In re: DAVID A. STEWART; TERRY P. STEWART, Debtors. SE PROPERTY HOLDINGS, LLC, Appellant, v. DAVID A. STEWART; TERRY P. STEWART; DOUGLAS GOULD, Chapter 7 Trustee; RUSTON C. WELCH; WELCH LAW FIRM, P.C.; KIRKPATRICK BANK, Appellees.
Nos. 19-6103 & 19-6104
United States Court of Appeals for the Tenth Circuit
August 14, 2020
Before HARTZ, BALDOCK, and EID, Circuit Judges.
PUBLISH. Appeals from the Bankruptcy Appellate Panel (BAP Nos. WO-18-068 & WO-18-079). FILED August 14, 2020, Christopher M. Wolpert, Clerk of Court.
David Cheek, Cheek & Falcone, PLLC, Oklahoma City, Oklahoma (Ruston C. Welch, Welch Law Firm, P.C., Oklahoma City, Oklahoma, with him on the brief) for Appellees.
Attorney Ruston Welch received $348,404.41 in fees for representing David and Terry Stewart in their Chapter 7 bankruptcy proceedings. This appeal arises out of his failure to disclose his fee arrangements and payments, as required by
The bankruptcy appellate panel (BAP) affirmed the sanction after the Stewarts’ largest creditor, SE Property Holdings (SEPH), which had initiated the proceedings as an involuntary bankruptcy, challenged the sanction as so inadequate as to constitute an abuse of discretion. SEPH appeals that decision. Exercising jurisdiction under
Attorneys for debtors perform an essential role in bankruptcy proceedings. But when it comes to compensation, they play second fiddle to creditors. In a Chapter 7 proceeding, such as the one before us, the attorney can be paid out of the bankruptcy estate only if first employed by the trustee and approved by the bankruptcy court. See Lamie v. U.S. Tr., 540 U.S. 526, 538–39 (2004). As a check on debtor attorneys, the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure require them to promptly disclose their fee arrangements and all payments for their bankruptcy services.
Section 329(a) of the Bankruptcy Code states:
Any attorney representing a debtor in a case under this title, or in connection with such a case, whether or not such attorney applies for compensation under this title, shall file with the court a statement of the compensation paid or agreed to be paid, if such payment or agreement was made after one year before the date of the filing of the petition, for services rendered or to be rendered in contemplation of or in connection with the case by such attorney, and the source of such compensation.
Rule 2016(b), which implements
Every attorney for a debtor, whether or not the attorney applies for compensation, shall file and transmit to the United States trustee within 14 days after the order for relief [see
11 U.S.C. § 303(h) (requirements that must be satisfied before issuance of order for relief after filing of a petition for involuntary bankruptcy)], or at another time as the court may direct, the statement required by§ 329 of the Code including whether the attorney has shared or agreed to share the compensation with any other entity. The statement shall include the particulars of any such sharing or agreement to share by the attorney, but the details of any agreement for the sharing of the compensation with a member or regular associate of the attorney‘s law firm shall not be required. A supplemental statement shall be filed and transmitted to the United States trustee within 14 days after any payment or agreement not previously disclosed.
The disclosure requirements enable bankruptcy judges to perform their core and traditional role of overseeing lawyers who represent bankrupt debtors. See 3 Richard Levin & Henry J. Sommer, Collier on Bankruptcy ¶ 329.LH, at 329–34 (16th ed. 2020) (“Under prior law, as under the modern Bankruptcy Code, compensation of the attorney for the debtor was scrutinized more closely than the compensation of other officers and professional persons.“). The oversight is justified by two significant concerns. Debtors can be exploited by overreaching lawyers who overcharge for their services. And creditors can be denied their proper share of the bankruptcy estate if debtors (particularly those who believe they will net nothing from the nonexempt assets of the estate) direct money to their attorneys in preference to other creditors. See Bethea, 352 F.3d at 1127 (when facing bankruptcy, “[d]ebtors may not care who gets what money remains (if the attorney gets more, other creditors get less), and, when clients do not haggle over price, some attorneys will be tempted to divert the funds to themselves by charging excessive fees“); In re Redding, 263 B.R. 874, 878 (B.A.P. 8th Cir.) (
II. THE RELATIONSHIP BETWEEN SEPH AND THE STEWARTS
SEPH has complained that Mr. Welch, through arrangements not timely disclosed to the bankruptcy court, has been paid large sums that should have gone to SEPH and other creditors. To understand this issue, we must review the relationship between SEPH and the Stewarts.
