Retention and Compensation of Investment Bankers in Bankruptcy Cases
When Certain Investment Banking Services Are Performed Pre-Petition
Written by:
Maxim B. Litvak
Pachulski, Stang, Ziehl, Young, Jones & Weintraub P.C.; San Francisco
mlitvak@pszyjw.com
Contributing Editors:
James H.M. Sprayregen
Kirkland & Ellis; Chicago
jsprayregen@kirkland.com
James A. Stempel
Kirkland & Ellis; Chicago
jstempel@kirkland.com
Laura Davis Jones
Pachulski, Stang, Ziehl, Young, Jones & Weintraub P.C.; Wilmington, Del.
ljones@pszyjw.com
Debra I. Grassgreen
Pachulski, Stang, Ziehl, Young, Jones & Weintraub P.C.; San Francisco
dgrassgreen@pszyjw.com
Web posted and Copyright © April 1, 2004, American Bankruptcy Institute.
Imagine this scenario. You are the debtor's chief executive officer. Prior to a bankruptcy filing, the board of directors charges you with the task of marketing the debtor's assets and consummating a transaction that will maximize the return for the debtor's creditors and equity-holders. You have been authorized to employ investment bankers to assist you with this task. You interview and hire investment bankers with whom you work closely to market the debtor's assets and to negotiate an asset-purchase agreement with a potential buyer. Although the investment bankers request a monthly fee for their services because the company is in a cash-flow crisis, you (on behalf of the debtor) successfully negotiate to only pay them a success fee or commission at the closing of the sale. The asset-purchase agreement is signed pre-petition. It contemplates that the sale will be consummated through a chapter 11 bankruptcy filing for the debtor. On the "first day" of the case, you direct counsel for the debtor to move the bankruptcy court to approve the retention of the investment bankers to assist in closing the sale. But the court denies the request on the basis that the investment bankers did substantially all of their work pre-petition and are merely general unsecured creditors of the estate.
Can that be right? Is it fair? As the debtor's chief executive officer, are you supposed to turn your back on the professionals with whom you have worked all these months? More importantly, how can a debtor ever pay investment bankers on a contingency basis in a bankruptcy case when some of their services were performed pre-petition?
This column addresses the issue of chapter 11 debtors seeking to employ and compensate pre-petition professionals on a post-petition basis and discusses several possible approaches that a debtor may adopt with respect to investment bankers instrumental to a bankruptcy sale. There are certainly different approaches that may be employed depending on the circumstances of a particular case.1
The Basics of Retaining and Compensating a Professional in Bankruptcy
With a few exceptions not relevant here, §327(a) of the Bankruptcy Code provides that a trustee or a debtor-in-possession (DIP), with the court's approval, may employ one or more attorneys, accountants, appraisers, auctioneers or other professional persons that do not hold or represent an interest adverse to the estate, and that are disinterested persons, to represent or assist the trustee or DIP in carrying out its duties. Investment bankers are uniformly treated as professionals that have to be formally retained by a debtor for purposes of §327. The question is whether investment bankers who performed pre-petition services under the factual scenario above satisfy the requisites for retention.
There are two basic requirements in §327 for a professional to be retained. First, the professional must not have an interest adverse to the estate. Second, he or she must be disinterested. The distinction between an interest adverse to the estate and disinterestedness is not always clear, and courts appear to treat the two concepts as interrelated. Indeed, the adverse-interest prong of §327 has been characterized as a "catch-all" for any relationships that could have a detrimental impact on the estate as a whole. See 3 Collier on Bankruptcy ¶327.04[2][a] (15th ed. 2003). In this regard, investment bankers who worked for the debtor pre-petition and have not been paid for such services do not necessarily hold an interest adverse to the estate. Rather, such investment bankers should have every incentive to maximize the value of the estate to ensure payment. Their interests are aligned with the estate.
The term "disinterested person" is defined in the Bankruptcy Code. See 11 U.S.C. §101(14). In relevant part, it refers to a person that is not a creditor.2 The term "creditor" means an entity that has a claim against the debtor arising pre-petition (or as a result of a rejection of an executory contract or unexpired lease). 11 U.S.C. §101(10). It may be argued that investment bankers who perform work for the debtor pre-petition have pre-petition claims, though they may be contingent, against the debtor. So long as such claims are in existence, the investment bankers are not disinterested and cannot be retained. However, as discussed below, there are ways that a debtor and its investment bankers may seek to address this issue.
Assuming for the moment that investment bankers are successfully retained, the next question is, how are they to be compensated? Section 330(a) of the Bankruptcy Code provides that, subject to §328 and certain other provisions, the court may award to a professional person employed under §327 reasonable compensation for actual, necessary services rendered by such professional person for the estate.3 Such compensation is treated as an administrative expense of the estate. See 11 U.S.C. §503(b). Section 328(a) provides some flexibility for the court (and the debtor) to retain a professional person pursuant to the terms of a contingency or success fee arrangement or other commission structure.
