Insights

Ever-Expanding Section 363(b): Compensation of Attorney Authorized as Non-Ordinary Course Use of Estate Property

The retention and compensation of bankruptcy professionals case have recently been the focus of a fair amount of controversy, particularly in complex "mega" cases involving a full panoply of sophisticated lawyers, accountants and financial advisors.  More than ever before, bankruptcy courts have been called upon to scrutinize potentially disqualifying conflicts of interest and non-traditional compensation arrangements to ensure that proposed professional retentions comply with the Bankruptcy Code's rigorous requirements.

The statutory procedures governing professional retentions and compensation in bankruptcy are well established.  Even so, a ruling recently handed down by a New York district court suggests that the mechanism traditionally employed to engage a professional may not be the exclusive means of doing so, albeit in a narrow range of circumstances.  In In re Enron Corp., the court held that a debtor-in-possession (“DIP”) can be authorized to retain and pay a law firm to represent employees as an appropriate non-ordinary course use of estate assets.

Retention and Compensation of Professionals in Bankruptcy

Bankruptcy trustees, DIP's and statutory committees are permitted to retain a wide variety of professionals, including lawyers, accountants, auctioneers and investment bankers, to represent their interests during a bankruptcy case.  In most cases, professionals are engaged pursuant to sections 327(a) and 1103 of the Bankruptcy Code, which authorize these entities, subject to bankruptcy court approval, to employ "disinterested" professionals to represent them during the course of the bankruptcy.  A trustee or DIP may also retain a lawyer for a "special purpose" other than acting as general bankruptcy counsel under section 327(e) (e.g., in connection with discrete litigation, real estate or labor matters).

Professionals retained under sections 327 or 1103 are paid in accordance with the interim and final compensation procedures delineated in sections 330 and 331 of the Bankruptcy Code.  Those procedures contemplate court scrutiny of services for which compensation is sought, and the discretion to reduce, or in some cases augment, the allowed amount of fees based upon the court's determination of what is reasonable and necessary under the circumstances.

Alternatively, section 328 provides for the retention and compensation of professionals "on any reasonable terms and conditions of employment, including on a retainer, on an hourly basis, or on a contingent fee basis."  If the bankruptcy court approves a fee arrangement under section 328, it retains the discretion to revisit that decision and modify the compensation to be paid, but only if the terms specified in the retention order "prove to have become improvident in light of developments not capable of being anticipated at the time of the fixing of such terms and conditions."

A separate provision in the Bankruptcy Code governs non-ordinary course expenditures of estate assets for purposes other than compensating professionals retained under sections 327, 328 or 1104.  Section 363(b) provides that a trustee or DIP, with bankruptcy court approval, "may use, sell, or lease, other than in the ordinary course of business, property of the estate."  In considering a request to use estate assets outside the ordinary course of a debtor's business, courts use the "business judgment" test.  That is, courts generally will grant the request if the debtor articulates a sound business reason for the use of the assets.  Whether a DIP can rely on section 363(b), rather than section 327, to justify the retention of a lawyer was addressed by the New York district court in Enron.

The District Court's Ruling in Enron

Enron Corporation and approximately 90 affiliated companies began filing for chapter 11 protection in December of 2001.  Both Enron and the creditors' committee appointed in the cases were authorized to retain counsel under sections 327(a) and 1103, respectively.  Enron also sought and obtained court authority to retain special counsel under section 327(e) to represent the company in connection with various investigations into its affairs being conducted by Congress, the Securities and Exchange Commission, the Department of Labor and the Department of Justice.  On the recommendation of its lawyers, who determined that various Enron employees should retain independent counsel in connection with the government investigations, Enron filed an application with the bankruptcy court to retain (and pay) lawyers for its employees.

Enron cited sections 105(a) (giving the bankruptcy court broad equitable powers), 327 and 363(b) as the statutory predicates for the retention.  According to Enron, its reorganization efforts would benefit from the expedient completion of the investigations, and independent counsel for the employees would facilitate that goal because the employees would be both more likely to focus on their work and more willing to cooperate if assured that their rights were being protected.  Enron also claimed that having one law firm represent all the employees would facilitate the coordination of employee responses to investigators' requests.  If retained, Enron stated, special counsel would represent only those employees who were not themselves the target of investigation.  In addition, Enron argued that the proposed retention was supported by a "sunshine policy" in chapter 11 cases, which favors actions designed to reveal the causes of losses to creditors.

The creditors' committee opposed the retention, contending, among other things, that it was not in Enron's best interests because some of the employees might provide testimony adverse to the company's economic interests.  The bankruptcy court approved Enron's motion under sections 105(a), 327 and 363(b), ruling that Enron had demonstrated a need for retaining lawyers on behalf of its employees and that any potentially negative impact on Enron from certain employees' testimony was outweighed by the benefits provided by the representation.  The committee appealed the ruling.

The committee fared no better before the district court.  Among other things, the committee argued that section 363(b) cannot be used to approve the payment of legal fees because section 327(e) expressly contemplates the retention by a DIP of a "special purpose" attorney.  The district court rejected this argument, explaining that courts are not prohibited from authorizing a certain category of payments under section 363(b) simply because another section of the Bankruptcy Code also relates to the same category.  According to the court, even though section 327(e) provides for the retention of attorneys (and therefore payment of their legal fees under sections 330, 331 or 328), nothing in section 327 "suggests that Congress intended [section 327(e)] to be the exclusive authority" for doing so.  Moreover, the court observed, section 327(e) provides for the retention of an attorney to represent a DIP, not third parties such as a debtor's employees.

The district court then addressed the committee's contention that the retention did not represent a sound exercise of Enron's business judgment.  At the outset, it found lacking any evidence of undue influence on the part of Enron insiders such that the proposed retention should be subjected to heightened scrutiny rather than the business judgment test.  Based upon the sound reasons articulated by Enron before the bankruptcy court to justify the retention, the district court concluded that deference to Enron's business judgment was appropriate under the circumstances.  It accordingly affirmed the bankruptcy court's ruling.

Outlook

The significance of the district court's ruling in Enron lies primarily outside the realm of professional retention and compensation in a bankruptcy case — if Enron were attempting to hire lawyers to represent itself, there is little room for doubt that sections 363(b) and 105(a) would not be the appropriate statutory predicates.  In addition, the employees themselves could not have relied on any of the provisions in question to retain and have the estate pay the attorneys; in fact, the employees, as creditors, would have to establish that their actions somehow made a "substantial contribution" to the chapter 11 case and that, therefore, payment of their attorneys’ fees was appropriate under section 503 of the Bankruptcy Code.

Even so, the decision is important because it illustrates the expanding versatility of section 363(b) as a vehicle for authorizing the expenditure of estate funds to pay for a wide range of costs and expenses deemed necessary to the success of a chapter 11 case.  In addition to providing authority for retaining and compensating professionals, section 363(b) has recently been successfully relied upon as authority for paying the pre-petition claims of “critical” vendors, a practice that, when based upon the controversial “doctrine of necessity,” has been increasingly subjected to criticism.

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In re Enron Corp., 335 B.R. 22 (S.D.N.Y. 2005).

 

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