Decided Oct 5, 2021 by a bankruptcy court in Kentucky in the Sixth Circuit

I debated whether to include this decision in this bifurcation case law summary, as it’s an interlocutory opinion. Also, when I looked at the docket, the judge appears to have demanded the fee agreements from the attorney sua sponte, ordered the UST to write a brief, and then wrote this interlocutory order before having an evidentiary hearing.

Plus, after the debtor’s attorney was denied a motion to reconsider this interlocutory opinion by the same judge who wrote it, the attorney settled with the UST. So this opinion isn’t even a final opinion. It is just a memorandum opinion that cannot be cited.

However, I decided to include this case anyway for completeness.

Before we get into this case, I’ll note that the attorney in this case used model prepeptition and postpetition contracts authored by Fresh Start Funding (“FSF”). The attorney also used FSF to finance its cases, by collaterally assigning clients’ accounts receivable to FSF in exchange for receiving funds advanced under a recourse line of credit for a percentage of the accounts receivable.^[1]

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The foundation of this opinion prohibiting bifurcation is that the court held that a local rule in Kentucky forbids limitations on the scope of services. And because a bifurcated bankruptcy splits a bankruptcy into two pieces, each piece of the bankruptcy can be interpreted as having limited its scope of services to one-half of the bankruptcy. Thus, the court held that this local rule forbids bifurcation itself.

Here is the text of Kentucky Local Rule 9011-1:

Attorneys-Duties.

(a) Extent of an Attorney’s Duty to Represent.

(1) Any attorney who files a bankruptcy petition for or on behalf of a debtor will remain the responsible attorney of record for all purposes including the representation of the debtor in all proceedings that arise in conjunction with the case.

(2) An attorney is relieved of his or her duties when the debtor’s case is closed, or when the attorney is specifically relieved after notice and a hearing upon motion and order of this Court.

This opinion cited the first Prophet decision to support its conclusion that Kentucky’s local rule forbade the unbundling of legal services into separate prepetition and postpetition contracts:

In Prophet, the Bankruptcy Court determined that a lawyer who used a Fresh Start [Funding] factoring agreement, similar to the one used by [the attorney in this case], violated [South Carolina Local Rule] 9011-1(b) because the attorney was only agreeing to provide limited services rather than agreeing to represent the debtor for the duration of the case as required by the local rule.

… While the wording of the Local Rule in South Carolina is different than the wording of Local Rule 9011-1 in this District, the intent and the meaning of the Rules are the same.

Once the court decided that Kentucky Local Rule 9011-1 forbids unbundling, and that bifurcation requires unbundling, the attorney effectively becomes responsible for the entire “bundle” of a client’s bankruptcy case, even if the client only signs the prepetition agreement. If an attorney in that position then requires clients to pay additional fees postpetition for services that the client should get for free because of a prepetition contract, then that attorney would be violating either the automatic stay or discharge injunction (depending on when the client made postpetition payments).

So given these assumptions, it’s no surprise that the Baldwin court ruled that:

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.

Oddly, this interlocutory opinion did not cite the Hazlett opinion in the Tenth Circuit, despite its remarkable similarity to the Baldwin case. It also made no mention of Slabbinck, a Michigan case that was also decided in the Sixth Circuit that approved of bifurcation despite a local regulation (the Michigan Rules of Professional Conduct) that forbids limiting the scope of restrictions. Both are persuasive authorities that other judges in similar cases have discussed at length.

In any case, a South Carolina District Court judge overturned the Prophet bankruptcy court decision cited in this case on March 14, 2022, several months after this opinion was issued. Notably, that Prophet appellate decision cited the Hazlett case in Utah at length, since Hazlett also affirmed bifurcation despite a similar local rule:

The intent of this [Utah local] rule is indeed to restrict the use of limited service agreements (unbundling) by debtor’s counsel. However, as noted above, the difference with [the attorney’s] bifurcated agreement procedure is that the law firm is willing to complete the representation, and it is only by the debtor’s election that the case proceeds pro se. Debtors are free at any time to terminate a lawyer’s services, so the Court does not see the use of bifurcated fee agreements as creating the problem addressed by [this local rule in Utah]. Thus, the Court finds that it is not a per se violation of this Rule if an attorney uses bifurcated fee agreements in a consumer Chapter 7 case to facilitate the debtor’s ability to afford legal representation.