SEPH is the largest creditor in the Stewarts’ bankruptcy, with a claim exceeding $20 million. It has loaned millions of dollars to businesses that were controlled and largely owned by the Stewarts, in particular Neverve, LLC, in which David Stewart owned at least a 50% interest. The Stewarts personally signed or guaranteed the loans.
As the maturity date of a $16 million note approached, SEPH agreed to extend it in return for additional security. The security was the assignment by the Stewarts and companies they controlled of an interest in claims against British Petroleum (BP) arising
The new maturity date came but the note was not paid. SEPH therefore filed on September 30, 2014, a petition in the United States Bankruptcy Court for the Southern District of Alabama to place the Stewarts in involuntary Chapter 7 bankruptcy. On March 18, 2015, the court ordered entry of orders for relief, and it entered an order on April 24 for joint administration of the cases for the two Stewarts.
The case was moved on June 12, 2015, to the United States Bankruptcy Court for the Western District of Oklahoma. Mr. Welch, who had not entered an appearance in Alabama, entered his appearance as attorney for the Stewarts in the Oklahoma proceedings on June 17.
III. WELCH‘S FEE ARRANGEMENT AND PAYMENTS
On the same day that Mr. Welch entered an appearance, he executed a representation agreement with the Stewarts. The engagement included general representation, debt counseling, and corporate-structure and bankruptcy representation to the Stewarts and certain named business affiliates. Also at that time, the named affiliates, including Neverve, guaranteed Mr. Welch‘s legal fees in connection with the bankruptcy representation.
The BP claims were settled in spring 2016. By that time Mr. Welch had obtained an interest in the settlement proceeds. Under a fee-sharing agreement executed on April 19, 2016, the total attorney fee was 40% of the proceeds; that amount was split
The settlement proceeds were disbursed in August 2016. All of Mr. Welch‘s $348,404.41 in fees in this case came out of proceeds that were wired to him. He received $144,591.85 under his contingency-fee contract, but he then credited all that toward what he was owed for his bankruptcy work. In his own words, this was “a matter of fairness and efficiency in [his] mind.” Id. at 3198. The remaining $203,812.56 came out of the $275,572.27 in net-settlement proceeds for Neverve. Mr. Welch paid himself because of Neverve‘s guarantee of his fee.
Although
Before negotiations on the settlement agreement the Stewarts had argued that the Trustee should abandon those membership interests because they were valueless. In particular, on November 3, 2015, the Stewarts had moved in bankruptcy court to have the Trustee abandon their membership interests in three companies: Raven Resources, LLC, Oklamiss Investments, LLC, and Shimmering Sands Development Company, LLC, claiming that the three entities were in so much debt that they provided no value to the Stewarts’ bankruptcy estate. See
This led to the settlement agreement between the Stewarts and the Trustee, and then the August 30, 2017 hearing on whether the court should approve it. It was when Mr. Welch stated at the hearing that he had paid himself out of the BP proceeds, that SEPH and the bankruptcy court began questioning Mr. Welch about his compensation arrangements. SEPH brought up that Mr. Welch had never filed his required disclosures, including anything regarding his compensation or representation agreement. Offering no explanation, Mr. Welch merely acknowledged his obligation to make disclosures. The bankruptcy court said that it did not understand why he had not turned over the Neverve BP claim proceeds to the Trustee, telling Mr. Welch that the Trustee “should be the one making these decisions, not you and not David Stewart.” Aplt. App., Vol. 29 at 6568. It told Mr. Welch to immediately make his disclosures. He filed disclosures on September 14 and 20, 2017.
IV. BANKRUPTCY COURT PROCEEDINGS ON FAILURES TO DISCLOSE
In October 2017 SEPH filed a motion seeking disgorgement of Mr. Welch‘s fees and the denial of future compensation for violation of his disclosure obligations under
To excuse his failure to disclose some of the payments, Mr. Welch argued that his contingency fees did not need to be disclosed because they were “earned for services not in connection with the bankruptcy case.” Id. at 3194; see
The bankruptcy court did not conduct a hearing on the motion for disgorgement. In its written order it found to be meritless Mr. Welch‘s argument that the contingency fee was not for services rendered “in connection with” the bankruptcy case because he applied the BP funds to his bankruptcy fees. It found Mr. Welch to be in clear violation of
Relying in part on a case involving sanctions against attorneys under
- “[T]o this Court‘s knowledge, Welch has not been previously sanctioned.”
