SE Property Holdings v. Stewart ( 2020 )

PUBLISH FILED
United States Court of Appeals
UNITED STATES COURT OF APPEALS Tenth Circuit
FOR THE TENTH CIRCUIT August 14, 2020
_________________________________
Christopher M. Wolpert
Clerk of Court
In re: DAVID A. STEWART; TERRY P.
STEWART,
Debtors.
------------------------------
SE PROPERTY HOLDINGS, LLC,
Appellant,
v. Nos. 19-6103 & 19-6104
DAVID A. STEWART; TERRY P.
STEWART; DOUGLAS GOULD, Chapter
7 Trustee; RUSTON C. WELCH; WELCH
LAW FIRM, P.C.; KIRKPATRICK
BANK,
Appellees.
_________________________________
Appeals from the Bankruptcy Appellate Panel
(BAP Nos. WO-18-068 & WO-18-079)
_________________________________
Richard M. Gaal, McDowell Knight Roedder & Sledge, LLC, Mobile, Alabama (S.
Fraser Reid, III, McDowell Knight Roedder & Sledge, LLC, Mobile, Alabama, Mark B.
Toffoli, The Gooding Law Firm, Oklahoma City, Oklahoma, with him on the briefs), for
Appellant.
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.
_________________________________
Before HARTZ, BALDOCK, and EID, Circuit Judges.
_________________________________
HARTZ, Circuit Judge.
_________________________________
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 11 U.S.C. § 329(a)
and Federal Rule of Bankruptcy Procedure 2016(b), until ordered to do so by the
bankruptcy court more than two years after he should have disclosed his fee agreement
and more than a year after he should have disclosed the payments. For these violations
the bankruptcy court sanctioned Mr. Welch by requiring him to pay $25,000 to the
bankruptcy estate.
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 28 U.S.C.
§ 158(d), we agree with SEPH and reverse and remand for further consideration. The
presumptive sanction for a violation of § 329(a) is forfeiture of the entire fee. For good
reason the bankruptcy court can impose a lesser sanction. But the court thus far has not
provided good reason. It assumed facts that were not in evidence and, most importantly,
apparently assumed good faith without examining the possible motives for nondisclosure.
2
I. ATTORNEY DISCLOSURE REQUIREMENTS UNDER
BANKRUPTCY LAW
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 § 329, states:
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.
3
These provisions “require[] every attorney representing a debtor in bankruptcy to file
with the court [within 14 days of the order for relief] a statement of all compensation
received during the preceding year, or to be received, in connection with the bankruptcy.”
Bethea v. Robert J. Adams & Assocs., 352 F.3d 1125, 1127 (7th Cir. 2003). The
disclosure obligation is a continuing one. Rule 2016(b) requires attorneys to submit
supplemental statements “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.) (§ 329 “reflects Congress’
concern that payments to attorneys in the bankruptcy context might be the result of
4
evasion of creditor protections and provide the opportunity for overreaching by
attorneys”), revised on rehearing on other grounds, 265 B.R. 601 (B.A.P. 8th Cir. 2001);
H.R. Rep. No. 95–595, at 329 (1977) (Congress adopted § 329 because “[p]ayments to a
debtor’s attorney provide serious potential for evasion of creditor protection provisions of
the bankruptcy laws, and serious potential for overreaching by the debtor’s attorney, and
should be subject to careful scrutiny”); S. Rep. No. 95–989, at 39 (1977) (same). The
required disclosures are necessary for that oversight. See Bethea, 352 F.3d at 1127(disclosures “enable[] the court to determine whether the lawyer has received a
preferential transfer”); Law Offs. of Nicholas A. Franke v. Tiffany (In re Lewis), 113 F.3d
1040, 1045 (9th Cir. 1997) (court must be able to rely on attorney’s disclosures).
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
5
out of the disastrous 2010 “Deepwater Horizon” oil spill in the Gulf of Mexico.
According to SEPH, the assignment document gave SEPH a security interest in the BP
claims of all entities that David Stewart owned directly or indirectly.
