State Law Permitting, Classic Retainers Are Not Property of the Estate

Classic Retainers: What Are They and Are They Permitted under State Law?
A classic retainer (which is also commonly referred to as a general retainer) is a sum of money that is paid by a client (or another party on the client’s behalf) to a law firm to secure the  law firm’s availability to represent the client over a specified period of time. The retainer is paid in exchange for the law firm’s agreement to represent the client (and, for the specified time period, no other client with respect to the subject matter of the engagement) and is not paid for actual legal services rendered or to be rendered. For that reason, classic retainers are earned by the law firm upon receipt and therefore are not client funds and should not be held in a client trust account. Rather, a classic retainer, once paid, should be placed in a bank account with the law firm’s general operating cash or otherwise commingled with the law firm’s own cash. As is discussed in greater detail below, whether a retainer is actually a classic retainer or another type of retainer—such as a security retainer (which is held as security by the law firm and remains property of the client until the law firm applies it toward fees and expenses)—is not always a straightforward exercise and therefore may be the subject of disputes between debtors and their creditors.

Whether classic retainers are permissible in connection with a particular representation depends on applicable state law and the applicable Rules of Professional Conduct. Generally, law firms and their prospective clients are afforded discretion to negotiate the terms of the engagement, similar to business dealings in other contexts, including agreeing on the terms of an engagement that provides for the payment of a classic retainer. See 7A C.J.S. Attorney & Client § 378 (2015). Moreover, nothing in the Model Rules of Professional Conduct prohibits the use of classic retainers. Of course, each state is free to adopt, modify, and expand those rules as appropriate. For example, the Delaware Lawyers’ Rules of Professional Conduct permit a classic retainer payment if such payment is (1) reasonable and (2) intended to compensate the law firm for loss of opportunity, such as the ability to represent other clients in that matter. See Del. Lawyers’ Rules of Prof’l Conduct R. 1.5 cmt. 12 (2010).

Classic Retainers Paid to Attorneys in Anticipation of a Chapter 11 Case
Often one of the most significant roles in a bankruptcy case, especially a large Chapter 11 case, is representing the debtor as bankruptcy counsel. However, once a law firm agrees to represent a client in connection with its anticipated bankruptcy case (or, in certain circumstances, even has an initial consultation with that client and the law firm learns confidential information about that client), the Bankruptcy Code, the Bankruptcy Rules, and the applicable Rules of Professional Conduct may prohibit that law firm from representing any other party in that case. Thus, it is not uncommon for a law firm, prior to agreeing to represent a client (or to even consult with a prospective client) in connection with the client’s anticipated bankruptcy case, to require the client to pay a classic retainer. Generally, under applicable state law, once a classic retainer is paid to the law firm, it becomes property of the law firm. But does that change when the bankruptcy case is commenced and the client becomes a debtor under the Bankruptcy Code? In other words, does the classic retainer become property of the client’s estate when a bankruptcy case is commenced?

Under section 541(a)(1) of the Bankruptcy Code, with limited exceptions not applicable here, a debtor’s estate includes “all legal or equitable interests of the debtor in property as of the commencement of the [bankruptcy] case.” If a classic retainer paid to a law firm is determined to be part of the debtor’s estate, pursuant to section 362(a)(3) of the Bankruptcy Code, a law firm may be prohibited from exercising dominion or control over the classic retainer without a court order. To determine whether the classic retainer is, in fact, property of the debtor’s estate requires an examination of state law because the extent of a debtor’s interest in property is defined by state law, and the Bankruptcy Code and the applicable law interpreting the Bankruptcy Code trump applicable state law only if there is an actual conflict between the laws and the conflict would frustrate the purpose of the Bankruptcy Code. Buttner v. United States, 440 U.S. 48, 54, 54 n.9 (1979).

Thus, if applicable state law permits a client to make a classic retainer payment to a law firm, then the payment, at least under state law, is solely the property of the law firm. There also appears to be nothing in the Bankruptcy Code that would alter state law and make that payment constitute property of the client’s estate upon the commencement of the client’s bankruptcy case. In fact, three sections of the Bankruptcy Code, when read together, strongly suggest that classic retainers remain property of the law firm after the commencement of the bankruptcy case.

