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  • Bankruptcy and divorce: Suggestions on how to get paid and stay paid

    Bankruptcy and divorce often go hand in hand. James McNeilly Jr. offers family law lawyers guidance on how a divorce client's bankruptcy filing can affect how they get paid — and how to minimize the risk of getting dragged into bankruptcy court.
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    James McNeillyThis article is adapted from the Spring 2010 Wisconsin Journal of Family Law, published by the State Bar Family Law Section.

    By com jmcneilly mcneillylawoffices James W. McNeilly Jr.

    July 7, 2010 – In March, consumer bankruptcy filings reached the highest monthly total since the 2005 bankruptcy amendments.1 As many lawyers know, bankruptcy and divorce2 often go hand in hand. Because of special bankruptcy concepts called “the automatic stay,” “preferences,” and “the discharge injunction,” family law attorneys would be well-advised to become fully informed about how a client’s bankruptcy filing can affect whether the attorney gets paid, stays paid, or can be best assured of payment for post-bankruptcy filing work, all while avoiding sanctions by the bankruptcy court. While there are many chapters under which clients can file bankruptcy, because divorcing debtors rarely file under the other chapters, this article assumes that the bankruptcy being filed is a Chapter 7. Counsel representing a client who has filed a Chapter 11, 12, or 13 petition should work closely with an experienced bankruptcy attorney rather than relying on the information contained here.

    Applicable Bankruptcy Code provisions

    Bankruptcy
  • The automatic stay. Upon the filing of the bankruptcy petition, virtually all actions against both the debtor and the debtor’s property are enjoined by the automatic stay.3 The stay is called “automatic” for two reasons. First, it is effective immediately upon the filing of the petition. Second, it is effective against creditors even if they have no knowledge of the bankruptcy filing. Creditors who violate the automatic stay can be and are often sanctioned by bankruptcy courts.
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  • Bankruptcy estate. In a Chapter 7 bankruptcy proceeding, virtually all of the debtor’s assets become the “property of the estate” immediately upon the filing of the bankruptcy.4 Those assets remain under the control of the trustee and are subject to being sold for the benefit of creditors until either exempted5 by the debtor or abandoned by the trustee. The trustee may formally abandon property of the estate, or will be deemed to have abandoned property of the estate, by failing to administer the property before the case is closed.6
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  • Preferences. Preferences, defined in 11 USC § 547, can take many forms, but are usually payments on unsecured debts. In a Chapter 7 bankruptcy, at least in theory, the trustee gathers the debtor’s assets, liquidates them, and then divides the proceeds among creditors. Common sense dictates that a debtor is insolvent before the actual filing. The creators of the Code decided it would be fair if the Code provided a “lookback” period during which payments on debts to some creditors could be recovered by the trustee and distributed to all creditors. These payments are called “preferences” because the debtor “preferred” those creditors by paying them instead of others. The lookback periods are 90 days from the date of filing for payments to creditors who are not “insiders” and one year for payments to “insiders” (generally, relatives in an individual bankruptcy filing). A payment of attorney’s fees that have been outstanding for some time (as opposed to the payment of the last monthly bill within 30 days) would likely be considered a preference if paid within the 90-day lookback period. However, because payments “in the ordinary course of business” are not considered preferences, if the client normally pays attorney’s fees on a regular, monthly basis within 30 days of the bill, arguably those payments would not normally be considered preferences.
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  • Postpetition transactions. 11 USC § 549 provides, in pertinent part, that “the trustee may avoid a transfer of property of the estate . . . that occurs after the commencement of the case . . .” This provision may allow a trustee to recover payments to an attorney for family law matters after the bankruptcy filing for the benefit of creditors.
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  • The discharge injunction. 11 USC § 524, Effect of Discharge, provides, in pertinent part:
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    (a) A discharge in a case under this title — . . .

    (2) operates as an injunction against the commencement or continuation of an action, the employment of process, or an act, to collect, recover or offset any such debt as a personal liability of the debtor, whether or not discharge of such debt is waived; and

    (3) operates as an injunction against the commencement or continuation of an action, the employment of process, or an act, to collect or recover from, or offset against, property of the debtor of the kind specified in section 541 (a)(2) of this title that is acquired after the commencement of the case, on account of any allowable community claim, except a community claim that is excepted from discharge under section 523, 1228 (a)(1), or 1328 (a)(1), or that would be so excepted, determined in accordance with the provisions of sections 523 (c) and 523 (d) of this title, in a case concerning the debtor’s spouse commenced on the date of the filing of the petition in the case concerning the debtor, whether or not discharge of the debt based on such community claim is waived.

    Applicable statutes and case law

    While not an exhaustive collection, two cases are relevant to the issues discussed in this article.