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
6
three ways with 52% of it going to the chief attorney, 32% to Mr. Welch, and 16% to the
person who referred the matter to the chief attorney. Mr. Welch’s fee would therefore be
about 13% of the amount recovered on the claims. There had been a previous attorney-
compensation agreement governing the BP claims. But according to Mr. Welch, it could
not be found; and the record apparently does not show what the terms of that earlier
agreement were, or even whether he was a party to it. To explain his receipt of a
contingency fee, Mr. Welch told the bankruptcy court that he “advised and assisted the
non-debtor claimants in providing substantiating documents to support [the chief
attorney] in the settlement process and negotiated specific language to the settlement
agreements.” Aplt. App., Vol. 13 at 3305.
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 11 U.S.C. § 329 and Bankruptcy Rule 2016(b) require attorneys for
debtors to disclose their fee arrangements and all payments for their bankruptcy services,
Mr. Welch failed to do so until September 2017, more than two years after entering into
the bankruptcy-fee arrangement and more than a year after being paid. His disclosure
was not voluntary. The failure to disclose was pointed out by SEPH during proceedings
7
on August 30, 2017, to determine whether the bankruptcy court would approve an
agreement between the Trustee and the Stewarts signed in April. The agreement stated
that the Trustee would abandon (thereby relinquishing to the Stewarts) all nonexempt
property, including the Stewarts’ membership interests in various limited liability
companies, and the Stewarts would pay $750,000.
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 11 U.S.C. § 554(a) (“[T]he trustee may abandon any
property of the estate that is burdensome to the estate or that is of inconsequential value
and benefit to the estate.”). At a hearing on the matter on January 20, 2016, Mr. Welch
acknowledged that at least one of the entities, Shimmering Sands, had a $600,000 claim
against BP and that “an attorney’s contingency fee firm [had] agreed to try it” (he makes
no mention that he was to receive any of that contingency fee). Aplt. App., Vol. 6
at 1516. But he downplayed the value of the claim, saying that it was “years from ever
even being heard” and that they still would need to put on evidence and witnesses and the
result was uncertain. Id. On March 18, however, Mr. Welch informed the Trustee that
he had just learned that there was movement on the BP claims. On April 13 the
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bankruptcy court denied the motion to abandon, at least in part because of the possibility
the estate could benefit from the BP claims.
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
§ 329(a) and Rule 2016(b). SEPH cited precedent within (and outside of) the Tenth
Circuit that such strong medicine was appropriate for violations like Mr. Welch’s. SEPH
also argued that it was entitled to the money received by Mr. Welch because it had a
security interest in the Neverve funds or, alternatively, they were property of the estate.
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It accused Mr. Welch of “conceal[ing] the fact that he was in possession of assets that
belonged to either the Estate or to SEPH and then [] convert[ing] those assets to pay
himself legal fees.” Aplt. App., Vol. 13 at 3105. SEPH also pointed out that Mr. Welch
had never said that he failed to disclose “because of ignorance of the law or because of
oversight.” Id. at 3106.
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 11 U.S.C. § 329(a) (requiring
reporting of compensation for services in connection with the bankruptcy case). He did
not otherwise seek to justify his failures to disclose even after SEPH’s accusations.
Instead, he argued that he had not taken property of the estate to pay his fees. He also
requested that the bankruptcy court consider the beneficial work he had done for the
estate. In reply, SEPH again argued that Mr. Welch’s payments were from estate
property and that in any event his violations warranted full disgorgement and denial of
his fees.
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 § 329(a) and Rule 2016(b). The bankruptcy court said it was “incredulous” that such
an able and experienced bankruptcy practitioner as Mr. Welch would commit such
misconduct. In re Stewart, 583 B.R. 775, 784 (Bankr. W.D. Okla. 2018). It lamented
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that the concealment of Mr. Welch’s fees, in light of the lack of candor and veracity of
the debtors, 1 generated even more suspicion and mistrust in the already contentious
bankruptcy proceedings. And it doubted that Mr. Welch would ever have made the
requisite disclosures without being ordered to do so. The bankruptcy court recognized
that Mr. Welch’s violations allowed it to order disgorgement of all his fees. But it did
not choose that path.
