1 NOT FOR PUBLICATION 2 3 UNITED STATES BANKRUPTCY COURT 4 EASTERN DISTRICT OF CALIFORNIA 5 6 In re: Case No. 21-22404-A-11 7 PAR 5 PROPERTY INVESTMENTS, LLC, MF-2, UST-2 8 9 Debtor. MEMORANDUM 10 11
17 Argued and submitted on October 3, 2022 at Sacramento, California 18 Honorable Fredrick E. Clement, Bankruptcy Judge Presiding 19
20 Appearances: Iain A. Macdonald, Macdonald Fernandez LLP for Par 5 Property Investments, LLC; Loris 21 L. Bakken for Tracy Hope Davis, United States Trustee for Region 17 22
26 27 1 Chapter 11 debtors may employ lawyers at the expense of the 2 estate, provided they do not hold adverse interests. Debtor hired a 3 law firm to file a Subchapter V, Chapter 11 bankruptcy; a security 4 retainer was paid and was deposited into the firm’s trust account. 5 Post-petition and without court approval, the firm paid its own pre- 6 petition fees from the trust account. That transaction is avoidable. 7 Does the firm hold an interest adverse to the estate? 8 I. FACTS 9 A. Par 5 Investments Files Bankruptcy 10 Par 5 Property Investments, LLC (“Par 5 Investments”) is a 11 limited liability company. Its members are Joseph Francis Prach 12 (“Prach”) and by Jane Sluse. Statement of Financial Affairs Item No. 13 28, ECF No. 36. Par 5 Investments did business as Auburn Valley Golf 14 and Event Center in Auburn, California. It offered paying guests the 15 use of a 17-acre golf course, club house, pro-shop, and event center. 16 Par 5 Investments was under financial pressure. Its most vocal 17 and largest creditor was Sutherland Grantor Trust, Series IV (the 18 “Sutherland trust”). As is frequently the case, distrust between Par 19 5 Investments and Sutherland trust overshadowed Par 5 Investments 20 financial problems. 21 Par 5 Investments sought the assistance of Macdonald Fernandez 22 LLP and one of its partners, Iain Macdonald (“Macdonald”). Macdonald 23 is a named partner in Macdonald Fernandez LLP, which “specializes in 24 bankruptcy and related litigation.” Macdonald has upwards of 50 years 25 in practice experience and has represented debtors and creditors in 26 “large and complex bankruptcy cases.” First Interim Application for 27 Compensation 3:1-4, 7:21-26, ECF No. 224. In late June 2021, Par 5 1 filing a Subchapter V Chapter 11 bankruptcy and the parties signed a 2 fee agreement. As pertinent here, that agreement provided: 3 1. IDENTIFICATION OF PARTIES. This Legal Services Agreement (this “Agreement”) is made between MACDONALD 4 FERNANDEZ LLP, a California limited liability partnership (“we,” “us,” the “firm” and similar terms) and PAR 5 5 PROPERTY INVESTMENTS, LLC., a California Limited Liability Company (individually and collectively “you,” the “Client” 6 and similar terms... 7 2. LEGAL SERVICES TO BE PROVIDED. We will provide representation in a Subchapter V Chapter 11 bankruptcy to 8 be filed in the United States Bankruptcy Court for the Eastern District of California... 9 ... 10 5. SECURITY RETAINER; LIEN. You have agreed to provide a 11 retainer of $35,000.00 as an advance payment for attorney’s fee as well as costs and expenses, as well as the court’s 12 filing fee of $1,738.00 for a total retainer of $36,738.00. You have agreed to wire $10,000 to us today, June 25, 2021, 13 and the balance in the amount of $26,738.00 on Tuesday, June 29, 2021. We expect to file the case by the close of 14 business on that day. You hereby grant the firm a lien against all funds held as a retainer to secure the payment 15 of attorney’s fees, costs and expenses. The firm’s fees, costs and expenses will be charged against this retainer. 16 The retainer, as well as any future deposit, will be held in a trust account. You authorize us to use that fund to 17 pay fees and other charges as they are incurred. You acknowledge that the initial retainer is not an estimate of 18 total fees and charges, but rather an advance for security. If any funds remain on deposit at the conclusion of the 19 matter, the deposit will be applied to any unpaid fees and charges, and you will be responsible for any amount due 20 over and above the deposit or be entitled to a refund of any amount remaining. 21 ... 22 8. BILLING AND PAYMENT. Unless a bankruptcy case is 23 pending and active, the following terms apply: Our bills are due upon receipt and are past due ten (10) calendar 24 days after mailing... 25 WHEREFORE, by signing below, the parties agree to the foregoing terms and conditions. 26 Dated: June 25, 2021 PAR 5 PROPERTY INVESTMENTS, LLC 27 A California Limited Liability Company 1 By: _______/s/__________________ 2 Joseph Frank Prach, Managing Member 3 Dated: June 28, 2021 MACDONALD FERNANDEZ LLP 4 By: ________/s/__________________ 5 Iain Macdonald, Partner
6 PERSONAL GUARANTEE
7 JOSEPH FRANK PRACH (the “Guarantor”) hereby guarantees the indebtedness of PAR 5 PROPERTY INVESTMENTS, LLC, referred 8 to in this Legal Services Agreement, above. Guarantor agrees to be liable for said indebtedness and all amounts 9 due under the Agreement, including but not limited to attorney’s fees, costs, expenses and interest. Guarantor 10 waives notice of demand and presentment prior to enforcing 11 this Personal Guarantee.