These provisions assume that professionals can only be paid on a post-petition basis for post-petition services to the estate. How then can a debtor employ and compensate investment bankers in a bankruptcy case when some of their services were performed pre-petition?
Case Law Considering Post-petition Professional Compensation for Arguably Pre-petition Work
Although there does not appear to be any published authority dealing specifically with the status of investment bankers performing pre-petition services, an analogous issue has arisen in published authorities involving real estate broker commissions. In those cases, the facts are generally as follows:
A broker is hired by the debtor pre-petition to sell a piece of real estate. The broker finds a buyer and signs up a sale. Before the sale closes, the debtor files for bankruptcy. The debtor then assumes the sale agreement under §365 of the Bankruptcy Code, but takes the position that the obligation to pay a broker's fee from the sale is non-executory in nature and cannot be assumed (or is an executory obligation that is severable from the sale agreement and can be rejected). As a result, the broker is not entitled to an administrative claim.
Although there is some dispute in the case law, the majority view appears to support this position. The broker performed substantially all of its services pre-petition and is therefore entitled to no more than a general unsecured claim for its commission contingent on the sale actually closing. See, e.g., Marcus & Millichap Inc. of San Francisco v. Munple Ltd. (In re Munple Ltd.), 868 F.2d 1129, 1130-31 (9th Cir. 1989) (concluding that the commission provision in the real estate sales agreement was not executory and could not be assumed by the debtor along with the remainder of the agreement, relegating the broker to general unsecured status); Byrd v. Gardinier Inc. (In re Gardinier Inc.), 831 F.2d 974, 976-78 (11th Cir. 1987) (holding that an agreement to pay a brokerage commission is a separate and distinct contract from the sale agreement), cert. denied, 488 U.S. 853 (1988); In re Indian River Homes Inc., 108 B.R. 46, 49-50 (D. Del. 1989) (following Munple and Gardinier), appeal dismissed, 909 F.2d 1476 (3d 1990); but, see In re Clavis Bldg. Inc., 112 B.R. 768, 770 (Bankr. E.D. Va. 1990) (finding that a debtor must assume all of the benefits and burdens of a sales contract, which included a provision to pay a broker's commission given that such provision was executory because the broker had not completed the details of the sale).4
These decisions are distinguishable from the typical scenario involving investment bankers in that the broker cases generally do not arise under §327 of the Bankruptcy Code. Real estate brokers and investment bankers also obviously perform different types of services. The underlying issue, however, is analogous. Whether dealing with real estate brokers or investment bankers, there is generally no basis to award an administrative expense claim on account of pre-petition services.
But does this result necessarily make sense in the context of a bankruptcy sale negotiated by investment bankers? Is not the sale of an ongoing operating business much more complicated than the typical real estate transaction? Does not the debtor need continued access to its investment bankers to close the deal‹to manage a sale auction in the bankruptcy case, to provide diligence materials, to negotiate with potential overbidders and to testify as to the adequacy of the sale process in order to obtain approval of the bankruptcy court for an ultimate disposition?
Possible Approaches to Retaining and Compensating Pre-petition Investment Bankers in a Bankruptcy Case
First, let us address the issue of disinterestedness, mentioned earlier. It may be argued that investment bankers are not disinterested if they have not been paid pre-petition for pre-petition work because they are contingent creditors of the estate. One counter to this argument is that there can be no pre-petition claims because no compensation is owed to investment bankers until a sale actually closes. Alternatively, even if pre-petition contingent claims arguably exist, investment bankers are only pre-petition creditors so long as they have not been retained. Once the bankruptcy court approves their retention, any contingent claims are effectively replaced by administrative obligations.
So, aside from the issue of whether pre-petition claims even exist, one way to address the issue of disinterestedness is to have the investment bankers agree to waive any pre-petition claims in the context of their application to be retained by the estate. As discussed below, this waiver may be accomplished in the form of a new post-petition retention agreement that supersedes the parties' pre-petition arrangement. If, however, the investment bankers are not inclined to waiving their pre-petition claims outright because they are concerned that the bankruptcy court may deny their application, they could disclose the claims and make any waiver contingent on approval of the application. Thus, if the retention is approved, the contingent claims cease to exist and the investment bankers are necessarily disinterested. If the retention is for some reason denied, then the contingent claims remain in existence. However, the safer route in terms of satisfying the disinterestedness prong is probably to simply waive any pre-petition claims that may exist.
