Second Circuit Adopts "Totality of the Circumstances" Test for Pre-Approval of Professional Retentions Under Section 328(a) of the Bankruptcy Code
The circumstances under which a bankruptcy professional’s fee arrangement pre-approved by the court will or will not be subject to subsequent court review were addressed as a matter of first impression in a ruling recently handed down by the Second Circuit Court of Appeals. In affirming a U.S. district court decision that a debtor’s fee arrangement with its special litigation counsel was pre-approved and not subject to modification, the Second Circuit in Riker, Danzig, Scherer, Hyland & Perretti v. Official Comm. of Unsecured Creditors (In re Smart World Technologies, LLC) adopted a “totality of the circumstances” standard for determining whether a professional retention has been pre-approved pursuant to section 328(a) of the Bankruptcy Code.
Professionals retained under sections 327 and 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 and reimbursable expenses, based upon the court’s determination of what is reasonable and necessary under the circumstances.
Alternatively, section 328(a) of the Bankruptcy Code provides for the retention and compensation of professionals “on any reasonable terms and conditions of employment, including on a retainer [basis], on an hourly basis, on a fixed or percentage fee basis, or on a contingent fee basis.” If a 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 been improvident in light of developments not capable of being anticipated at the time of the fixing of such terms and conditions.” Approval of a fee arrangement under section 328 provides professionals with some reassurance that only in exceptional circumstances will a bankruptcy court tamper with their fee arrangements. Accordingly, any dispute over whether or not a retention was indeed pre-approved under section 328 is likely to be hotly contested, particularly where one party stands to receive an unexpected windfall under the arrangement.
A number of circuit courts have developed tests for determining whether a bankruptcy court pre-approved the retention of a professional pursuant to section 328 of the Bankruptcy Code. In holding that an accounting firm’s retention was not pre-approved, the Third Circuit in its 1995 ruling in Zolfo, Cooper & Co. v. Sunbeam-Oster Co. stated that “the burden should rest on the applicant to ensure that the court notes explicitly [in the retention order] the terms and conditions if the applicant expects them to be established at that early point.” In 2002, the Ninth Circuit held in In re Circle K Corp. that an investment banking firm’s fee application was reviewable for reasonableness. The court held that section 328 did not govern review of the fee application because the professional failed to invoke section 328 in its retention application, and provisions of the retention application and order stated that the retention remained subject to review by the court. A third test emanates from the Sixth Circuit’s 2004 ruling in Nischwitz v. Miskovic (In re Airspect Air, Inc.), in which the court of appeals stated that “whether a court ‘pre-approves’ a fee arrangement under § 328 should be judged by the totality of the circumstances.” The Sixth Circuit elaborated that factors relevant to the determination may include whether the debtor’s motion specifically requested pre-approval of fees, whether the court’s order assessed the reasonableness of the fee, and whether either the motion or the order expressly invoked section 328(a) of the Bankruptcy Code.
In Smart World, the Second Circuit Court of Appeals adopted the Sixth Circuit’s “totality of the circumstances” test to determine whether a professional retention was pre-approved under section 328(a) of the Bankruptcy Code.
From 1996 to 2000, Smart World Technologies, LLC, and its affiliates (collectively, “Smart World”) failed to generate a profit providing free dial-up internet service to subscribers. In 2000, Smart World agreed to sell its most valuable asset, its subscriber list, to Juno Online Services, Inc. (“Juno”). Juno required Smart World to file for bankruptcy as a condition of the sale. The ultimate sale price was to be determined with reference to the number of Smart World subscribers who transferred their internet service to Juno. A dispute arose when Smart World accused Juno of obscuring the true number of subscribers that had switched to Juno in an alleged effort to depress the sale price.
Smart World sought an order from Judge Cornelius Blackshear of the United States Bankruptcy Court for the Southern District of New York approving the retention of Riker, Danzig, Scherer, Hyland & Perretti LLP (“Riker Danzig”) as special litigation counsel to pursue resolution or litigation of the dispute with Juno. On November 16, 2000, the bankruptcy court issued an order approving Smart World’s retention of Riker Danzig “pursuant to 11 U.S.C. §§ 327 and 328.” According to the terms of retention, Riker Danzig was to receive a percentage of any monies obtained from Juno in addition to payment of Riker Danzig’s expenses. Riker Danzig’s percentage entitlement varied in specific amounts according to the amount of any award or settlement and the duration of the dispute.
