The Supreme Court two years ago ruled in Baker Botts v. Asarco that bankruptcy professionals entitled to compensation from a debtor’s bankruptcy estate had no statutory right to be compensated for time spent defending against objections to their fee applications.  Since then, “estate professionals,” i.e., those retained in a bankruptcy case by a trustee, debtor in possession or an official committee of creditors, have sought ways to limit the potentially harsh impact of that decision.  A subsequent opinion in a Delaware bankruptcy case, In re Boomerang Tube, declined to allow Baker Botts to be circumvented by contract.  However, decisions in another Delaware case, Nortel Networks, and more recently in a New Mexico case, Hungry Horse LLC, have distinguished Boomerang Tube and permitted contractual provisions that allow payment for the defense of fees.  The pragmatic approach taken in Hungry Horse in particular offers a template that other courts will likely be urged to adopt.

In every bankruptcy case, the retention of estate professionals must be approved by the bankruptcy court. Their fees and expenses are paid out of the debtor’s bankruptcy estate and are subject to review and approval by the bankruptcy court pursuant to Section 330 of the Bankruptcy Code.  Objections from other parties have always been a recognized hazard for such professionals.  Prior to Baker Botts a majority of courts permitted the recovery of fees incurred in defending against such challenges.

The Court’s analysis in Baker Botts was straight-forward.  Under American jurisprudence, each side in a litigated dispute bears its own attorneys’ fees unless there is an applicable statute or agreement that provides otherwise.  Section 330(a)(1) of the Bankruptcy Code states: “After notice to the parties in interest and . . . a hearing . . . the court may award to . . . a professional person . . . reasonable compensation for actual, necessary services[.]”  The Court ruled that the plain text of Section 330(a) does not support a deviation from the “American Rule” regarding attorneys’ fees.  The Court’s majority stated, “[t]he word ‘services’ ordinarily refers to ‘labor performed for another.’”  Since Baker Botts was litigating to defend its own fees, the Court reasoned that it was not providing an “actual, necessary service” to the bankruptcy estate and therefore was not entitled to compensation for such time.

Baker Botts makes clear that the Bankruptcy Code does not provide a statutory exception to the American Rule.  The question remaining is whether estate professionals can sidestep it by contract.

In Boomerang Tube, Judge Mary Walrath answered that question in the negative.  The law firm chosen in that case to represent the official committee of unsecured creditors, in its application to the bankruptcy court, asked for the approval order to include a provision that would entitle it to be compensated from Boomerang Tube’s bankruptcy estate for fees incurred in defending its fees against any challenges.  The firm pointed to Section 328 of the Bankruptcy Code, which allows for the retention of estate professionals “on any reasonable terms and conditions.”  It argued that the Supreme Court in Baker Botts had noted that parties could and regularly did contract around the American Rule.

Judge Walrath denied the request. She first held that Section 328 does not create a statutory exception to the American Rule, as it makes no mention of awarding fees or costs in the context of an adversarial proceeding. She observed in contrast that several discrete Bankruptcy Code provisions do contain express language providing for payment of fees to a prevailing party.  She next rejected the law firm’s argument that Section 328 permitted a contractual agreement for the payment of defense fees.  The retention agreement was between the law firm and the official creditors’ committee, but it would be Boomerang Tube’s bankruptcy estate, a non-party to such agreement, that would bear the costs.  Finally, she determined that the proposed fee shifting provisions were simply not “reasonable” terms of employment of professionals with the meaning of Section 328.

In view of the extent to which challenges to estate professionals’ fees (or at least the threat of doing so) are ingrained in chapter 11 practice, it was unlikely that Boomerang Tube would be the last word on this issue.  Recent decisions in two cases, Nortel Networks and Hungry Horse, have distinguished Boomerang Tube.

Judge Kevin Gross, a Delaware colleague of Judge Walrath, ruled in Nortel Networks that Baker Botts and Boomerang Tube did not apply to a fee dispute between an indenture trustee and certain bondholders, and permitted the trustee to recover its attorneys’ fees for defending against the challenge.  Although this case is not directly on point as it did not involve an estate professional, and Judge Gross was not opining on whether Section 328 would permit such an agreement, he held that the bond indenture qualified as a contractual exception to the American Rule, noting that, unlike the retention agreement in Boomerang Tube, it was an agreement directly between the debtor and the trustee.

In Hungry Horse New Mexico Bankruptcy Judge David Thuma looked to Nortel Networks for support in holding that a retention agreement in a chapter 11 case between proposed debtor’s counsel and the debtor could pass muster under Section 328, thereby permitting a contractual work-around to Baker Botts.  Judge Thuma first determined that nothing in Baker Botts prevented a bankruptcy court from finding a fee defense provision in a retention agreement to be “reasonable” within the meaning of Section 328.  In his reading of Baker Botts, the Court simply limited the compensation an estate professional could receive under Section 330 to fees for services to the client, rather than on its own behalf, and noted that Section 328 had no applicability to that issue.

He then considered various other provisions typical of retention agreements, and observed that several were “reasonable” under Section 328 even if they were intended to favor the professional, rather than the client. He pointed to provisions, among other things, setting out retainer requirements, permitting an attorney to withdraw under certain conditions, and granting a lien on certain recoveries.  “A typical employment agreement between a lawyer and a client has many terms; some benefit the client, while others benefit the lawyer.  Considered together, they may be reasonable.”  The overall effect, he noted, is that “the client obtains the services of needed, able professionals.”

Judge Thuma concluded that Section 328 therefore can permit contractual exceptions to the American Rule, and outlined the terms of a fee defense provision in a retention agreement that he believed was “reasonable” and “violat[ed] neither the letter nor spirit of [Baker Botts].”  He stated that, among other things, it needed to be agreed to by the bankruptcy estate, in order to avoid the issue highlighted by Judge Walrath in Boomerang Tube, and provided also that it extended to the creditors’ committee’s professionals, in order to “level the playing field.”  He suggested sample language that he believed could be acceptable under Section 328:

Fee Defense. The Client agrees to pay all reasonable legal fees and expenses incurred by the Firm, and also by any counsel retained by the unsecured creditors’ committee (if one is formed in the Client’s bankruptcy case) for successfully defending their respective fee applications. The bankruptcy court must approve all of such fees as reasonable. The Client will have no obligation to pay for any fees or expenses the Firm incurs defending fees that are not allowed.

Disputes over payment of estate professionals’ fees will invariably remain part of the bankruptcy landscape. Estate professionals in chapter 11 cases are likely to ask bankruptcy judges in other jurisdictions to follow the pragmatic approach of Judge Thuma in Hungry Horse in order to blunt the detrimental impact of Baker Botts.