The Prophet appellate decision thus ruled in favor of its bifurcating bankruptcy attorney appellant, finding that the local rule in South Carolina prevent unbundling but did not preclude bifurcation, because bifurcation doesn’t involve the unbundling of services:

The court is persuaded by this reasoning. Like debtors in Utah, South Carolina debtors are free to terminate an attorney’s services at any time, and the local rules provide a method for an attorney to request court permission to withdraw from a case “upon motion and cause shown or upon the consent of the represented party.”

This overturned Prophet appellate decision undermines a cornerstone of this interlocutory opinion.

Separately, the court ruled that an attorney may not advance the bankruptcy filing fee to a client, for four reasons.

First, the Baldwin court agreed with the decision in Brown that the filing fee is a dischargeable prepetition debt. Quoting Brown:

The filing fee is due upon the filing of the Bankruptcy Petition. Therefore, the Debtor’s obligation to repay the filing fee to the firm is a pre-petition obligation that is dischargeable.

Thus, an attorney who attempts to get paid back after advancing a filing fee would be violating the automatic stay or discharge injunction.^[2]

Second, the Baldwin court also agreed with Brown that advancing a filing fee violated more than the Bankruptcy Code. Specifically, Brown found that advancing a filing fee violated Rule 4-1.8(a) of the Florida Bar Rules. As it happens, this Florida rule is identical to the Kentucky Rule on Professional Conduct, SCR 3.130(1.8)(e)(1), so the Baldwin court concurred with Brown on this issue as well.

Third, the court said that an attorney advancing the filing fee created a scenario that could violate Rule 1006(b)(3), which states that:

All installments of the filing fee must be paid in full before the debtor or chapter 13 trustee may make further payments to an attorney or any other person who renders services to the debtor in connection with the case.” Specifically, the postpetition contract:

The Baldwin court noted that the Carr opinion:

approved an arrangement whereby an attorney advanced a client’s filing fee as part of a post-petition fee contract where the debtor paid the attorney’s fee over twelve months with a monthly payment of $98.75. In Carr, the contract required the installment payments received by the attorney to be applied first to the filing fee before the attorney could access any of the funds paid by the debtor.

However, the Baldwin court dismissed this persuasive authority because it believed that:

The scenario presented in Carr is not the same scenario presented in the FSF contracts. … There is no holdback of fees for services rendered until the filing fee is paid in full first, as was the case in Carr.

However, the Baldwin court also described an agreement between the attorney and FSF called the Line of Credit and Accounts Receivable Management Agreement (“LOCARMA”). In its description, the Baldwin court noted that the attorney agreed to seven requirements, including:

5) He will pay the filing fee promptly if the client does not pay it in advance and FSF has allocated the Initial Amount to [the attorney].

In other words, in the Baldwin case, the attorney was legally obligated to pay the filing fee immediately by an agreement between the attorney and a third-party financing company. And in the Carr case, the attorney was legally obligated to pay the filing fee immediately by a postpetition agreement between the attorney and his client.

At the end of the day, in both the Baldwin and Carr cases, the attorneys were legally bound to pay the filing fee first. So the scenarios seem almost identical, in that it was impossible for the attorney to violate Rule 1006(b)(3) without violating a binding agreement that the attorney had signed.

Fourth, the court also found a disclosure problem with Form 101. Specifically, the court concluded that the debtors’ representation was incomplete:

It is clear in the Voluntary Petitions herein, that the Debtors represented that the entire fee would be paid when the Petition was filed. However, in most of the eleven cases … , the filing fee was advanced by [the attorney], not paid by the Debtor.

The court seemed to reach this conclusion based on the following response on the Voluntary Petition:

Question 8 on Form 101 asks the Debtor to indicate how the fee will be paid. In each of the cases, the first box was checked which indicated, “I will pay the entire fee when I file my Petition.”

Looking at the Voluntary Petition for the eponymous Ricky and Lorie Jean Baldwin in the Baldwin file, it’s true that the first box does have that sentence in bold in the first checkbox. However, the rest of the paragraph makes it clear that checking the first checkbox on Form 101 does include scenarios where an attorney pays on the client’s behalf:

I will pay the entire fee when I file my petition. Please check with the clerk’s office in your local court for more details about how you may pay. Typically, if you are paying the fee yourself, you may pay with cash, cashier’s check, or money order. If your attorney is submitting your payment on your behalf, your attorney may pay with a credit card or check with a pre-printed address.