Smart World’s largest creditor, WorldCom, continued negotiating with Juno, and 18 months after the retention of Riker Danzig, WorldCom requested approval of a proposed settlement whereby Juno would pay $5.5 million to WorldCom, of which $1.5 million would be returned to the Smart World estate. Riker Danzig objected to the settlement on behalf of Smart World, in part on the ground that WorldCom lacked standing to settle the proceeding. The bankruptcy court approved the settlement over Smart World’s objection, but the Second Circuit reversed on the standing issue. Smart World’s exclusive right to propose and solicit acceptances for a chapter 11 plan having expired, however, its unsecured creditors’ committee attempted to impose a settlement on Smart World by filing a plan of liquidation that included a proposed settlement with Juno in the amount of $6.5 million. Once again, Riker Danzig contested the settlement, this time on the ground that Juno was undervaluing the claim, but the bankruptcy court disagreed and confirmed the plan.
Riker Danzig applied for a fee award in excess of $2 million plus expenses, consistent with the terms of its retention agreement. In the bankruptcy court, Judge James Peck (who succeeded Judge Blackshear, the judge presiding when Riker Danzig was retained) found that Judge Blackshear pre-approved the terms and conditions of Riker Danzig’s retention under section 328 of the Bankruptcy Code but that four events were not capable of being anticipated at the time of the approval. The four occurrences were that: (a) the positions of Smart World and its creditors diverged with respect to the Juno matter; (b) Riker Danzig took instruction directly from the officers and majority shareholders of Smart World; (c) the litigation was unusually prolonged; and (d) Riker Danzig was an obstacle, not an asset, to approval of the settlement. Judge Peck accordingly disallowed approximately one-half of the fees requested by Riker Danzig.
On appeal, the district court agreed that the retention had been pre-approved under section 328. Without opining as to which test for pre-approval it preferred, the district court noted that Riker Danzig’s retention appeared to pass each of the various tests employed throughout the circuits. The district court reversed the bankruptcy court with respect to the reduction in fees, concluding that the four developments identified by the bankruptcy court may have been unforeseen but were not incapable of being anticipated.
The Second Circuit affirmed the judgment of the district court and adopted the Sixth Circuit’s test for determining whether a retention has been pre-approved pursuant to section 328. According to the Second Circuit, the Bankruptcy Code does not “mandate that the application specifically mention §328 or that the court’s approval order expressly and unambiguously state specific terms and conditions.” Rather, the court emphasized, “pre-approval of a fee agreement under 11 U.S.C. section 328(a) depends on the totality of the circumstances, including whether the professional’s application, or the court’s order, referenced section 328(a), and whether the court evaluated the propriety of the fee arrangement before granting final, and not merely preliminary, approval.” The Second Circuit concluded that the retention met the “totality of the circumstances” standard because the retention application expressly invoked section 328(a) of the Bankruptcy Code, and the retention order expressly incorporated this language.
In addition, the court agreed that the bankruptcy court erred in disturbing the pre-approval of Riker Danzig’s retention because, although each of the events recited by the bankruptcy court may not have been anticipated, they were not incapable of being anticipated.
Retention of Professionals in Bankruptcy Cases
A bankruptcy trustee, chapter 11 debtor-in-possession (“DIP”), or statutory committee is permitted to retain a wide variety of professionals, including lawyers, accountants, auctioneers, and investment bankers, to represent its interests during a bankruptcy case. In most cases, professionals are engaged pursuant to sections 327(a) and 1103 of the Bankruptcy Code, which authorize DIPs and statutory committees, respectively, 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 that has previously represented the debtor 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 and 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 and reimbursable expenses, based upon the court’s determination of what is reasonable and necessary under the circumstances.
