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Bankruptcy Rules and Policy Changes Coming Dec. 1

By Karen Cordry, Bankruptcy Counsel

Two current and proposed changes to bankruptcy rules and guidelines may be of interest, and concern, to government counsel. The first is an amendment to Bankruptcy Rule 2019. This provision has been on the books for many years but has become increasingly controversial in recent years with the rise of “claims trading” in bankruptcy cases. That practice, as the name implies, involves third parties offering to buy the claims of existing creditors against bankrupt debtors. In the simplest scenario, the buyer merely seeks to convince the creditor that a low-priced bird in the hand now is worth giving up the chance of getting a higher-priced bird down the road, some day. Bankruptcies have a great deal of inherent uncertainty and, even where a case looks promising a creditor may well rather have the certainty of an immediate return rather than counting on that outcome. In addition, though, buyers have emerged with more sophisticated strategies that may involve seeking to acquire the debtor through the purchase of debt or otherwise control the outcome of the case. Those purchasers, in turn, have begun to work together to achieve those goals of determining the outcome of the case.

These changes and particularly the notion that groups of outside parties may be able to influence the case – with little or no transparency about the size of their interests or their economic motives – have concerned debtors and the courts. Under the existing Rule 2019, whenever there is a “committee” representing a group of creditors, a notice is supposed to be filed on the names of the represented entities, the amount, nature, and date of acquisition of their claims, and a general statement about the nature of the representation. A number of cases, though, have come to differing conclusions about how formal a “committee” needed to be in order to be covered by this provision and what disclosure was required. The Bankruptcy Rules Committee held hearings in 2010 on proposed rules and considered a number of variations to tighten up the existing language. The debate largely focused on whether the amount of disclosure would unfairly invade the business interests of the purchasers and reveal their business strategies.

In the end, a compromise provision was completed, received approval by Congress and the Supreme Court, and is scheduled to go into effect Dec. 1, 2011. The new provision has a number of aspects. First, it defines a “disclosable economic interest,” as any sort of right (including derivative rights) that is “affected by the value, acquisition, or disposition of a claim or interest.” That definition is meant to broadly cover any sort of economic connection with the case. Second, it defines “represents” as meaning that an entity or committee “takes a position before the court” or “solicits votes regarding the confirmation of a plan” on behalf of others. Thus, mere discussions and out-of-court work with varying clients will not trigger the rule, but any in-court appearance will. It then provides that any “committee” or “entity” that represents “multiple creditors . . . that are (A) acting in concert to advance their common interests, and (B) not composed entirely of affiliates or insiders of one another” must file a verified statement of their interests. That statement must detail the nature of the committee or entity, members being represented, the nature and amount of the “disclosable economic interest,” the date of acquisition of the interest by calendar quarter unless held for more than a year on the petition date, and a copy of the instrument authorizing the representation. Failure to comply with the rules can prohibit the committee or entity from being heard.

On its face, the language is broad enough to cover governmental entities in many, if not all of their guises in the case. Whether it is the government’s own economic interests, such as for tax claims, or its protection of the economic interests of consumers, or even where it is presenting regulatory interests that still may have economic consequences, it could well be argued that the government has a “disclosable economic interest.” As a result, anytime that multiple state entities work together and seek to appear in court collectively, there is the possibility that this Rule might apply to them and require that someone file the appropriate notice. The Rule is not, in fact, markedly different from the prior language where this was rarely, if ever done, but with the new prominence of the Rule, the issue may be raised where it had not been brought up before.

There is one exception in Rule 2019(b)(2) that states that, unless the court orders otherwise, “an entity is not required to file . . . solely because of its status as: . . . (D) a governmental unit . . . .” While that is certainly of some benefit, it is unclear how far it extends; i.e., does this mean that governmental units are categorically excluded from this provision – even where several band together? Or does it simply mean that a government, which represents millions of constituents, is not, thereby, inherently transformed into one of these “committee” type entities that might file a claim. While one might hope the former is true, the somewhat odd wording of the phrase tends to suggest the latter is more likely. If so, then groups of governmental entities would be well-advised to file this statement.