Moreover, Question 8 asks “How you will pay the fee?” The bolded headlines for the other options are: “I need to pay the fee in installments.” and “I request that my fee be waived.” Thus, it seems that the purpose of this question is to ascertain whether the debtor will pay the fee immediately, in installments, or not at all. If so, then checking an answer in Question 8 does not necessarily indicate whether the debtor is financing the filing fee (or not).

With that said, reviewing the Form 2030, the attorney did not appear to have disclosed separately that the filing fee had been advanced by the attorney. This could have been done with the following sentence on the Form 2030:

​​The fees described above include the filing fee.

So while I don’t agree that checking a particular box on Question 8 of the Voluntary Petition causes a disclosure problem, I do think that a disclosure about the attorney advancing the filing fee should have been made on the Form 2030. Unfortunately, because this disclosure wasn’t made, it opens the door to the possibly draconian penalties associated with even minor disclosure problems (see Wright).

Next, on the general issue of disclosures, the court expressed displeasure with several aspects of how the attorney filled out the Form 2030.

First, Question 1 was filled out improperly:

[The attorney] indicated in response to Question 1, that the Debtor had agreed to pay $0.00 for legal services, that [the attorney] had prior to the filing of this statement received $0.00, and that the balance due was $0.00.

To be fair, the attorney did disclose the payments properly in long form in Paragraph 7 of the Form 2030. However, there’s no doubt that $0 was improperly given as the answer to in the 3 blanks given on Question 1.

The court also found several other disclosure issues:

In the Thomas case, Case No. 20-10207, the Debtor had paid $580 up front although the Disclosure states that nothing had been paid. The same defect is found in Debtor’s answer to Question 16 on the SOFA. In the Carlton case, Case No. 20-10088, the disclosure states that the Debtor agreed to pay $2,500, when actually the documents indicated that $2,100 was due from the Debtor.

As per Wright, even small disclosure issues can warrant draconian responses from a judge.

The court also took issue with how the attorney checked the following standardized response on the Form 2030:

In response to Question 4, [the attorney] stated, “I have not agreed to share the above-disclosed compensation with any other person unless they are members and associates of my law firm.”

Here, the court had two concerns:

This Court is concerned with the fee splitting between [the attorney] and FSF. There is no mention by [the attorney] in the Disclosures regarding a portion of the fee going to FSF.

The first concern was that the attorney was potentially fee-sharing with a non-attorney. Specifically, the attorney’s agreement with a financing company, Fresh Start Funding, specified that a percentage of the amount financed would be paid to the financing company.

This is a substantive concern, because as the court notes, fee-sharing can bias an attorney:

The Kentucky Rules of Professional Conduct on fee sharing are the same as those cited in the Wright case [in Oklahoma]. SCR 3.130(5.4) states, “(a) [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.”

With that said, this arrangement doesn’t appear to be true fee-sharing. Here’s how Fresh Start Funding defends against this charge on its website^[3]:

Rule 5.4(a) of the Rules of Professional Conduct prohibits attorneys sharing fees with non-attorneys. However, the ethics opinions and case law interpreting this rule have concluded that as long as financing is recourse—so long as the attorney has to repay the debt whether or not the client pays—you are not fee sharing by financing cases. Additionally, it is OK to use a third party to collect payments if they are collecting them as your agent and [they] get paid whether [or not] they collect particular fees.

The Form 2030 did allude to the financing being both recourse and non-contingent, although it didn’t make the connection to how these factors insulate a non-lawyer from charges of fee-sharing:

Counsel has a recourse line of credit from a third-party lender secured by (among other things) a collateral assignment of the accounts receivable of counsel, including amounts owed by Debtor(s) to counsel. Counsel’s obligation to repay this indebtedness is not contingent upon receipt of payment from Debtor(s).

When I first read this interlocutory opinion, It seemed likely that once the judge took briefs from defendant’s counsel, this issue would be resolved prior to the final opinion being issued. However, the final opinion was never issued.

The court’s second concern was that the attorney didn’t sufficiently disclose on Form 2030 that a portion of the fee was going to FSF.

This concern seems reasonable, especially given the huge sanctions available for even minor disclosure violations (again, see Wright). To avoid problems, disclosures to the court need to be extremely detailed. I would be much more explicit on a Form 2030 than the attorney was in this case. (See Form 2030 submitted for Ricky and Lorie Jean Baldwin here). I’ve seen the model Form 2030 recommended by Fresh Start Funding for use by clients, and it is much more detailed than the disclosures on the eponymous Baldwin petition.