Alternatively, section 328(a) of the Bankruptcy Code provides for the retention and compensation of professionals “on any reasonable terms and conditions of employment, including on a retainer [basis], on an hourly basis, on a fixed or percentage fee basis, or on a contingent fee basis.” If a 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 been improvident in light of developments not capable of being anticipated at the time of the fixing of such terms and conditions.” Approval of a fee arrangement under section 328 provides professionals with some reassurance that only in exceptional circumstances will a bankruptcy court tamper with their fee arrangements. Accordingly, any dispute over whether or not a retention was indeed pre-approved under section 328 is likely to be hotly contested, particularly where one party stands to receive an unexpected windfall under the arrangement.
A number of circuit courts have developed tests for determining whether a bankruptcy court pre-approved the retention of a professional pursuant to section 328 of the Bankruptcy Code. In holding that an accounting firm’s retention was not pre-approved, the Third Circuit in its 1995 ruling in Zolfo, Cooper & Co. v. Sunbeam-Oster Co. stated that “the burden should rest on the applicant to ensure that the court notes explicitly [in the retention order] the terms and conditions if the applicant expects them to be established at that early point.” In 2002, the Ninth Circuit held in In re Circle K Corp. that an investment banking firm’s fee application was reviewable for reasonableness. The court held that section 328 did not govern review of the fee application because the professional failed to invoke section 328 in its retention application, and provisions of the retention application and order stated that the retention remained subject to review by the court. A third test emanates from the Sixth Circuit’s 2004 ruling in Nischwitz v. Miskovic (In re Airspect Air, Inc.), in which the court of appeals stated that “whether a court ‘pre-approves’ a fee arrangement under § 328 should be judged by the totality of the circumstances.” The Sixth Circuit elaborated that factors relevant to the determination may include whether the debtor’s motion specifically requested pre-approval of fees, whether the court’s order assessed the reasonableness of the fee, and whether either the motion or the order expressly invoked section 328(a) of the Bankruptcy Code.
The Second Circuit’s Ruling in Smart World
In Smart World, the Second Circuit Court of Appeals adopted the Sixth Circuit’s “totality of the circumstances” test to determine whether a professional retention was pre-approved under section 328(a) of the Bankruptcy Code.
From 1996 to 2000, Smart World Technologies, LLC, and its affiliates (collectively, “Smart World”) failed to generate a profit providing free dial-up internet service to subscribers. In 2000, Smart World agreed to sell its most valuable asset, its subscriber list, to Juno Online Services, Inc. (“Juno”). Juno required Smart World to file for bankruptcy as a condition of the sale. The ultimate sale price was to be determined with reference to the number of Smart World subscribers who transferred their internet service to Juno. A dispute arose when Smart World accused Juno of obscuring the true number of subscribers that had switched to Juno in an alleged effort to depress the sale price.
Smart World sought an order from Judge Cornelius Blackshear of the United States Bankruptcy Court for the Southern District of New York approving the retention of Riker, Danzig, Scherer, Hyland & Perretti LLP (“Riker Danzig”) as special litigation counsel to pursue resolution or litigation of the dispute with Juno. On November 16, 2000, the bankruptcy court issued an order approving Smart World’s retention of Riker Danzig “pursuant to 11 U.S.C. §§ 327 and 328.” According to the terms of retention, Riker Danzig was to receive a percentage of any monies obtained from Juno in addition to payment of Riker Danzig’s expenses. Riker Danzig’s percentage entitlement varied in specific amounts according to the amount of any award or settlement and the duration of the dispute.
Smart World’s largest creditor, WorldCom, continued negotiating with Juno, and 18 months after the retention of Riker Danzig, WorldCom requested approval of a proposed settlement whereby Juno would pay $5.5 million to WorldCom, of which $1.5 million would be returned to the Smart World estate. Riker Danzig objected to the settlement on behalf of Smart World, in part on the ground that WorldCom lacked standing to settle the proceeding. The bankruptcy court approved the settlement over Smart World’s objection, but the Second Circuit reversed on the standing issue. Smart World’s exclusive right to propose and solicit acceptances for a chapter 11 plan having expired, however, its unsecured creditors’ committee attempted to impose a settlement on Smart World by filing a plan of liquidation that included a proposed settlement with Juno in the amount of $6.5 million. Once again, Riker Danzig contested the settlement, this time on the ground that Juno was undervaluing the claim, but the bankruptcy court disagreed and confirmed the plan.