Relying in part on a case involving sanctions against attorneys under Federal Rule
of Civil Procedure 11, the bankruptcy court applied “the overriding principle in applying
sanctions that ‘the appropriate sanction should be the least severe sanction adequate to
deter and punish’ the offender and deter future violations of the rules.” Id. at 786(quoting White v. Gen. Motors, Inc., 908 F.2d 675, 684 (10th Cir. 1990)). Also, the court
agreed with Mr. Welch that his services had benefited the bankruptcy estate. Notably, it
deviated from the parties’ briefing to consider mitigating factors never raised by the
parties:
• “[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.”
1
For example, the Trustee brought a fraudulent-transfer proceeding to recover property
given by the Stewarts to their children and to a trust for which David Stewart was the
primary beneficiary. The bankruptcy court found that the transfers took place after SEPH
had commenced litigation against the Stewarts and were made without consideration, that
the Stewarts’ personal tax returns continued to claim losses with respect to the property,
that financial statements provided to lenders continued to claim personal ownership, and
that David Stewart retained control over the companies.
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• “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
12
significant discretion in determining the amount of sanctions . . . subject to the principle
that the sanction should not be more severe than reasonably necessary to deter repetition
of the conduct by the offending person or comparable conduct by similarly situated
persons.” In re Stewart, Bankr. No. 15-12215-JDL, 2018 WL 3388925, at *3 (Bankr.
W.D. Okla. July 10, 2018). Although the bankruptcy court had appeared to say in its
initial order that the BP proceeds were not property of the estate, it clarified that it had
not decided the issue.
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.,
13
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 § 329(a) and Rule 2016(b) for abuse of discretion). “A [bankruptcy] court
abuses its discretion when it (1) fails to exercise meaningful discretion, such as acting
arbitrarily or not at all, (2) commits an error of law, such as applying an incorrect legal
standard or misapplying the correct legal standard, or (3) relies on clearly erroneous
factual findings.” Farmer, 791 F.3d at 1256.
A. Required Disclosures and Sanctions for Noncompliance
It is undisputed that Mr. Welch violated the disclosure requirements of § 329(a) of
the Bankruptcy Code and Bankruptcy Rule 2016(b). The attorney’s duty of disclosure is
that of a fiduciary. See Mapother & Mapother, P.S.C. v. Cooper (In re Downs), 103 F.3d
472, 480 (6th Cir. 1996) (“Section 329 and Rule 2016 are fundamentally rooted in the
fiduciary relationship between attorneys and the court. Thus, the fulfillment of the duties
imposed under these provisions are crucial to the administration and disposition of
proceedings before the bankruptcy courts.”); Futuronics Corp. v. Arutt, Nachamie &
Benjamin (In re Futuronics Corp.), 655 F.2d 463, 470 (2d Cir. 1981).
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
14
caused by the agreement.” Id.; see Fed. R. Bankr. P. 2016(b) (disclosure shall include
“whether the attorney has shared or agreed to share the compensation with any other
entity”). The law firm argued that “none of the evils that otherwise might be attributable
to fee-sharing or their other acts manifested themselves” in the case because the
bankruptcy proceedings were a great success, Futuronics, 655 F.2d at 471, with general
creditors possibly receiving 100% payment, see id. at 466. Apparently recognizing this,
the bankruptcy judge allowed the firm $850,000 in fees (including a $200,000 bonus!)
after imposing a penalty of $190,000. See id. at 468. But because of the potential harm
from the firm’s conduct, the circuit court affirmed the district court’s ruling that the
bankruptcy court had abused its discretion by allowing any fees. See id. at 471. Perhaps
the harshness of sanctions has had the desired deterrent effect, because there are
relatively few reported cases of violations among the many, many bankruptcy
proceedings that are filed.
Other circuits have similarly supported the full disgorgement or denial of fees for
§ 329(a) violations. See Lewis, 113 F.3d at 1045–46 (affirming bankruptcy court’s
exercise of its inherent authority over debtor attorney’s compensation by completely
denying attorney fees for failure to disclose under § 329(a)); Downs, 103 F.3d at 478(reversing district court’s affirmance of bankruptcy court’s order because it failed to
impose complete disgorgement and denial of fees, explaining that “[i]n cases involving
an attorney’s failure to disclose his fee arrangement under § 329 or Rule 2016, . . . the
courts have consistently denied all fees.”); Neben & Starrett, Inc. v. Chartwell Fin. Corp.