Second, we come to the issue of post-petition compensation for what may be construed as pre-petition services. One approach is for the debtor to pay for all pre-petition investment banking services (or the pre-petition portion of any anticipated success fee) prior to a bankruptcy filing. Of course, this presumes that the debtor is in the envious position of having sufficient cash to pay the investment bankers and is willing to take the risk that such investment bankers can refund the money in the event that the sale on which the commission is based does not close.
Another approach to compensating investment bankers for pre-petition work is through the mechanism of an escrow. This happened in the case of Redback Networks Inc. in the District of Delaware, Case No. 03-13359. A buyer escrows a portion of the ultimate purchase price on account of the debtor's obligations to investment bankers. The escrow is created through an independent third party who has directions to release the funds to the investment bankers upon the occurrence of a certain event, such as the approval of a sale transaction by the bankruptcy court. Under these circumstances, the investment bankers arguably do not need to be formally retained in the case at all. However, it is possible that a debtor's estate (possibly through a creditors' committee) could take the position that the assets in the escrow constitute property of the estate or that the transfer of the funds into escrow constitutes a fraudulent or preferential transfer.5
Alternatively, a debtor could seek to assume an engagement agreement with its investment bankers (or a pre-petition asset-purchase agreement that contemplates payment of investment bankers) as an executory contract under §365 of the Bankruptcy Code or to have the agreement approved as a valid use of estate property outside the ordinary course of business under §363 of the Bankruptcy Code. Although these provisions do not address the issue of professional retention under §327, there is authority (as in Clavis) allowing debtors to pay professionals without formally retaining them. In certain jurisdictions or under particular circumstances, tying the issue of professional compensation to the approval or assumption of an asset-purchase agreement or engagement agreement may be sufficient.
If a debtor intends to utilize the services of its investment bankers during a bankruptcy case, however, their retention generally needs to be approved by the bankruptcy court. In this context, it usually makes sense for the debtor and its investment bankers to execute a new, post-petition engagement agreement that clearly delineates the tasks that the investment bankers will be retained to perform on a post-petition basis and the compensation that will be payable for such services. The post-petition engagement agreement will then form the basis for an application to retain the investment bankers in the bankruptcy case. The application should emphasize the continuing role of the investment bankers, the importance of retaining professionals familiar with the debtor's assets, and the complex tasks that remain in the case, particularly if the debtor continues to have an operating business.6 Even if an asset-purchase agreement has been executed pre-petition, it often takes considerable effort on the part of every professional on the debtor's team to obtain approval of the sale by the bankruptcy court and then to successfully close the deal with the buyer. Terminating the employment of the investment bankers on the petition date could jeopardize the continuity of this process.
Conclusion
So where does that leave us? At a minimum, the issue of post-petition compensation of professionals for what is partially pre-petition work requires careful consideration and advanced planning prior to the commencement of a case. Most debtors need continued post-petition access to their investment bankers to ensure that a transaction negotiated pre-petition actually closes. In order to achieve this objective, debtors and investment bankers alike must be aware of the risks associated with a bankruptcy filing and the possible effects on pre-petition arrangements between them. This column outlines a few approaches for dealing with the issue. There are certainly others. The debtor and its investment bankers should plan accordingly.
Footnotes
1 This column should not be construed as legal advice and is not intended to foreclose any approaches or arguments that may be asserted in connection with the issues addressed herein.
2 A "disinterested person" also refers to, among other things, a person that has not been, within three years prior to the bankruptcy filing, an investment banker for the debtor in connection with the offer, sale or issuance of any outstanding security of the debtor. 11 U.S.C. §101(14). However, this provision does not apply to investment bankers who were not previously employed by the debtor in connection with a securities transaction.
3 Although not particularly on point, it is interesting to note that the Supreme Court recently held that a chapter 11 professional cannot be compensated for services performed on behalf of the debtor after conversion of the case to chapter 7, unless such professional is employed by the chapter 7 trustee under §327 of the Bankruptcy Code. Lamie v. U.S. Trustee, 124 S. Ct. 1023 (2004).
4 The decision in Clavis allowed a debtor to assume an agreement under §365 of the Bankruptcy Code with a broker who could have been treated as a professional in the case. As discussed below, this approach is arguably distinct from issues involving retention and compensation of professional persons under §§327 and 330 of the Code.
5 Certain bankruptcy courts have upheld escrow arrangements with investment bankers when properly structured. However, the issue has not yet been addressed in the Redback case.
6 As discussed previously, it will also probably be necessary for investment bankers to waive any contingent claim under their pre-petition agreement to the extent that the post-petition agreement does not supersede the pre-petition arrangement.
This information first appeared in the April 2004 issue of the ABI Journal. Reprinted with the permission of the American Bankruptcy Institute.