- “It appears that he has not had much experience representing debtors in Chapter 7 in which court approval is not required for either employment or payment of counsel.”
“It may well be that Welch . . . overlooked the attorney fee disclosure requirements imposed upon counsel in all chapters of the Bankruptcy Code.” - “The Court also believes that ordering disgorgement of all fees as sought by SEPH (or even a substantial portion of such fees) would be financially catastrophic to someone as Welch engaged in a largely solo practice.”
Id. at 786–87. In addition, the court expressed its view that it lacked authority to require Mr. Welch to pay funds to the debtors’ estate, which never had an interest in them, so it would have to order repayment to the entities that paid him and the entities would then likely simply repay him. The bankruptcy court ordered Mr. Welch to pay $25,000 to the Trustee for the benefit of the estate. It said that this disgorgement and the court‘s public chastisement of Mr. Welch would adequately deter him from future misconduct.
Unsatisfied with only a 7% reduction in Mr. Welch‘s fee, SEPH moved to alter or amend the bankruptcy court‘s order. It argued that the bankruptcy court‘s sua sponte consideration of mitigating circumstances lacked an evidentiary basis in the record because the parties themselves had not anticipated that such mitigating circumstances would be applied. SEPH also asked the bankruptcy court to clarify whether it concluded that the BP funds were property of the estate.
The bankruptcy court declined to alter the $25,000 sanction. It justified its sua sponte consideration of mitigating factors in light of the bankruptcy judge‘s common sense and 30 years of experience in bankruptcy private practice. The only specific argument it addressed on that score was its agreement that Mr. Welch never raised the issue of his ability to pay. But the bankruptcy court maintained that “it was appropriate for the Court to not require specific evidence as to Welch‘s net worth, but to exercise its
SEPH appealed to the BAP, which affirmed the $25,000 sanction and the denial of SEPH‘s motion to alter or amend as within the bankruptcy court‘s discretion. See SE Prop. Holdings, LLC v. Stewart (In re Stewart), 600 B.R. 425, 436 (B.A.P. 10th Cir. 2019). It stated that the sanction fell under the bankruptcy court‘s inherent power and should be exercised with restraint. Although it acknowledged that the Tenth Circuit had not previously recognized the mitigating factors relied on by the bankruptcy court, the BAP saw no problem with the bankruptcy court‘s considering them in deciding on its sanction. It did not address SEPH‘s argument that the bankruptcy court‘s sua sponte assessment of mitigating factors was without evidentiary basis.
V. ANALYSIS
“Although this appeal is from a decision by the BAP, we review only the Bankruptcy Court‘s decision.” First Nat‘l Bank of Durango v. Woods (In re Woods), 743 F.3d 689, 692 (10th Cir. 2014) (internal quotation marks omitted). “We review the imposition of an attorney-fee sanction, whether rooted in statute, rule, or a court‘s inherent authority, only for an abuse of discretion.” Farmer v. Banco Popular of N. Am., 791 F.3d 1246, 1256 (10th Cir. 2015); see Jensen v. U.S. Tr. (In re Smitty‘s Truck Stop, Inc.), 210 B.R. 844, 846, 847–48 (B.A.P. 10th Cir. 1997) (reviewing sanctions for violations of
A. Required Disclosures and Sanctions for Noncompliance
It is undisputed that Mr. Welch violated the disclosure requirements of
Courts have found violations of the duty to be intolerable, and the sanctions imposed have been harsh, going far beyond the need to compensate for the damage done or even to deter the specific offender. For example, in Futuronics a law firm had failed to disclose a fee-sharing arrangement with another firm. See id. at 470. Such arrangements are prohibited by the bankruptcy statute “because of their natural tendency to cause an attorney to inflate his fees in order to offset the diminution in compensation
Other circuits have similarly supported the full disgorgement or denial of fees for
The view underlying the imposition of total disgorgement for failure to disclose has been well-expressed by Bankruptcy Judge Michael of this circuit:
Ours is a system built upon the principle of full and candid disclosure. Debtors must truthfully and accurately list all of their assets and all of their liabilities. Counsel must honestly and completely disclose the full nature of their relationship with their clients. Creditors must honestly and correctly calculate and state their claims. It is these disclosures which allow the public to have confidence in the system, and hopefully to believe that bankruptcy laws exist to protect the “honest but unfortunate” debtor, that those creditors who receive funds receive only their just and proper share, and that those who represent debtors perform a service beyond satisfaction of their selfish avarice. Without those beliefs, public confidence in the bankruptcy process, and perhaps far more, is placed at risk.
