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A 5th U.S. Circuit Court of Appeals opinion that one former bankruptcy judge calls "scary" for lawyers requires Dallas-based Winstead to disgorge up to $500,000 in attorneys' fees the firm received for its work on the restructuring of a restaurant chain that filed for bankruptcy.
In an Aug. 28 decision in Wooley v. Faulkner, a three-judge panel of the 5th Circuit concluded that the doctrine of equitable mootness did not apply to attorneys representing clients in a Chapter 11 bankruptcy.
R. Glen Ayers, a former judge on the U.S. Bankruptcy Court for the Western District of Texas in San Antonio, says the 5th Circuit's opinion is worrisome for debtors' counsel and other lawyers whose fees are subject to court approval in a Chapter 11 case, because it says the doctrine of equitable mootness may not protect them.
Under the equitable mootness doctrine, appeals courts typically recognize that there is a point at which they cannot order fundamental changes in a debtor's reorganization plan approved by a bankruptcy court once that plan has been consummated.
Ayers, who served as the bankruptcy court's chief judge from 1986 through 1988 and now is a shareholder in San Antonio's Langley & Banack, says under the 5th Circuit's opinion in Wooley, the protection that equitable mootness affords other parties in the case does not apply when a party is before the court. That means lawyers -- who are parties before the court whether they represent the debtor or a committee of creditors -- may not be protected from having to disgorge the fees they've been paid, he says.
"This says, 'You got paid, you're still here and you're still at risk,' " Ayers says of the opinion.
The Wooley case stems from the August 2004 filing for Chapter 11 bankruptcy protection by Schlotzsky's Inc., a chain of sandwich restaurants. Under Chapter 11 of the U.S. Bankruptcy Code, a business can propose a reorganization plan to keep the business alive and pay its creditors over time.
The 5th Circuit panel concluded in Wooley that two lower courts erred when they gave a green light to Dennis Faulkner, who administers the plan for distributing the assets of Schlotzsky's bankruptcy estate, to pay the plan's attorneys from a reserve fund established to pay certain secured claims of John and Jeffrey Wooley. The Wooleys are former officers and directors of Schlotzsky's.
Fifth Circuit Judge W. Eugene Davis wrote the panel's opinion, joined by 5th Circuit Judge Leslie Southwick and U.S. District Judge Ron Clark of the Eastern District of Texas, sitting by designation.
According to the 5th Circuit's opinion, the U.S. Bankruptcy Court for the Western District in San Antonio erred in April 2007 when it granted Faulkner's motion for authorization to disburse the $500,000 in the reserve fund to pay the plan's counsel, and the U.S. District Court for the Western District in Austin erred in July 2007 by affirming the bankruptcy court's order. In vacating the judgments of the two lower courts, the 5th Circuit concluded that both lower courts erred in determining that the reserve fund that the parties in the bankruptcy case expressly negotiated to protect certain of the Wooleys' secured claims was not needed for that purpose. [See the opinion.]
The 5th Circuit's Aug. 28 opinion is its second decision in Wooley. On June 20, the appeals court held in Wooley I that the bankruptcy and district courts erred in equitably subordinating the Wooleys' claims -- an action that changed the status of those claims from secured to unsecured and made it unlikely the Wooleys could recover all money they had loaned to Schlotzsky's. After the bankruptcy court equitably subordinated the Wooleys' claims, Faulkner moved for that court's permission to disburse the $500,000 in the reserve fund to pay the attorneys representing Faulkner in his role as plan administrator.
According to the 5th Circuit's June 20 opinion in Wooley I, to relieve a critical cash crunch, the Wooleys made two loans totaling $3.5 million to the company in April and November 2003. In March 2005, the Schlotzsky's committee of unsecured creditors brought an adversarial proceeding against the Wooleys in the bankruptcy court, challenging their right to be treated as secured creditors with respect to the two loans. In a February 2007 decision, the bankruptcy court found that the Wooleys, as Schlotzsky's fiduciaries, engaged in inequitable conduct in regard to the November 2003 loan for $2.5 million by proposing it as the only option available at a time when the company was facing a financial crisis. The bankruptcy court found that the Wooleys positioned themselves ahead of other creditors by securing the loan with the revenue stream from the restaurant chain's franchise company, Schlotzsky's most stable subsidiary. The district court affirmed the bankruptcy court's order converting the Wooleys' loans from secured to unsecured status in June 2007, but the 5th Circuit, acting on the Wooleys' appeal, reversed the district court's decision on June 20.
