Representing an individual debtor in a Chapter 11 case presents unique problems and challenges for the practitioner and for the debtor. Informing the client of these considerations before filing the case is imperative so that the client can make an informed judgment about whether Chapter 11 is worth the risks. Putting that advice in writing is one way to ensure that the client understands the issues. Some of the considerations may be set forth in the engagement agreement. Others, however, may belong instead in a side-letter. If the individual debtor is not satisfied with how the case ends, that side-letter may be the only thing standing between the practitioner and a malpractice claim, especially if the client does not recall the verbal advice the practitioner gave months before.
But why use a side-letter, instead of just describing the potential problems and land mines in the engagement agreement? One reason is that the rules for engagement of attorneys in Chapter 11 cases are different from the rules in Chapter 7 and 13 cases. Unlike in Chapters 7 or 13, a debtor in Chapter 11 may retain professionals only with court approval – even if the debtor is an individual. An application to retain counsel must set forth the engagement’s terms and satisfy other disclosure obligations that the bankruptcy law and rules impose. In many jurisdictions, the debtor is expected to attach a copy of the engagement agreement as an exhibit to the retention application. In those jurisdictions, publicly disclosing confidential advice or risk assessments in the engagement agreement could vitiate the attorney-client privilege and give creditors a leg-up at the negotiating table. A side-letter may minimize such concerns.
While negotiating the engagement arrangements and preparing the side-letter, a practitioner must identify and evaluate the legal issues that the particular individual debtor may face in the Chapter 11 case. Those issues may include: the nature of the debtor’s fiduciary duties; what may happen if a trustee is appointed to oversee the bankruptcy estate; what the debtor can and cannot do without first obtaining court approval; potential limitations on what the practitioner can do or advise; and how the practitioner will be paid.
Identifying the “Client”
Initiating a bankruptcy case creates an estate that includes a debtor’s legal and equitable interests in most types of property. The vast majority of courts have held that a debtor’s attorney in a business bankruptcy case represents the estate, rather than the business’s individual principals or decision-makers. Practitioners sometimes do not realize, though, that the same is true if the Chapter 11 debtor is an individual. The attorney represents the individual debtor’s bankruptcy estate, not the individual personally. Drawing a distinction between the individual and that individual’s estate seems nonsensical to a lay person. (As noted below, it also creates a tension for practitioners between fulfilling their own duties to the estate and zealously representing their individual clients.) Nonetheless, the individual must understand what the distinction means. A side-letter may give the practitioner an opportunity to explain this.
The explanation should address at least two points: First, advising the individual debtor of his or her fiduciary duty to creditors; second, articulating the estate attorney’s duties to the client and estate in the Chapter 11 case. An individual Chapter 11 debtor owes a fiduciary duty to his or her creditors to act in the estate’s best interests. In general, this means the individual debtor must put creditors’ interests ahead of the debtor’s personal interests, and must work to benefit the estate even if this may disadvantage the debtor personally. Fulfilling these fiduciary duties can raise issues on which courts disagree or have not spoken and that may place the attorney in an awkward position.
For example, can an individual Chapter 11 debtor claim and defend exemptions for his or her property, given that doing so would make those assets unavailable to pay creditors’ claims? Conversely, does the individual Chapter 11 debtor have a fiduciary duty to relinquish his or her own exemptions in order to maximize creditors’ recoveries? The duty to benefit the estate also may require individual debtors to pursue actions to set aside preferential transfers, even if this may increase the debtor’s exposure on guarantied debts.
An individual debtor’s attorney must advise the prospective client of these obligations, but at the same time is constrained from advising the individual how to improve his or her financial position at the expense of the estate and creditors. In a pre-filing side-letter, the practitioner can alert the client to these and other issues and the limitations they may impose on the practitioner’s advice.
In the side-letter, the practitioner also can explain the possible adverse consequences that may occur if a Chapter 11 debtor does not fulfill these fiduciary duties. For instance, the debtor may be sanctioned. The debtor’s case might be dismissed. If permissible, the case might be converted to a Chapter 7 liquidation, in which a trustee would be appointed to marshal the debtor’s non-exempt assets, sell or otherwise liquidate them, and distribute the proceeds to pay expenses of administration and creditors’ claims. Potentially, a trustee might even be appointed in the Chapter 11 case itself, wresting control of the estate from the individual debtor and seeking the maximum return for creditors. It may be prudent for the practitioner to include admonitions about these points in the side-letter.
