Financial advisors, investment bankers, lawyers and other professionals in reorganization cases should pay close attention to a decision of the U.S. Court of Appeals for the Second Circuit handed down on Jan. 6, 2009. In re Smart World Technologies, LLC, ___ F.3d ___ (2d Cir. 1/6/2009). In a case of “first impression” for the Second Circuit, the court affirmed the district court’s holding that the bankruptcy court had “pre-approved” a professional’s contingent fee arrangement under Bankruptcy Code (“Code”) § 328(a), and that “no later developments rendered that approval improvident.” Opinion at 2.  

Relevance of Decision

The Smart World decision dealt with a law firm’s pre-approved contingent fee arrangement as special litigation counsel to a Chapter 11 debtor, but also has important ramifications for financial advisors and investment bankers who typically seek bankruptcy court pre-approval of their fees so as to avoid later judicial review of the fees under a “reasonableness” standard. The advisors and bankers also seek to avoid keeping time records and being compensated on an hourly basis. When a court “pre-approves” the terms of a professional’s retention under Code § 328(a), it may not later change those terms unless it finds that the prior arrangement was, in the words of the statute, “improvident” in light of developments not capable of being anticipated at the time of the court’s disposition of the retention application.  


The law firm (“Firm”) in Smart World had acted as the debtor’s special litigation counsel in a post-bankruptcy suit against a third party. The bankruptcy court had approved the Firm’s contingent fee arrangement, stressing the contingent nature of any fees to be awarded, and noting that it would not have to review any time records for the Firm. Shortly after the Firm started prosecuting the litigation, the creditors’ committee agreed to a settlement with the third party over the debtor’s objection. After two years of litigation, the debtor, represented by the Firm, convinced the Second Circuit in 2005 to reverse the lower courts’ approval of the committee settlement by holding that the creditors’ committee had no standing to settle the suit “over the objections of the debtor-in-possession.” In re Smart World Technologies, LLC, 423 F.3d 166 (2d Cir. 2005). The bankruptcy court later confirmed a plan of liquidation that included an enhanced settlement with the third party. When the Firm applied for its fees, relying on the terms of its contingent fee arrangement, the bankruptcy court acknowledged its earlier pre-approval of the fee arrangement, but still reduced the Firm’s award, reasoning that certain events had been “incapable of being anticipated” at the time of the pre-approved contingent fee arrangement. Among other things, the bankruptcy court stressed the “divergence of positions between” the debtor and creditors, the “unusually prolonged litigation,” and the belief that the Firm had been “an obstacle, not an asset, to the approval of the settlement.”  

The Appellate Courts

The Second Circuit affirmed the district court’s reversal of the bankruptcy court, expressly holding that there had been no developments incapable of being anticipated when the bankruptcy court had pre-approved the fee agreement. First, the precise language of Code § 328(a) “permits a bankruptcy court to forgo a full post-hoc reasonableness inquiry if it pre-approves the ‘employment of a professional person under section 327… on any reasonable terms and conditions of employment, including on a retainer, on a hourly basis, on a fixed or percentage fee basis, or on a contingent fee basis.’“ Opinion, at 7-8. When a court “pre-approves the terms and conditions of the [professional’s] retention under § 328(a), its power to amend those terms is severely constrained.” Id. In the words of the statute, the court may only change the pre-approved terms if they “prove to have been improvident in light of developments not capable of being anticipated at the time of the fixing of such terms and conditions.” Id., citing Code § 328(a). Thus, the bankruptcy court may not conduct a later review of fees for reasonableness if the court has previously approved the professional’s employment.  


Like the lower courts, the Court of Appeals agreed that the bankruptcy court here had pre-approved the Firm’s fee arrangement. Agreeing with the Sixth Circuit’s reasoning in In re Airspect Air, Inc., 385 F.3d 915, 921–22 (6th Cir. 2004), it explained that “pre-approval of a fee agreement under [Code] § 328(a) depends on the totality of the circumstances, including whether the professional’s application, or the court’s order referenced Code § 328(a), and whether the court evaluated the propriety of the fee arrangement before granting final, and not merely preliminary, approval.” Smart World’s application to retain the Firm expressly relied on § 328(a). The Firm’s retention order also incorporated the language of the debtor’s application and the Firm’s engagement letter. Opinion, at 10. At the original hearing on the Firm’s retention, the bankruptcy court further stressed the contingent nature of the retention, fixing and approving the calculation of the amount to be paid to the Firm. The retention order, moreover, made no provision for any “additional layer of substantive approval prior to payment.” Id., at 11.  

