The Bankruptcy Code authorizes a debtor (or its bankruptcy trustee) to retain and compensate attorneys and other professionals during the course of the debtor's bankruptcy case. Specifically, Section 327 allows a debtor, with bankruptcy court approval, to employ attorneys, accountants or other professionals to represent or assist the debtor in connection with its bankruptcy case. Section 328, in turn (and again subject to court approval), allows the debtor to retain such professionals “on any reasonable terms and conditions of employment, including on a retainer, on an hourly basis, on a fixed or percentage fee basis or on a contingent fee basis.” Finally, Section 330 permits a court to award to a professional retained under Section 327 “reasonable compensation for actual, necessary services” and “reimbursement for actual, necessary expenses.” Given this framework, the retention and compensation of professionals in a bankruptcy case is often a routine affair. The debtor will seek, and usually receive, authority to retain its professionals on specified terms. Thereafter, professionals may periodically file applications seeking payment of fees and expenses incurred during the course of the bankruptcy case. If the court concludes that the requested compensation is reasonable, it will award payment by the debtor's estate. However, if any party objects to a professional's fee application, this process can take an unwelcome turn.

Contested fee application litigation can result in additional professional fees and expenses. Vexingly for the professional, these “fee defense” costs may not be payable from the debtor's bankruptcy estate: In Baker Botts v. ASARCO (135 S. Ct. 2158 (2015)), the U.S. Supreme Court held that fees and costs incurred by a professional on account of fee-defense litigation are not compensable under Section 330. To mitigate this risk, bankruptcy professionals have begun to include fee-defense provisions in their retention agreements. While these types of provisions have been met with objection, the U.S. Bankruptcy Court for the District of New Mexico in In re Hungry Horse, Case No. 16-11222 (Bank. D.N.M. Sept. 20, 2017) recently approved a retention agreement between a debtor and its counsel that entitled counsel to payment of all reasonable fees incurred in defending its fee applications. Importantly, the bankruptcy court determined that such a provision was not barred by the Supreme Court's holding in ASARCO.

In ASARCO, the Supreme Court began its analysis by recognizing the “bedrock principle known as the American Rule” which requires each litigant to pay its own attorney fees—win or lose—unless a statute or contract provides otherwise. Because none of the parties in ASARCO relied on the contract exception to the American Rule, the Supreme Court considered whether Section 330 of the Bankruptcy Code provides a statutory exception to the American Rule in the context of fee defense litigation. On this point, the Supreme Court concluded that nothing in Section 330 warranted an exception to the American Rule. Indeed, the Supreme Court recognized that Section 330(a)(1) authorizes compensation only for “actual, necessary services rendered” by the professional. The Supreme Court therefore concluded that because “litigation in defense of a fee application is not a 'service' [to the debtor's estate] within the meaning of Section 330(a)(1),” fees and expenses incurred in connection therewith are not allowable as compensation under Section 330.

In response to ASARCO, bankruptcy professionals have incorporated fee defense provisions into their retention agreements. By including such provisions, the professionals hope to come within the contract exception to the American Rule. Unfortunately, this approach was analyzed—and rejected—by the Delaware Bankruptcy Court in In re Boomerang Tube, 548 B.R. 69 (Bankr. D. Del. 2016).

In Boomerang Tube, proposed counsel for the unsecured creditors' committee included a term in its retention agreement that provided for payment of expenses incurred defending counsel's fee applications. The U.S. trustee objected to the inclusion of this fee defense provision as contrary to Section 328 and ASARCO. The court sustained the trustee's objection on several grounds. First, relying on ASARCO, the court concluded that Section 328 does not contain a statutory exception to the American Rule because it lacks any specific and explicit language awarding litigation fees or costs to a prevailing party. Second, the court determined that the retention agreement between the unsecured creditors' committee and its counsel was insufficient to trigger the contract exception to the American Rule. The court noted that the retention agreement was “not a contract between two parties providing that each will be responsible for the other's legal fees if it loses a dispute between them.” Rather, the court found, the retention agreement provided that a third party (i.e., the debtor's estate) would pay counsel's defenses, even if the estate were not the objecting party. Because the retention agreement could not bind the debtor's estate, it failed to establish a contract exception to the American Rule. Finally, the court determined that fee defense provisions could not be approved under 328 because such a provision could never be deemed reasonable. According to the court, fee defense provisions are de facto unreasonable since they inure to the benefit of the professional and not the professional's client.

The bankruptcy court in Hungry Horse considered a similar issue but reached a different conclusion. There, the debtor sought court authorization to retain bankruptcy counsel. The parties' retention agreement expressly provided that the debtor agreed “to pay all reasonable legal fees incurred in obtaining court approval of all employment and fee applications including dealing with any objections to any of the applications.” The debtor's unsecured creditors' committee objected to the approval of this fee defense provision as contrary to ASARCO.

The Hungry Horse court overruled the objection and approved the fee defense provision. In doing so, the court concluded that nothing in ASARCO prevents approval of a fee defense provision in a retention agreement as a “reasonable term and condition” under Section 328(a). As the bankruptcy court pointed out, the Supreme Court in ASARCO construed Section 330 as limiting an attorney to compensation for services rendered to the client. However, the ASARCO court did not consider any contractual fee defense provision or consider whether such a provision could be approved under Section 328. The court also rejected the Boomerang Tube holding that a fee provision can never be a reasonable term under Section 328, since nothing in the Bankruptcy Code requires that all the terms of a professional's employment directly benefit the estate.

The court distinguished Sections 328 and 330, noting that “if employment terms and conditions are approved by a bankruptcy court under Section 328(a), then the professional's compensation is governed by those terms and conditions, rather than the general 'reasonable compensation for services rendered' language of Section 330(a)(1)(A).” The court specifically relied on the fact that the authority of the bankruptcy court to award compensation under Section 330 is expressly subject to the provisions of Section 328. As a result, the court held that Section 330 does not preclude payment of fee defense costs if the terms and conditions of a professional's compensation include a fee defense provision approved under Section 328.

The court also considered practical realities to reach its conclusion. It recognized that in smaller bankruptcy cases with smaller fees, fee defense costs can become a sizeable percentage of the total amount of fees billed in a case. Consequently, “if estate counsel were forced to successfully defend its fees 'on its own dime,' the net compensation in a bankruptcy case could be substantially reduced,” minimizing the incentive for counsel to undertake a debtor representation. Moreover, allowing a professional to recover fee defense costs from the estate limits objections to fee applications to bona fide disputes.

In conclusion, the court in Hungry Horse offered an example of a fee defense paragraph that might be approved as reasonable under Section 328(a): “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.”

Whether such language will be approved by other courts remains to be seen. In the meantime, in order to reduce the risk that they bear the expense of their own fee defense, bankruptcy professionals should consider specifically providing for the payment of such costs in their retention agreements.

Rudolph J. Di Massa Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights.

Jarret P. Hitchings, an associate with the firm, practices in the area of commercial finance, financial restructuring and business bankruptcy.