Restructuring

Contributed by Danielle Donovan
In a previous blog post, we examined Waterscape, a decision by Judge Bernstein, in which the bankruptcy court held that the debtor, the owner of a hotel and condominium project, possessed only bare legal title, as opposed to equitable title, in certain trust funds.  The court held that the use of such funds to pay off the principal and interest of a bank’s secured project loan instead of unpaid contractors was a diversion of funds prohibited under New York’s Lien Law.  Even though the court found that the debtor had diverted funds, the debtor successfully defended against claims brought in an adversary proceeding by the general contractor, Pavarini McGovern, LLC, which sought recovery for the benefit of a class comprising the general contractor and its subcontractors on a theory of restoration.
A debtor may defend against a diversion claim by demonstrating that the diverted funds have been “restored” and that the funds are available to pay trust claims.  The restoration defense is rooted in the principle that the “law is not designed to impose a penalty upon a violator so as to create a windfall of double repayment for creditors.” The debtor satisfied restoration requirements under its plan of reorganization, which provided that the debtor would sell its hotel free and clear of all liens, claims and interests.  All but $14 million from the sale proceeds would be paid to the bank in partial satisfaction of its claim.  Of the $14 million remaining, $11 million would be carved out for the purposes of establishing a trust fund account for the benefit of the unpaid contractors.  The $11 million figure was based upon the amount asserted in the general contractor’s proof of secured claim.
Here we examine a more recent decision from Judge Bernstein that addresses whether the general contractor may be reimbursed for its attorneys’ fees and expenses from the trust fund account.
Almost two years after the plan’s confirmation, and over a year after Judge Bernstein’s decision, the general contractor moved for an order allowing the reimbursement of its attorneys’ fees and expenses incurred in the bankruptcy case and in the related class action adversary proceeding.  The general contractor did not seek recovery from the debtor or its estate, but instead sought payment from the trust established to pay the unpaid contractors on the grounds that the “common fund” doctrine, provisions of New York Lien Law, and federal and state procedural rules permit a class representative to recover legal fees and expenses.  Although none of the direct beneficiaries of the trust objected to the general contractor’s motion, the debtor and the bank did.
The debtor’s opposition emphasized that the general contractor had failed to show that it was entitled to a “substantial contribution” award under section 503(b)(3) of the Bankruptcy Code.  Additionally, the debtor argued that the general contractor was not entitled to payment for its efforts in the adversary proceeding because the prosecution of the class action neither created the trust nor conferred any benefit on the class that it had not already received under the plan.
The bank took a different approach and focused on its being a defendant or potential defendant in various subcontractor actions pending in state court against the debtor.  It argued that surcharging the trust to pay the general contractor’s legal fees would limit the amount available to pay the subcontractors and thereby expose the bank to more liability.  Further, because the trust was created to pay the project-related claims covered by the general contractor’s proof of claim, the bank argued that the general contractor proposed to use the trust in a manner that undermined the plain language of the plan.  The bank also pointed out that, to the extent the general contractor sought reimbursement based on a “substantial contribution,” its application was time-barred.
As the general contractor did not assert a claim against the estate, but rather against the trust fund account, the bankruptcy court gave little attention to the substantial contribution arguments of the debtor and the bank.  Instead, the court focused its analysis on the application of the “common fund” doctrine and its intersection with section 1141(a) of the Bankruptcy Code.  Unfortunately for the general contractor, the “common fund” doctrine could not trump the finality provided by section 1141(a).
The “common fund” doctrine is based on principles of unjust enrichment.  A litigant or lawyer who creates, enhances or restores a common fund for the benefit of himself and others is entitled to recover reasonable attorneys’ fees and expenses from the fund.  It provides a way for the beneficiaries of such fund to share the cost of its creation.  The court held that the general contractor had established its right to recover at least some of its fees under the “common fund” doctrine.  The general contractor persistently had objected to Waterscape’s original plan and had argued that the proposed disposition of the proceeds violated New York’s Lien Law.  As a result of the general contractor’s objections, the debtor amended its plan, which, as confirmed, provided for the creation of the trust fund account.  If not for the general contractor’s efforts, the debtor and the bank never would have agreed to carve out $11 million from the hotel sale proceeds to create the trust fund account.
Notwithstanding the general contractor’s rights under the “common fund” doctrine, confirmation of the debtor’s plan closed the door on the general contractor’s recovery.  As provided in section 1141(a), the confirmation of a plan binds all parties to the bankruptcy case and constitutes a final judgment on the merits entitled to preclusive effect under the doctrine of res judicata.  The general contractor failed to include its claim for attorneys’ fees in its proof of claim and even failed to raise the issue of reimbursement during the confirmation proceedings.  Although the trust fund account was not actually funded until the sale of the hotel six months after confirmation of the plan, the funding followed from the provisions of the plan.  The general contractor also failed to prove that it did any work during those six months that warranted compensation from the fund.  Confirmation of the plan constituted a final determination of the parties’ respective rights in the trust fund account.  Neither the “common fund” doctrine nor any other theory could salvage the general contractor’s tardy claim.
Finally, the court noted that, even if the general contractor’s claim were not barred by the plan, the general contractor failed to meet its burden of proving that it was entitled to reimbursement for the amount it requested.  The general contractor’s motion did not distinguish between the fees incurred for prepetition, postpetition/pre-confirmation, and post-confirmation services.  In addition, the motion failed to differentiate between the legal services rendered in the bankruptcy case and in the class action adversary proceeding.  The court rejected the general contractor’s argument that it was entitled to reimbursement for services rendered post-confirmation because it had successfully moved for partial summary judgment in the adversary proceeding.  Even though the court found that the debtor had diverted trust funds to the bank, the general contractor’s argument failed because the trust fund account was created as a result of the plan, and not as a result of the general contractor’s work in the adversary proceeding.
Simply put, the general contractor’s efforts were too little, too late.