Riker, Danzig, Scherer, Hyland & Perretti LLP v. Official Committee of Unsecured Creditors

Citations: 383 B.R. 869; 2008 U.S. Dist. LEXIS 21507Docket: No. 07 Civ. 3603(MGC)

Court: District Court, S.D. New York; March 19, 2008; Federal District Court

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Riker Danzig, a law firm, appealed a Bankruptcy Court decision that reduced its fee award for serving as special litigation counsel to Smart World Technologies, LLC and its affiliates. The Official Committee of Unsecured Creditors cross-appealed, seeking a further reduction of Riker Danzig's fees. The appellate court reversed the Bankruptcy Court's order, remanding the case for a fee award of $2,142,006.27 plus $73,981.18 in expenses.

Smart World, which provided free internet services from 1996 to 2000, faced profitability issues and sold its subscriber list to Juno Online Services, Inc., which required Smart World to file for bankruptcy. Disputes arose regarding the sale, leading Smart World to request a good faith hearing, alleging that Juno misrepresented subscriber numbers. Juno counter-sued Smart World for false claims.

On November 7, 2000, Smart World sought court approval to retain Riker Danzig as special litigation counsel under sections 327 and 328 of the Bankruptcy Code, which relate to compensation for debtor counsel. The court approved this retention on November 16, 2000, following the terms outlined in Riker Danzig's Rothschild Letter. The letter specified a contingency fee structure, detailing various percentages based on the amount recovered and the duration of the litigation. Riker Danzig would receive all expenses first, then 33-1/3% of the first $1.5 million recovered, followed by tiered percentages for amounts beyond that, with specific rates applying depending on the length of the litigation and a 33-1/3% rate for amounts received after 18 months.

Debtors' counsel indicated that the agreement included a provision reducing the amount owed from thirty-seven percent to thirty-three percent after eighteen months to incentivize Riker Danzig to settle within that timeframe. Litigation continued until early 2001 when Juno's attorneys claimed a settlement was reached with Smart World's creditors. However, during a February hearing, the bankruptcy court found no settlement had been finalized but noted that the parties were close, granting a stay of the litigation at Juno's request. Over the next two years, the court denied Smart World's motions to resume litigation, despite the absence of a settlement and evidence suggesting World-Com, a creditor, was seeking a quick settlement that could harm the estate's interests.

In October 2002, the bankruptcy court ordered mediation, which Riker Danzig attended. By May 2003, Juno and Smart World's creditors moved to settle the adversary proceeding for $5.5 million. Smart World objected, arguing it had not been able to adequately assess the value of its claims due to insufficient discovery and that the creditors lacked standing to settle against the debtor's objections. The bankruptcy court dismissed these objections and approved the settlement, which was later affirmed by the district court.

Riker Danzig appealed, and in September 2005, the Second Circuit vacated the settlement approval, ruling that Smart World's creditors lacked standing to settle over the debtor-in-possession's objections. On remand, a discovery schedule was set, and after Smart World's exclusive period for filing a reorganization plan ended, the Committee, now having standing, filed a Plan of Liquidation that included a $6.5 million settlement with Juno. Riker Danzig objected, claiming the subscriber list was overvalued, but the bankruptcy court dismissed this assertion as "rank speculation." The court confirmed the plan, determining the $6.5 million settlement was reasonable. Riker Danzig then requested a fee award totaling $2,320,959.02. After hearings, the bankruptcy court reduced this fee per 11 U.S.C. § 328(a), which permits adjustments to pre-approved fees when unforeseen developments arise.

The court deemed the contingency fee arrangement improvident for four primary reasons: 

1. **Litigation and Settlement Strategy Conflicts**: There was significant discord between the Debtor and the Committee, leading to antagonism and a lack of cooperation.
  
2. **Influence of Officers**: Riker Danzig, acting as special litigation counsel, took directives from Steven and Pamela Daum, the majority shareholders of Smart World, prioritizing their interests over those of the creditors, to whom they owed a fiduciary duty.

3. **Prolonged Litigation**: The litigation was unduly lengthy, largely due to Riker Danzig's actions directed by the Daums.

4. **Obstruction in Settlement Approval**: Instead of facilitating settlement approvals, Riker Danzig's actions, again at the Daums' direction, became an obstacle.

The document outlines the standard of review for appeals in bankruptcy cases, noting that legal conclusions are reviewed de novo, while factual findings are set aside only if clearly erroneous. Decisions on fee awards are subject to abuse of discretion review. It highlights that a bankruptcy judge can only modify pre-approved fees if the fee agreement proves improvident due to unforeseen developments at the time of approval, as stated in 11 U.S.C. § 328(a). The Bankruptcy Reform Act of 1978 allows for pre-approval of contingent fee agreements, with the court retaining authority to adjust compensation based on circumstances that could not have been anticipated.

Section 328 of the Bankruptcy Code allows for the pre-approval of attorneys' fees, facilitating the hiring of counsel by the estate's trustee, in contrast to § 330, which provides for post-service compensation based on what a court deems "reasonable" after a hearing. Before the 1978 Bankruptcy Act, professionals were hesitant to work on bankruptcy estates due to the unpredictability of compensation determined by judges after services were rendered. Under current § 330, the court assesses "reasonable compensation" based on various factors, but § 328 allows professionals to obtain court approval for agreed compensation beforehand, avoiding uncertainty.

The Ninth Circuit has ruled that if a bankruptcy court has pre-approved a professional's employment under § 328, it cannot later question the reasonableness of fees under § 330. The Fifth Circuit also interprets § 328 as limiting the bankruptcy court's ability to alter pre-approved compensation, which must be modified only for unforeseen developments. If a compensation rate or payment method has been approved under § 328, the court cannot later approve a "reasonable" fee under § 330 unless the original arrangement was deemed improvident due to unforeseen circumstances.