    The first is Bethea v. Robert J. Adams & Associates.7 In that case, the U.S. Court of Appeals for the Seventh Circuit held that any attorney’s fees owed by the debtor for representation in a Chapter 7 bankruptcy remaining unpaid after the filing are discharged. The court specifically considered and rejected the holding in In re Hines.8 In Hines, the Ninth Circuit held that with a fee agreement providing for a pre-petition down payment followed by post-petition payment of the remainder, any claim for fees for pre-petition services was discharged upon the bankruptcy filing, but a claim for services performed post-petition was immune from discharge.

    The Hines court reasoned that only claims existing on the date of filing are discharged, and there could be no claim for post-petition services at the time of the bankruptcy filing. The Bethea court rejected the Hines holding, because it “shattered each retainer agreement into multiple claims . . .” Bethea, p. 1129. The Bethea case effectively eliminates the deferred payment agreement option. The court in Bethea, albeit in dicta, did propose two alternatives: (1) full payment before the filing; or (2) partial payment for the pre-petition services, with a separate agreement, entered into after the filing, for post-petition services. While these cases dealt with attorney’s fees incurred for representation in the bankruptcy itself, the legal principles would also apply to attorney’s fees and fee agreements for representation in a family law proceeding.

    The second important case is In re Edl.9 In that case, the debtor retained an attorney to represent her in a divorce and paid a $600 retainer, but the attorney neglected to have the debtor sign a written fee agreement. The debtor was never billed nor did the debtor pay any amount after the initial retainer. After a trial, the debtor was awarded a property division judgment in the amount of $3,400. In the process of satisfying the judgment, the attorney had opposing counsel make the check payable to both the debtor and himself. The debtor initially refused to permit the attorney to take any amount from the award check, but eventually reluctantly agreed that the attorney could be paid the remaining amount owed him ($1,660), out of the award. Twenty-five days later, the debtor filed a Chapter 7 bankruptcy. While the trustee did not pursue a preference action against the attorney, the (obviously grateful) debtor moved to avoid any lien in the divorce judgment proceeds under 11 USC § 522(h) and (g)(1), and claimed that the payment of the attorney’s fees for the divorce was a preference under § 547. The attorney countered by alleging that he had a common law possessory attorney’s lien on the property division award. Judge Martin found that there was no agreement to create a lien (because of the lack of a written fee agreement) and that the debtor’s payment of the fees was involuntary.

    The case turned on the question of whether the attorney had a lien on the proceeds. If he did, there was no preference. If he did not, there was a preference, and the money could be recovered from the attorney.

    Judge Martin then addressed the very confusing history of attorney’s liens in Wisconsin, including those cases implying that attorneys may not be able to obtain liens on the proceeds of a divorce (e.g., property division, maintenance, or child support), along with Wis. Stats. § 757.36 - Lien on proceeds of action to enforce cause of action,10 which apparently applies only to torts and unliquidated contract claims. Judge Martin ultimately concluded that the attorney had an equitable lien in the property settlement for his attorney’s fees because a judgment had been awarded.11

    Wis. Stats. § 767.264(2) states:

    Attorney fees and other amounts owing. (a) Upon making an order for dismissal of, for substitution of attorney in, for withdrawal of attorney from, or for vacation of a judgment granted in an action affecting the family, the court shall, prior to or in its order, grant separate judgment in favor of an attorney who has appeared for a party to the action and in favor of a guardian ad litem for a party or a child for the amount of fees and disbursements to which the attorney or guardian ad litem is, in the court’s judgment, entitled and against the party responsible for the fees and disbursements.”

    Suggested methods of getting paid and staying paid

    Of course, requiring and obtaining adequate advances for fees and costs is a good practice to follow with all clients in all types of legal matters, not just divorce clients who may file a bankruptcy. However, because all property of the debtor becomes property of the estate upon the bankruptcy filing, if there are funds in your trust account on the day the bankruptcy is filed, the trustee may claim that those funds are property of the estate and you may be forced to surrender those funds, if the debtor cannot exempt them. Therefore, you will want to use up all advances for fees and costs before the bankruptcy filing.

    While there is some doubt as to whether an attorney can contract for a lien on the proceeds of a divorce, it is wise to obtain a written fee agreement granting you a lien on both the advanced fees and any property settlement, because that will allow you to argue (hopefully successfully) that the funds are not property of the estate and that payments from the advanced fees are not preferences.

    In order to minimize the chances of a trustee or client claiming that payment of your attorney’s fees and costs was a preference, you should take one of the following actions, in the specified order of priority:

    1. Upon receipt of the advanced fees and costs, comply with the special rules regarding placing the advances in your business account rather than your trust account. Although there may be no legal difference between the two, some trustees may be reluctant to ask an attorney to refund an advanced fee out of pocket as opposed to asking the lawyer to turn over funds in a trust account.
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    3. If you deposit advanced fees into your trust account, bill your client monthly, give the required five-day notice to withdraw funds from your trust account, and withdraw the funds in a timely manner.
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    5. Even if you do not obtain advanced fees, or in the event the advances have been exhausted, you should, at the very least, bill your client monthly and provide in your fee agreement that you may withdraw in the event the client does not stay current. Monitor the case to ensure that your client stays current on payment of fees, and if he or she does not, give plenty of advance warning of your intent to withdraw, and follow through and withdraw well in advance of any hearing, trial, or other important occurrence. Make sure to comply with the ethics rules regarding withdrawal.

