UNITED STATES BANKRUPTCY COURT FOR

EASTERN DISTRICT OF KENTUCKY

COVINGTON DIVISION

IN RE:

ATLAS CONTRACTORS, INC.

DEBTOR CASE NO. 03-21319

MEMORANDUM OPINION

Introduction

Michael L. Baker (the "Applicant") is before the court on the Application for Compensation that he filed in the above-styled case on April 7, 2004 (the "Application"). On April 26, 2004, James D. Lyon (the "Trustee"), as trustee of the bankruptcy estate of Atlas Contractors, Inc. (the "Debtor"), filed a Trustee's Objection [to] Application to Pay Administrative Expenses and Demand for Turnover of Property of the Estate. Having considered the Applicant's application and supporting memorandum, the Trustee's objection and demand, and the arguments of counsel, the court concludes that the Application should be sustained and the objection/demand should be overruled.

Factual and Procedural Background

On May 20, 2003 the Debtor filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. Filed with the petition in accordance with 329(a) of the Code and Rule 2016(b) of the Federal Rules of Bankruptcy Procedure was an attorney's disclosure of compensation, which indicated that the Applicant had received a $9,170 retainer, in addition to $830 in filing fees, from which he would be compensated on an hourly-rate basis in amounts to be approved by the court. On May 21, 2003 the Debtor filed an application to employ the Applicant as its attorney and, on June 17, 2003, the court entered an order sustaining that application.

On August 5, 2003 the United States Trustee (the "UST") filed a motion to convert the case to a case under Chapter 7 of the Bankruptcy Code, for reasons including the Debtor's failure to provide proof of insurance, monthly operating reports, and other information and documentation requested by the UST. On August 15, 2003 the motion was granted. Three days later, the court entered an order requiring the Debtor to file a list of postpetition, pre-conversion debts within 30 days. No such list has been filed to date. On August 25, 2003 the UST appointed the Trustee as interim trustee of the Chapter 7 estate and, on September 29, 2003, the Trustee became designated permanent Chapter 7 trustee.

As stated above, the Applicant filed his fee Application on April 7, 2004. The Application seeks the allowance of compensation in the amount of $12,239.00 for services rendered prior to the conversion of the case plus $445.60 as reimbursement of expenses incurred in connection with those services. (1) The Application seeks authority to apply the prepetition retainer but does not seek payment, at the present time, to the extent that the compensation and expense reimbursement exceed the amount of the retainer. As stated above, the Trustee filed his objection on April 26, 2004. The objection does not question the reasonableness of the amounts sought by the Applicant, but asserts that the Applicant may not "draw down" the retainer but must turn it over to the Trustee and receive payment of the fee award only after the payment of Chapter 7 administrative expenses and then only on a pro rata basis with other Chapter 11 administrative expenses. The court conducted hearings on the Application and objection on May 11, 2004 and June 8, 2004.

Legal Discussion

The Trustee suggests that the Debtor's bankruptcy estate may be "administratively insolvent," i.e., that the funds of the estate may not be sufficient to pay all administrative expenses in full. (2) In such cases, Chapter 7 administrative expenses must be paid before Chapter 11 administrative expenses and, if there is insufficient money to pay all administrative expenses in one of those categories in full, the claimants in the category share pro rata. 11 U.S.C. 726(b). Hence, argues the Trustee, the Applicant should not be paid, even from his retainer, until it is determined whether the estate is administratively insolvent and, if so, the Applicant should be paid only in accordance with 726(b). However, the Trustee overlooks 725 of the Code, which requires the disposition of "any property in which an entity other than the estate has an interest, such as a lien," before any distribution is made under 726. The Applicant holds an "interest, such as a lien" in his retainer, so he is entitled to apply that retainer before unsecured administrative expenses may be paid.

