Fees, Fees, Fees: SDNY Bankruptcy Court Questions the Ongoing Validity of the “Blackstone Protocol” for Investment Banker Fees in Chapter 11 Cases

Background: Professionals’ Fees in Chapter 11 cases
Chapter 11 reorganizations are a complex affair. They often require various professionals – attorneys, accountants, investment bankers, appraisers and other professionals – to represent and assist the trustee or debtor in possession in carrying out its duties under the Bankruptcy Code. Section 327 of the Bankruptcy Code provides that the trustee or debtor-in-possession may employ such professionals (as long as they are “disinterested persons” and do not hold or represent an interest adverse to the estate).

Two sections of the Bankruptcy Code deal with the compensation of such professionals. First, section 328(a) of the Bankruptcy Code provides that a trustee, with the court’s approval, may approve the retention of a professional “on any reasonable terms and conditions of employment, including on a retainer, on an hourly basis, on a fixed or percentage fee basis, or on a contingent fee basis.” Section 328(a) further states that “. . . the court may allow compensation different from the compensation provided under such terms and conditions after the conclusion of such employment, if such terms and conditions prove to have been improvident in light of developments not capable of being anticipated at the time of the fixing of such terms and conditions.” 11 U.S.C. § 328(a) (emphasis added). Section 330 of the Bankruptcy Code provides for a second (alternative) route for review of fees. Under section 330(a)(1), the Court may award the professionals retained by the debtor-in-possession (or trustee), “[r]easonable compensation for actual, necessary services” rendered by the professional, and “reimbursement for actual, necessary expenses”. 11 U.S.C. § Section 330(a)(1) (emphasis added). Furthermore, section 330(a)(3) clearly states that in determining the amount of reasonable compensation to be awarded to a professional, the court shall consider “the nature, the extent, and the value of such services” and shall take into account “all relevant factors”, including time spent, rates charged, whether services were necessary or beneficial at the time such services were rendered, whether the services were performed in a reasonable amount of time, and whether the compensation is reasonable based on customary compensation charged by comparably skilled practitioners in nonbankruptcy cases. 11 U.S.C. § Section 330(a)(3) (A-F).
In a recent bench decision by Judge Michael Wiles, in In Relativity Fashion, LLC, Ch. 11 Case No. 15-11989 (Bankr. S.D.N.Y. December 16, 2016) [ECF 2194], the Bankruptcy Court for the Southern District of New York discussed, in the context of investment bankers’ fee applications under section 328 of the Bankruptcy Code, the differences between these two sections and their underlying rationale. The Court also questioned the validity of the so-called “Blackstone Protocol”, an agreement developed over time that allows only the U.S. Trustee to raise objections to investment bankers’ fees under section 330 while all other parties are bound to the strict standard of section 328 of the Bankruptcy Code.
The Relativity Decision
(i) The Different Standards under Sections 328 and 330 Explained
Two investment banking firms – PJT Partners LP (formerly Blackstone Advisory Partners LP) and Houlihan Lokey Capital, Inc. – were retained in the Relativity case. Both firms’ retention agreements provided for a compensation structure that is relatively common to investment banker retentions, both within and outside bankruptcy. Both firms were to be paid monthly fees on an ongoing basis, plus a “transaction fee” to be paid if and when a transaction was consummated, so long as any other conditions in the agreement were met. Both firms filed fee applications and requested approval of “transaction fees” according to the retention agreements in the sums of $4.5-$5 million each. Two objections were filed. The objecting parties – a creditor and the fee examiner – argued that the Court should review the investment bankers’ fee applications for reasonableness using the standards set forth in section 330 of the Bankruptcy Code and not under section 328(a) of the Bankruptcy Code. They then argued that the applications do not satisfy the section 330 reasonableness requirements with respect to the proposed transaction fees.
The Court took the opportunity to comment on how the standards under section 328(a) differ from those under section 330 of the Bankruptcy Code. The Court noted that under section 328(a), once the fees are approved, they are payable unless the approved terms and conditions “prove to have been improvident in light of developments not capable of being anticipated at the time of the fixing of such terms and conditions.” 11 U.S.C. §328(a). Essentially, the Court noted, under section 328(a), reasonableness is judged in advance, and the issue is not revisited except in the very narrow circumstances permitted by the statute. On the other hand, the Court further noted that if the fees are not approved in advance under section 328(a), the fees are reviewed under the various reasonableness factors listed in section 330, which “calls for a review of reasonableness that, to some extent, is made after-the-fact, although the case law makes clear that the judgment is not supposed to be done completely with 20/20 hindsight.”
