Cash-Strapped Chapter 7 Debtors Get Lift in New Ruling Over Fees

Individuals wishing to file Chapter 7 bankruptcy but lacking funds for it got a push from a recent federal court decision that supports a potential solution.

The U.S. District Court for the District of South Carolina last month said the jurisdiction’s local rules don’t prevent a bankruptcy attorney from “bifurcating” Chapter 7 services into pre- and post-filing parts—and split-charging clients accordingly.

Marketing of such bifurcated services to Chapter 7 debtors has been controversial for years, as bankruptcy attorneys have traditionally collected fees upfront and worked through a case’s conclusion. But the practice is appearing nationwide amid debtors’ pandemic-driven financial struggles and despite a history of the U.S. Trustee’s Office challenging the process.

Bifurcated arrangements will saddle debtors with more debt, and payment schedules may not correspond with work performed, critics say.

But the South Carolina district court’s ruling in In re Prophet further affirms the practice for attorneys and clients who want to strike bifurcated payments deals to allow partial payments upfront and more money later.

“This opinion makes unbundling [of services] in states where this rule exists easier for bankruptcy courts to approve,” said Jeffrey Carbino, a bankruptcy attorney at Offit Kurman PA.

New Payment Option

Much of attorneys’ work—consulting and determining whether bankruptcy is appropriate—is done before clients actually file Chapter 7 in a bankruptcy court. If attorneys don’t collect fees before a Chapter 7 filing, what they’re owed becomes a debt that can be wiped out by the bankruptcy filing.

In such situations, an attorney would have to advise the client “you have no obligation to pay me; you really don’t need to” before accepting debtors’ voluntary post-filing payments, said Ed Boltz, a North Carolina bankruptcy attorney who serves on the board of the National Association of Consumer Bankruptcy Attorneys.

Traditionally most attorneys try to collect on their fees before the Chapter 7 filing, including fees for anticipated work still left to do after filing.

Often the debtor who is best served by Chapter 7—a consumer without much property who is being chased by creditors—lacks the cash to pay fees in advance, Boltz said.

The pandemic led to a lot of people losing good-paying jobs and needing banrkuptcy relief, Carbino said.

As the pandemic began, Benjamin R. Matthews & Associates, a bankruptcy law firm in South Carolina, began offering clients two payment options.

The client could prepay all fees prior to the filing. Alternately, a new “file now pay later” option would bifurcate client engagement into two parts: pre- and post-petition services.

The new option was so popular among the firm’s clients during the tough economy that it filed around 65 or 70 such cases, attorney Benjamin Matthews said.

“To collect my fee upfront, it’s taking four to eight months, when they need the help now. They’re overwhelmed and threatened by creditors. Some of them are literally knocking on their door,” Matthews said.

But the U.S. Trustee, the bankruptcy watchdog unit of the Justice Department, objected to the firm’s new payment option, as it had in other jurisdictions throughout the country. The U.S. Trustee asked a bankruptcy court in the state to review and cancel the firm’s use of bifurcated fee agreements, arguing that such arrangements—which don’t require a client to hire the same lawyer, or any, for the back end of the proceedings—violated the local rule requiring debtor attorneys to see a case through to its finish.

Regional U.S. Trustees have been objecting to the unbundling of services and bifurcation of fees for years. They have also pointed out that bifurcated fees don’t match up with the amount of services provided before and after a filing.

In the South Carolina case, the bankruptcy court sided with the U.S. Trustee, citing a local rule that says “the law firm/attorney which files the bankruptcy petition for the debtor shall be deemed the responsible attorney of record for all purposes including the representation of the debtor at all hearings and in all matters arising in conjunction with the case.”

But the U.S. District Court for the District of South Carolina overruled the bankruptcy court.

Courts in Delaware, Michigan, and Florida have approved bifurcated fee arrangements. Some courts have sanctioned lawyers using the practice but not necessarily because of it, instead finding other problems with attorney representation, or how they advertise for services.

Controversial Practice

Bankruptcy attorneys, trustees, and judges recognize “how people come up with the money to pay for their attorney is a problem,” said Robert Lawless, a professor at the University of Illinois College of Law who specializes in bankruptcy and consumer finance.

“What you’re seeing are people looking for a solution,” he said.

Benjamin R. Matthews & Associates is hardly alone in attorneys offering bifurcated services to serve clients who would be best served in Chapter 7 but lack means to pay all upfront.

“These cases present an issue that Chapter 7 debtors’ attorneys and courts around the country are grappling with,” wrote David Duncan, a judge at the U.S. Bankruptcy Court for the District of South Carolina, whose ruling was overturned by the district court in the state.

The American Bankruptcy Institute Consumer Bankruptcy Commission and many others oppose bifurcated services.

Whether the split of fees actually matches up with the services provided is questionable, said retired bankruptcy Eugene Wedoff, who also served on the ABI Consumer Bankruptcy Commission.

In a typical consumer bankruptcy case, “the bulk of the work is in assembling the debtors’ financial information to determine the appropriateness of bankruptcy and the most suitable chapter, all done before the case is filed,” he said.

Another problem with the bifurcating model is that it can saddle debtors with more debt. Companies are offering high-interest loans to pay for a bankruptcy case, taking the right to pursue the post-bankruptcy payments from the client. Debts incurred after a filing are not discharged.

The debtor is still taking on more debt in order to file the bankruptcy, said Monique Almy, an attorney with Crowell & Moring LLP.

“Are they really getting the benefit of bankruptcy by adding a new post-filing expense?” she said

“It’s sad to see what some people are paying for a simple Chapter 7,” Almy said.