Attorney-Client Privilege Issues
If a trustee displaces the individual as the manager of the debtor’s estate, the debtor may face another risk – the trustee may be able to learn what the debtor and the debtor’s counsel have discussed during the representation. This means the trustee might find out what the practitioner advised the debtor before or during the case, whether verbally or in any side-letter. In some situations, the trustee may be able to use that information to challenge actions the individual debtor took before or during the bankruptcy case.
In business bankruptcy cases, who holds the attorney-client privilege basically is settled. In Commodity Futures Trading Corporation v. Weintraub, 471 U.S. 343 (1985), the Supreme Court held that in a corporation’s Chapter 7 bankruptcy case the attorney-client privilege belongs to the trustee, and that the trustee can waive the privilege notwithstanding the objections of the debtor’s pre-bankruptcy management. But the Court declined to extend its holding to individual debtors’ bankruptcy cases:
[R]espondents maintain that the result we reach today would also apply to individuals in bankruptcy, a result that respondents find ‘unpalatable.’ . . . But our holding today has no bearing on the problem of individual bankruptcy, which we have no reason to address in this case. As we have stated, a corporation, as an inanimate entity, must act through agents. . . . When the corporation is solvent, the agent that controls the corporate attorney-client privilege is the corporation’s management. Under our holding today, the power passes to a trustee because the trustee’s functions are more closely analogous to those of management outside of bankruptcy than are the functions of the debtor’s directors. An individual, in contrast, can act for himself; there is no ‘management’ that controls a solvent individual’s attorney-client privilege. If control over the privilege passes to a trustee, it must be under some theory different from the one we embrace in this case.
(Italics in original; citations omitted).
In the absence of controlling Supreme Court precedent on this question for individual debtors, how the practitioner explains to the prospective client that the attorney-client privilege might be waived likely will depend upon which view the courts in the applicable jurisdiction follow.
At least three viewpoints exist regarding whether an individual Chapter 11 debtor “owns” or controls the attorney-client privilege and, therefore, whether a trustee succeeding to the debtor’s bankruptcy estate can waive the privilege and require the individual debtor’s attorney to disclose communications with the debtor or other confidential information gained during the representation. Some courts believe that the attorney-client privilege passes to the estate. Under this view, the debtor is expected to exercise the attorney-client privilege to fulfill the debtor’s fiduciary duty to creditors. That may include having to waive the privilege if doing so is necessary to benefit the estate. Likewise, under this view a trustee succeeding to an individual debtor’s bankruptcy estate may be able to waive the attorney-client privilege.
Under the second view, some courts have concluded that the attorney-client privilege belongs to the individual debtor, both before and during the Chapter 11 case, and that, therefore, a trustee appointed in an individual’s case cannot waive that privilege. Courts applying this approach have concluded that the attorney-client privilege should not pass to the estate or to an individual debtor’s trustee due to the enhanced privacy concerns that exist when an individual holds the privilege.
Still other courts take an intermediate approach, weighing the particular circumstances of the case. Such courts may balance the policies underlying the privilege and the potential harm that disclosure may cause to the individual debtor against a bankruptcy trustee’s duty to maximize the value of the estate. Courts following this intermediate view generally conclude that an individual debtor does not retain an attorney-client privilege for post-petition communications with the estate’s attorney, because the estate’s attorney ordinarily cannot give an individual debtor legal advice (in the debtor’s capacity as an individual) while acting as the estate’s attorney. Nonetheless, courts adhering to this approach also typically conclude that the privilege applies to pre-bankruptcy communications between the individual debtor and the debtor’s attorney.
Accordingly, in the side-letter practitioners should advise individual debtors carefully about who the practitioner will represent in the Chapter 11 case (typically, the bankruptcy estate) and the effect this may have upon the attorney-client privilege. They also should caution individual debtors about the risk that a trustee who succeeds to the bankruptcy estate may be able to waive the privilege and learn what the individual debtor and the estate’s attorney discussed.
Ordinary Course Expenses: What Can a Debtor Pay?
The side-letter also should explain what types of actions an individual Chapter 11 debtor can and cannot undertake without first seeking court approval. The list of acts requiring judicial blessing may surprise the client.
An individual debtor’s responsibility to seek judicial pre-approval of various actions arises primarily from two factors: First, because of the principle that most property that an individual Chapter 11 debtor owns or acquires during the bankruptcy is property of the estate; second, because of the rule that a debtor, absent court permission, may pay only “ordinary course of business” expenses from property of the estate.