There are at least three different types of retainers:

For example, a retainer can be paid simply to ensure an attorney's availability to represent the client, whether or not services are ever performed. Or a retainer can be a prepayment for all future services to be performed, amount to a flat fee. Under either one of these arrangements, the attorney acquires title to the retainer fee at the time he receives it, regardless of whether he thereafter performs legal services for the client. On the other hand, if the relationship is a trust arrangement in which the attorney holds the retainer for the client as security for the payment of future fees, then the retainer so held, less any fees charged against it, constitutes the property of the client.

U.S. Trustee v. Equip. Servs., Inc. (In re Equip. Servs., Inc.), 290 F.3d 739, 746 (4th Cir. 2002) (citations omitted), aff'd sub nom. Lamie v. U.S. Trustee, 124 S. Ct. 1023 (2004). The ethical rules of most states mandate this "security" type retainer. Snyder v. Dewoskin (In re Mahendra), 131 F.3d 750, 756 (8th Cir. 1997); see Equip. Servs., 290 F.3d at 747. (3) Attorneys become entitled to fees as they earn them, so the portion of a retainer earned prepetition does not become property of bankruptcy estate. Id.; Mahendra, 131 F.3d at 756. The unearned portion remains property of the estate, but the courts hold that it is subject to the attorney's interest so that, once the compensation is allowed, the attorney has priority over all unsecured claims, including administrative expenses.

For example, the facts of Weinman, Cohen & Niebrugge, P.C. v. Peters (In re Printcrafters, Inc.), 233 B.R. 113 (D. Colo. 1999), are indistinguishable from this case. There, a law firm received a prepetition retainer then filed a Chapter 11 petition for the client and was authorized to represent the debtor in possession, id. at 115. The case was later converted to Chapter 7, the attorneys filed a fee application, and the Chapter 7 trustee objected "to the extent that it sought an order authorizing payment of approved attorney fees from the retainer prior to payment of all other administrative expenses incurred post-conversion." Id. The bankruptcy court accepted the trustee's position, id. at 115-16, but the district court reversed.

The court first quoted Collier's explanation of the operation of a "security" retainer:

Prior to commencement of a chapter 11 case, it is common for a debtor's professionals to obtain retainer agreements and fees to insure compensation for costs anticipated during the pendency of the case.... With respect to [such] 'secured' retainers, courts generally hold that a professional with such a prepetition retainer is a "secured creditor" and has a security interest in the retainer, noting that the professionals receiving prepetition retainers to insure payment of fees to be earned in the chapter 11 case (or postpetition retainers authorized by the court) become secured creditors, by virtue of a possessory interest in cash.

Id. at 116-17 (quoting 1 Lawrence P. King, Collier on Bankruptcy  328.02[1][b], [c][iii] (3d ed. 1998)). The court then noted that other cases have held that the attorney remains protected upon conversion of the Chapter 11 case to Chapter 7: "'If the case fails and is converted to [c]hapter 7, the retainer enables the debtor's attorney to avoid the subordination of the [c]hapter 11 expenses of administration to those incurred in administering the [c]hapter 7 estate mandated by section 726(b) of the [] Code.'" Id. at 117 (quoting In re Burnside Steel Foundary Co., 90 B.R. 942, 944 (Bankr. N.D. Ill. 1988)). The court then concluded that the attorneys "did obtain a prepetition security interest in the retainer in accordance with state statute, the Code, and the bulk of relevant bankruptcy case law." Id. at 118. (4) "Having complied with the fee application process, [the law firm] is now entitled to be paid from the retainer and shall not be required to share the security with other administrative claimants." Id. at 120 (citing In re Printing Dimensions, Inc., 153 B.R. 715, 719 (Bankr. D. Md. 1993) ("Counsel . . . will not be required to share a prepetition retainer pro rata with other administrative claimants where either the retainer is treated as security or the retainer is held in trust.")) (other citations omitted).

