Restructuring

Contributed by Kyle J. Ortiz

Napoleon Hill, America’s original financial self-help guru, wrote in his 1928 book, The Laws of Success:

“The [person] who does more than [he/she] is paid for will soon be paid for more than [he/she] does.”

Three petitioning creditors who filed an involuntary petition against Ponzi scheming debtors in the United States Bankruptcy Court for the Middle District of Florida might beg to differ with Hill’s statement following the court’s decision in In re Engler, Case No. 9:08-bk-04360, 2013 WL 5441730 (Bankr. M.D. Fla. Sept. 30, 2013).
Background
Prepetition, the petitioning creditors invested with the debtors (a brokerage firm and its founder who claimed to have sophisticated, proprietary software enabling the debtors to effectuate trades faster than other brokerages and reap outsized profits for their customers).  When the advertised profits did not materialize for the petitioning creditors, they decided to pursue legal action to try and recover their “investment.”
The creditors retained a law firm to investigate potential claims against the debtors in October 2007 and filed a complaint in state court seeking damages and injunctive relief against the debtors in November 2007.  As they continued their investigation of the debtors, the petitioning creditors uncovered the Ponzi scheme and, as they realized the extent of the fraud being perpetrated by the debtors, the creditors began to consider filing an involuntary petition in an effort to halt the scheme before more of creditors’ “investment” could be squandered.  The petitioning creditors filed an involuntary petition against the debtors in March 2008.  In April 2008, the court entered an order for relief, and a chapter 7 trustee was appointed.  The law firm representing the petitioning creditors was retained as special counsel six months after the involuntary petition was granted.
In October 2012, the petitioning creditors filed a fee application requesting reimbursement of fees totaling $95,000, of which $39,000 was for fees and expenses incurred prepetition in connection with filing the involuntary petition and $56,000 was for fees and expenses allegedly incurred in connection with recovering assets for the estate during the six-month period between the date of the order for relief and the date the petitioning creditors’ law firm was retained as special counsel.  The trustee objected to all of the postpetition fees and all but $6,000 of the prepetition fees and expenses.
The court, faced with a dispute at the intersection of two competing policy goals (minimizing the expenses of the estate and incentivizing creditors to take actions for the benefit of the estate), essentially articulated two bright line rules in an attempt to balance the conflicting policy goals:

• Petitioning creditors are not entitled to recover as administrative expenses prepetition fees for work they would have undertaken even if an involuntary cases had not been filed; and
• Creditors cannot, recover fees under section 503(b)(3)(B) of the Bankruptcy Code for work performed in connection with recovering property of the estate prior to court approval to undertake such work.

Prepetition Fees
Both the petitioning creditors and the trustee agreed that, when sections 503(b)(3)(A) and 503(b)(4) are read together, the petitioning creditors were entitled to reasonable attorney’s fees for work “directly related to” the filing of the involuntary petition.  They disagreed, however, as to what constitutes work “directly related to” an involuntary filing.
The petitioning creditors asserted that all of the fees incurred prior to the petition investigating the debtor’s Ponzi scheme were incurred in connection with “legal and factual” research “directly related to” the involuntary filing.  The trustee asserted that the petitioning creditors should be limited to seeking reimbursement of fees incurred after January 2008, when the petitioning creditors first considered filing an involuntary case.  The court resolved the issue by articulating a “bright line” rule where “a petitioning creditor is not entitled to recover any prepetition fees under section 503(b)(3)(A) for work it would have done had the involuntary bankruptcy case not been filed.”  The court stated that its “bright line” rule “harmonize[d] the two competing goals of section 503(b)” because it “reimburses petitioning creditors for successfully filing and prosecuting an involuntary case, which advances the public policy of marshaling a debtor’s assets and equitably distributing them before they are squandered” and also “keeps the administrative expenses to a minimum thereby preserving the estate for the benefit of its creditors.”
Although its “bright line” rule may require a fact intensive inquiry into when a particular creditor began working on an involuntary filing, the court stated that its rule created a fairer standard than one promoted by other courts based purely on timing in relation to the filing, while still ensuring that the fees being reimbursed were not for work too remote from the filing to justifiably be borne by the estate.  Additionally, although the court acknowledged the need to incentivize petitioning creditors, it ultimately weighted the need to keep administrative cost to a minimum as the more important policy concern.  Thus, the court limited the petitioning creditors to reimbursement for the $6000 that could be shown to be directly related to the involuntary petition and that would not have been incurred but for their efforts in connection with the involuntary petition.
Postpetition Fees
Section 503(b)(3)(B) of the Bankruptcy Code allows a creditor to recover as an administrative expense, fees for work authorized by the court and performed in connection with the recovery of transferred or concealed property for the benefit of the estate.  Because the petitioning creditors sought approval of fees incurred for recovery work already undertaken, the court stated that the question was “whether the petitioning creditors [could] recover their postpetition fees as an administrative expense under [section] 503(b)(3)(B) without first obtaining court approval.”
The court noted that caselaw is split on this question, with some courts holding that the plain language of the statute is clear and no fees incurred prior to court approval of the recovery work are to be awarded, while other courts allow creditors to recover fees absent prior court approval under “exceptional circumstances.”
The court sided with the courts adopting a bright line rule and holding that prior court approval of the recovery work is an absolute prerequisite and stated that it favored such a rule because it “ensure[s] that the actions taken by creditors [are] necessary and not duplicative of work performed by the trustee.”  The court went on to note that even under the “exceptional circumstances” standard, the petitioning creditors and their law firm had failed to offer any reason for their delay in seeking approval as special counsel, and thus, the court would have denied the request under either standard.  The court acknowledged that the petitioning creditors may have made a substantial contribution to the case that would entitle them to reimbursement of fees under section 503(b)(3)(D) had the case been a chapter 9 or a chapter 11, but that section 503(b)(3)(D) is not applicable to chapter 7 cases.
Thus, the court sent a clear signal to creditors that if they want to be able to recover fees for actions taken to recover transferred or concealed property for the benefit of the estate in a chapter 7 case, they will want to be proactive in seeking approval to have fees reimbursed in connection with recovery work prior to taking any action.  Consequently, contrary to Mr. Hill’s advice, creditors will want to get court approval to be paid for work performed prior to doing any work.