The Committee note may help, in that it states that “Subdivision (b)(2) excludes certain entities from the rule’s coverage. Even though these entities may represent multiple creditors . . ., they do so under formal legal arrangements of trust or contract law that precludes them from acting on the basis of conflicting economic interests. For example, an indenture trustee’s responsibilities are defined by the indenture, and individual interests of bondholders would not affect the trustee’s representation.” Nevertheless, though, until some further clarification is forthcoming, the provision needs to be kept in mind. The disclosure requirements could raise concerns, though, even if the government does seek to adhere to them if the “economic interest” of the government relates to matters arising from ongoing investigations where the interest is either not yet known or is subject to confidentiality requirements. One must hope that the court will take those constraints into account in reviewing any statements that are filed.

Fees in Large Chapter 11 Cases

The other proposed change has to do with the U.S. Trustee guidelines for fee applications in large Chapter 11 cases. Such fees have long been a source of controversy in bankruptcy cases. Prior to the 1978 act that set the framework under which bankruptcy courts currently function, bankruptcy billings were guided by an “economic approach,” whereby professionals were expected to take into account the distressed nature of the bankrupt debtor and reduce their billings accordingly. As a result, payments were consistently at the low end of the range of reasonableness. The concern was that, as a result, bankruptcy could not attract the best counsel and that the debtor’s ability to reorganize (and provide higher returns for all) would be adversely affected and few large firms participated. Thus, the 1978 Bankruptcy Code rejected that approach and explicitly adopted the view that bankruptcy counsel should be paid at a scale comparable to that of counsel in the non-bankruptcy sector.

The result, not surprisingly, was that fees increased markedly, and that large bankruptcy firms, who can throw large numbers of associates at resolving large numbers of claims, have blossomed since 1978. Clearly, the courts are still supposed to compare the rates charged by counsel in bankruptcy with those outside of bankruptcy, but some of the intangibles are difficult to measure. For instance, while there is a chance in bankruptcy that the case will become “administratively insolvent,” and be unable to pay the costs of administering the case, including professional fees, the vast majority do not fall into that category. Rather, even where all of an estate’s funds may be subject to first liens by a lender, that entity will routinely “carve out” a portion of the estate assets for professionals to ensure that they continue to process the case. And, except in such insolvency situations, professionals can be assured that their bills will be paid as the debtor’s first priority, not as one of those bills that “I’ll get to you as soon as I can,” which surely is the result for many attorneys dealing with failing clients.

In large cases the amount of fees on an absolute scale can hit startling numbers. In the Lehman Brothers case, for instance, nearly $1.4 billion has been billed from September 2008 through August 2011 and the numbers continue to mount. Any attempt to review these sorts of bills becomes equally difficult. Bankruptcy typically requires filing hours in excruciating detail (all of which work is also compensable). Sifting through it, entry by entry, often seems an exercise in futility or nit-picking yet there often remains a sense that the fees are too high, especially when billings in some cases have soared above the $1,000 per hour mark. So long as the estate is solvent, there are few incentives for counsel to limit their billings, or their hourly rates and it is difficult for individual creditors to second guess the results. Meaningful review becomes even more difficult when members of a small, closely integrated bankruptcy bar in any given locale have to decide whether or not to contest fees of a firm with which they constantly do business.

The U.S. Trustee’s office has over the years attempted to play some role in reviewing fees and ensuring their reasonableness. Since 1996, they have operated under a set of short, high-level guidelines that provided few substantive requirements or limitations. They have now recently issued new proposed guidelines that are much longer, and more detailed than the prior guidelines. Among other provisions, they strongly encourage/require the use of budgets for work done during the case, require detailed and specific information about the high, low, and average amounts actually billed to other clients inside and outside the bankruptcy arena, and provide greater clarity about the types of items that may be billed and the types that should be considered part of normal firm overhead. The proposed guidelines and the cover memo detailing how to comment thereon may be reviewed at:

http://www.justice.gov/ust/eo/rules_regulations/guidelines/proposed.htm and comments may be submitted through Jan. 31, 2012.

In some cases, the amount of fees is not a major consideration. In others, though, particularly where the debtor is struggling, such fees may swallow up a large portion of the funds in the case and leave little or nothing for even priority creditors, such as the taxing authorities. As a result, this is an issue that may well behoove states to review and comment upon.

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