Riker Danzig applied for a fee award in excess of $2 million plus expenses, consistent with the terms of its retention agreement. In the bankruptcy court, Judge James Peck (who succeeded Judge Blackshear, the judge presiding when Riker Danzig was retained) found that Judge Blackshear pre-approved the terms and conditions of Riker Danzig’s retention under section 328 of the Bankruptcy Code but that four events were not capable of being anticipated at the time of the approval. The four occurrences were that: (a) the positions of Smart World and its creditors diverged with respect to the Juno matter; (b) Riker Danzig took instruction directly from the officers and majority shareholders of Smart World; (c) the litigation was unusually prolonged; and (d) Riker Danzig was an obstacle, not an asset, to approval of the settlement. Judge Peck accordingly disallowed approximately one-half of the fees requested by Riker Danzig.
On appeal, the district court agreed that the retention had been pre-approved under section 328. Without opining as to which test for pre-approval it preferred, the district court noted that Riker Danzig’s retention appeared to pass each of the various tests employed throughout the circuits. The district court reversed the bankruptcy court with respect to the reduction in fees, concluding that the four developments identified by the bankruptcy court may have been unforeseen but were not incapable of being anticipated.
The Second Circuit affirmed the judgment of the district court and adopted the Sixth Circuit’s test for determining whether a retention has been pre-approved pursuant to section 328. According to the Second Circuit, the Bankruptcy Code does not “mandate that the application specifically mention §328 or that the court’s approval order expressly and unambiguously state specific terms and conditions.” Rather, the court emphasized, “pre-approval of a fee agreement under 11 U.S.C. section 328(a) depends on the totality of the circumstances, including whether the professional’s application, or the court’s order, referenced section 328(a), and whether the court evaluated the propriety of the fee arrangement before granting final, and not merely preliminary, approval.” The Second Circuit concluded that the retention met the “totality of the circumstances” standard because the retention application expressly invoked section 328(a) of the Bankruptcy Code, and the retention order expressly incorporated this language.
In addition, the court agreed that the bankruptcy court erred in disturbing the pre-approval of Riker Danzig’s retention because, although each of the events recited by the bankruptcy court may not have been anticipated, they were not incapable of being anticipated.
Outlook
Apparently agreeing with the Sixth Circuit that the formalistic requirements imposed on professionals seeking payment of fees under section 328 of the Bankruptcy Code by several circuit courts were “too restrictive,” the Second Circuit, in addressing the question for the first time in Smart World, adopted a “totality of the circumstances” test for section 328 pre-approval. As demonstrated in the Smart World ruling, however, consideration of the factors required by other tests—express invocation of section 328 in the retention application or order, express approval of the terms of retention in the order, and an absence of conditional language in the papers—may prove dispositive in applying the “totality of the circumstances” standard.
The Smart World decision should provide comfort to parties seeking section 328 pre-approval of professional retentions in the Second Circuit. The court of appeals adopted the least restrictive test for determining whether a professional’s retention was pre-approved pursuant to section 328. In addition, the court confirmed that a section 328 retention may be disturbed only in circumstances incapable of being anticipated, as opposed to those that were merely unanticipated. Nevertheless, although the “totality of the circumstances” test may be less restrictive than its counterparts, as suggested by the Smart World court, to ensure that its terms are satisfied, the best practice will be to continue satisfying the bright-line requirements of other tests.
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Riker, Danzig, Scherer, Hyland & Perretti v. Official Comm. of Unsecured Creditors (In re Smart World Technologies, LLC), 552 F.3d 228 (2d Cir. 2009).
Zolfo, Cooper & Co. v. Sunbeam-Oster Co., 50 F.3d 253 (3d Cir. 1995).
In re Circle K Corp., 279 F.3d 669 (9th Cir. 2002).
Nischwitz v. Miskovic (In re Airspect Air, Inc.), 385 F.3d 915 (6th Cir. 2004).