Next, the court expressed concerns that an analysis performed by the UST of 2019 Chapter 7s filed by the attorney found that he “consistently used a flat fee of $1,250” for Chapter 7 for clients paying cash. However, for bifurcated cases, the UST found that the attorney charged “an increased rate of $950 for those clients using the bifurcated fee arrangements.”

Baldwin cites Allen as a persuasive authority, which it summarized as follows:

In In re Allen, a Chapter 7 lawyer offered his clients two options to pay his attorney’s fees. Under option 1, the debtor could pay in full, pre-petition, $1, 500, which included $1,165 for attorney’s fees and the filing fee of $335. Option 2, required the debtor to pay $2,000 post-petition, which included $1, 665 in attorney’s fees and the filing fee of $335. … The debtors in Allen chose option 2 and paid $500 more than those who chose option 1. The court examined each of the debtor’s cases and determined that each debtor was provided with the same services, regardless of whether they chose option 1 or 2. The court rejected counsel’s argument that the reasonableness of his fee should be determined under the lodestar analysis, even though the attorney did not keep contemporaneous time records on his Chapter 7 cases. The Bankruptcy Appellate Panel determined that the Bankruptcy Court was well within its authority to reduce the attorney’s fees in the two cases before it by the enhanced $500 fee under option 2.

The court observes that:

The Court has not been provided with a justification by [the attorney] 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.

To my knowledge, this interlocutory opinion was issued before the attorney had a chance to offer a justification in an evidentiary hearing for any price difference in attorney’s fees. However, even if the attorney had a perfect lodestar analysis justifying the increase, a court armed with the persuasive authority of Allen can rule that the reasonableness of attorney’s fees do not necessarily have to be determined under the lodestar analysis.

Plus, there are plenty of USTs out there who will get excited about using Allen as a new tool to file a motion for a Section 329 hearing.

For that reason, this case is another example of how it makes sense for bifurcating bankruptcy attorneys to “equalize” the attorney’s fees between the “paid in full” cash price, and the “pay over time” financed price. As discussed in our review of the Allen opinion, a separate “administrative fee” can still be charged.

Beyond challenging the reasonableness of higher price for financed filings, the judge also used a analysis of fees in the Western District of Kentucky to conclude that the attorney’s bifurcated fees are unreasonable:

The U.S. Trustee also took a sampling of fees charged in consumer Chapter 7 cases in all four Divisions of the Western District of Kentucky. The U.S. Trustee used ten total cases per District. The U.S. Trustee determined that the average fee charged by an attorney for a consumer Chapter 7 was less than $1, 000. The fees ranged from $900 to $1, 600. Given the random sampling, [the attorney’s] $2,500^[4] fee far exceeds the highest figures from the sampling. The Court concludes that [the attorney’s] bifurcated fees are unreasonable.

However, this “average fee” analysis is not relevant to assessing reasonableness, as it compares the price of one attorney to another. However, when assessing the reasonableness of a flat attorney’s fee, what’s relevant is an assessment of whether that flat fee is less than the attorney’s reasonable hourly rate times a reasonable number of hours worked.

For instance, in In re Hazlett, the debtor contacted a law firm that offered to file his bankruptcy for $1,2000 if he paid in full. The debtor then retained a different law firm that performed a bifurcated bankruptcy for $2,400, collected postpetition. But despite the bifurcated Chapter 7 costing twice what another attorney charged, the Hazlett court held that:

However, after reviewing the facts of this case, the Court finds that the Debtor received reasonable value for the fee paid. First, the $2,400 fee included the post-petition payment of the $350 filing fee along with other costs, with the balance of $2,007 constituting the attorney’s fee. Second, [the law firm] provided billing records showing that the post-petition services, excluding time spent dealing with the Debtor’s installment payments, had a lodestar value of $2,240. Third, [the law firm] adequately represented the Debtor in the case in that there were no complications, the Debtor was not required to turnover assets or provide additional information to the Chapter 7 trustee, the Debtor expeditiously received a discharge 118 days after the petition date, and the Debtor’s discharge is now final under §727(e). This is an appropriate result for the fee paid. For these reasons, the Court finds that there is no basis to “order the return of any such payment” to the Debtor under §329.