As in Chapter 12 and 13 cases, property of an individual debtor’s Chapter 11 estate encompasses three categories: First, all legal and equitable interests in property that existed on the petition date, with certain exceptions (e.g., exempt property); second, most property the debtor acquires during the case; and third, the individual debtor’s earnings from services performed between the commencement and closing of the case.
The estate’s breadth can create problems for an individual in Chapter 11. One such problem concerns the debtor’s living expenses. A Chapter 11 debtor can pay only “ordinary course of business” expenses from wages and other property of the estate under Sections 363(c)(1) and 1108 of the Bankruptcy Code without court approval. If the expenses do not qualify as “ordinary course,” the debtor may need to seek court permission first under Section 363(b)(1). Some courts have recognized living expenses as “ordinary course” because, without paying them, the debtor cannot remain gainfully employed and continue to generate post-petition wages to enhance the estate.
But even under this permissive view other questions can emerge, such as which expenses courts will consider to be “ordinary.” For example, can an individual debtor pay an emancipated child’s wedding expenses, or pay a grandchild’s college tuition bill, cover a spouse’s automobile lease payments, or pay mortgage debt on a vacation home? Are charitable donations, tithing, or contributions into a 401k, IRA, or other retirement plan “ordinary course” expenses? Even if a court in one instance answers “yes” to these and other, similar questions, doubt may linger in other instances.
Unless these issues are settled in the applicable jurisdiction, the practitioner’s side-letter should set forth these concerns. The side-letter also may propose solutions. One potential solution is to have the client prepare a detailed budget at the outset of the case that sets forth all expenses he or she proposes to pay from estate income, and then request the court’s approval to pay those expenses. In some judicial districts, local rules or standing orders require an individual Chapter 11 debtor to do this. Seeking early judicial approval minimizes the risk that creditors later might challenge a given disbursement as being impermissible or unreasonable.
Aside from warning an individual Chapter 11 debtor about paying expenses outside the “ordinary course,” the practitioner’s side-letter also should alert the debtor about other activities that may not be “ordinary course” and that, therefore, may require prior court approval. Examples include conveying or selling estate property, granting liens on estate property, loaning money to the debtor’s business, entering into transactions with family members or other “insiders,” or incurring substantial debt. Depending upon the particular debtor’s situation, a new car loan or car lease, a new credit card or line of credit, refinancing a mortgage loan, or guarantying repayment of a child’s college loans, to name just a few, might be actions outside the ordinary course that require the court’s imprimatur. A practitioner presumably cannot anticipate every possible contingency, so the side-letter might explain that any such list is not exhaustive and advise the debtor that, if in doubt about undertaking a particular act, the debtor should ask the practitioner beforehand.
The engagement agreement and application to retain the debtor’s attorney typically must recite the attorney’s anticipated services and compensation arrangements, but that does not necessarily mean that the estate can or will pay the attorney for all work performed. A Chapter 11 debtor ordinarily can pay the attorney from post-petition wages or other estate income for services that benefit the estate, upon application to and approval of the court and after notice and opportunity for hearing. The same may not be true for services the practitioner renders on the debtor’s personal issues that do not also benefit the estate. Section 330(a)(4)(B) of the Bankruptcy Code expressly authorizes an individual debtor to pay counsel from property of the estate for personal services rendered during Chapter 12 and 13 cases. But it does not mention payment for such services in a Chapter 11 case. Consequently, unless the services benefit the estate too, an individual in Chapter 11 potentially cannot pay counsel to handle criminal, domestic relations, discharge, exemption, tax, or other personal matters. To the extent a practitioner anticipates performing “personal services” for which the estate may not be permitted to pay, the practitioner might consider obtaining a pre-bankruptcy retainer for such work. This arrangement should be addressed in the engagement agreement and disclosed to the court in the retention application.
But, even in that situation, the individual debtor and the practitioner may not be out of the woods. Section 329 provides that an attorney representing a debtor in connection with the case must file a statement of the compensation paid (or agreed to be paid) within the year preceding the filing for services rendered (or to be rendered) in contemplation of or in connection with the case, as well as the source of that compensation. If that compensation exceeds the “reasonable value of any such services,” the court may cancel the agreement or order the return of any excessive amount to the estate, if applicable, or to the entity that paid that amount. Accordingly, before commencing the case the practitioner and prospective debtor client should think through what “personal service” work the debtor may need, check the prevailing case law in the circuit or district, and, if needed, quantify (and disclose) a suitable retainer or other permissible method to ensure payment.
