The U.S. Bankruptcy Trustee recommended that the bifurcated fee agreements offered by attorney Michael Harris to Debtors filing Chapter 7 Voluntary Petitions be invalidated. The Court entered an order indicating that it believes the contracts used by Harris violate the United States Bankruptcy Code, the Federal Rules of Bankruptcy Procedure, and the Kentucky Rules of Professional Conduct. The Court directed Harris to seek an opinion from the Kentucky Bar Association on the ethical propriety of the specific fee agreements referenced herein, but the Bar Association declined to weigh in.  Finally, Judge Lloyd met with all of the Bankruptcy Judges from the Western District of Kentucky regarding their views on the matters addressed, who all agree with his conclusions.

Initially, the Court summarized the problem as follows:

“Bankruptcy represents a complex set of statutes that have been codified in one form or another since 1898. The success of a Chapter 7 bankruptcy largely depends upon the debtor receiving a discharge of unsecured claims, and at times, secured claims. Only Congress may write legislation to afford relief to debtors. This Court, like all bankruptcy courts, is presented with determining whether certain written contracts for legal representation of debtors in Chapter 7 proceedings pass the legal and ethical requirements established by Congress and the Kentucky Bar Association. These contracts generally seek to avoid the discharge of unpaid sums for legal services rendered pre-petition to Chapter 7 debtors. Absent very specific circumstances, a Chapter 7 debtor may expect discharge of pre-petition unsecured claims and debtor’s legal counsel can be expected to enforce the discharge injunction of 11 U.S.C. § 524 on debtor’s behalf against any adverse actions of the holders of the discharged claims. Waiting for a client to have a sufficient sum to pay a legal fee is not new to anyone who has practiced law. Bankruptcy lawyers, however, are well aware that waiting to get their fee or any portion of it after the Chapter 7 petition is filed means their fee will be discharged and collection forbidden. Thus, Chapter 7 bankruptcy practice is trying to transition from the traditional upfront payment in full of the quoted fee to legal representation contracts that seek to divide counsel’s responsibilities to their clients on a pre- and post-petition basis in order to avoid the discharge injunction applying to the lawyer’s fees. The Bankruptcy Court has the unenviable job of looking into the lawyer/client relationship to determine if these types of legal contracts violate the Bankruptcy Code, Rules and ethical rules governing the practice of law. Inherent in Bankruptcy law is a situation where a lawyer’s own financial interests in getting their fees paid up front or quickly, clashes directly with their client’s need for a discharge of debts and a fresh start, which is the primary goal of filing bankruptcy in the first place.Attorneys, therefore, must balance their right to attorney’s fees against the inherent conflict of interest presented by creating constructive devices and contracts to avoid Congressional statutes and rules designed to protect the debtor. Until Congress addresses this problem, this Court is left to identify the problems involved and attempt to correct practices which threaten the integrity of legal practice before it.”

In this case, Harris entered into a Line of Credit and Accounts Receivable Management Agreement (LOCARMA) with Fresh Start Funding (FSF) (an Arizona company that provides financing and other services to law firms who represent consumer clients), under which FSF provides a $50,000 line of credit to Harris in exchange for a lien on and right to collect his accounts receivable. As summarized by the Trustee:

1. Harris engages a client using a bifurcated fee agreement which allows for collection of fees after the filing of the petition.
2. Harris uploads the client contract to FSF’s online database.
3. FSF reviews the client contract for compliance with its underwriting requirements and, if the client meets these requirements, it becomes an Approved Account (“Approved Accounts”).
4. After the client contract becomes an Approved Account, FSF has three business days to make an advance to Harris of 60 percent of the entire fee charged to the client (“Initial Amount”).
5. Contemporaneously, FSF retains 15 percent of the entire fee charged to Harris’ client (the “Holdback Amount”) “as security for the performance of all Approved Accounts funded by FSF” under the terms of the LOCARMA.
6. The remaining 25% of the fee is retained by FSF as compensation for its services.

In order to operate as designed, the LOCARMA is dependent on FSF’s ability to collect fees from Harris’ debtor-clients post-petition. As such, the prefatory stipulations contained in the LOCARMA state that Harris’ clients enter “into a post-petition fee agreement…with the Firm to pay a fixed fee for the post-petition chapter 7 services.” Accordingly, the use of a bifurcated agreement is a requirement of Harris’ ability to participate in the LOCARMA and access the line of credit.

While the Court recognizes the underlying attorney fee problem faced by debtors, the Court finds the practices used by Harris violate the United States Bankruptcy Code, the Federal Rules of Bankruptcy Procedure and the Kentucky Rules of Professional Conduct:

“The essential problem presented by Harris and FSF through the LOCARMA is that Harris is using the post-petition contract to get the debtor/client to pay fees they could not pay quite literally the moment before the petition is filed, adding a complex nondischargeable contract and exorbitant expenses to a debtor/client instead of the promised ‘fresh start’.  Harris, like all counsel to Chapter 7 debtors in the Western District of Kentucky, cannot avoid the very specific obligations of legal services to a debtor once they file the Chapter 7 on their behalf. Bankruptcy Courts do not allow counsel to pick and choose what they ‘do’ for a debtor in a Chapter 7 pre- or post-petition, as will be more fully discussed. Legal advice to a debtor is one thing, but following through with concrete and established steps of Chapter 7 legal representation is another.”