In an effort to clarify the underlying rationale for the different approach set forth in sections 328(a) and 330, the Court relied on a previous Fifth Circuit decision – Donaldson Lufkin & Jenrette Securities Corp. v. National Gypsum Co. (In re National Gypsum Co.), 123 F.3d 861 (5th Cir. 1997). The Fifth Circuit in National Gypsum explained that under section 330 of the Bankruptcy Code there is uncertainty as to the amount of fees that a professional will be awarded, since section 330 authorizes the Court to ascertain in retrospect what is the “reasonable compensation” based on the relevant factors of time, comparable costs, etc. The Fifth Circuit emphasized that under section 328 the Bankruptcy Code a professional may avoid that uncertainty by obtaining court approval of compensation agreed to with the trustee (or debtor-in-possession). Id, 862-863. Based on National Gypsum, the Court in Relativity reasoned that section 328(a) reflects the view that professionals are entitled to know what they are likely to be paid for their work: “If you agree to hire someone on a flat fee or percentage-fee basis, there should be some comfort that the compensation will be paid and that a court will not simply impose a new and different deal after all the work has been done.”
The Court in Relativity also found this case to be an appropriate opportunity to comment on investment bankers’ fees in general, and in particular on the subject of “transaction fees.” The Court noted that it is common practice in the investment banking industry to include a provision for payment of monthly fees as well as transaction fees in the retention agreement, and that investment bankers’ main compensation is through the “transaction fees” mechanism. Those fees usually are contingent on the consummation of a transaction so that they are not paid if a transaction does not occur, but apart from that condition, they often have no other requirements. The Court also noted that usually, but not always, the transaction fees are independent of the amount of time it takes to complete the transaction, the involvement of other people, etc. Finally, the Court noted that transaction fees are not unique to bankruptcy, that it has long been the practice of investment bankers to charge for their services in this exact same way outside of bankruptcy, and that there is a long line of cases in which New York courts have reviewed and enforced similar transaction fee provisions.
(ii) Questioning the validity of the “Blackstone Protocol”
The Court stated that the “Blackstone Protocol” was an arrangement that started in the Southern District of New York and represents a “negotiated truce” between investment banks and the Office of the U.S. Trustee for the Southern District of New York. Historically, the Court noted, the U.S. Trustee has been a much larger opponent of section 328(a) approvals than other parties have been, and to some extent, this was based on a philosophical view that retentions and fees should always be reviewed after-the-fact. The “Blackstone Protocol” says, in effect, that parties are bound by the section 328(a) standards, except for the U.S. Trustee, who has the right to object on Section 330 grounds. (The Court further noted that some investment bankers sought modified versions of the New York Blackstone Protocol when they were retained in Delaware. The primary focus of the limitation was an effort to obtain an agreement that the United States Trustee could object on section 330 grounds, but that the reasonableness of fees would not be based on hourly rate criteria.) In other words, agreements following the “Blackstone Protocol” generally say that the U.S. Trustee may object on all grounds set forth in section 330 of the Bankruptcy Code, while barring other parties from doing so.
The Court in Relativity noted that, in effect, the Blackstone Protocol creates a “hybrid situation” in which the court may apply the section 330 standards to an objection made by the U.S. Trustee, but otherwise must apply the section 328(a) standard. The court commented that “[f]rankly, it is not at all clear that Congress contemplated this kind of hybrid approach when it enacted Section 328(a)”. The Court cited a Second Circuit decision that expressly held that sections 328 and 330 of the Code are “mutually exclusive” and that the court may not conduct a section 330 inquiry if there has been a section 328 approval. Riker, Danzig, Scherer, Hyland & Perretti v. Official Committee of Unsecured Creditors (In re Smart World Technologies, LLC), 552 F.3d 228, 233 (2d Cir. 2009). Furthermore, the Court commented that “[e]xactly what it means for the United States Trustee to reserve rights to object under Section 330 is, frankly, not clear.” One possibility, the Court said, was that the Court should treat this reserved right as if no pre-approval of the transaction fees had been given at all, and as if there had been no prior determination as to the reasonableness of the fees or as to whether the fees were consistent with market standards. Another possibility was that the reservation of rights in the “Blackstone Protocol” means that the U.S. Trustee is not collaterally estopped on the question of whether the fee is market-based and can raise that issue later. The Court noted, however, that both these possibilities did not make sense and that both were unfair to the professionals and the other parties. The real aim of the arrangement, the Court concluded, was not to postpone the litigation of issues that could and should be litigated at the outset, but instead to provide greater flexibility to deal with changed circumstances that the parties think may be relevant but that might not be capable of being considered under the literal terms of section 328(a).
Ultimately, because the U.S. Trustee did not object to the fee applications in this case, the Court found that the question of the validity and scope of the “Blackstone Protocol” did not need to be addressed further. The Court went on to find that the objecting parties did not retain a right to object to the fees under the reasonableness standard of section 330. Accordingly, the Court applied section 328 of the Code, denied the objections and approved the investment bankers’ fees as requested.
While the Relativity Court’s comments regarding the “Blackstone Protocol” are dicta, the Court clearly conveyed its doubts regarding the validity and scope of this “Protocol”, and it is not unreasonable to think that these comments will be revisited by the same court or other Bankruptcy Courts in the future, under the right circumstances.