12 Dated: June 25, 2021 _____________/s/___________________ Joseph Frank Prach 13 Legal Services Agreement, Exh. 1 to Macdonald Decl., ECF No. 275 14 (emphasis original and added). 15 On June 28, 2021, Par 5 Investments paid the firm $10,000 and 16 Prach paid the firm $27,538. Ex. To Macdonald Decl., Trust Account 17 Ledger p. 3, ECF No. 313. Those funds were deposited into Macdonald 18 Fernandez LLP’s trust account. 19 On June 29,2021, Par 5 Investments filed a Subchapter V, Chapter 20 11 bankruptcy. Vol. Pet., ECF No. 1. It did so by skeletal petition. 21 On the date of the petition, Macdonald Fernandez LLP held $37,538.00 22 in its trust account. 23 On the same day, Macdonald Fernandez LLP sent Par 5 Investments 24 an invoice for services rendered during the four days prior to filing 25 its Chapter 11 petition. Ex. 3 pp. 11-13 to Reply by Macdonald 26 Fernandez LLP, ECF No. 267. The amount of that invoice was $7,866.50. 27 No costs (including the filing fee) were included. 1 Walter Dahl was appointed, and remains, the Subchapter V trustee. 2 Notice, ECF No. 7. 3 On July 9, 2021, without seeking court approval, Macdonald 4 Fernandez LLP paid itself $7,866.50 from the trust account in full 5 satisfaction of the June 21, 2021, invoice. Ex. to Macdonald Decl., 6 Trust Account Ledger p. 3, ECF No. 313. After the payment, Macdonald 7 Fernandez LLP held $29,671.50 in trust for Par 5 Investments. 8 B. Macdonald Fernandez Seeks Employment 9 On July 14, 2021, Macdonald Fernandez LLP sought approval to be 10 employed as counsel for the debtor. Appl. to Employ, ECF No. 24. 11 That application stated: 12 Other than as described herein, neither I, nor Macdonald Fernandez LLP, nor any member or employee of the Firm, has 13 any connection with the Debtor in Possession; its known employees, creditors, attorneys or accountants; the United 14 States Trustee, or any person employed with the Office of the United States Trustee; nor holds an interest adverse to 15 the estate, and is a “disinterested person” within the meaning of Bankruptcy Code Section 101(14) and as required 16 by Bankruptcy Code Section 327(a). 17 Id. at 2:16. 18 The application was supported by Macdonald’s declaration. In 19 support of the application, Macdonald stated, “The Firm does not have 20 a prepetition claim against the estate.” Macdonald decl. 1:25, ECF 21 No. 25. Macdonald represented: “The firm received the sum of $35,0001 22 from the Debtor’s principal, Joseph Francis Prach, as an advance 23 against fees incurred by the firm, and the firm, upon applying to the 24
25 1 Both the source of payment and the amount are incorrect. As to the source of payment, the most reliable evidence is MacDonald Fernandez LLP’s Client 26 Ledger. Ex. A, Trust Account Ledger p. 3 to Macdonald Decl., ECF No. 313. That shows $10,000 paid by the debtor and $27,538.00 paid by Prach. The 27 amount is also incorrect. The amount paid was $37,538.00, not $35,000. The difference appears to be $1,738 collected for the filing fee and $800 1 court for compensation, will request authority to reimburse the 2 principal from amounts received from the Debtor’s estate.” Id. at 3 2:3-5. Neither the application, nor the declaration, mention a 4 personal guarantee of Macdonald Fernandez LLP’s fees and/or costs. 5 Moreover, Macdonald’s fee agreement was not filed with the court. 6 Neither the application, nor the declaration in support, mention that 7 post-petition and immediately prior to filing the application for 8 employment Macdonald Fernandez LLP paid itself $7,866.50. Ex. to 9 Macdonald Decl., Trust Account Ledger p. 3, ECF No. 313. 10 On July 22, 2021, the court approved Macdonald Fernandez LLP’s 11 employment. In the pertinent part, the order stated: 12 2. No compensation is permitted except upon court order following application pursuant to Bankruptcy Code Section 13 330(a). 14 ... 15 4. All funds received in connection with this matter for post-petition services, regardless or whether denominated 16 as a retainer or as a non-refundable flat fee, are deemed to be an advance payment of fees and to be property of the 17 estate. 18 5. Funds that are deemed to constitute an advance payment of fees shall be maintained in a trust account with an 19 authorized depository, which account may be either a separate interest[-]bearing account or a trust account 20 containing commingled funds. Withdrawals are permitted only after approval of an application for compensation and after 21 the Court issues an order authorizing disbursement of a specific amount. 22 Order, ECF No. 32 (emphasis added). 23 C. Par 5 Investments Stipulates to Its Removal from Possession 24 On July 16, 2021, between the date Macdonald Fernandez LLP filed 25 its application to be employed and the date the court approved that 26 employment, Macdonald made a strategic move to increase trust, and 27 reduce hostilities, between the debtor and Sutherland trust; he 1 engineered an emergency stipulation to remove debtor from possession 2 of the estate and allow trustee Dahl to assume the expanded trustee 3 duties described in Subchapter V of Chapter 11. Stip., ECF No. 29 (11 4 U.S.C. § 1183(b)(5) describing the expanded powers of the trustee). 5 That stipulation was approved first on an emergency and, later, on a 6 final basis. Orders, ECF Nos. 30, 58. 7 On July 27, 2021, with Macdonald Fernandez LLP’s assistance, Par 8 5 Investments filed the remainder of the schedules and statements 9 required. Those schedules revealed that Prach was a co-debtor for no 10 fewer than 24 of Par 5 Investment’s scheduled debts. Schedule H, ECF 11 No. 36. Consistent with the employment application, those filings show 12 that Macdonald Fernandez LLP received $35,000. Statement of Financial 13 Affairs, Item No. 11, ECF No. 36; Disclosure of Compensation, ECF No. 14 36. But the representations are inconsistent as to the source of 15 those payments. Compare Statement of Financial Affairs, Item No. 11, 16 ECF No. 36 ($35,000 paid by Prach) with Disclosure of Compensation, 17 ECF No. 36 ($35,000 paid by the debtor). 