 548(a)(1)(B) of the Bankruptcy Code and sections 271 to 273 of the New York Debtor and Creditor Law, the court noted that its decision was “not meant to set any bright line tests or standards for determining what constitutes fair consideration in future cases involving services provided by professionals.”  As to the first retainer agreement, the court found that the law firm did not provide reasonably equivalent value or fair consideration for payments made based on hourly billing because the defendants fixed the value of their services at $3,300.  Thus, amounts paid in excess of $3,300 were not made in exchange for reasonably equivalent value.
As to the second retainer agreement, the court found that the agreement was unenforceable under state law, and the payments were “not entitled to the presumption of reasonableness that normally applies where the parties’ relations [are] governed by contract.”  The court cited to the unrefuted testimony of one of the debtors demonstrating that a meeting of the minds was lacking:  The debtors did not understand why they were signing the second agreement, and no one from the law firm explained its significance and the financial obligations it imposed.  The court also found that the defendants violated the New York Rules of Professional Conduct because they failed to explain the fees being charged.  Based on its review of the record, including the defendants’ timesheets and notes, the court concluded that the defendants did not provide reasonably equivalent value in connection with the foreclosure proceeding.  Finally, because the court found in favor of the debtors on fraudulent transfer grounds, it declined to rule on the preference action, finding it moot.
Although the facts of Ruffini seem extreme, the case is a cautionary tale to professionals.  The decision provides a somewhat bumpy road map for disgruntled clients claiming they did not receive fair value in exchange for what they agreed to pay.  Unlike the individual debtors in Ruffini, however, corporate clients might find it more difficult to claim they failed to understand the terms of an engagement.  The court itself noted that it did not articulate a standard on attorney compensation.  Interestingly, the decision rests less on an evaluation of the merits of the attorneys’ services and more on the debtors’ apparent confusion over the terms of the engagement.  Therefore, at a minimum, the decision highlights the need to explain clearly the billing practices governing a relationship with a client.