Rethinking Retainers in Bankruptcy

A prospective client calls you to represent the client as a defendant in a bankruptcy lawsuit where the client is also the debtor. The client offers to pay your usual retainer. What could go wrong?

Lawyers in private practice generally have some idea of what retainers are, but that understanding varies regionally. A lawyer’s general understanding of retainers, and the legal and ethical implications of retainers, may be wrong in the context of bankruptcy cases. Bankruptcy courts have taken positions on retainer issues that should be understood by counsel in order to avoid surprise and economic pain, and this is particularly true for lawyers representing clients in bankruptcy. The right way for debtor’s counsel to handle a retainer is not always clear. A recent South Carolina case offers one strategy for balancing the lawyer’s need for financial security against the implications of bankruptcy and helps bring the threads together.

Retainer Basics.

In this article, a retainer means a payment received by a lawyer before the work is performed in connection with legal services to be provided, with a primary focus on security retainers. Attorneys and judges often refer to retainer agreements, which in this article will be called engagement agreements. This article is not meant to address earned upon receipt retainers, which include “classic retainers,” where a payment ensures the lawyer is available in the case, and “advance payment retainers,” where the lawyer is paid an advance fee as a flat fee for work to be performed.

Excluding such earned upon receipt retainers, the usual understanding of a retainer is a payment as security for payment of bills for future legal services. Unlike either a classic retainer to obtain the lawyer’s services, or an advance payment retainer, a security retainer remains client property, and should be deposited in the attorney’s client trust account. The funds held as a security retainer may be paid to the lawyer only after services are rendered and provided the fee is reasonable. Conversely, if an attorney is discharged, or the reasonable bill is less than the retainer, the unused balance of the security retainer is refundable.

Prepetition Retainers for Post-petition Services.

In a Chapter 7 context, the debtor may not retain counsel at estate expense. A pre-petition payment by the debtor as a security retainer for post-petition service may be at risk of disgorgement because the estate may not receive reasonably equivalent value via prospective service to the debtorand property of the estate may not be used to represent the individual debtor. If the security retainer is viewed as property of the estate, it is refundable to the trustee. Conversely, courts usually approve reasonable pre-petition advance fee retainers for ordinary bankruptcy services, such as a flat fee to handle a “routine” Chapter 7 case, and occasionally for agreed provision of post-petition services, such as defense of non-dischargeability proceedings.The debtor needing post-petition legal service must find a source of payment not the debtor’s property, or use post-petition or exempt assets to pay counsel. An agreement concerning debtor representation, including the terms, and amount and source of compensation, must be disclosed.

In Chapter 11, the trustee or debtor in possession may retain counsel at estate expense to provide post-petition services with disclosure and court approval. It is not unusual for debtor’s counsel or other professionals to receive pre-petition retainers as security for fees anticipated to be charged for post-petition services not yet performed.Such security retainers must be disclosed as part of the employment process, and may be charged after the bankruptcy filing only in accordance with the Code and Rules and usually with a court order. The security retainer usually is estate property subject to the lawyer’s claim.

In a Northern District of Illinois case, In re Caesars Ent. Operating Co., Inc., junior noteholders argued that proposed DIP counsel (Kirkland) received payments on and improperly drew on retainers the day after involuntary petitions were filed against Caesars entities, and a day or two before Caesars’ own voluntary filing. Kirkland treated its pre-petition retainers as Kirkland property under either an earned upon receipt agreement or classic retainer theory (but after bankruptcy, treated the retainer balance as debtor property subject to a security retainer). The bankruptcy court approved Kirkland’s employment, finding the retainers were not debtor property until Kirkland’s pre-petition bills were paid from the retainers and the balance converted into a security retainer.

Post-Petition Retainers.

Counsel occasionally seek post-petition retainers. In a Kentucky case, In re A Top New Casting, Inc., counsel unsuccessfully sought a payment arrangement in the nature of an escrow, which is more lawyer-friendly than a security retainer. Less frequently, a post-petition retainer is paid with bankruptcy court approval, with payments from the retainer subject to court approval.

Refunding Retainers.

If an attorney is not entitled to charge the client, and thus be paid from the security retainer, the unused balance must be refunded. A line of cases in Chapter 15 matters hold that the presence of such an unused retainer is property of the debtor located in the United States to establish eligibility for bankruptcy relief.

In the context of payment from estate property, no payment to counsel may be authorized absent compliance with Bankruptcy Code §§ 329, 330, 331 and applicable Bankruptcy Rules. Among other requirements, the court must approve employment of counsel, disclosure of compensation terms, and ultimately the fees and expenses sought. Failure to comply with the requirements of the Code and Rules can result in denial of compensation and disgorgement of a retainer.Where counsel has received a retainer that is property of the estate, any refund of the retainer is refunded to the estate.

Even a properly disclosed retainer may be at risk if the Chapter 11 case is converted. After conversion, the debtor may not hire counsel at estate expense, so the lawyer may no longer use estate property to pay for legal services. And because chapter 11 administrative expenses, like fees of debtor in possession counsel, are subordinated in chapter 7 to chapter 7 bankruptcy expenses of administration, like fees of a trustee and counsel, if the trustee seeks subordination of Chapter 11 claims for legal services to Chapter 7 administrative expenses under § 726(b), the trustee may seek disgorgement of the retainer for reallocation under bankruptcy priorities.

Non-Debtor Retainer.

A South Carolina case, In re Parast, addressed the scenario where a debtor sought post-petition authority to retain counsel, and the attorneys required a retainer as a condition of the representation. Absent authority to make an out of the ordinary course of business transfer under § 363(b)(1), the debtor may not use estate property to pay the retainer, nor is counsel protected against the risk of disgorgement if retention of counsel is not approved. And counsel is not protected with respect to fees incurred before court approval of retention of counsel. However, the rules are less clear when the retainer is paid by a third party.

In Parast, proposed counsel received and disclosed a $25,000 retainer paid by the debtor’s brother as part of the firm’s employment application. The retainer was fashioned as a conditional gift from the brother to the debtor, conditioned upon court approval of counsel’s retention. Due to objections, the firm eventually withdrew the employment application (after incurring over $40,000 in charges). The court held that the payment from the third party (brother) was not property of the estate, because the condition to the gift was not satisfied, and so the estate was not entitled to a refund. Therefore, the dispute between the law firm and the brother over the retainer would have to be resolved in a non-bankruptcy forum.

Conclusion.

Obtaining a retainer as a condition of representing a debtor in bankruptcy court litigation without understanding the legal environment for payment, including from a retainer, may create grave risks for the lawyer. Those risks include potential denial of compensation, refund of the retainer balance, and even disgorgement of sums paid from the retainer.