18 On August 9, 2021, Macdonald Fernandez LLP generated another 19 invoice for services rendered and costs incurred, this time in the 20 amount of $30,156.50 (including the $1,738.00 filing fees). Ex.3 pp. 21 14-23 to Reply by Macdonald Fernandez LLP, ECF No. 267. On the same 22 day and without court approval, Macdonald Fernandez LLP paid itself 23 $29,671.50 from the trust account for services rendered. After 24 deducting that amount, Macdonald Fernandez LLP held no funds in trust 25 for Par 5 Investments and Par 5 Investments owed the firm an 26 additional $485.00. Ex. A, Trust Account Ledger p. 3 to Macdonald 27 Decl., ECF No. 313. 1 invoice for services rendered and costs incurred, this time in the 2 amount of $7,423.00. Ex. 3 pp. 134-23 to Reply by Macdonald Fernandez 3 LLP, ECF No. 267. The firm requested no costs.2 4 On September 16, 2021, Prach, personally, paid Macdonald 5 Fernandez LLP $7,423.00. Reply by Macdonald Fernandez LLP 2:23, 4:5- 6 10, ECF No. 267. Those funds were not deposited into Macdonald 7 Fernandez’s trust account but were applied directly to the firm’s 8 outstanding invoice. See Ex. A, Trust Account Ledger p. 3, to 9 Macdonald Decl., ECF No. 313 (no activity after August 10, 2021). 10 On September 24, 2021, Macdonald Fernandez LLP, filed its first 11 supplemental disclosure indicating that Prach, personally, paid it an 12 additional $7,423.00 for fees and costs. Disclosure of Compensation, 13 ECF No. 105. 14 Between November 2021, and January 2022, Macdonald Fernandez 15 generated three more invoices, aggregating $11,711.30. Ex. 3 pp. 28- 16 35 to Reply by Macdonald Fernandez LLP, ECF No. 267. 17 On January 11, 2022, Prach paid Macdonald Fernandez LLP 18 $12,196.30.3 Second Supplemental Disclosure of Compensation, ECF No. 19 171. That amount was not deposited into Macdonald Fernandez’s trust 20 account but applied directly to outstanding invoices. 21 On January 14, 2022, Par 5 Investments, acting through Macdonald 22 Fernandez LLP, filed its Second Supplemental Disclosure of 23 Compensation indicating that Prach, personally, paid it an additional 24 $12,196.30 for fees and costs. Disclosure of Compensation, ECF No. 25 171. 26 Between February and June 2022, Macdonald Fernandez LLP generated 27 2 The $485 unpaid from the August 2021, invoice carried forward unpaid. 1 five invoices to Par 5 Investments, aggregating $43,437.49. Ex. 3 pp. 2 37-54 to Reply by Macdonald Fernandez LLP, ECF No. 267. That amount 3 remains unpaid. 4 D. MacDonald Fernandez LLP Applies for Fees and Costs 5 In April 2022, Macdonald Fernandez LLP filed its First Interim 6 Application for Compensation and Reimbursement of Expenses. First 7 Interim Appl. Comp., ECF No. 224. The application sought $40,202.50 8 in fees and $1,738.00 in costs for an aggregate of $41,940.50. Id. at 9 2:11-17. The firm sought compensation for 94.4 hours by three 10 different billers. Id. at 6:20. Timekeepers who worked on the case 11 were: (1) Iain A. Macdonald, partner: $690/hour; (2) Daniel Vaknin, 12 associate: $335/hour; and (3) Brenda Johnson, paralegal: $175/hour. 13 Id. at 5:5-8. The application did not specify the period for which 14 fees were sought, Application, ECF No. 224, but time records submitted 15 in support of the application show time expended from June 29, 2021 16 (the day the petition was filed) through August 4, 2021 (the date the 17 court gave final approval for removal of the debtor from possession). 18 Order, ECF No. 58.4 The application stated: 19 Prior Compensation. There have been no prior requests or awards for compensation or reimbursement of expenses. The 20 Firm [Macdonald Fernandez LLP] held unapplied fees of $29,648.50, much of which was from the Debtor’s principals 21 or other entities on the petition date.” Id. at 2:8-10.5 22 Neither the application, nor supporting documentation, mentioned: (1) 23
24 4 Apparently, counsel for the debtor believes that it may not collected fees after the debtor is removed from possession in a Subchapter V Chapter 11 25 case. Mem. P.& A. 3:15-19, ECF No. 311. Debtor’s counsel citing Lamie v. U.S. Trustee (In re Lamie), 540 U.S. 526 (2004) (Chapter 7 case). Some 26 courts have so ruled. In re NIR W. Coast, Inc., 638 B.R. 441 (Bankr. E.D. Cal. 2022). This court need not reach that question. 27 5 The court is unclear as to the meaning of “unapplied fees of $29,648.50. It does not match the fee request, $41,940.50, less the two payments: $7,866.50 1 the balance of Macdonald Fernandez LLP’s trust account; (2) the firm’s 2 post-petition payment of pre-petition fees $7,866.50 from trust 3 account funds; or (3) the firm’s payment of August 9, 2021, invoice 4 (covering June 30, 2021, to July 30, 2021) in the amount of $29,671.50 5 from trust account funds. Neither the application, nor supporting 6 documents, disclose Prach’s personal guarantee of Macdonald Fernandez 7 LLP’s fees; additionally, those documents do not disclose the amount 8 Macdonald Fernandez LLP is holding in trust. 9 In response, trustee Dahl raised concerns about the impact of 10 Macdonald Fernandez LLP’s fees on performance of the plan, as well as 11 the amount of the fees and the period of time for which compensation 12 was sought. Resp., ECF No. 235. At the hearing on the motion, 13 trustee Dahl augmented his concerns about Macdonald Fernandez LLP’s 14 fees, informing the court that: (1) Prach had personally guaranteed 15 fees due Macdonald Fernandez LLP in arising from the Par 5 16 Investment’s bankruptcy and that the personal guarantee had not been 17 appropriately disclosed in the employment application; (2) that Prach 18 paid Macdonald Fernandez LLP for Par 5 Investment’s post-petition 19 services without court approval; and (3) accounting discrepancies 20 existed in the Macdonald Fernandez LLP’s representations. Tr. Hr’g. 21 on Appl. Compensation at 6:17-7:9, 8:2-9:3, 10:2-12:8, 22:23-23:6, May 22 23, 2022, ECF No. 330. The colloquy between the court and trustee 23 Dahl proceeded as follows: 24 THE COURT: Thank you. Was that the additional problem, Mr. Dahl? 25 MR. DAHL: Yes, Your Honor. and I – 26 THE COURT: Has this— 27 MR. DAHL: --there’s a – there’s this –there’s a relatively 1 THE COURT: Oh. 2 MR. DAHL: -- which is, well, actually it may not be minor. But it’s hard to understand how much money the Macdonald 3 Fernandez firm has or had upon the filing. The Rule 2016 statement that came with the schedules, it’s the last page 4 of the schedules, docket 36, indicates the firm was paid $35,000. The application to employee [sic] the firm 5 indicates that the firm had on deposit $26,843, and that’s docket 25. The statement of financial affairs docket, item 6 number 36 at question 11, discloses that the firm got a payment of $10,0000, which followed by a payment of $25,000 7 for a total of [$]35[,000], which matches the Rule 2016(b) statement. 