In In re XO Communications,1 the United States Bankruptcy Court for the Southern District of New York declined to approve payments to a debtor’s financial advisor according to the terms of a retention letter executed eight months prior to the debtor’s pre-packaged chapter 11 filing. The decision addresses the extent to which bankruptcy courts approve “transaction fees” or “success fees” for professionals in pre-packaged bankruptcy proceedings and sheds light on the interplay between sections 328 and 330 of the Bankruptcy Code, both of which concern payment of professionals.

Factual Background

Following a downturn in the telecommunications market that began in 2000, XO Communications, Inc. (“XO”) retained a financial advisor (the “Financial Advisor”) to evaluate a variety of investment and de-leveraging options. XO and the Financial Advisor entered into an engagement letter in 2001 that provided for a monthly payment, reimbursement of expenses and a “transaction fee” dependent on the occurrence of certain “restructuring transactions.”2

On June 17, 2002, after XO failed to obtain the support of its secured lenders for a proposed asset sale, XO commenced a pre-packaged bankruptcy case. On the petition date, XO submitted a disclosure statement and reorganization plan, which included two alternatives for reorganization: a plan premised upon closing a proposed stock sale (“Plan A”) and an alternative “stand alone” reorganization (“Plan B”). On the same date, XO sought to retain the Financial Advisor under the terms of the existing engagement letter and scheduled a hearing on the Financial Advisor’s retention for July 19, 2002, one month into the case and more than eight months after the parties executed the engagement letter.

A number of parties objected to the Financial Advisor’s retention under the terms of the engagement letter, and the Financial Advisor was forced to compromise. To the extent it sought payment of monthly fees and expenses, the Financial Advisor agreed to seek retention pursuant to section 328 of the Bankruptcy Code. Additionally, the Financial Advisor agreed to a bifurcated success fee: If

XO confirmed Plan A, the Financial Advisor would receive a specified transaction fee pursuant to section 328 of the Bankruptcy Code. If XO confirmed Plan B, the reasonableness of any transaction fee would be determined at a later date. XO confirmed Plan B in November 2002, and the plan became effective in January 2003. During this period, XO attempted to withdraw the portion of the Financial Advisor’s retention application pertaining to the Financial Advisor’s transaction fee for Plan B (which had not yet been heard by the court). The Financial Advisor objected to the notice of withdrawal and claimed that the court should approve its fees, including a $20 million transaction fee (the amount it would have received had Plan A been confirmed), under section 328 of the Bankruptcy Code. In other words, the court was asked to approve the largest possible fee contemplated by the parties, without regard to whether that fee was reasonable in light of the outcome of the case. The court rejected the Financial Advisor’s request.

Relevant Statutory Framework

Section 327 of the Bankruptcy Code allows a chapter 11 debtor in possession, with the bankruptcy court’s approval, to employ “professional persons” to represent or assist the debtor in carrying out its duties, provided the professional does not hold an interest adverse to the debtor’s estate.3 Compensation for professionals retained under section 327 of the Bankruptcy Code may be authorized under either section 328 or section 330 of the Bankruptcy Code.

Section 330 of the Bankruptcy Code permits the bankruptcy court to award a professional “reasonable compensation for actual, necessary services rendered” and compensate a professional for “actual, necessary expenses.” While “reasonable compensation” requires a fact-specific analysis, section 330(a)(3) of the Bankruptcy Code enumerates six nonexclusive factors relevant to the court’s review of a request for payment.4 Additionally, section 330(a)(2) of the Bankruptcy Code expressly permits the bankruptcy court to award a lower amount of compensation than that requested by the professional. Thus a professional that has been retained pursuant to section 327 may not be paid for services rendered until the court has evaluated the reasonableness of the charges and granted approval pursuant to section 330 of the Bankruptcy Code.

In contrast to section 330 of the Bankruptcy Code, which addresses compensation for services that have already been provided, section 328 of the Bankruptcy Code allows the debtor, with court approval, to employ a professional and to define the terms of compensation on a prospective basis. This compensation may be based on an hourly fee, percentage fee, or contingency fee basis, but any agreement retaining a professional must specify “reasonable terms and conditions of employment.”5 Once a fee agreement is approved pursuant to section 328 of the Bankruptcy Code, the court may award compensation inconsistent with the agreement only if the terms of the agreement prove “improvident” in light of developments that could not have been anticipated when the parties executed the agreement.6


On initial hearing, Bankruptcy Court for the Southern District of New York awarded the Financial Advisor a $4 million transaction fee pursuant to section 330 of the Bankruptcy Code. The court rejected the Financial Advisor’s argument that it should receive the entire $20 million transaction fee described in its engagement letter, and instead calculated the $4 million award by applying a rate of 40 basis points to the $1 billion of secured debt that the Financial Advisor had assisted in restructuring.7 Although the United States District Court for the Southern District of New York upheld the bankruptcy court’s decision, on appeal the Second Circuit remanded the matter for “clarification” of the method of calculation of the fee.