First, the Court held that: An Attorney May Not Advance a Client’s Filing Fee:

“Bankruptcy Rule 1006 requires that the filing fee shall accompany every petition. In other words, the fee must be paid at the time the petition is filed. In ten of the eleven cases herein, Harris advanced the filing fee for the client at the time the petition was filed. However, the client repaid Harris the advanced fee amount post-petition through the monthly installment payments….  Harris’ advancement of the filing fee on an expectation of repayment post-petition violates 11 U.S.C. §526(a)(4). By advising a client to incur debt in order to pay for bankruptcy related legal services, the practice violates 11 U.S.C. §362 and, assuming the debtor gets his or her discharge, violates 11 U.S.C. §524.  It is also violative of Kentucky Supreme Court Rule 3.130(1.8)(e)(1) [Kentucky Rule of Professional Conduct 1.8(e)(1)].”

The Court also concludes that: The Factoring of Fees Under the LOCARMA and FSF Agreement Violates the United States Bankruptcy Code, the Federal Rules of Bankruptcy Procedure, the Local Rules of the United States Bankruptcy Court for the Western District of Kentucky, and the Kentucky Rules of Professional Conduct:

“11 U.S.C. §330(a)(1) does not authorize compensation awards to debtors’ attorneys from estate funds, unless they are employed as authorized by §327. Any unpaid balance of pre-petition fees is dischargeable in bankruptcy. If the fee obligation arises pre-petition, the Chapter 7 lawyer cannot look to the debtor or the estate post-petition for payment. Thus, Harris and FSF use the LOCARMA to ensure that the debtor is legally obligated to pay post-petition on a contract an amount that if included in a pre-petition contract, would be discharged. Yet, lawyers filing Chapter 7 petitions have very specific responsibilities to their clients that they must perform and they cannot use a post-petition contract to avoid those obligations. Encouraging a client to sign the post petition contract on the premise that the lawyer will finish preparation of required Bankruptcy filings, attend the Section 341 meeting(s) and provide advice regarding reaffirmations and attendance at any hearing thereon, is on its face, a violation of the discharge injunction of 11 U.S.C. §524 since the lawyer owes these duties to their clients once they file the Chapter 7 petition, whether they have been paid or not.

“Further, the factoring of fees, whether called ‘insurance’ (15%) or the compensation for FSF (25%), charged via the LOCARMA are among the financial costs of this post-petition arrangement. Factoring is a financing device secured by collateral which in this case is the obligation of the debtor under the post-petition contract. The burden of the borrowing cost is relative depending upon who pays it. The LOCARMA terms are negotiated by Harris and FSF, but Debtors who pay the bill, apparently do not get to negotiate on the price. Harris’ disclosures to his clients fall far short of what would be appropriate in this Court’s view. Harris is passing on to his clients his cost (15% + 25%) of ‘borrowing’ his legal fees and a return of the advanced filing fee so that he can receive his 60% installment within three days of acceptance by FSF. Harris is asking his Chapter 7 clients to sign the LOCARMA which creates nondischargeable obligations, including terms highly favorable to Harris, in return for legal services Harris must render to his clients whether they sign the agreement or not. The Court has found no contractual terms or disclosures where these conflicting financial incentives and legal responsibilities to the Debtors post-petition have been adequately set forth whether in documents the Debtors are asked to sign or in disclosures of counsel required in Court documentation. This arrangement evidences overreaching by counsel and it is doubtful that any amount of disclosure can remedy the problem. Moreover, assuming entering a post-petition contract for legal services already fully owed to a debtor due to a pre-petition filing can withstand §524 vetting, Harris could allow his clients to pay his fees (presumably between $1,250 and $1,500 per case) over a similar twelve month period. This ‘financing’ by Harris would cut the 15% + 25% FSF fees out of the post-petition contract saving the debtor a great deal of money, except Harris would not get the advance of 60% of the legal fee within three days of the acceptance by FSF. On its face, the LOCARMA is wholly beneficial for counsel and disturbingly expensive for his clients. Herein lies a serious conflict of interest that this Court believes is not appropriately disclosed to the debtor/clients. This Court concludes that this practice violates the United States Bankruptcy Code, the Local Rules of the United States Bankruptcy Court for the Western District of Kentucky, and the Kentucky Rules of Professional Conduct.”