8 The – this application, the fist [sic] application states 9 that the firm has or had, $29,648.50 and –- 10 ... 11 MR. DAHL: Oh, and finally, the firm’s most recent statement issued to Frank Prock [sic], which I have a copy of, is 12 dated May 22, 2022, and it shows a trust balance of zero dollars. 13 Id. at 10:2-11:3. 14 Based on the concerns raised by the Subchapter V trustee the court 15 denied the Application for Compensation without prejudice. Order, ECF 16 No. 252. 17 E. Macdonald Fernandez LLP Withdraws the Denied Fee 18 Application 19 Almost two weeks after the court denied the application for 20 compensation, Macdonald Fernandez LLP filed a “Notice of Withdrawal of 21 First Interim Application for Approval of Compensation.” Notice, ECF 22 No. 255. 23 In response, trustee Dahl outlined areas of concern arising 24 related to Macdonald Fernandez LLP’s receipt and handling of retainers 25 in this case: (1) the amount of the pre-petition retainer; (2) source 26 of the pre-petition retainer; (3) post-petition invoices; (4) post- 27 petition payments; (5) supplement Rule 2016(b) statements; and (6) trust accountant balance as of May 9, 2022. Reply, ECF No. 261. 1 Macdonald Fernandez LLP filed a reply to trustee Dahl’s concerns. 2 Reply, ECF No. 267. The reply answered some of Dahl’s questions and, 3 in other areas, admitted accounting errors. Resp., ECF No. 267. It 4 stated that payments to Macdonald Fernandez LLP by, or on behalf of, 5 Par 5 Investments aggregated $57,157.30, pre-petition and post- 6 petition. Of that amount $37,538.00 ($10,000 by Par 5 Investments and 7 $27,538 by Frank Prach) was paid pre-petition. Id. at 2:21-24. The 8 remainder, $19,619.30, was paid post-petition by Prach. Id. 9 Macdonald Fernandez LLP explained that it sent Par 5 Investments 10 and/or Prach 1 pre-petition invoice and 10 post-petition invoices. 11 Id. at 3:21-25. Most telling was Macdonald Fernandez LLP’s response 12 to a zero trust account balance. Dahl’s Reply raised the following 13 concern: “Trust Account. According to the invoice dated 9-May-2022, 14 no monies are currently held in a trust account which apparently 15 conflicts with the Order authorizing employment [Docket # 32].” Reply 16 2:16-17, ECF No. 261. Macdonald Fernandez LLP responded: “This is 17 correct. The invoices do not show monies held in a trust account 18 because no funds received for post-petition services were property of 19 the estate, having been paid by Mr. Prach.” Id. at 4:13-19. 20 F. Chapter 11 Plan 21 Prior to plan confirmation, trustee Dahl sold most of the 22 debtor’s real and personal property, e.g., 17-acre golf course, 23 resolving most of the claims of secured creditors. 24 Consistent with the mandates of Subchapter V of Chapter 11, Par 5 25 Investments--acting through Macdonald Fernandez LLP--proposed, and 26 this court confirmed, a plan of reorganization. Plan, ECF Nos. 233, 27 1 302.6 As of the date of confirmation, trustee Dahl held approximately 2 $306,000 and hoped to recover additional funds by sale of a Type 57 3 liquor license and avoidance of preferential transfers. The plan 4 provided: (1) assets of the estate would remain under the supervision 5 and control of trustee Dahl, and not revest in the debtor, Plan § 6 7.01, ECF No. 233; (2) Dahl would continue to liquidate Par 5 7 Investment’s assets, id.; and (3) that it would pay administrative 8 claimants and, to the extent of available funds, priority creditors. 9 Id. at 2.01-4.01. 10 G. PROCEDURE 11 Troubled by the information received at the hearing on Macdonald 12 Fernandez’ first interim fee application, this court issued two orders 13 to show cause to Macdonald Fernandez LLP for revocation of the 14 employment order. The first Order to Show Cause for failure to 15 disclose Frank Prach’s personal guarantee of Par 5 Investment’s legal 16 fees arising from its bankruptcy. Order to Show Cause, ECF No. 271. 17 The second Order to Show Cause for failure to obtain leave of court 18 prior to withdrawing funds from Macdonald Fernandez LLP’s trust 19 account. 20 Thereafter, the U.S. Trustee filed a motion to “review and 21 return” attorney’s fees paid by the debtor and by Prach. Mot. to 22 Review and Return Attorney’s Fees, ECF No. 327. The United States 23 Trustee cited three bases for its motion: (1) failure to disclose 24 Prach’s personal guarantee; (2) Macdonald Fernandez LLP’s application 25 of trust funds to outstanding invoices without leave of court; and (3) 26 violation of ethical standards. 27 6 In Subchapter V of Chapter 11, only the debtor may propose a plan. 11 1 II. JURISDICTION 2 This court has jurisdiction, 28 U.S.C. §§ 1334, 157(a), (b)(1); 3 General Order No. 182 of the U.S. District Court for the Eastern 4 District of California; this is a core proceeding in which this court 5 may enter final orders and judgment, 28 U.S.C. § 157(b)(2)(A)-(B); In 6 re Castellucci, 2007 WL 7540955 * 5 (9th Cir. BAP July 26, 2007); In 7 re Miller, 620 B.R. 637, 640 (Bankr. E.D. Cal. 2020) (employment and 8 compensation of professionals). 9 III. LAW 10 A. Employment 11 Professionals employed to assist the debtor in possession and/or 12 trustee are regulated by the bankruptcy code and rules. 