(In re Park-Helena Corp.), 63 F.3d 877, 882 (9th Cir. 1995) (“Even a negligent or
15
inadvertent failure to disclose fully relevant information may result in a denial of all
requested fees. . . . The court’s denial of all fees was within its discretion.”). See
generally Redding, 263 B.R. at 880 (“It is well settled that disgorgement of fees is an
appropriate sanction for failure to comply with the disclosure requirements of section 329
and Rule 2016. Indeed, the Courts of Appeal which have addressed this and similar
disclosure issues are emphatic in affirming the grant of sanctions.”).
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
16
majority of those who utilize it are honest, that those who are dishonest are [not] 2 likely
to be caught, and that the penalties for dishonesty are severe.” Id. at 603 n.16.
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 § 329(a)
violations. See Turner v. Davis, Gillenwater & Lynch (In re Investment Bankers), 4 F.3d
1556, 1565 (10th Cir. 1993) (“[A]n attorney who fails to comply with the requirements of
§ 329 forfeits any right to receive compensation for services rendered on behalf of the
debtor, . . . and a court may order an attorney sua sponte to disgorge funds already paid to
the attorney.”); Fairshter v. Stinky Love, Inc. (In re Lacy), 306 F. App’x 413, 419–20
(10th Cir. 2008) (unpublished) (following Turner); Quiat v. Berger (In re Vann), 986
F.2d 1431, at *2 (10th Cir. 1993) (unpublished) (affirming full disgorgement of fees
2
The not is not in the original text. But we assume that is a scrivener’s error. After all,
the sentence appears in a footnote to the sentence in the text that says that “many of the
required disclosures are difficult if not impossible to police, at least in a cost-effective
manner.” 309 B.R. at 603. And it would be somewhat inconsistent to say that we are so
dependent on the honesty of lawyers in bankruptcy cases if we are usually able to detect
the dishonesty. Besides, the usual thinking is that sanctions must be harsher when
detection of misconduct is difficult. A severe sanction on those who misbehave may
deter people even if the likelihood of being caught is small. See Jeremy Bentham, The
Theory of Legislation 325 (C.K. Ogden ed. 1931) (“The more deficient in certainty a
punishment is, the severer it should be.”); cf. Dixon v. District of Columbia, 666 F.3d
1337, 1343 (D.C. Cir. 2011) (“An individual officer can catch only so many speeding
motorists. . . . It is precisely the severity of such sanctions that can be expected to deter
some motorists from speeding.”); Directv, Inc. v. Barczewski, 604 F.3d 1004, 1010 (7th
Cir. 2010) (“One economically sound way to determine a penalty is to divide the harm
done by the probability of apprehension. See Gary S. Becker, Crime and Punishment: An
Economic Approach, 76 J. Pol. Econ. 169 (1968), a theory of sanctions that played a role
in his receipt of a Nobel Prize in 1992. . . . Thus if signal theft enables a person to avoid
paying $200 in fees to DirecTV, and only 1 in 50 signal thieves is caught, the appropriate
penalty would be $10,000.”).
17
when attorney failed to comply with Rule 2016(b) and disclosure statements were wholly
inadequate to determine reasonableness of fees); Smitty’s Truck Stop, 210 B.R. at 847,
849 (affirming full disgorgement of $5000 retainer and denial of fees even though
Chapter 11 attorney argued inadvertence and that the information was disclosed in part in
debtor’s statement of affairs because “a clear violation of § 329 and Rule
2016(b)[,] . . .[e]ven if this failure was negligent or inadvertent, . . . is sufficient, in itself,
to deny all fees”); In re Brown, 371 B.R. 486, 492 n.17, 501–04 (Bankr. N.D. Okla.