As further discussed in Hazlett, reasonableness the Tenth Circuit is determined by:

the factors set forth in §330(a)(3) must be considered in determining whether an attorney’s fees are reasonable. These factors include: (1) the time spent on such services; (2) the rate for such services; (3) whether the services were necessary to the  administration of a case; (4) whether the services were performed within a reasonable amount of time; (5) whether the professional has demonstrated skill and experience in the bankruptcy field; and (6) whether the compensation is reasonable for a comparably-skilled practitioner outside the bankruptcy context.

As Carr held, reasonableness must be assessed on the basis of the legal services provided for each part of the flat fee, rather than comparing each to each other:

[The U.S. Trustee[ assumes, in effect, that the Attorneys must charge Debtor a comparable hourly rate for prepetition and post-petition work. This is incorrect. The Attorneys essentially agreed to perform prepetition services for one flat rate and post-petition services for a second flat rate. No party has argued that either flat rate was unreasonable.

The Brown court agreed with Carr:

The Court agrees [with Carr]; reasonableness is not gauged by a comparison between the prepetition charges and the postpetition charges.

In this case, the Baldwin court has taken an approach to the reasonableness of an attorney’s fees based on the fees of other attorneys in the area. The court did not cite case law or regulations to support this approach, while there is substantial case law to support the lodestar method.

Finally, the Baldwin court seems persuaded by the UST’s argument that if you take the income as measured by a debtor’s Schedule I and subtract the expenses as measured by a debtor’s Schedule J (including the monthly payment for postpetition fees), the resulting sum must be positive:

The Court is very concerned that the higher fee charged by [the attorney] is not in his clients’ best interest financially. … The U.S. Trustee’s analysis concluded that when the monthly payment was added to each of the eleven Debtors’ Schedule J, each of the eleven Debtors’ expenses exceeded their monthly income as stated on their Schedule I. Under such a scenario, while the monthly payments are part of the Debtors’ obligations, the bifurcated fee increases the Debtors’ expenses and delays the Debtors’ ability to improve their financial position. Under such circumstances, the Court cannot determine that the bifurcated fee contracts are in the Debtors’ best financial interests.

The Baldwin court seems to be applying the same “undue hardship” test to the postpetition agreement between the debtor and the attorney as it would to an agreement reaffirming a prepetition debt, which is covered by Section 524(m)(1):

Until 60 days after [a reaffirmation] agreement of the kind specified in subsection (c) is filed with the court (or such additional period as the court, after notice and a hearing and for cause, orders before the expiration of such period), it shall be presumed that such agreement is an undue hardship on the debtor if the debtor’s monthly income less the debtor’s monthly expenses as shown on the debtor’s completed and signed statement in support of such agreement required under subsection (k)(6)(A) is less than the scheduled payments on the reaffirmed debt. This presumption shall be reviewed by the court.

However, applying the undue hardship test only makes sense if the postpetition agreement between the debtor and the attorney is indeed a reaffirmation agreement of a prepetition debt. other words, if bifurcation is allowed, the postpetition agreement would not be treated as a prepetition agreement to be reaffirmed, and this issue would become moot.

In any case, this memorandum opinion is not a final opinion and cannot be cited, and it’s based on a Local Rule so it has no national implications. With that said, if I were an attorney in the WDKY, I wouldn’t be filing bifurcated cases anytime soon, even with the persuasive authority of a favorable-to-bifurcation final opinion in the nearby EDKY (Carr). That seems to be the desired result of this judge, who opened this issue sua sponte, ordered the UST into action, wrote a scathing memorandum opinion, denied a motion to reconsider, and approved a lopsided settlement favoring the UST.

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^[1] The judge in this case refers to this practice repeatedly as “factoring,” which describes a practice where a third party purchases an accounts receivable outright. However, since the legal accounts receivable in question were not purchased, it’s not accurate to use “factoring” to refer to this financing arrangement.

^[2] We discussed this issue in the Brown summary, so I won’t rehash those arguments again here.

^[3] Normally, I wouldn’t quote a website in a case law review, but again, this is an interlocutory opinion, and the defendant wasn’t given a chance to write a brief about this.

^[4] It appears that the $2,500 fee mentioned here includes the $335 filing fee which was advanced by the attorney in 10 of the 11 cases, which would make the attorney’s fee $2,165.