13 Section 327 of the code describes who is eligible to be employed 14 to assist the debtor and/or trustee in bankruptcy. 15 Except as otherwise provided in this section, the trustee, with the court's approval, may employ one or more 16 attorneys, accountants, appraisers, auctioneers, or other professional persons, that do not hold or represent an 17 interest adverse to the estate, and that are disinterested persons, to represent or assist the trustee in carrying out 18 the trustee's duties under this title. 19 11 U.S.C. § 327(a). 20 “[D]isinterested” is a defined term. 21 The term “disinterested person” means a person that-- 22 (A) is not a creditor, an equity security holder, or an insider; 23 (B) is not and was not, within 2 years before the date of 24 the filing of the petition, a director, officer, or employee of the debtor; and 25 (C) does not have an interest materially adverse to the 26 interest of the estate or of any class of creditors or equity security holders, by reason of any direct or 27 indirect relationship to, connection with, or interest in, the debtor, or for any other reason. 1 11 U.S.C. § 101(14). 2 Adverse interest is not a defined term but has a well-accepted 3 meaning. 4 A generally accepted definition of “adverse interest” is the (1) possession or assertion of an economic interest 5 that would tend to lessen the value of the bankruptcy estate; or (2) possession or assertion of an economic 6 interest that would create either an actual or potential dispute in which the estate is a rival claimant; or (3) 7 possession of a predisposition under circumstances that create a bias against the estate. 8 In re Sundance Self Storage-El Dorado LP, 482 B.R. 613, 625–26 (Bankr. 9 E.D. Cal. 2012), citing Dye v. Brown (In re AFI Holding, Inc.) (AFI 10 Holding I), 355 B.R. 139, 148–49 (9th Cir. BAP 2006). 11 Section 327 is implemented by Rule 2014, which governs 12 applications for employment; in the pertinent part, that rule 13 provides: 14 The application shall state the specific facts showing the 15 necessity for the employment, the name of the person to be employed, the reasons for the selection, the professional 16 services to be rendered, any proposed arrangement for compensation, and, to the best of the applicant's 17 knowledge, all of the person's connections with the debtor, creditors, any other party in interest, their respective 18 attorneys and accountants, the United States trustee, or any person employed in the office of the United States 19 trustee. The application shall be accompanied by a verified statement of the person to be employed setting forth the 20 person's connections with the debtor, creditors, any other party in interest, their respective attorneys and 21 accountants, the United States trustee, or any person employed in the office of the United States trustee. 22 Fed. R. Bankr. P. 2014(a) (emphasis added). 23 As one court thoughtfully articulated the standards in Rule 24 2014(a): 25 The disclosure requirements of Bankruptcy Rule 2014(a) are 26 strictly applied with the burden on the applicant to come forward and make full, candid, and complete disclosure of 27 all connections with the debtor, debtor in possession, insiders, creditors, and parties in interest regardless of 1 omitted). ‘It is the bankruptcy court that determines whether a professional's connections render him or her 2 unemployable under § 327(a)— not the other way around.’ 3 In re NIR W. Coast, Inc., 638 B.R. 441, 449 (Bankr. E.D. Cal. 2022). 4 “[T]he need for professional self-scrutiny and avoidance of 5 conflicts of interest does not end upon appointment.” Rome v. 6 Braunstein, 19 F.3d 54, 57-58 (1st Cir. 1994); In re Sundance Self 7 Storage-El Dorado LP, 482 B.R. 613, 625, fn. 32 (Bankr. E.D. Cal. 8 2012). 9 B. Compensation 10 Like employment, compensation of estate professionals is also 11 regulated by the bankruptcy code. 12 After notice to the parties in interest and the United 13 States Trustee and a hearing, and subject to sections 326, 328, and 329, the court may award to a trustee, a consumer 14 privacy ombudsman appointed under section 332, an examiner, an ombudsman appointed under section 333, or a professional 15 person employed under section 327 or 1103-- 16 (A) reasonable compensation for actual, necessary services rendered by the trustee, examiner, ombudsman, professional 17 person, or attorney and by any paraprofessional person employed by any such person; and 18 (B) reimbursement for actual, necessary expenses. 19 11 U.S.C. § 330(a)(1) (emphasis added). 20 Section 330 is implemented by Rule 2016, which governs 21 applications for compensation; in the pertinent part that rule 22 provides: 23 An application for compensation shall include a statement 24 as to what payments have theretofore been made or promised to the applicant for services rendered or to be rendered in 25 any capacity whatsoever in connection with the case, the source of the compensation so paid or promised... 26 Fed. R. Bankr. P. 2016(a) (emphasis added). 27 Court approval is mandatory for professionals seeking 1 compensation from the estate. 11 U.S.C. § 330(a); Fed. R. Bankr. P. 2 2016(a); In re Knudsen Corp., 84 B.R. 668, 672 (B.A.P. 9th Cir. 1988) 3 (“professionals must file applications for compensation which are 4 subject to a noticed hearing prior to allowance or payment of fees”). 5 C. Remedies for Noncompliance 6 This court has discretion to determine an appropriate remedy as 7 it considers: (1) counsel’s failure to disclose connections with the 8 debtor, creditors, and/or parties in interest under Rule 2014(a); (2) 9 counsel’s failure to seek an order approving employment in a timely 10 fashion; (3) counsel’s inaccurate representations with respect to the 11 application for employment; and (4) counsel’s failure to seek leave of 12 court before applying funds held in trust. Compare In re Park-Helena 13 Corp., 63 F.3d 877, 880-882 (9th Cir. 1995) (failure to disclose all 14 connections is, itself, a basis to deny all compensation) with In re 15 Film Ventures Intern, Inc., 75 B.R. 250, 253 (9th Cir. BAP 1987) 16 (bankruptcy court may excuse original failure to disclose 17 connections); see also, In re Atkins, 69 F.3d 970, 975-976 (9th Cir. 18 1995) (exceptional circumstances justifying retroactive employment); 19 In re Lewis, 113 F.3d 1040 (9th Cir. 1997) (failure to seek timely 20 employment and failure to seek approval of fees). 