The fragility of the system is found in the fact that many of the required disclosures are difficult if not impossible to police, at least in a cost-effective manner.
In re Lewis, 309 B.R. 597, 602–03 (Bankr. N.D. Okla. 2004). As a result, sanctions must sting hard: “The bankruptcy system functions on the premise that the overwhelming
It should come as no surprise that this circuit, and, at least until now, the lower courts in this circuit, have also consistently affirmed the denial of all fees for
In short, the disgorgement sanction imposed on attorneys for violating their duties of disclosure to the bankruptcy court is of the nature of a sanction for breach of fiduciary
A better analogy than Rule 11 is presented by Eastman v. Union Pacific Railroad Co., 493 F.3d 1151, 1158–60 (10th Cir. 2007), where we held that a debtor who failed to disclose to the bankruptcy court a cause of action that could be an asset of the estate was judicially estopped from bringing the claim after closure of the bankruptcy proceeding. Before filing for bankruptcy, the debtor had brought a personal-injury suit against nine defendants in federal court. See id. at 1153, 1159. He intentionally failed to disclose this litigation in his filings and testimony in bankruptcy court. See id. at 1153–55, 1158–59. About a year after the debtor obtained a discharge in his Chapter 7 bankruptcy, his personal-injury lawyer discovered that there had been bankruptcy proceedings and promptly informed the bankruptcy trustee. The trustee successfully moved to reopen the bankruptcy and was substituted as the real party in interest in the personal-injury action. See id. at 1154. The trustee settled with two of the personal-injury defendants, obtaining
That [the debtor‘s] bankruptcy was reopened and his creditors were made whole once his omission became known is inconsequential. A discharge in bankruptcy is sufficient to establish a basis for judicial estoppel, even if the discharge is later vacated. Allowing [the debtor] to “back up” and benefit from the reopening of his bankruptcy only after his omission had been exposed would suggest that a debtor should consider disclosing potential assets only if he is caught concealing them. This so-called remedy would only diminish the necessary incentive to provide the bankruptcy court with a truthful disclosure of the debtor‘s assets.
Id. at 1160 (original brackets, citations, and further internal quotation marks omitted). In our view, a similar approach is warranted when the debtor‘s attorney does not make the required disclosures regarding the terms of the representation and compensation received.
This is not to say that full disgorgement is always appropriate for failure to disclose under
“In exercising the discretion granted by the statute we think the court should lean strongly toward denial of fees, and if the past benefit to the wrongdoer fiduciary can be quantified, to require disgorgement of compensation previously paid that fiduciary even before the conflict arose. This approach is most in keeping with common law fiduciary principles and best serves the deterrence purpose of the rule.” Gray v. English, 30 F.3d 1319, 1324 (10th Cir. 1994) (emphasis added).
Nevertheless, we held that the bankruptcy court had not abused its discretion in declining to require disgorgement of fees earned before the conflict of interest arose or of fees for work by other attorneys in the conflicted attorney‘s law firm, who knew nothing of his conflict. We noted that the bankruptcy court had “credited [the attorney] with having performed extraordinary services to the estate both before and after he acquired the creditor‘s interest,” that there was no embezzlement or self-dealing, and that “the principal harm done by [the conflicted attorney] was to the creditor whose claim he acquired” and that creditor had apparently obtained satisfaction from the attorney for that harm. Id. We concluded, “It is a close case, and we might well have upheld more severe punishment of [the conflicted attorney] and his law firm, to whom his conflict was attributable under ordinary agency principles,” but we deferred to the bankruptcy judge. Id. at 1324–25.
