Applying Pre-Petition Retainer To Pre-Petition Fees After Bankruptcy Filing: Subchapter V (In re Ozcelebi)

By: Donald L Swanson

Ooops!  Debtor’s counsel fails to apply its pre-petition retainer to its pre-petition fee before filing Debtor’s Subchapter V Petition.

The result is a reduced fee claim (to a $9,999 amount, as authorized by § 1195) and a fight over the post-petition application of retainer funds to the reduced claim. 

Debtor’s counsel wins [fn. 1]—but only after a fight in court and a failed mediation. Ouch!

Facts

Debtor files a Subchapter V case, with Debtor’s counsel disclosing a $75,000 pre-petition retainer, from which $5,605.52 had been applied, pre-petition, to earned fees and expenses.

However, a significant glitch occurs:

• Debtor’s counsel is still owed $21,696.91 for pre-petition fees and expenses;
• Such fees and expenses were not billed or paid prior to the bankruptcy filing, because of “an internal miscommunication”;
• To address the problem after bankruptcy filing, Debtor’s counsel writes off $11,697.91 of it’s pre-petition claim (so that only $9,999 remains) and seeks Bankruptcy Court authority to pay the $9,999 amount from retainer funds; and
• The reduction to $9,999 is because of § 1195, which provides, “a person is not disqualified for employment” by a debtor “solely because that person holds a [pre-petition] claim of less than $10,000” against the debtor.

Analysis

The Bankruptcy Court identifies and resolves the issue like this:

• In Chapter 11 cases, section 327(a) governs the employment of professionals by the debtor in possession or trustee and requires disinterestedness (e.g., “is not a creditor,” per § 101(14)(A));
• However, § 1195 modifies § 327(a) by authorizing a <$10,000 exception to disinterestedness in Subchapter V cases;
• What § 1195 does not answer is whether a Subchapter V debtor’s counsel may draw post-petition on a pre-petition retainer to pay a $9,999 pre-petition claim, over a creditor’s objection—this is what the Court must resolve; and
• The Bankruptcy Court approves the $9,999 payment from retainer funds and provides a discussion of retainers under local State law, because state law governs property rights after a bankruptcy filing, including property rights under attorney retainer agreements.

There are three types of retainer agreements under local State law: (1) classic retainers, (2) advance payment retainers, and (3) security retainers.

1. A classic or true retainer involves payment of a sum of money to secure the attorney’s availability over a period of time. This type of retainer fee is earned when paid, since the attorney is entitled to the money regardless of whether he or she actually performs any services under the agreement. Because the debtor has no further right to the money, it does not become property of the debtor’s bankruptcy estate.
2. An advance payment retainer exists when the client pays in advance for services the attorney is expected to perform on the client’s behalf. Advance fee retainers paid prepetition from unencumbered assets become the attorney’s property prepetition, subject to review by the bankruptcy court for “reasonableness.”
3. A security retainer is created when a debtor pays counsel for prospective services. Until services are rendered by counsel, the attorney holds the funds for the debtor and the debtor retains an interest in those funds. Because the debtor retains an interest in these funds, they become property of the estate at filing subject to §§ 329 and 330.

The pre-petition engagement letter in question states:

“[Debtor has] agreed to deposit an additional $75,000 over what is currently in trust with [Debtor’s counsel] for fees and costs associated with this representation. . . . The retainer will be treated as a prepayment of legal fees, subject to a return of any amounts not actually earned. As of the petition date, any unused portion of the retainer will convert into a retainer securing payment of any post-petition fees approved by the bankruptcy court.”

The Court finds that the retainer described in the engagement letter is a “security retainer”—money held by Debtor’s counsel for prospective legal services subject to refund of any amounts in excess of billed hours.

Conclusion

Presumably, Debtor’s counsel would have been within its rights to apply the retainer, immediately before filing, to the entire $21,696.91 pre-petition balance—they are undoubtedly kicking themselves for failing to do so.

One issue not discussed is the law firm’s right of setoff of the pre-petition retainer funds against the pre-petition $9,999 balance, under § 553.  It would be interesting to consider how § 553 might apply in this situation.   

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Footnote 1.  The opinion is In re Ozcelebi, from Case No. 20-70295 in the Southern Texas Bankruptcy Court, issued July 20, 2021 (Doc. 179).

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