Alliotts Bankruptcy Article Retention Agreements

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BANKRUPTCY LAW Retention Agreements

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URNAROUND MANAGERS and investment bankers are often engaged by companies for the purpose of finding a business partner that will infuse capital as part of a reorganization or, failing that, finding an entity to purchase the company’s assets as a going concern. During the recent high-tech meltdown and overall negative economic climate, boards of directors have turned to these professionals as a means of gracefully exiting a sinking ship. As third parties, turnaround managers and investment bankers are typically not entirely familiar with a client’s financial condition or the extent of its problems at the outset of their engagement. In many situations, a Chapter 11 filing will be necessary to facilitate a reorganization or, more commonly in recent years, a sale transaction. While turnaround managers and investment bankers tend to be familiar with the principal provisions of the Bankruptcy Code that help corporate debtors reach their business objectives, they are typically less familiar with some of the more technical statutory provisions relating to the administration of a bankruptcy estate. These provisions may have a significant impact on how much, or even whether, such professionals may be paid by a company in bankruptcy, despite the terms of a retention agreement entered into before the bankruptcy filing.

Craig M. Rankin is a partner at the Los Angelesbased bankruptcy boutique Levene, Neale, Bender, Rankin and Brill. Christopher Alliotts is of counsel to the Menlo Park, Calif., office of Los Angelesbased Sulmeyer Kupetz. They can be reached at [email protected] and [email protected]

By Craig M. Rankin and Christopher Alliotts

Craig M. Rankin

Christopher Alliotts

Bankruptcy filing can affect a professional’s contract The last thing a professional wants, after being retained and performing most, if not all, of the contractual services, is a dispute over the payment of fees. In order to avoid such disputes, it is necessary for turnaround managers and investment bankers to avoid any negative consequences that a bankruptcy could have on their right to contractual compensation. Here are some suggestions: ■ Retain separate counsel. Because a bankruptcy filing is not completely unforeseeable, a professional needs to anticipate a potential filing and plan accordingly. Professionals will often be tempted to rely on the company’s insolvency counsel in an attempt to avoid paying legal fees, but such a decision is risky. Although the professional may well be on the same “team” as company counsel, counsel may have a conflict of interest with the professional’s personal interests and may be constrained in the advice its provides.

Thus, fees paid for advice from separate counsel on structuring the retention agreement will be well spent, as such advice will often prevent or limit compensation disputes at the conclusion of the project. ■ Plan for a bankruptcy filing at the outset. Advice on the structuring of a professional’s compensation should be obtained at the outset of the engagement, even if a bankruptcy filing seems remote. The reason for this precaution is that any subsequent modification could be attacked in a later bankruptcy case. The strong-arm powers set forth in the Bankruptcy Code, including the right to avoid and recover preferences, fraudulent transfers and other transactions, can be applied to the restructuring of a professional-services contract, especially when the restructuring was done to avoid the negative consequences of the bankruptcy filing on the professional. Promptly obtain court approval of employment. In all bankruptcy cases, a professional needs to obtain approval from the court in order to be compensated by the company’s bankruptcy estate. See 11 U.S.C. 327. While a turnaround manager hired as an employee will generally not be considered a profes- sional whose retention needs to be approved, the professional should seek approval of any special compensation provisions, such as a bonus or success fee. A professional needs to submit an application early in the case for two reasons. First, a professional will probably have the most leverage early on because of the knowledge of the client’s business he or she has gained over time and the disruption that the loss of such knowledge would have on reorganization efforts. Second, any delay in seeking such approval can be a basis for denying compensation. ■

