Paying Pre-Petition Retainers To Debtor’s Counsel From A Lender’s Collateral? (In re 3P4PL, LLC)

The wheels of commerce must continue to turn (photo by Marilyn Swanson)

By: Donald L Swanson

Under UCC § 9-332, a debtor’s attorney can receive, and keep, pre-petition retainers paid from a lender’s collateral proceeds—absent collusion.

That’s the conclusion of a recent Bankruptcy Court opinion in Walters v. Lynch (In re 3P4PL, LLC), Adv. No. 15-1120, Colorado Bankruptcy Court (Doc. 235, Decided 06/22/2020).

The opinion is a highly-technical and complex review of secured transactions law, as applied to the facts of the case.  What follows is an attempt at condensing, highlighting and summarizing the essence of the opinion.

Issue

The Bankruptcy Court describes the general issue like this:

  • “This case tests the limits of a debtor’s power to fund their strategic litigation plan at the expense of secured creditors”; and
  • “At the heart of this case is” Debtor’s attorneys’ “connections to and facilitation of” Debtor’s payments “through their attorney trust accounts.”

Retainer Payments

Here are the pre-bankruptcy retainer payments to Debtor’s attorneys, out of bank account funds against which lender claims a lien:

  • Attorney Sherman receives six “advance deposits” ranging from $20,000 to $50,000, for a grand total of $200,000, of which Sherman applies $165,000 to fees and refunds the remaining balance of $35,000 back to Debtor;
  • Attorney Haynes receives payments totaling $302,110, of which Haynes applies $141,646 to fees, refunds $155,000 back to Debtor, and continues holding a small remaining balance in a trust account; and
  • Attorney Vellone receives two payments totaling $38,000, all of which Vellone applies to fees.

Bankruptcy Proceedings

Then, creditors file an involuntary bankruptcy against Debtor. 

In that Chapter 7 proceeding, the Trustee and secured creditors file an adversary proceeding alleging various fraudulent transfer and conversion claims against twenty-three defendants, including attorneys Sherman, Haynes and Vellone.

The Question

Do Debtor’s attorneys have a right to impair the value of a secured party’s lien on general intangibles by drawing on Debtor’s funds in its trust account?

Analysis

The Court’s preliminary analysis goes like this:

  • Lender retains its lien on Debtor’s right to demand return of its property from its attorneys as a general intangible; but
  • That right is limited by the attorneys’ engagement agreements, which empower the attorneys to take Debtor’s money from their trust accounts, without regard to the liens on Debtor’s general intangibles; and
  • The right to do so, despite its diminution in value of Lender’s security interest in Debtor’s general intangibles, comes from the attorneys’ contractual rights under the engagement agreements, not from a superior security interest.

A “Not Unfair Result”

This result is not unfair because the Lender is always protected by the anti-collusion provisions of UCC § 9-332

Such section is titled “Transfer of money; transfer of funds from deposit account.”  It provides in part:

“A transferee of funds from a deposit account takes the funds free of a security interest in the deposit account unless the transferee acts in collusion with the debtor in violating the rights of the secured party.”

Underlying Policy

Under this 9-332 UCC section (and in the absence of collusion):

  • Debtors’ transactions with their attorneys “were simple commercial exchanges whereby the companies purchased legal services from a vendor”; and
  • The attorneys, like any other commercial vendor, “are entitled to the benefit of the policy underlying § 9-332, which is to place a premium on the finality of commercial transactions by protecting completed transactions from being placed in jeopardy, thereby moving forward the wheels of commerce.”

A Persuasive Precedent

A Florida bankruptcy opinion (In re Tuscany Energy, 581 B.R. 681 (Bankr.S.D.Fla. 2018)) highlights the policy considerations behind UCC § 9-332.

In Tuscany, the debtor pays a pre-petition retainer to its attorney.  A lien-holding Bank sues the attorney for converting Bank’s secured funds by taking the retainer.  The Florida court rejects this argument because:

  • Once the retainer is paid to debtor’s attorney, Bank loses any and all interest it held in the funds used to pay the retainer, pursuant to UCC § 9-332.

Historical Background

And then there’s this historical background, explained in the Tuscany opinion:

  • Experienced bankruptcy lawyers rarely undertake representation of a debtor-in-possession without a retainer—and rightly so, because failing to do so would risk not being paid; and
  • As a practical matter, (i) almost no secured creditor claims otherwise, and (ii) there are almost no reported decisions on the issue.

What Constitutes “Collusion”?

“Collusion” would allow a secured creditor to recover the retainer funds under UCC § 9-332. 

What qualifies as “collusion”? The Colorado Bankruptcy Court will apply the following principles (identified by the Tuscany court) in further proceedings, following discovery, in its case:

  • Knowledge alone, by Debtor’s counsel, of Debtor’s loan defaults and of a lender’s blanket lien is insufficient to carry lender’s burden to show “collusion within the meaning of the statute”;
  • Since finality of payments is favored under UCC § 9-332, the ability to pursue a transferee such as debtor’s counsel is severely limited;
  • The recipient of transferred funds need not give value, (i) to the debtor for § 9–332 protection, or (ii) in reliance on the transfer in any way;
  • To be in collusion, the recipient must be a “bad actor”—i.e., must have “affirmatively engaged in wrongful conduct,” like aiding and abetting an intentional tort; and
  • Mere knowledge of the rights of others and that the transferor’s act is wrongful is not sufficient to support a claim of collusion.

Conclusion

The recent Colorado bankruptcy opinion described above provides a helpful analysis of an exceedingly important issue in the day-to-day practice of bankruptcy law.

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