21 The court’s authority to award or deny compensation is inherent 22 to the court’s role in employing and compensating professionals 23 employed by the estate. In re Lewis, 113 F.3d 1040 (9th Cir. 1997); 24 In re Park-Helena Corp., 63 F.3d 877, 882 (9th Cir. 1995) (court had 25 discretion to deny all fees where the attorney failed to disclose a 26 $150,000 pre-petition retainer from the debtor’s principal 27 shareholder). 1 monies paid to an attorney in connection with representation of the 2 debtor. In re Lewis, 113 F.3d 1040 (9th Cir. 1997). The court need 3 not review fees for reasonableness, 11 U.S.C. § 329. That authority 4 exists without regard to the source of the payment. Id.; In re 5 Walters, 868 F.2d 665, 668 (4th Cir. 1989) (“[A]ny payment made to an 6 attorney for representing a debtor in connection with a bankruptcy 7 proceeding is reviewable by the bankruptcy court notwithstanding the 8 source of payment”); In re Land, 943 F.2d 1265, 1267 (10th Cir. 1991); 9 In re 38-36 Greenville Ave LLC, No. 21-2164, 2022 WL 1153123, at * 4 10 (3d Cir. Apr. 19, 2022), cert. denied sub nom. Kevin Kervang Tung, 11 P.C. v. Forman, No. 21-1605, 2022 WL 4652203 (U.S. Oct. 3, 2022). 12 IV. DISCUSSION 13 A. Violations of the Bankruptcy Code and Federal Rules of Bankruptcy Procedure 14 1. Failure to make full and accurate disclosures 15 At least three flavors of disclosure errors exist. At the 16 outset, the application fails to mention the third-party guarantee by 17 Frank Prach. Rule 2014 specifically requires that the application 18 describe “any proposed arrangement for compensation.” Third-party 19 guarantees are not necessarily disqualifying interests under § 327 but 20 must be disclosed. In re Sundance Self Storage-El Dorado LP, 482 B.R. 21 613, 632 (Bankr. E.D. Cal. 2012) (“Thus, apparently [debtor’s counsel] 22 was relying solely on [the guarantor], and not on the debtor, for any 23 compensation over and above the amount of his retainer”). Since the 24 fee agreement was not appended to the application, the court was 25 deprived of the opportunity of confirming Macdonald Fernandez’s 26 representations. 27 Additionally, the declaration offered in support of the 1 application states that “[Macdonald Fernandez] does not have a pre- 2 petition claim against the estate.” Macdonald decl. 1:25-28, ECF No. 3 25. This is not true; the firm was owed $7,886.50 on the petition 4 date. Ex. 3 pp. 11-13 to Reply by Macdonald Fernandez LLP, ECF No. 5 267. Historically, a debt owed by the bankrupt debtor to proposed 6 counsel is a disqualifying interest. In re Sundance Self Storage-El 7 Dorado LP, 482 B.R. 613, 631 (Bankr. E.D. Cal. 2012). The Small 8 Business Reorganization Act (“SBRA”) carved out a small exception to 9 this rule. “Notwithstanding section 327(a) of this title, a person is 10 not disqualified for employment under section 327 of this title, by a 11 debtor solely because that person holds a claim of less than $10,000 12 that arose prior to commencement of the case.” 11 U.S.C. § 1195. But 13 the SBRA did not alter Rule 2014(a)’s duty of disclosure as to “all of 14 the person’s connections with the debtor.” Moreover, even if 15 disclosed, the existence of a prepetition debt between the bankrupt 16 debtor and proposed counsel aggregated with other connections may be a 17 disqualifying interest. 11 U.S.C. § 1195 (an applicant is not 18 disqualified “solely” by virtue of a prepetition debt). 19 Finally, the source and amount of the retainer on the date of the 20 petition was inaccurate. As to the source of payment, the application 21 represents that $35,000 was paid by Frank Prach. Macdonald decl. 2:3- 22 5, ECF No. 25. In reality, $10,000.00 of the retainer was paid by the 23 debtor and $27,538.00 by Prach. Ex. A, Trust Account Ledger p. 3 to 24 Macddonald Decl., ECF No. 313. The amount of the retainer was also 25 inaccurate. Macdonald Fernandez represented that it held $26,843.00 26 at filing. Macdonald decl. 1:25-27, ECF No. 25. Actually, the firm 27 held $37,538.00 on the date of the petition. Ex. A, Trust Account 1 Ledger p. 3 to Macdonald Decl., ECF No. 313.7 2 2. Adverse interest 3 Macdonald Fernandez held an interest adverse to the estate by 4 virtue of its post-petition payment of Par 5 Investments prepetition 5 debt ($7,866.50) to it. Because the law firm had not drawn down the 6 retainer prior to the filing of the Par 5 Investment bankruptcy 7 petition, the entire $37,538.00 was property of the estate.8 In re 8 Woodcraft Studios, Inc., 464 B.R. 1, 14 (N.D. Cal. 2011); Barron v. 9 Countryman, 432 F.3d 590, 595-596 (5th Cir. 2005). Section 549 10 provides: 11 (a) Except as provided in subsection (b) or (c) of this section, the trustee may avoid a transfer of property of 12 the estate-- 13 (1) that occurs after the commencement of the case; and 14 (2)(A) that is authorized only under section 303(f) or 542(c) of this title; or 15 (B) that is not authorized under this title or by the 16 court. 17 11 U.S.C. § 549(a) (emphasis added). 18 Moreover, since § 1195 excepted Macdonald Fernandez LLP’s pre- 19 petition debt as a disqualifying interest, 11 U.S.C. § 327, the firm 20 could merely have sought leave of court to withdraw funds from its 21