Contingent Fee Arrangement Not Improvident

The Court of Appeals found no ground for disturbing the pre-approved fee arrangement. In order to change a pre-approved fee agreement, a bankruptcy court must find that “developments which made the approved fee plan improvident had been incapable of anticipation at the time the award was approved.” Id. at, 12, citing In re Barrron, 325 F.3d 690, 693 (5th Cir. 2003). Thus, “simply because the size and scope of the settlement had not actually been anticipated. . . does not follow that it was incapable of anticipation.” Id. Moreover, merely because a contingent fee “may appear excessive in retrospect” hardly justifies a fee reduction because “early success by counsel is always a possibility capable of being anticipated.” Id., quoting In re Gilbertson, 2007 WL 433096, at *5(E.D. Wis. 2/4/07).  

The Second Circuit agreed with the district court that any antagonisms and animosity between the debtors and its creditors “can be expected. . . . “ Id. Moreover, the debtor here, represented by the Firm, mounted a “successful appeal” that increased the total recovery from the third party “by nearly twenty percent, benefiting the estate and its creditors alike.” Id. Further, “the prospect of prolonged litigation always exists,” and had been clearly anticipated by the parties. Finally, because the Firm “was not pursuing frivolous litigation to. . . increase its payday,. . . none of these developments were incapable of being anticipated at the time” of the bankruptcy court’s pre-approval of the Firm’s retention. Id.  


  1. Consistency with Other Circuits. Smart World generally follows the decisions of other appellate courts over the past 12 years. See, e.g., In re Barron, 325(F.3d 690, 691-92 (5th Cir. 2003) (held, when court pre-approves terms of professional’s retention under Code § 328(a), it may not later change those terms unless it finds they were “improvident”); In re Reimers, 972 F.2d 127 (9th Cir. 1992) (in absence of finding that retention agreement was improvidently approved under § 328(a), bankruptcy court erred in modifying special counsel’s compensation); In re Northwestern Corp., 332 P.R. 534 (D. Del. 2005) (fee arrangement not “improvident” when potential duplication of services between two investment banks was “not unforeseeable” because services to be performed had been clearly set forth in banks’ engagements).

The Second Circuit, however, takes a more flexible approach as to “what kind of a showing is required to deem a retention order a pre-approval” under § 328(a). In the Third Circuit (which includes Delaware), the burden rests “on the applicant to insure that the court notes explicitly the terms and conditions [of the retention] if the applicant expects them to be established at that early point” in the case. In re Zofo, Cooper & Co. v. Sunbeam-Oster, Inc., 50 F.3d. 253, 262 (3d Cir. 1995). According to the Ninth Circuit, “unless a professional’s retention application unambiguously specifies that it seeks approval under § 328, it is subject to review [for reasonableness] under § 330.” In re Circle K Corp., 279 F.3d 669, 671 (9th Cir. 2002). In other words, the Ninth Circuit requires a clear reference to Code § 328 in any retention application and order. Id., at 674. As noted, the Second Circuit in Smart World adopted the Sixth Circuit’s “totality of the circumstances” analysis in determining whether the bankruptcy court had approved a retention under Code § 328. In re Airspect Air Inc., 385 F3d. 915, 921-22 (6th Cir. 2004).

  1. Lower Courts and U.S. Trustees Prefer Reasonableness Review. The bankruptcy courts and U.S. Trustees generally resist § 328 fixed fee arrangements and push for a reasonableness review of all professional fee applications under Code § 330. A professional, therefore, should address the issue at the outset to avoid any last-minute surprises. Indeed, in one case, the Third Circuit held that a bankruptcy court may alter a professional’s proposed compensation and limit that compensation at the outset if the court finds the proposed terms to be unreasonable. In re Federal Mogul-Global, Inc., 348 F3d. 390 (3d Cir. 2003) (bankruptcy court allowed equity committee to retain financial advisor, but limited advisor to $30,000 monthly fee rather than proposed fee structure of $200,000 per month; when imposing fee cap, court instructed advisor to rely on information previously compiled by advisors for debtors and creditors’ committee).
  2. Validity of Appointment Still Important. The bankruptcy court still must consider the adequacy of the professional’s compliance with the Code (e.g., disinterestedness) and the professional’s initial disclosures prior to considering a proposed § 328(a) retention. For example, even when a professional has been appointed under either §§ 327 or 328, another party may later attack the retention on substantive grounds. See, e.g., In re Federated Dep’t. Stores Inc., 44 F3d. 1310, 1317 (6th Cir. 1995) (investment banker “knew [the United States] Trustee objected to its appointment [on disinterestedness grounds] and it elected to continue providing services to the estate knowing that the retention order would be reviewed. . . on appeal and would be subject to reversal.”).