The Court also found that: Harris’ Fee Splitting with FSF is Not Adequately Disclosed to the Court:

“The factoring of the Debtor’s legal fees under the bifurcated fee agreements also raises issues concerning fee splitting. Either the factoring expense of 15% + 25% due to FSF is Harris’ cost of borrowing his fees or the FSF LOCARMA involves fee splitting. For all the debtor knows, and frankly all this Court knows, FSF is also counsel in these representations as well since Attorney Garrison interacted with the Kentucky Bar Association on behalf of Harris and the LOCARMA. The contract, however, does not adequately disclose this information to the Debtor, nor was this information disclosed to the Court.

“In general, Courts have articulated four concerns regarding factoring agreements such as the ones used by Harris herein. These are as follows:

1. An attorney’s failure to list in the Disclosure of Compensation all aspects of the fee splitting arrangements with entities such as Fresh Start;
2. Debtors who use the ‘zero money down’ option with their fees factored by entities like Fresh Start ended up paying more than those who paid the retainer up front;
3. The improper shifting of most, if not all, of the fees to the post-petition agreement; and
4. A conflict of interest in both creating a nondischargeable debt through the use of a post-petition agreement and a conflict arising from the attorney’s desire to maintain a favorable relationship with companies such as FSF while representing the client.

“In In re Wright, 591 B.R. 68 (N.D.Okla. Bankr. 2018), the court found that in a situation similar to the one presented by Harris and FSF’s contract, the Disclosure of Compensation was problematic. First, the disclosure was misleading because it indicated, as here, the attorney received a flat fee for legal services, when in actuality the attorney received a portion of the fee and the financing company received a percentage as well. The court in Wright called the disclosure of compensation grossly misleading and not of the level of candor required under §329. The attorney in Wright made the same disclosures Harris made in these cases. Both attorneys disclosed they had agreed to accept the total fee for legal services, when in fact, the attorney did not reveal in his Disclosure of Compensation that he shared his fee with any other person. The Disclosure ‘conflates the total amount he agreed to accept for his services, even though those amounts differ by several hundred dollars in each of the BK Billing Cases.’ The court in Wright was less concerned with the ethical ramifications of the fee sharing arrangement, citing 11 U.S.C. §504(a) and Rule 5.4(a) of the Oklahoma Rules of Professional Conduct which states, ‘a lawyer or law firm shall not share legal fees with a non-lawyer.’ The court was more concerned with the attorney’s ‘rather brazen’ position that the collection of a fee from his client that is split between himself and the financing company did not constitute the sharing of compensation. The Kentucky Rules of Professional Conduct on fee sharing are the same as those cited in the Wright case. SCR 3.130(5.4) states, ‘a lawyer or law firm shall not share legal fees with a non-lawyer.’ The Supreme Court commentary on the above Rule states, ‘the provisions of this Rule express traditional limitations on sharing of fees. These limitations are to protect a lawyer’s independence of judgment.’

“This Court is concerned with the fee splitting between Harris and FSF. There is no mention by Harris in the Disclosures regarding a portion of the fee going to FSF. This is particularly troubling since Harris is charging a higher fee to those debtors using the FSF contract, than those debtors who pay the entire fee prior to the filing of the Petition. Under the FSF contract, a debtor is charged $2,500 for attorney’s fees, when in fact Harris only receives 75% of that or $1,875. The Court determines that Harris’ Disclosures of Compensation are misleading and violate 11 U.S.C. §329.”

Finally, the Court determines that Harris’ Fee is Not Reasonable:

“This Court is charged with determining the reasonableness of fees charged by a debtor’s attorney pursuant to 11 U.S.C. §329(b). The Court must compare the reasonableness of the fee charged under the bifurcated contract and the fee charged under the traditional format of the full fee paid pre-petition. Any such analysis rests on, whether the debtor receives sufficient value from the bifurcated contract model to justify the increased cost. The U.S. Trustee undertook an analysis of Harris’ fees in Chapter 7 cases filed during 2019. During calendar year 2019, excluding Chapter 13 cases and any Chapter 7 case filed in which he used a bifurcated fee arrangement, Harris filed fifty-three Chapter 7 cases in the Western District of Kentucky. Harris consistently used a flat fee of $1,250. On his Form 2030, Compensation of Disclosure, Harris indicated that his services excluded ‘representation of the debtors in any dischargeability actions, judicial lien avoidances, relief from stay actions or any other adversary proceeding.’ This is the same exclusion Harris uses in his bifurcated fee contracts. As the U.S. Trustee noted, it appears that Harris is providing both sets of clients with the same services, but at an increased rate of $950 for those clients using the bifurcated fee arrangements. The only distinction between the two fee structures, other than the increased cost, is that in the bifurcated fee cases, the debtors in those cases were able to make payments over time, and, of course, FSF fees are added. The Court has not been provided with a justification by Harris for this $950 increase for services under the bifurcated fee contracts. Without an explanation, other than the convenience factor for debtors to pay over time, the increase is simply not justified.”

 

In re Baldwin, No.20-10009, 2021 WL 4592265 (W.D.Ky. Bankr. Oct. 5, 2021).