Plan Confirmation Hurdles
The ultimate objective of a Chapter 11 case is to obtain bankruptcy court approval (“confirmation”) of a reorganization plan that improves a debtor’s balance sheet and provides for payment of creditors’ claims in accordance with the repayment hierarchy the Bankruptcy Code establishes. To be “confirmed,” the debtor and the Chapter 11 plan must satisfy numerous requirements. If those requirements are not fulfilled, the plan will not be confirmed.
In many respects, the confirmation requirements for an individual debtor are the same as for a business debtor. For example, as in a business case, an individual debtor’s Chapter 11 plan must group holders of claims into various categories called “classes.” A class of claims is “impaired” if the plan will alter the claimants’ rights. Each impaired class can vote to accept or reject the debtor’s plan. To be confirmed, a plan must be accepted by all impaired classes; if it is not, the debtor may be able to “cram-down” the plan on dissenting classes and obtain confirmation anyway. “Cram-down” requires the debtor to meet additional requirements.
Obtaining Chapter 11 plan confirmation is a challenge in business cases, and for various reasons it can be even more difficult for individual debtors. Ultimately, this is where the greatest client dissatisfaction can arise. If a court refuses to confirm a plan, the disgruntled debtor will question counsel’s decisions. The practitioner therefore should consider memorializing the most likely obstacles to plan confirmation in the side-letter, such as those listed below.
For an individual debtor, creditors have several ways to prevent plan confirmation. First, if any class of claims is impaired under the plan, at least one impaired class must vote to accept the plan (without counting the vote of any creditor who is related to the debtor or otherwise is an “insider”). If no impaired class votes to accept the plan, the court cannot confirm it. Because individual debtors often have few impaired classes of claims – perhaps only one secured creditor class (such as a mortgagee) and a single class of unsecured claims – convincing even one impaired class to accept may be difficult.
Second, even if all impaired classes of creditors vote to accept the plan, a single objecting creditor may be able to impede plan confirmation. If any creditor objects, the individual Chapter 11 debtor likely will be required to make distributions to creditors with a value not less than the debtor’s “projected disposable income” for five years or the duration of the plan, whichever period is longer, to repay the claims in the objector’s class.
Third, if an impaired class of creditors rejects the individual debtor’s Chapter 11 plan, the “absolute priority rule” may derail the debtor’s plan. Under this rule, each “dissenting” class of claims must be paid in full before any classes that include holders of junior claims or ownership interests can receive or retain any property or distributions on account of those junior claims or ownership interests. A Chapter 11 debtor invariably wishes to keep as many assets as possible (especially if the debtor operates a business and the debtor’s assets are the sole means of supporting the business), but the debtor’s ownership interest in estate property is junior to all creditors’ claims. Therefore, if any impaired class of claimants rejects the plan, the debtor’s plan cannot be confirmed unless the debtor pays that dissenting class in full or modifies the plan in such a way that the dissenting class accepts less than full repayment.
Section 1129(b)(2)(B)(ii) of the Bankruptcy Code includes an exception to the absolute priority rule regarding how much property an individual Chapter 11 debtor may keep without paying creditors in full, but courts disagree regarding how expansive that exception is. Those courts that follow a “narrow” interpretation assert that Section 1129(b)(2)(B)(ii) enables a debtor to retain only post-petition property and earnings from services, but does not permit a debtor to retain pre-petition property or, potentially, exempt property, without paying dissenting unsecured classes in full. The Fifth and Sixth Circuits, as well as numerous lower courts, have adopted this interpretation. Various lower and intermediate courts following the “broad,” more forgiving interpretation have concluded that Section 1129(b)(2)(B)(ii) enables individual Chapter 11 debtors to retain all property of the estate, whether arising post-petition or existing pre-petition, without having to pay all dissenting classes in full.
Any one of these three impediments may require a debtor to give creditors larger recoveries under the plan (to obtain those classes’ acceptance) than the debtor anticipated when filing bankruptcy. This may mean having to contribute money that the debtor borrows or is given by family or friends, or having to contribute some or all of the debtor’s “exempt” property to enhance creditors’ payouts. If the debtor lacks sufficient disposable income, outside sources of capital, or exempt assets from which to pay creditors a large enough dividend under the plan, the debtor’s attempt to reorganize in Chapter 11 may fail. Once again, these are among the risks a practitioner should consider including in a side-letter.
An individual Chapter 11 debtor faces many unsettled problems – problems that may jeopardize the debtor’s ability to reorganize successfully or that may require the debtor to pay more to creditors than the debtor hoped or expected. Managing the client’s expectations and mitigating the risk of professional liability therefore are critical. An up-front side-letter that explains the most common legal hurdles a debtor may encounter is one method to further both of those objectives.