Tracing Proceeds to Attorneys' Pockets (and the Dilemma of Paying for Bankruptcy)

Abstract

Part I of this Article considers the mechanics of awarding attorneys' fees in bankruptcy. Specifically, Part I surveys three separate components of attorneys' fees in bankruptcy: disclosure; application for and approval of employment; and compensation. The Article pays particular attention to the operation of “classic” and special retainer agreements under the Bankruptcy Code.

Part II reviews a secured party's possible challenges to the payment of attorneys' fees in bankruptcy. As Part II details, a secured party can challenges such payments directly and indirectly. In making a direct challenge to payment, the secured party claims that the fee recipient who is paid with the proceeds of secured collateral has converted the secured party's collateral. Pursuant to an indirect challenge, the secured party argues that payment to a recipient constitutes a preference under section 547(b) or a fraudulent transfer under section 548 of the Bankruptcy Code of 1978 and thus may be recovered under section 550(a).

In Part III, this Article discusses defenses to both types of challenges. In particular, Part III explores an attorney's defenses of authorization and priority in the context of direct challenges. In doing so, this Article notes two anomalous cases: the case in which payments are made for an executory promise to perform future services, and the case in which a bank exercises its right to set-off. Part III concludes by analyzing an attorney's defenses to an indirect challenge: that payment to the attorney falls within a section 547(c) exception to section 547(b) or does not meet the requirements of section 548.

Irrespective of the challenges to the payment of attorneys' fees a secured creditor can offer, Part IV contends that paying attorneys' fees in bankruptcy from the proceeds of secured collateral is consistent with the language, legislative history, and purposes of the Bankruptcy Code, and is supported by game theory analysis. In developing this contention, Part IV first explores the manner in which the former Bankruptcy Act assessed bankruptcy costs to secured creditors. It then details the current method for charging costs and expenses to secured parties under section 506(c) of the Bankruptcy Code. Utilizing section 506(c), this Article asserts that a trustee may recover from a secured party's interest in secured collateral the reasonable costs of preserving that collateral, including attorneys' fees. As Part IV posits, such fees may be recovered under section 506(c) because of the overall benefits a bankruptcy proceeding affords vis-a-vis other creditors' remedies. Lastly, Part IV advances a theoretical argument for permitting the payment of attorneys' fees in bankruptcy. Specifically, through the use of game theory modelling, this Article demonstrates that financing attorneys fees through the use of secured collateral coheres with notions of economic efficiency. As this Article illustrates, the benefits bankruptcy offers both the secured party and the debtor vis-a-vis alternative creditors' remedies suggests that, acting rationally, both parties should prefer bankruptcy and that the secured party should therefore accept the costs of such a proceeding.

Keywords: Bankruptcy, Attorneys' Fees, Secured Party