    Ask your client if there is someone who will guaranty the payment of your fees. Oftentimes a client can find a family member to do so. Of course, comply with the relevant ethics rules regarding confidentiality and not allowing the guarantor to direct the provision of legal services to the client.

    Obtain a judgment pursuant to Wis. Stats. § 767.264(2) and take aggressive action to get it paid before the bankruptcy filing. If lucky enough to do so, based on the reasoning in Edl, you stand a chance of keeping what you get paid even if the client files a bankruptcy within 90 days.

    Have the client sign a new fee agreement after the bankruptcy filing in order to comply with the Bethea and Hines directives regarding post-filing fees and costs.

    Communicate with your client’s bankruptcy counsel to coordinate the payment of your fees in order to minimize your risk. Most bankruptcy attorneys are sensitive to this issue and will assist you in that endeavor.

    What not to do when your client files for bankruptcy

    Do not:

    1. Ask for payment of a large sum of past due fees just prior to the client’s filing bankruptcy. That request would not only create a preference issue but would put your client and your client’s bankruptcy counsel in an awkward position.
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    3. Directly or indirectly ask the client for payment of either past due fees or an advance during the bankruptcy. Such payment is almost always a violation of the automatic stay, and you may be brought into bankruptcy court for sanctions.
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    5. After the bankruptcy filing, ask for payment for pre-petition attorney’s fees. This will almost always violate the automatic stay (if payment is made before the stay is lifted) and the discharge injunction (if payment is made after the discharge is granted).
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    7. After the bankruptcy filing, accept a payment or advance for fees or costs without ensuring that the funds are not property of the estate.
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    9. Require payment of pre-petition attorney’s fees in order to provide services post-petition. Again, such a payment will almost always violate the automatic stay (if made before the stay is lifted) and the discharge injunction (if made after the discharge is granted).

    Conclusion

    Following the suggestions outlined will not guarantee that you will get and stay paid when your client files a bankruptcy, nor will it ensure that you will never be dragged into bankruptcy court. However, it is the author’s opinion that following these suggestions will minimize those risks. In addition to following the recommendations set forth above, you should also completely familiarize yourself with the Rules of Professional Conduct for Attorneys applicable to fee agreements, taking liens on client funds and property settlements, advanced fees, third-party guarantors, and withdrawals from trust accounts. Attorney Timothy Pierce,12 the State Bar’s ethics counsel, is a wonderful resource and can assist you with this process. Finally, you should communicate with the bankruptcy attorneys who are representing your clients. Good luck!

    Jim McNeilly is the principal of the Law Offices of James W. McNeilly, Jr. LLC, with offices in La Crosse and Kenosha. Jim has represented debtors and creditors in proceedings under all chapters of the Bankruptcy Code. A Chapter 7 Panel Trustee since 1987, Jim has also administered thousands of Chapter 7 bankruptcies. Jim is the chair of the State Bar Bankruptcy, Insolvency & Creditors’ Rights Section. He can be contacted at (262) 843-3400, ext. 12, or jmcneilly@mcneillylawoffices.com.

    Endnotes

    1April 2, 2010, ABI Daily Headlines Delivered: March Consumer Bankruptcy Filings Reach Highest Monthly Total Since 2005 Bankruptcy Overhaul. The 149,268 consumer bankruptcies filed in March represented the highest monthly consumer filing total since Congress overhauled the Bankruptcy Code in 2005, according to the American Bankruptcy Institute (ABI), relying on data from the National Bankruptcy Research Center (NBKRC).
    2My good friend and fellow bankruptcy attorney/trustee Bruce Lanser (whom I thank for his thoughtful contributions to this article) calls bankruptcy and divorce the “happiness package.”
    311 § USC 362.
    411 § USC 541.
    511 § USC 522(b).
    611 § USC 554.
    7352 F.3d 1125 (7th Cir. 2003)
    8147 F.3d 1185 (9th Cir. 1998).
    9207 B.R. 611, (Bankr. W.D. Wis. 1997).
    10“Any person having or claiming a right of action, sounding in tort or for unliquidated damages on contract, may contract with any attorney to prosecute the action and give the attorney a lien upon the cause of action and upon the proceeds or damages derived in any action brought for the enforcement of the cause of action, as security for fees in the conduct of the litigation; when such agreement is made and notice thereof given to the opposite party or his or her attorney, no settlement or adjustment of the action may be valid as against the lien so created, provided the agreement for fees is fair and reasonable. This section shall not be construed as changing the law in respect to champertous contracts.”
    11Score one for the good guys!
    12tpierce@wisbar.org, (608) 250-6168 or (800) 444-9404, ext. 6168.