Bankruptcy and Unpaid Counsel Fees

Unpaid Counsel Fees and Other Administrative-Expense Claims Will Be Discharged

by: Steven R. Neuner
Neuner & Ventura LLP; Marlton, N.J.

It is no secret that a significant percentage of bankruptcies commenced by individuals under chapter 11 or 13 fail and get converted to chapter 7 where the case is eventually closed on a “no-asset” basis. After the bankruptcy is filed and while the case is in chapter 11 or 13, the debtor will normally incur additional debts, including counsel fees. Upon conversion to chapter 7, the interplay of §§ 727(b) and 348(b) of the Bankruptcy Code creates a trap for the unwary post-petition claimant, including debtor’s counsel. Simply put, debts incurred post-petition but pre-conversion will be discharged in the converted case to the extent not paid by the trustee in the chapter 7 case, unless a timely nondischargeability complaint is filed. This may come as a surprise to many debtor’s counsel and other creditors who expect that once a debtor files for bankruptcy, their rights to collect unpaid post-petition debts survive a bankruptcy discharge and can be collected thereafter.

Section 727(b) provides that except for those debts that are specified as nondischargeable under § 523, a discharge of an individual debtor under § 727(a) “discharges the debtor from all debts that arose before the date of the Order for Relief under this chapter and any liability on a claim that is determined under Section 502 of this title as if such claim had arisen before the commencement of the case.” This applies whether or not a proof of claim has been filed or allowed. Section 348(b) specifies that “[u]nless the court for cause orders otherwise” the “Order for Relief under this chapter” in a case converted from chapter 11, 12 or 13 to chapter 7 is not the original petition date but the date of conversion to chapter 7.

Taken together, these sections would permit discharge of all post-petition preconversion claims. (Post conversion fees and claims are protected from discharge.) However, § 348(d) seems—at first blush—to create an exception for post-petition and pre-conversion administrative expenses. It provides that a “claim against the estate or the debtor that arises after the order for relief but before conversion in a case that is converted under section 1112, 1208 or 1307 of this title, other than a claim specified in section 503(b) of this title, shall be treated for all purposes as if such claim had arisen immediately before the date of the filing of the petition.”

The few cases addressing this conflict read § 348(d) as only preserving priority of post-petition preconversion administrative claims in distribution, but not preventing them from being discharged to the extent not paid. The leading case addressing the interplay of these bankruptcy code sections is In re Fickling.[1] In this case, the debtor’s chapter 11 was converted to chapter 7, and upon conversion, his counsel was granted leave to withdraw based on a claimed inability of the debtor to continue paying fees. After the debtor received his discharge, his counsel filed a motion seeking an order that its unpaid preconversion fees and expenses were a nondischargeable debt. On appeal, the Second Circuit rejected the argument that § 348(d) created an “administrative-expense” exception to discharge.

Instead, without much analysis other than to state such a construction would create an “unwarranted conflict,” it read § 348(d) only as preserving “administrative-expense claims priority of payment upon distribution.”[2] A more reasoned analysis is found in In re Toms[3] where the court reviewed and found support for discharge of preconversion administrative-expense claims in the legislative history and the procedural rules treating such claims as dischargeable in the converted case.[4]

While some room for a contrary interpretation exists, debtor’s counsel in individual chapter 11 or 13 cases would have their fees at risk upon conversion under this line of cases. One possible avoidance strategy might be to request that the court “otherwise order” application of the petition date rather than the conversion date pursuant to § 348(b) so that the attorney fees are not treated as a pre-petition debt, but this requires a showing of “cause” that in the few cases addressing the issue equates to bad faith, under the totality of the circumstances.[5]

The practical effect of these rules is to put debtor’s counsel and all parties who deal with persons attempting to reorganize under chapter 13 or 11 on notice that they had better make sure they are paid on a COD or secured basis. This is contrary to the bankruptcy policy of encouraging creditors to deal with debtors in distress thereby facilitating a successful reorganization.

1. 361 F.3d 172 (2d Cir. 2004).

2. 361 F.3d, at 175.

3. 229 B.R. 646, 654-656 (Bankr. E.D. Pa 1999).

4. See also In re Morris, 155 B.R. 422, 425 (Bankr. W.D. Tex. 1993) (noting that “[s]ection 348(d) was obviously intended to deal with the order of payment between unsecured claims that arose pre-petition and unsecured claims that arose during the chapter 11 case before its conversion to chapter 7”).

5. Toms, 229 B.R. at 657; Morris, 155 B.R. at 426.

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