In a cross-appeal regarding Riker Danzig’s fee agreement, the Committee argues that the contingency fee was not pre-approved under § 328, noting that the bankruptcy court's retention order and related documents did not explicitly reference § 328. The Committee cites tests from other circuit courts that determine the pre-approval of fee agreements, asserting that none would support a conclusion that the bankruptcy court failed to pre-approve the fee arrangement in this case. In contrast, a Third Circuit case affirmed a fee reduction due to the lack of pre-approval under § 328.

The court emphasized the necessity for retention orders to clearly articulate the specific terms and conditions of professional employment as mandated by § 328(a). In Friedman, the Ninth Circuit ruled that a fee was not pre-approved since the bankruptcy court included a condition stating that all fees were subject to court approval, indicating incompleteness in its approval process. The bankruptcy court's lack of explicit reference to § 328 in its ruling was noted but deemed not decisive. The Sixth Circuit established that determining whether a fee arrangement is pre-approved under § 328 requires a holistic analysis of circumstances, including the debtor's request for fee pre-approval and the court's assessment of fee reasonableness. While explicit reference to § 328 in retention orders is not mandatory, it helps eliminate ambiguity. Zolfo necessitates clear terms in retention orders, while Friedman underscores the need for advance approval of fees without reserving final approval for later. The analysis concluded that the fee application in question was approved under § 328, as Judge Peck found that the parties intended the fee agreement with Riker Danzig to align with § 328, despite the order's silence on statutory standards. The U.S. Trustee's objections regarding fee reasonableness under §§ 330 and 331 were addressed by the bankruptcy judge, affirming that the fee application was approved under § 328, highlighting the distinction between contingency fees and those subject to §§ 330 and 331.

Smart World requested the retention of the law firm Riker, Danzig as Special Counsel under 11 U.S.C. § 327 and § 328. The U.S. Trustee objected, arguing that approval under § 328 would grant a super-priority administrative claim potentially unreasonable according to §§ 330 and 331. Under § 328, Riker Danzig’s fee can only be modified if the terms were improvident based on unforeseen developments. 

Citing precedent, the document explains that a bankruptcy court may not alter a pre-approved fee absent a finding of unanticipated circumstances. Several cases illustrate this principle, differentiating between unforeseen events and those that could have been anticipated. For example, the Fifth Circuit reversed a fee reduction based solely on unforeseen circumstances, emphasizing that simply being unanticipated is insufficient for altering a fee. 

The bankruptcy court in this case identified four developments it deemed to render the fee terms improvident; however, all were found to be foreseeable. Specifically, the emergence of conflicting litigation and settlement strategies between the Debtor and the Committee was cited as unexpected. The court noted the extreme antagonism that developed, but the Third Circuit has indicated that some level of conflict is typical in bankruptcy situations. Thus, the developments identified by the bankruptcy court do not meet the stringent criteria outlined in § 328(a).

The bankruptcy court noted that the lengthy litigation process was largely due to Riker Danzig's actions under the Daums’ direction, along with Judge Blackshear's nearly two-year stay of the adversary proceeding and the appeal of the initial settlement, both of which were foreseeable. Riker Danzig's successful appeal in the Second Circuit indicated that the litigation's procedural developments were also foreseeable. The court found it unexpected that Riker Danzig acted on the Daums' instructions, which appeared to prioritize equity over the creditors' interests, thus positioning Riker Danzig as an obstacle to settlement approval. The Second Circuit's opinion contested the notion that the Daums' litigation pursuit and settlement objections were unforeseeable. As fiduciaries, debtors are required to maximize the estate's value, which may necessitate pursuing or settling claims, as established in prior case law. While the court deemed the Daums’ litigation pursuit against Juno as foreseeable, it ultimately ruled that no fiduciary duty violation occurred regarding the debtors' obligations to their creditors. Consequently, the bankruptcy court's reduction of Riker Danzig's contingency fee was reversed, as it exceeded the allowable adjustments under 11 U.S.C. § 328(a). Riker Danzig sought fees totaling $2,320,959.02 plus expenses, with a fee structure that included a percentage based on the duration and amount recovered from Juno, revealing miscalculations in their fee request according to their agreement. The fee arrangement specified various rates depending on the litigation duration and established a lower percentage for amounts received after 18 months.

Riker Danzig's fee structure stipulates a 33 1/3% fee for amounts received after 18 months of litigation, contrasting with the 37% fee for earlier settled amounts. Riker Danzig argues that this fee reduction is only applicable to recoveries exceeding $8,000,000, claiming irrelevance due to a lower settlement amount. However, this interpretation is deemed strained, as the final sentence of the agreement applies to all fees and mandates a reduction to one-third after 18 months. The bankruptcy court had previously rejected an initial fee agreement lacking incentives for quick settlements and subsequently required that any modified agreement reflect such incentives. During a hearing, it was clarified that the fee would drop to 33% after 18 months, invalidating the 37% rate for Riker Danzig. 

Riker Danzig's expenses total $73,981.18, deducted from a settlement of $6,500,000, resulting in a fee award of $2,142,006.27, which equates to one-third of the remaining funds. The court's conclusion is to reverse and remand for a judgment totaling $2,215,987.45, inclusive of expenses and fees. The Committee contests Riker Danzig's entitlement to fees, asserting that the recovery was solely due to their own efforts rather than Riker Danzig's litigation success. However, Riker Danzig's fee agreement is based on funds obtained rather than litigation outcomes, and the settlement was influenced by Riker Danzig's threat of litigation. Additionally, Riker Danzig’s actions led to an increased settlement amount. The Ninth Circuit emphasizes that professionals must explicitly invoke § 328 in their retention applications to ensure it governs fee reviews rather than § 330.