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■ Limit bankruptcy court review of fees. In bankruptcy, professional fees are generally subject to review by the bankruptcy court under a standard of reasonableness. See 11 U.S.C. 330(a). Unlike some other professionals that are employed under § 327 of the Bankruptcy Code, financial advisors are typically retained pursuant to § 328, which recognizes the contingent nature of fee agreements earned by investment bankers. See In re Federal-Mogul Corp., 348 F.3d 390 (3d Cir. 2003). That type of arrangement will often insulate a subsequent review of compensation from attack as unreasonable. See In re Drexel, Burnham & Lambert Group Inc., 133 B.R. 13 (Bankr. S.D.N.Y. 1991); In re United Artists Theatre Co., 315 F.3d 217 (3d Cir. 2003). ■ Understand the nature of retention agreements in bankruptcy. One of the more unfortunate situations in which turnaround managers and investment bankers find themselves comes about when a Chapter 11 filing is required after most of their work is done. With all energies focused on closing the deal, the professionals may proceed with the Chapter 11 filing without understanding the potentially harsh consequences to their compensation. Retention agreements are generally considered “executory contracts” for purposes of § 365 of the Bankruptcy Code. When a debtor assumes an executory contract, the debtor’s performance of the contract becomes a post-petition obligation of the bankruptcy estate entitled to administrative priority, which provides significant assurance that it will be paid. If, on the other hand, the contract is rejected, then the debtor’s obligation under the retention agreement is rendered a pre-petition unsecured claim, which will be paid on a pro rata basis with other general unsecured claims. Clearly, whether a contract is assumed or not will have a significant impact on the amount that the professional will be paid. Prepetition, a turnaround manager or investment banker can get the client to agree to assume the retention agreement in the event of a Chapter 11 proceeding, but a professional should not rely upon such a promise for two reasons. First, if the client reneges after the bankruptcy case is commenced, that breach,

MONDAY, MAY 17, 2004

like the underlying contract itself, will generally only be accorded the status of a general unsecured claim. Second, and more commonly, an official committee of unsecured creditors is often formed as a countervailing force to the company in a Chapter 11 case. If the debtor seeks to have its retention agreement with a professional assumed, the committee can, and may have a fiduciary duty to, oppose the assumption when most services were performed before the bankruptcy filing.

Two approaches may reduce nonassumption risk

in every engagement in which the client is in or near the zone of insolvency. First, when there is an organized creditor body existing before the bankruptcy filing, the professional should get the approval of the creditor body to the professional’s retention agreement and the assumption of it in the bankruptcy case. The debtor and/or the committee may still try to back away from this agreement in the bankruptcy case, but the professional can then make the argument that such parties should be estopped from reneging on their promise, when the professional worked in reliance on it and provided a substantial benefit to the bankruptcy estate. Second, using letters of credit in commercial deals not involving international shipments of goods has emerged as a new phenomenon. The effectiveness of this expanded use on employment or retention agreements was illustrated in In re Condor Systems Inc., 296 B.R. 5 (B.A.P. 9th Cir. 2003). In that case, the 9th U.S. Circuit Court of Appeals Bankruptcy Appellate Panel essentially held that the use of letters of credit insulated severance and other payments from attack. As in life, there are few absolutes in bankruptcy. There are factual nuances upon which the Condor court relied in reaching its conclusion, and such nuances should be evaluated on a case-by-case basis. Still, letters of credit, particularly at the inception of the relationship, can be very helpful in ensuring that professionals receive the compensation for which they bargained at the beginning of the engagement. And while some clients may be unwilling or unable to provide a letter of credit, it is a protection that should be explored. By taking the foregoing precautions, turnaround managers, investment bankers and other professionals will have a better chance of recovering their bargained-for compensation in bankruptcy cases. NLJ

The risk of nonassumption under § 365 that comes with working for a client that subsequently files for bankruptcy cannot be entirely ameliorated. However, two approaches may minimize this risk. They may not always be feasible, but should nonetheless be considered

This article is reprinted with permission from the May 17, 2004 edition of THE NATIONAL LAW JOURNAL. © 2004 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited. For information, contact American Lawyer Media, Reprint Department at 800-888-8300 x6111.#005-06-04-0022

Certain code provisions may have a significant impact on how much, or even whether, outside financial advisors are paid. This development could be extremely unfair to the professional who, for example, agreed to forgo a significant portion of compensation until the closing of a transaction. When little remains to be done post-filing, the committee and/or the company may be able to close the deal without the professional’s services and may seek to have the professional’s contract rejected in order to avoid the payment of fees that are largely attributable to prepetition services. While certain judges might be sympathetic to the professional’s predicament, it is a matter best not left to a court’s discretion.