2007) (ordering disgorgement of all $10,697.08 in payments because of failure to seek
approval under § 330 and to disclose under § 329, but allowing $460 used toward court
costs), amended on other grounds by 370 B.R. 505 (Bankr. N.D. Okla. 2007); In re
Bartmann, 320 B.R. 725, 750 (Bankr. N.D. Okla. 2004) (ordering disgorgement of
undisclosed compensation in the amount of $28,000 for violations of §§ 327 and 329, and
Bankruptcy Rules 2014 and 2016; although the Trustee argued that the attorney should
disgorge all undisclosed fees and the attorney had been paid $38,000 prepetition, the
Trustee sought disgorgement of only $28,000, perhaps because it was debatable whether
some of the fees were paid in connection with the bankruptcy); Lewis, 309 B.R. at 606,
611 (ordering disgorgement of all $892 in one case and denial of all fees sought in
another because of failure to disclose); In re Woodward, 229 B.R. 468, 475 (Bankr. N.D.
Okla. 1999) (ordering disgorgement of $2500 fee because the “law is clear that the failure
to properly disclose compensation received is in and of itself grounds for disgorgement”).
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
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duty. The case law under Federal Rule of Civil Procedure 11 invoked by the bankruptcy
court and the BAP in this proceeding is inapposite. Unlike a failure to make disclosures
required by § 329(a) and Bankruptcy Rule 2016(b), a violation of Rule 11—generally
based on the lack of factual or legal support for a party’s claims or defenses—is highly
likely to see the light of day. When the great majority of violations are likely to be
discovered, the need for harsh sanctions is greatly diminished. The lesson of the case law
discussed above is that imposition of the least possible sanction as the standard for
violations of § 329(a) and Bankruptcy Rule 2016(b) would not be effective in assuring
compliance. Or, to put the matter another way, the least possible sanction to assure
compliance by others is generally disgorgement of the entire fee.
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
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enough funds to pay all allowable creditor claims. See id. at 1155. The district court
ruled that the debtor could not pursue the personal-injury claims, holding that he was
judicially estopped because he had obtained his discharge in bankruptcy on the
representation that he had no such asset. See id. at 1154–55 & n.3. We affirmed. In light
of the seductive “motive to conceal legal claims and reap the financial rewards,” “[t]he
doctrine of judicial estoppel serves to offset such motive, inducing debtors to be
completely truthful in their bankruptcy disclosures.” Id. at 1159. We explained that it
would not be enough to simply return the debtor to the position he would be in if he had
made the proper disclosures:
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 § 329. But it should be the default sanction, and there must be sound
reasons for anything less. For example, in a case where the attorney violated a different
fiduciary duty (the attorney had a conflict of interest when he acquired a creditor’s
interest in the bankruptcy estate while providing legal services to the trustee) we said:
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“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
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fees, often less than $200, “would be administratively unworkable, since some of the funds
paid by the debtors pre-petition were allocated to court fees and other miscellaneous
services.” Id.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 § 329(a) and
Bankruptcy Rule 2016(b). As the bankruptcy judge noted, he probably never would have
made the disclosures had the court not ordered him to. The disclosures came more than
two years after he was required to disclose his compensation agreement with the Stewarts
and more than a year after he was required to report the $350,000 paid him.
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
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bankruptcy court could order a lesser disgorgement, but only for sound reasons supported
by solid evidence. Otherwise, the failure to disgorge all fees is an abuse of discretion.
On the record before us, we must hold that there was an abuse of discretion in this case.
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
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strong reason to keep the payments secret. If, for example, he had thought that disclosure
would lead to substantial challenges to the payments (as indeed occurred), he would have
had a motive not to disclose. The lure of an uncontested $350,000 might induce some
people to violate the disclosure requirements, particularly if the downside risk was
limited to a $25,000 penalty and criticism in a bankruptcy-court opinion.
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
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Neverve for the Stewarts’ benefit was a dividend to them and therefore property of the
estate.
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
3
We realize that if further disgorgement seems proper, a question may arise regarding
where the disgorged funds should go. We leave that possibility for the bankruptcy court
to resolve in the first instance, because what is determined on remand may moot the
issue. There may be no further disgorgement; or it may be determined that all the funds
paid to Mr. Welch were property of the estate or subject to liens of creditors.
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VI. CONCLUSION
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.
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