22 7 There are two layers of errors here. First, the applicant appears to represent that the pre-petition amounts due the firm had been deducted from 23 its trust account prior to filing the petition. That is not true. The pre- petition fees ($7,866.50) were paid from the applicant’s trust account on 24 July 9, 2021, the filing fees ($1,738.00) were deducted from the applicant’s trust account on August 10, 2021. It is unclear when the LawPay fee ($800.00) was paid. Second, even if those amounts had been deducted from the 25 trust account before the petition was filed, the applicant’s math is incorrect; the amount in trust would have been $27,133.50 ($37,538.00 less 26 pre-petition fees $7,866.00 less filing fees $1,738.00 less LawPay fee $800). Reply by Macdonald Fernandez LLP 2:7-10, 267. 27 8 Macdonald Fernandez could have sought court authority for payment of the prepetition fees under 11 U.S.C. § 330. In re Busetta-Silvia, 314 B.R. 218 1 trust account. 11 U.S.C. § 330; In re Busetta-Silvia, 314 B.R. 218 2 (10th Cir. BAP 2004) (Chapter 13). Had it done so, the firm would 3 have avoided the jaws of 11 U.S.C. § 549. But it did not do so and, 4 as a result, created an adverse interest in the form of a plausible, 5 unresolved avoidance action. 6 Unresolved avoidance actions preclude employment of the involved 7 professional. In re Dexter Distrib. Corp., No. BAP AZ-09-1386MKKIJU, 8 2010 WL 6466583, at * 7 (B.A.P. 9th Cir. Oct. 21, 2010) (preference 9 action); In re Triple Star Welding, Inc., 324 B.R. 778, 783 (B.A.P. 10 9th Cir. 2005), abrogated by In re AFI Holding, Inc., 530 F.3d 832 11 (9th Cir. 2008). 12 Here, between the date of the petition and the application for 13 employment Macdonald Fernandez deducted prepetition fees from its 14 trust account. It did so without authorization; that payment was not 15 disclosed and would be avoidable. 16 Any argument that advanced court approval was unnecessary for 17 trust monies paid by a third-party, i.e., Frank Prach, is foreclosed. 18 Not less than $10,000 was paid to Macdonald Fernandez by Par 5 19 Investments. Moreover, longstanding circuit law applies the approval 20 of court requirement of § 330 trust funds paid by a third-party on 21 behalf of the debtor. In re Lewis, 113 F.3d 1040 (9th Cir. 1997). 22 3. Payment without court approval 23 On four occasions post-petition Macdonald Fernandez affirmatively 24 paid itself from the trust account or received funds from Prach 25 without court approval. A professional must obtain court approval 26 prior to accepting payment. 11 U.S.C. § 330 (after notice “the court 27 may award” compensation and expenses); In re Woodcraft Studios, Inc., In re Knudsen Corp 1 (B.A.P. 9th Cir. 1988). Circuit law authorizes the court to deny 2 compensation for violation of the employment or compensation statutes. 3 The Bankruptcy Code contains a number of provisions (e.g., §§ 327, 329, 330, 331) designed to protect the debtor from 4 the debtor's attorney. See, e.g., In re Walters, 868 F.2d 665, 668 (4th Cir.1989) (noting that § 329 and Rule 2017 5 are designed to protect the creditors and the debtor against overreaching by attorney). As a result, several 6 courts have recognized that the bankruptcy court has broad and inherent authority to deny any and all compensation 7 when an attorney fails to meet the requirements of these provisions... 8 We agree with these courts, and so we have little 9 difficulty in rejecting [debtor’s counsel’s] argument that the bankruptcy court’s disgorgement order must be reversed 10 because the court made no findings of excessiveness under § 329. 11 In re Lewis, 113 F.3d 1040, 1045 (9th Cir. 1997) (emphasis 12 added). 13 Moreover, insofar as Macdonald Fernandez removed the $37,538.00 14 from its own trust account, the firm violated Rule of Professional 15 Conduct 1.15. In the pertinent part, that rule provides: 16 (a) All funds received or held by a lawyer or law firm for the benefit of a client, or other person to whom the lawyer 17 owes a contractual, statutory, or other legal duty, including advances for fees, costs and expenses, shall be 18 deposited in one or more identifiable bank accounts labeled “Trust Account” or words of similar import, maintained in 19 the State of California, or, with written consent of the client, in any other jurisdiction where there is a 20 substantial relationship between the client or the client's business and the other jurisdiction. 21 ... 22 (c) Funds belonging to the lawyer or the law firm shall not 23 be deposited or otherwise commingled with funds held in a trust account except: 24 ... 25 (2) funds belonging in part to a client or other person 26 and in part presently or potentially to the lawyer or the law firm, in which case the portion belonging to 27 the lawyer or law firm must be withdrawn at the earliest reasonable time after the lawyer or law firm's interest in that portion becomes fixed 1 client or other person disputes the lawyer or law firm's right to receive a portion of trust funds, the 2 disputed portion shall not be withdrawn until the dispute is finally resolved. 3 Cal. Rule Prof. Conduct 1.15(a),(c) (emphasis added). 4 While Rule 1.15(c) does not specifically define the word “fixed,” 5 commentators make the issue clear: 6 When attorney's interest “becomes fixed”: No legal criteria 7 have been established to determine when an attorney's interest in funds held in a trust account becomes “fixed.” 8 Comment: An attorney's interest in trust account funds may 9 be earned (after performing the legal services and having sent a billing), but not yet “fixed,” because CRPC 10 1.15(c)(2) (formerly CRPC 4-100(A)(2)) requires the lawyer to maintain any fees not yet approved by the client or 11 disputed on deposit until they are “fixed.” 12 By implication, an attorney's interest in trust account funds is “fixed” when: 13 [1] the client expressly approves the attorney's 14 interest in a certain amount of the trust funds (e.g., by expressly approving a billing or an accounting of 15 the funds setting forth the amount of fees earned by the attorney) (see Cal. State Bar Form.Opn. 2006-171); 16 or 17 [2] the attorney and client agree to the amount of the attorney's interest following a dispute; or 18 [3] the amount of the attorney's interest has been set 19 forth in a civil judgment, court order or binding arbitration award. 20 Mark L. Tuft et al., California Practice Guide: Professional 21 Responsibility § 9:162.1-.2 (Rutter Group 2021) (emphasis added). 