In March, the U.S. Supreme Court overruled the so-called Fobian rule in the Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co. decision. (Click here for a copy of the decision.) That rule, named for decision by the United States Court of Appeals for the Ninth Circuit in a case called In re Fobian, 951 F.2d 1149 (9th Cir. 1991), had barred unsecured creditors from recovering as part of their unsecured claim attorney’s fees incurred post-petition litigating bankruptcy issues.

The Open Question. As discussed in a post on the Travelers decision, although the Supreme Court dispatched the Fobian rule, it did not decide whether an unsecured creditor could actually recover its attorney’s fees. Left unresolved, among other issues, was whether Section 506(b) of the Bankruptcy Code, which expressly allows attorney’s fees to oversecured creditors, precludes recovery of post-petition attorney’s fees as part of an unsecured claim.

The Question Gets Asked Post-Travelers. In the In re Qmect, Inc. Chapter 11 cases pending in the U.S. Bankruptcy Court for the Northern District of California, an unsecured creditor sought allowance of post-petition attorney’s fees, incurred litigating bankruptcy issues, as part of its unsecured claim against debtors who were individual guarantors of its debt owed by the corporation. The creditor had prevailed in an adversary proceeding on its guaranty (an appeal is pending) and sought post-petition attorney’s fees as part of its judgment.

After first denying the creditor’s request without prejudice last November, the Bankruptcy Court asked for supplemental briefing on the issue after the Travelers decision was decided. In the debtors’ supplemental brief, they argued that Section 506(b) of the Bankruptcy Code implicitly provides for the disallowance of post-petition attorney’s fees as part of unsecured claims (as opposed to secured claims). In the creditor’s supplemental brief, it argued that all of the other circuits that have addressed the issue agree that such fees are recoverable and that there is nothing in Section 502(b) or Section 506(b) that prohibits their recovery. Both the debtors and the creditor filed reply briefs as well, further arguing their contentions.

California Bankruptcy Court Gives An Answer. On May 17, 2007, in perhaps the first post-Travelers decision to rule on the issue, Judge Leslie Tchaikovsky held that an unsecured creditor was entitled to include post-petition attorney’s fees incurred litigating bankruptcy-related issues in its unsecured claim, where the parties’ underlying contract provided for recovery of attorney’s fees. In its Memorandum of Decision re Motion for Post-Petition Attorneys’ Fees, the Bankruptcy Court held that (1) the creditor’s post-petition attorney’s fees qualify as a "claim" under Section 101(5) of the Bankruptcy Code, and (2) none of the exceptions in Section 502(b) of the Bankruptcy Code apply to require disallowance of the fees as part of the claim.

The Court’s Analysis. In elaborating on the second holding, the Bankruptcy Court explained as follows:

The only category [of Section 502(b)’s exceptions] that arguably supports the disallowance of an unsecured claim for post-petition attorneys’ fees is 11 U.S.C. § 502(b)(1): i.e., that ‘such claim is unenforceable against property of the debtor and property of the debtor, under any agreement or applicable law for a reason other than because such claim is contingent or unmatured….’ 11 U.S.C. § 502(b)(1). The debtor contends that this category applies to post-petition attorneys’ fees because 11 U.S.C. § 506(b) renders the claim for post-petition attorneys’ fees unenforceable against the debtor and property of the debtor. Section 502(b)(1) refers to ‘applicable law,’ not ‘applicable nonbankruptcy law.’ Thus, Section 506(b) qualifies as ‘applicable law.’ Section 506(b) provides as follows:

(b) To the extent that an allowed secured claim is secured by property, the value of which is greater than the amount of such claim, there shall be allowed to the holder of such claim, interest on such claim, and reasonable fees, costs or charges provided for under which such claim arose.

Thus, according to the debtor, by providing that a secured claim shall be allowed reasonable fees to the extent the claim is secured by property, the Bankruptcy Code is implicitly saying that fees are not available to an unsecured creditor. The Court finds this reading of 11 U.S.C. §§ 502(b) and 506(b) too strained to be persuasive. First, 11 U.S.C. § 506 is entitled ‘Determination of Secured Status.’ A statute so entitled would not be a logical place to provide for the disallowance of an element of an unsecured claim. If Congress, in enacting the Bankruptcy Code, had wanted to disallow claims for post-petition attorneys’ fees, the logical place for it to have done so was surely in 11 U.S.C. § 502(b). Moreover, 11 U.S.C. § 506(b) does not distinguish between pre-petition and post-petition attorneys’ fees. Thus, if 11 U.S.C. § 506(b) is read as an additional ground for objecting to claims, arguably, an unsecured creditor would be prohibited from including its pre-petition attorneys’ fees in its claim as well as its postpetition fees.

(Footnotes omitted.) After being unable to find any Court of Appeals decision decided under the Bankruptcy Code directly addressing the issue, the Bankruptcy Court then examined the policy argument underlying the debtors’ objection:

The strongest rationale for implying a prohibition on the inclusion of post-petition attorneys’ fees in a unsecured creditor’s pre-petition claim is that, unless the debtor is solvent, the unsecured creditor’s augmented claim will diminish the dividend to other unsecured creditors. However, a similar effect flows from allowing secured creditors to include their post-petition attorneys’ fees in their secured claims. While equality of distribution is one of the basic tenets of bankruptcy law, another important policy in bankruptcy is the preservation of nonbankruptcy legal rights except to the extent necessary to facilitate the purpose of the bankruptcy proceeding. Absent a clear provision of the Bankruptcy Code modifying a creditor’s nonbankruptcy legal rights, the Court concludes that those rights should be deemed to be left intact.

Now What? If the Bankruptcy Court’s decision is followed by other courts, the main question left open in Travelers will have been answered. However, this decision raises some additional issues:

• Will the potential allowance of post-petition attorney’s fees for bankruptcy-related issues impact a debtor’s reorganization prospects?
• What procedures will debtors propose for managing the process as unsecured creditors amend their claims to add attorney’s fees incurred in protecting their rights during the course of a bankruptcy case?
• Will individual unsecured creditors become more active in Chapter 11 cases, particularly in those cases in which a large distribution is likely?
• What standards will bankruptcy courts use to assess the reasonableness of an unsecured creditor’s post-petition attorney’s fees for bankruptcy-related issues?  
• Will claims buyers pay more for unsecured claims based on contracts providing for recovery of post-petition attorney’s fees now that bankruptcy-related fees are recoverable?
• Will creditors be more insistent on including attorney’s fees provisions in contracts?

It will be interesting to see how these issues unfold as the impact of this decision, and those of other courts facing this issue, are felt. Stay tuned.