It would be unwise to try to catalog all potential mitigating circumstances. But they must be compelling ones. For example, in In re Wright, 591 B.R. 68 (Bankr. N.D. Okla. 2018), an opinion consolidating 13 bankruptcy proceedings, the court said that full disgorgement of all fees was appropriate, but it limited disgorgement to postpetition payments. See id. at 95. According to the court, ordering disgorgement of the prepetition
Or the breach may have been only a technical one. See Vergos v. Mendes & Gonzalez PLLC (In re McCrary & Dunlap Const. Co.), LLC, 79 F. App‘x 770, 780 (6th Cir. 2003) (unpublished) (“[W]hile a bankruptcy court does not abuse its discretion if it denies all compensation where, through mere negligence, an attorney fails to satisfy the requirements of the Code and Rules, . . . a ‘technical breach’ of the Code and Rules generally warrants a sanction far more lenient than full disgorgement and denial of all compensation.“). But see id. at 786 (Batchelder, J., dissenting) (full disgorgement was appropriate because law firm held itself out as experienced and should be held to that standard).
Additional situations when leniency may be warranted can be addressed when they arise.
B. Application to This Case
Mr. Welch egregiously violated the disclosure requirements of
As explained above, the default sanction for Mr. Welch‘s failures to disclose is that he must disgorge all fees received in connection with the bankruptcy. The
The bankruptcy court‘s reasons for disgorging only a small fraction of Mr. Welch‘s fee were wholly inadequate. Without any evidence, or even a supporting argument from Mr. Welch, it speculated that Mr. Welch had never been sanctioned, had not represented debtors in Chapter 7 proceedings and was not familiar with the disclosure requirements, and would face financial catastrophe if he had to disgorge the full fee. The court relied on its common sense and long experience with bankruptcy practice. We fail, however, to see how those sources could provide a basis for those grounds favoring only partial disgorgement. We believe the bankruptcy judge‘s experience and participation in the proceedings could support its determination that Mr. Welch had provided exceptional representation to his clients. But a conclusory statement does not suffice. Particularly given the court‘s observation about the lack of candor and honesty of his clients, we should note that it would not be enough to fight tooth and nail in defense of indefensible improprieties of a client. On the other hand, credit should be given to an attorney who manages to convince the client of the need for full disclosure and candor in the proceedings.
Most importantly, however, the bankruptcy court failed to examine the source of the payments to Mr. Welch. The court seems to have inferred from Mr. Welch‘s talent and experience that his failures to disclose must have been inadvertent. But an alternative hypothesis is that he surely knew of his duty and must have had some very
We would therefore expect the court to examine those payments before deciding not to require complete disgorgement. Consider the contingency-fee payment of $144,591.85. The only document entitling him to that fee is dated shortly before the BP settlement and about a month after he had informed the Trustee that there was movement in the BP litigation. That is pretty late in the litigation to be adding a recipient of a contingency fee, yet there is no evidence that he had been promised any contingency fee before the document was executed. Also, there is a question about the value of the work he purportedly performed to earn that fee—“advis[ing] and assist[ing] the non-debtor claimants in providing substantiating documents to support [the chief attorney] in the settlement process and negotiat[ing] specific language to the settlement agreements.” Aplt. App., Vol. 13 at 3305. Mr. Welch would not be entitled to the fee if it were merely a device to divert to him money that would otherwise be available for creditors of the Stewarts’ companies.
The other payment was $203,812.56 out of Neverve‘s net share of the BP proceeds. SEPH makes two plausible arguments why that payment was improper. First, it contends that it had a security interest in BP payments to any of the Stewarts’ companies. Second, as we understand the point, it argues that any disbursement by
We make no judgment on the validity of the challenges to these payments to Mr. Welch. The challenges may lack merit. But Mr. Welch‘s burden on the disgorgement issue requires more than simply prevailing on the challenges. Even if they fail, they may have caused sufficient concern to induce him to avoid the challenges by keeping the payments secret. As we said before about a debtor‘s failure to disclose a cause of action as an asset of the estate, allowing the debtor “to back up and benefit from the reopening of his bankruptcy only after his admission had been exposed would suggest that a debtor should consider disclosing potential assets only if he is caught concealing them.” Eastman, 493 F.3d at 1160 (brackets and internal quotation marks omitted). If the sole penalty for not disclosing is that the debtor‘s attorney has to face the challenges that would have presented themselves had he disclosed the matter as required, then there is no incentive to comply with disclosure requirements.
For the above reasons, we must reverse the bankruptcy court‘s disgorgement order and remand for further proceedings.3
We REVERSE the bankruptcy court‘s order requiring Mr. Welch to pay to the Trustee $25,000 for the benefit of the estate and REMAND for further proceedings consistent with this opinion.