22 That source continues: 23 Definition by agreement: In the absence of a statute 24 specifically providing for attorney fees, attorney and client are free to agree to the “measure and mode” of 25 attorney compensation. Consequently, the attorney and client may prescribe when the attorney's interest in earned 26 fees will “become fixed” for purposes of CRPC 1.15(c)(2) (formerly CRPC 4-100). [See CCP § 1021]. 27 Id. at § 9:162.3 (emphasis added). 1 Moreover, 11 U.S.C. § 330 is such a statute defining when 2 Macdonald Fernandez’ fees were “fixed” within the meaning of Rule 3 1.15(c). 4 Here, on four separate occasions Macdonald Fernandez LLP received 5 payment without court approval: (1) July 9, 2021: $7,866.50 (monies 6 withdrawn from trust account); (2) August 10, 2021: $29,671.50 (monies 7 withdrawn from trust account); (3) September 16, 2021: $7,423.00 8 (application of monies received from Frank Prach without deposit into 9 the trust account); and (4) January 14, 2022: $12,196.30 (application 10 of monies received from Frank Prach without deposit into the trust 11 account). 12 B. Remedy 13 In this case, the facts require complete disgorgement of all 14 funds received. First, the existence of a facially plausible 15 avoidance action, 11 U.S.C. § 549, results in a per se 16 disqualification. In re Dexter Distrib. Corp., No. BAP AZ-09- 17 1386MKKIJU, 2010 WL 6466583, at * 8 (B.A.P. 9th Cir. Oct. 21, 2010) 18 (preference action). 19 Second, even if the court had discretion in this case, it would 20 not exercise it in favor of a lesser remedy. From the applicant’s 21 long years before the bar and sophistication, the court infers 22 knowledge of the impropriety of his actions and, in turn, willfulness. 23 Willful disregard of fiduciary obligations weighs in favor of the most 24 severe remedy. In re Downs, 103 F.3d 472, 479 (6th Cir. 1996). 25 Moreover, the number and seriousness of the violations require an 26 unbending response by this court. As a result, the order of 27 employment will be revoked and the full amount of funds Macdonald 1 Since this court believes that both Par 5 Investments’ and 2 Prach’s interest in these funds appear to have been extinguished, 3 disgorgement will be made to Walter Dahl, Subchapter V trustee. In re 4 Lewis, 113 F.3d 1040, 1045 (9th Cir. 1997) (approving deposit of 5 disgorged funds pending resolution of ownership). Property rights are 6 determined by state law. Butner v. United States, 440 U.S. 48, 54 7 (1979); In re Coupon Clearing Service, Inc., 113 F.3d 1091, 1099 (9th 8 Cir. 1997). California law provides that a security retainer “remains 9 property of the client (in this case, the estate) until the attorney 10 applies to it charges actually rendered.” In re Dick Cepak, Inc., 339 11 B.R. 730, 736 (9th Cir. BAP 2006); In re Montgomery Drilling Co., 121 12 B.R. 32, 37 (Bankr. E.D. Cal. 199)); In re GOCO Realty Fund I, 151 13 B.R. 241, 251 n. 11 (Bankr. N.D. Cal. 1993). That rule has been 14 extended to retainers paid by third parties: 15 In other words, notwithstanding an ultimate third[-]party owner of the funds, the retainer is held in trust for 16 Debtor's estate to the extent it is utilized to compensate the estate's attorney. The estate, therefore, has an 17 equitable interest in the trust funds. Property of the estate includes any legal or equitable interests of the 18 debtor in property as of the commencement of the case. 19 In re Stevenson, No. 0-10-BK-30556-JMM, 2011 WL 2413172, at * 5 20 (Bankr. D. Ariz. June 9, 2011); In re Miller Automotive Group, Inc., 21 521 B.R. 323, 333 (Bankr. W.D. Mo. 2014). Because all funds received 22 from the debtor and/or Prach, whether paid from the trust account or 23 post-petition directly, had been applied to outstanding invoices for 24 services rendered and costs incurred, the court believes that all 25 funds Macdonald Fernandez LLP received were property of the estate. 26 Notwithstanding that belief, the court is aware that Frank Prach is 27 not a party to the present proceedings and should be given the 1 personally paid on behalf of Par 5 Investments. And the court will 2 craft an order allowing Frank Prach to be heard, should he so elect. V. CONCLUSION 4 For each of these reasons, the orders to show cause are sustained 5 and the motion to disgorge granted. The order approving Macdonald 6 Fernandez LLP’s employment will be revoked. Subject to Frank Prach’s 7 right to recover some--or all--of the funds that he individually paid, 8 Macdonald Fernandez LLP shall disgorge $57,157.30 to Subchapter V 9 trustee Walter Dahl. The court will issue an order from chambers. 10 Dated: October 26, 2022 11 ) MSS CL¢- Fredrick E. Clement 13 United States Bankruptcy Judge 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 26
1 Instructions to Clerk of Court
2 Service List - Not Part of Order/Judgment
3 The Clerk of Court is instructed to send the Order/Judgment or other court generated document transmitted herewith to the parties below. The Clerk of Court will send the document 4 via the BNC or, if checked ____, via the U.S. mail.
6 Debtor(s) Attorney for the Debtor(s) (if any)
7 Bankruptcy Trustee (if appointed in the case) Office of the U.S. Trustee Robert T. Matsui United States Courthouse 8 501 I Street, Room 7-500 9 Sacramento, CA 95814 J. Francis Prach Walter R. Dahl 10 100 Harrison Ave, #817 2304 N St Auburn, CA 95604 Sacramento, CA 95816-5716 11 Placer County Office of the Treasurer - Tax Tracy Davis 12 Collector Attn: Justin C. Valencia Robert Kannigiesser Deputy Tax Collector 2500 Tulare St #1401 13 2976 Richardson Dr Fresno, CA 93721 Auburn, CA 95603 14 Sutherland Grantor Trust, Series IV Tri Counties Bank 15 Attn: Reed S. Waddell c/o Bruce L. Belton 1000 Wilshire Blvd 19th Fl PO Box 992570 16 Los Angeles, CA 90017 Redding, CA 96099-2570 Harvego Real Estate, LLC AmTrust North America, Inc. 17 Attn: Jason L. Hoffman Maurice Wutscher LLP 18 700 University Ave #100 23611 Chagrin Blvd #207 Sacramento, CA 95825 Beachwood, OH 44122 19
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