On remand, the bankruptcy court considered whether to approve the reduced fee under section 328 or section 330 of the Bankruptcy Code. For a retention considered under section 328 of the Bankruptcy Code, the court held that it must consider the reasonableness of a requested success or transaction fee in light of the information available at the time the debtor retained the advisor (which typically is approximately the same time the retention agreement is submitted to the court for approval). Once a fee agreement containing a success or transaction fee is approved, the court may only revisit the fee if an objecting party demonstrates that the court “improvidently” granted the fee. Consequently, the court is generally precluded from reviewing the role that an advisor plays in any subsequent transactions on grounds that “the parties agree to assume the attendant risks involved as to the potential for underpayment or overpayment for the services rendered.”8

By contrast, for a retention considered under section 330 of the Bankruptcy Code, courts typically consider whether the advisor’s services were necessary and beneficial to the estate at the time they were rendered, and whether the fee is comparable with compensation charged by similarly skilled practitioners outside of bankruptcy.9

In a typical chapter 11 bankruptcy case, a debtor will seek court approval of its professional retentions under section 328 of the Bankruptcy Code shortly after it agrees upon terms with its proposed advisors. However, as the court noted, in a prepackaged bankruptcy case like XO’s, a financial advisor performs most of its work before the petition date, often creating a significant gap of time between the initial agreement and the retention hearing. Importantly, the court emphasized that in that situation, the section 328 reasonableness inquiry is not limited to the facts known to the parties when they initially agree to the terms of the retention, but instead includes all facts known at the time of the retention hearing. Specifically, the court is not required “to ignore those events that may have taken place during the period between the initial engagement and the bankruptcy filing.”10 Stated simply, although a court may not “look back” once it agrees that a proposed fee is reasonable, it is entitled to consider all facts available when it is considering reasonableness, including the ongoing progress of any transaction envisioned by the parties at the time of their initial agreement.11

When a transaction or success fee is not approved in advance under section 328 of the Bankruptcy Code, it is evaluated like all other ongoing professional fees under section 330 of the Bankruptcy Code, which permits “reasonable compensation for actual, necessary services.” 12 Contrasting the two sections, the court observed that

unlike the typical section 328 situation where the tasks to be performed and the results to be achieved are examined prospectively because usually neither the tasks nor the results have occurred at that stage, the “reasonable standard” of section 330 allows a court to view, on an ongoing basis, the nexus between the tasks performed and the results achieved.13

In this case, the court concluded that the Financial Advisor’s proposed success fee required evaluation under section 330 of the Bankruptcy Code, rather than section 328. Because the court confirmed Plan B, and the prepetition engagement letter left the terms of the fee to be determined “at a later date,” the court determined that it was appropriate to consider the reasonableness of the fee amount before approving it. However, the court held that no discernible difference between a section 328 analysis and a section 330 analysis existed in this case. The court stated that eight months had passed between the signing of the engagement letter and the retention hearing and that “as more of the relevant facts, including the outcome of certain efforts become known prior to the section 328 hearing . . . the section 328 analysis as to whether the terms and conditions of compensation are reasonable merges into the section 330 analytical structure concerning reasonableness.”14

The court rejected the Financial Advisor’s argument that the reasonableness of the October 31, 2001 engagement letter should be based exclusively on the facts available to the parties at the time of execution of the engagement letter when it was executed. The court observed that with respect to transaction fees not already approved under section 328 of the Bankruptcy Code, a market-driven analysis of the proposed fees requires an examination of the nexus between any debt that was restructured and the role played by a financial advisor or other professional in the restructuring.15 In adopting the market-based method, the court also explicitly rejected the “lodestar method” that courts often apply in evaluating the reasonableness of transaction fees, which is based on the number of hours worked and rates charged by similar professionals.

The court then reconsidered the reasonableness of the $4 million success fee previously awarded. The court acknowledged that this fee failed to compensate the Financial Advisor for its efforts with respect to the unsecured debt. Because the unsecured creditors were “out of the money,” the Financial Advisor had been unable to demonstrate the value of its role in restructuring the unsecured debt. However, the court noted that the Financial Advisor assisted in the confirmation process with respect to Plan B by offering input on the disclosure statement, attending various meetings and participating in the confirmation hearing. The court also acknowledged that it should have considered the degree of difficulty posed by restructuring the unsecured debt and the resources the Financial Advisor appropriated to this task. Taking all of these factors into consideration, the court awarded the Financial Advisor an additional $1 million, for a total success fee of $5 million (rather than the requested $20 million).16


This decision is important to financial advisors and other professionals participating in prepackaged bankruptcy proceedings. Professionals seeking to obtain approval of transaction fees or success fees would be well served, when feasible, to specifically outline those fees in their retention agreement and to have their fee structures approved under section 328 of the Bankruptcy Code at the outset of their engagement. Approval under section 328 ensures that the fee can only be later reduced if it was found to be “improvidently granted.”

However, because this pre-approval can be impossible in a pre-packaged bankruptcy, where the parties negotiate retention agreements long before the bankruptcy filing, professionals assisting in pre-packaged reorganizations should recognize that a court will consider all information known at the time the court is asked to approve the retention (including the success of the prepackaged bankruptcy), rather than the facts known to the parties at the time they entered into the engagement. Accordingly, courts may evaluate the reasonableness in light of the facts known at the time of the courts’ consideration, and may potentially reduce the fees below the agreed amount.