Printcrafters was followed by another appellate court in Rajala v. Hodes (In re Hodes), 289 B.R. 5, 16-17 (D. Kan. 2003), noting that differences between Colorado's and Kansas's attorney's lien statutes were not controlling. Fees are "earned" when approved by the court and, "[w]hen the fees are earned, the liens then operate to place the debtor's attorney's interest in those assets above those of competing creditors or administrative claimants." Id. at 17. The bankruptcy courts, both within and outside the Sixth Circuit, are in virtually unanimous agreement that an attorney for a Chapter 11 debtor in possession is a secured creditor vis-à-vis the prepetition retainer, and that the security interest allows the lawyer to avoid the subordination provisions of 726(b) to the extent that the fees for pre-conversion services are approved by the court. E.g., In re Golf Augusta Pro Shops, Inc., No. 01-11989, 01-11990, 2003 WL 22176082, at *2 (Bankr. S.D. Ga. Aug. 28, 2003); In re Zukoski, 237 B.R. 194, 198 (Bankr. M.D. Fla. 1998); In re Pannebaker Custom Cabinet Corp., 198 B.R. 453, 460 (Bankr. M.D. Pa. 1996) (rejecting argument that "prepetition retainers should be subject to disgorgement to achieve parity among administrative claimants"); In re Quincy Air Cargo, Inc., 155 B.R. 193, 197 (Bankr. C.D. Ill. 1993); In re Matthews, 154 B.R. 673, 677 (Bankr. W.D. Tex. 1993); Printing Dimensions, 153 B.R. at 719; In re Viscount Furniture Corp., 133 B.R. 360, 367-68 (Bankr. N.D. Miss. 1991); In re K & R Mining, Inc., 105 B.R. 394 (Bankr. N.D. Ohio 1989) (also rejecting argument that security interest was limited to prepetition fees); Burnside Steel Foundary, 90 B.R. at 944.

Although the court has not been presented with any evidence of the terms under which the retainer was placed with the Applicant, it appears that the retainer constitutes a "security" retainer. As such, the unearned portion of the retainer did become property of the bankruptcy estate when the Debtor filed its Chapter 11 petition. However, the estate's interest is subject to the Applicant's security interest. The Applicant having complied with the Bankruptcy Code's fee application process, and there having been no issue raised with regard to the reasonableness of the compensation sought and the court's independent review leading to the conclusion that the compensation and expense reimbursement satisfy the requirements of 330(a) of the Code, the Applicant is entitled to apply the retainer under 725 prior to the payment of unsecured administrative expenses under 726.

Conclusion

For the foregoing reasons, the court will enter a separate order sustaining the Application and overruling the Trustee's objection thereto and demand for turnover of the retainer.

Copies to:

Michael L. Baker, Esq.

James D. Lyon, Trustee

1. The Application actually seeks expense reimbursement of $1,275.60, which includes the $830.00 in filing fees. However, the court will treat the $830 as having been held in trust for the payment of the fees, and so will consider that amount to be part of neither the expense reimbursement sought nor the retainer that the Applicant wishes to apply. See In re Dees Logging, Inc., 158 B.R. 302, 307 (Bankr. S.D. Ga. 1993).

2. The Trustee complains that the reason for the uncertainty in this regard is that the Debtor has failed to comply with the court's order of August 18, 2003 requiring the Debtor to file a list of postpetition, pre-conversion debts. The court concludes that whether or not the Debtor has complied with its obligations after conversion is irrelevant to a determination of the Applicant's right to compensation for services rendered before conversion.

3. Kentucky appears to be among those states. Ky. Sup. Ct. R. 3.130(1.16(d)) (requiring refund of unearned portion of advance payment upon termination of representation); see id. R. 3.130(1.5) comment [2].

4. The district court addressed the bankruptcy court's holdings that the lien would violate the automatic stay and disqualify the attorneys as "disinterested" by noting that 328(a) of the Bankruptcy Code explicitly contemplates retainers. Printcrafters, 233 B.R. at 119-120 (citing In re Martin, 817 F.2d 175, 180 (1st Cir. 1987)); accord, e.g., In re K & R Mining, Inc., 105 B.R. 394, 397 (Bankr. N.D. Ohio 1989) (citing Martin).