Classic Retainers: Not Property of Estate after Commencement of Client’s Case
The first of the three sections—section 328(a) of the Bankruptcy Code—permits a debtor to retain counsel on “any reasonable terms and conditions of employment, including on a retainer . . . basis.” The second section—section 329 of the Bankruptcy Code—requires counsel representing a debtor in its case (or in connection with the debtor’s case) to file “a statement of the compensation paid or agreed to be paid” in the year leading up to the commencement of the case, and provides that the court may order the return of any payment identified on the statement to the debtor (or the party that made the payment) if “the compensation exceeds the reasonable value of any such services . . . to the extent excessive.” Finally, section 541(c)(3) of the Bankruptcy Code provides that any payment returned to the debtor pursuant to section 329 of the Bankruptcy Code is property of the estate.

Thus, those sections, when read together, lead to the following conclusions: (1) Retaining counsel under a retainer (such as a classic retainer) is permissible; (2) the payment of such retainer should be disclosed and is subject to review under section 329 of the Bankruptcy Code; and (3) if the payment is found to be excessive and the excessive portion is ordered returned to the estate, then the portion that was returned, and only that portion, is property of the estate under section 541(c)(3) of the Bankruptcy Code.

If the Retainer Is Not a Classic Retainer, It May Be Property of the Estate
If a law firm seeks a classic retainer, it is obviously important for that law firm to take the necessary steps as required by applicable state law and the applicable Rules of Professional Conduct to ensure that the payment is treated as a classic retainer in the event that there is a dispute over the proper characterization of the retainer. Such steps can include, among other things, (1) reducing the retainer agreement to writing (in certain states, including Delaware, classic retainer agreements must be reduced to writing in order to be enforceable), (2) having the writing include a statement that the client understands that the retainer is earned upon receipt, (3) having the writing recite the consideration that the client is receiving in exchange for the payment (e.g., that the law firm is available and will not represent any other party in the matter during the specified period) and include a statement that the client believes that the value of the consideration is at least equal to the amount of the payment, and (4) commingling the classic retainer payment with the law firm’s general operating cash and not placing it in a client trust account.

If these steps, among others, are not followed, then there is a risk that a court may find that the retainer is another type of retainer, such as a security retainer, in which the estate holds an interest. This precise issue was recently briefed, argued and ruled on in In re Caesars Entertainment Operating Company, Inc., No. 15-01145 (ABG) (Bankr. N.D. Ill. Jan. 15, 2015). In that case, creditors of Caesars Entertainment Operating Company filed an involuntary Chapter 11 petition against that entity. Three days later, that entity, and certain of its affiliates, commenced voluntary Chapter 11 cases. During that three-day period, counsel to the debtors made several draws, alleged to total more than $7 million, from what the debtors and counsel to the debtors agreed was a classic retainer. The Official Committee of Second Priority Noteholders argued that the retainer was not a classic retainer and, based on the conduct of the parties, was instead a security retainer. If it was a security retainer, then, according to the Official Committee of Second Priority Noteholders, counsel to the debtors violated the automatic stay by drawing down on the retainer during “gap” period (i.e., the three-day period between the filing of the involuntary and voluntary petitions). As a result, according to the committee, the draws were improper and the amounts should be disgorged and returned to the estate. On the other hand, if the retainer was a classic retainer, then the retainer was not property of the estate so there can be no argument that counsel to the debtors violated the automatic stay by drawing on the retainer.

Conclusion
On May 27, 2015, the bankruptcy court in an oral bench ruling (with a written opinion to follow that has yet to be issued and will supersede the bench ruling), found that, while “the retainer’s exact nature is a tough call, the most reasonable conclusion based on the engagement letter’s language and the parties’ course of dealing . . . is that the retainer was an advance payment retainer [and] certainly not a security retainer.” Thus, at least based on the bankruptcy court’s bench ruling, it would appear that the court found that the retainer was not a classic retainer but, instead, was an advance payment retainer. However, an advance payment retainer, which is a retainer that is paid in advance to a law firm for some or all of the services that the law firm is expected to perform, is, similar to a classic retainer, also earned upon receipt. Therefore, because the retainer was earned upon receipt, it was not property of the estate and the draws from the retainer during the “gap” period did not violate the automatic stay. This particular dispute illustrates the importance of taking the necessary steps to ensure that a classic retainer is treated as such.

Keywords: bankruptcy and insolvency litigation, retainer, Rules of Professional Conduct, property of the estate