But by the time the 5th Circuit issued its decision on the equitable subordination issue, the plan administrator had disbursed the $500,000 reserve fund to his attorneys. In its April 2007 order granting the plan administer permission to disburse that money, the bankruptcy court reasoned that the Wooleys had no allowed secured claims and, therefore, the $500,000 reserve was "superfluous," and the district court affirmed the bankruptcy court in July 2007.
"By reversing the judgment of the district court in Wooley I, this Court determined that the Wooleys' secured claims should be fully recognized," Davis wrote for the 5th Circuit in Wooley II.
According to the 5th Circuit's opinion in Wooley II, the $500,000 at issue in this case is in addition to the more than $2.8 million that the Schlotzsky's restructuring plan distributed to the Wooleys while the equitable subordination litigation was pending.
Gregory S. Coleman, the Wooleys' lead appellate counsel and a partner in Yetter, Warden & Coleman in Austin, says, "My guys put their money into it [the company]. They're owed the money."
Donald F. Campbell, a shareholder in Winstead in Dallas and Faulkner's lead counsel, says his firm is evaluating all options with its client but declines further comment. "We can't comment on the specifics of the case," Campbell says. Faulkner could file a motion for rehearing with the 5th Circuit panel or file a motion for a rehearing by the full court.
In his briefing to the 5th Circuit, Faulkner argued that the appeals court did not have jurisdiction to hear the Wooleys' appeal, which Faulkner contended was equitably moot because the reserve fund has been disbursed.
Ayers explains that under the equitable mootness doctrine, "If money goes out the door and you don't stop it from going out the door, you may not get it back, because the plan has been consummated."
In his July 21 supplemental brief to the 5th Circuit, Faulkner asserted, among other things, that the restructuring plan for Schlotzsky's "has been substantially consummated" and a reversal of the disbursement order would undermine the distributions and affect the rights of parties not before the court.
The 5th Circuit panel disagreed, noting in the Aug. 28 opinion that the Wooleys are seeking the return of money paid from the reserve fund to Faulkner's attorneys and are not seeking any return of money from third-party creditors to the company's estate.
"It is clear that Appellee's [Faulkner's] counsel, who was paid from the reserve fund, is not a party who is not before the court," Davis wrote for the panel.
Coleman says, "The attorneys are in a different position; they're officers of the court.
"If somebody's filed as a creditor to get money back, that is different from an attorney who appears before the court and is very much involved in making the plan work," Coleman says.
As noted in Faulkner's supplemental brief to the 5th Circuit, Winstead has received a total of $1.5 million in fees for its representation of the plan administrator.
Citing the 9th U.S. Circuit Court of Appeals' 2004 decision in Focus Media Inc. v. National Broadcasting Co., the 5th Circuit reasoned in Wooley II that an order compelling disgorgement of attorneys' fees and expenses would not unravel a complicated bankruptcy plan but instead "would require only that one party disgorge the money it has received, money that would then be distributed pursuant to the bankruptcy court's final decree."
The 5th Circuit panel also determined that the Wooleys were oversecured -- meaning that they put up more security than the amount they are owed -- and are entitled to litigate the amount of their secured claims, including post-petition interest and attorneys' fees.
In remanding the case to the bankruptcy court, the 5th Circuit ordered that court to determine the amount the Wooleys are owed for attorneys' fees and interest. The 5th Circuit also instructed the bankruptcy court to order disgorgement of the attorneys' fees paid to Winstead out of the reserve fund.
Ayers, the former bankruptcy judge, says the 5th Circuit's opinion in Wooley leaves open the possibility that a lawyer's fees in a Chapter 11 bankruptcy case are subject to recapture for an indefinite period.
Notes Ayers, "This is scary, because it leaves you in the dark as to when a Chapter 11 case is finally over."
