In re Grasso
586 B.R. 110 (2018)
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Rule of Law:
An attorney seeking compensation in a bankruptcy case must prove that their services were actual, necessary, and reasonably likely to benefit the debtor's estate, while also upholding duties of competence, thorough factual inquiry, and candor to the court; failure to do so, or involvement in schemes to conceal estate assets or use cash collateral without authorization, warrants denial of compensation and disgorgement of fees.
Facts:
- Joseph Grasso (the Debtor) filed for Chapter 11 bankruptcy.
- Paul J. Winterhalter, Esquire (Winterhalter), counsel for Grasso, initially omitted two related bankruptcy cases from Grasso's voluntary petition, despite being counsel for those entities.
- Grasso's bankruptcy schedules inaccurately claimed he held partnership interests (e.g., in WSC 717, Sansom Street Partnership, Curtis Investors, L.P.) as tenants by the entirety with his wife, and Winterhalter failed to investigate these claims despite knowing of inconsistencies from tax returns and other filings.
- Sansom Street Partnership, in which Grasso held a one-third interest, sold its only asset, the Sansom Street Property, yielding over $2.4 million in net proceeds.
- Grasso personally negotiated with Wilmington Savings Fund Society (WSFS) to settle a $929,259.69 claim for $500,000.00.
- Winterhalter facilitated a 'sham transaction' where Sansom Street Partnership 'purchased' the WSFS Claim for $500,000.00 using Grasso's share of the Sansom Street Sale proceeds, despite knowing it was Grasso's personal settlement and used estate assets.
- Winterhalter advised Grasso's accountant that distributions from entities controlled by Grasso, used for Grasso's personal benefit (such as a $125,000 roofing repair), did not need to be fully reported if not directly deposited into the debtor-in-possession (DIP) account.
- Winterhalter requested and received a $30,000 post-petition payment from Curtis Investors, L.P. on behalf of Grasso without prior court approval, directly violating his firm's Rule 2016(b) disclosure statement.
Procedural Posture:
- Joseph Grasso filed a Chapter 11 Voluntary Petition in the United States Bankruptcy Court for the Eastern District of Pennsylvania on February 6, 2012.
- The case was initially assigned to Judge Bruce I. Fox, then reassigned to Judge Eric L. Frank due to a related case, and subsequently transferred to Judge Magdeline D. Coleman on March 7, 2012.
- The Law Offices of Paul J. Winterhalter, P.C. (the Firm) filed an Application to Employ as Debtor's counsel on February 7, 2012, which the United States Trustee (UST) objected to, but Judge Frank approved the application despite concerns about Winterhalter's disclosure obligations.
- The Firm filed a First Interim Application for Compensation on July 17, 2012, seeking $47,912.50 in fees and $1,388.66 in expenses, which the Bankruptcy Court approved as unopposed on August 17, 2012.
- Madison Capital Company, LLC, a substantial unsecured creditor, filed a motion to convert Grasso's case from Chapter 11 to Chapter 7 on July 23, 2012, which the Bankruptcy Court denied without prejudice on September 7, 2012, but ordered more detailed financial reporting.
- Madison Capital then filed a motion for the appointment of a Chapter 11 Trustee on September 14, 2012, which the Bankruptcy Court granted on October 16, 2012, and Christine C. Shubert was appointed as Chapter 11 Trustee on December 18, 2012.
- The Firm filed a Second Interim and Final Application for Compensation (the "Final Application") on December 28, 2012, seeking an additional $69,468.75 in fees and $566.56 in expenses, plus final approval of all compensation.
- Madison Capital filed an objection to the Final Application on February 5, 2013, which the Chapter 7 Trustee (Shubert) joined on May 24, 2013.
- The Bankruptcy Court entered a Compensation Denial Order on January 17, 2014, denying both applications and ordering disgorgement of all fees paid to date.
- The Firm appealed the Compensation Denial Order to the United States District Court for the Eastern District of Pennsylvania in February 2014.
- The District Court vacated the Compensation Denial Order on July 10, 2014, and remanded the case to the Bankruptcy Court to reconsider the benefit the Firm's legal services provided to the Debtor's estate.
- Following remand, the Bankruptcy Court entered an Appraisal Order on August 12, 2014, identifying specific issues and concerns for the Firm to address, and held several evidentiary hearings from December 2014 to May 2015.
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Issue:
Does an attorney for a Chapter 11 debtor-in-possession remain entitled to compensation and retention of fees under 11 U.S.C. § 330(a)(1) and (a)(4) when the attorney's services were found to be incompetent, failed to benefit the estate, involved aiding the debtor in concealing assets and making unauthorized payments from cash collateral, and breached the attorney's duty of candor to the court?
Opinions:
Majority - Magdeline D. Coleman, United States Bankruptcy Judge
No, an attorney for a Chapter 11 debtor-in-possession is not entitled to compensation or retention of fees when the attorney's services are found to be incompetent, fail to benefit the estate, involve aiding the debtor in concealing assets and making unauthorized payments from cash collateral, and breach the attorney's duty of candor to the court. The court denied all compensation to the Law Offices of Paul J. Winterhalter, P.C. (the Firm) and ordered disgorgement of all fees, including an unauthorized post-petition payment and the initial retainer. The court found that Winterhalter's services failed to provide any benefit to the Debtor's estate, and in many instances, caused substantial harm. The court detailed several areas of deficient representation: (1) Incompetent Representation Regarding Schedules: Winterhalter failed to conduct a reasonable inquiry into the accuracy of Grasso's schedules and petition despite obvious inconsistencies, such as the omission of related bankruptcy cases and the inaccurate characterization of partnership interests as tenancy by the entirety property, thus violating his duty of inquiry under Fed. R. Bankr. P. 9011(b) and Pa. R.P.C. 1.1. (2) Failure to Ensure Compliance with Monthly Operating Reports (MORs) and Rule 2015.3 Reports: Winterhalter's client controls were inadequate, leading to untimely, inaccurate, and incomplete MORs and Rule 2015.3 Reports. These reports omitted significant income and expenses, depriving creditors of vital information and contributing to extensive litigation and the eventual conversion of the case to Chapter 7. (3) Improper Administration of the WSFS Claim: Winterhalter's involvement in the 'sham purchase' of the WSFS Claim by Sansom Street Partnership using Grasso's estate funds was not for the estate's benefit but rather to conceal Grasso's personal settlement and divert assets. He failed to disclose this opportunity or the use of estate assets to the court or creditors, and relied solely on the opinion of adverse counsel without independent analysis of its legality. (4) Unauthorized Use of Cash Collateral: Winterhalter's advice regarding Grasso's use of partnership distributions, which constituted cash collateral, failed to account for the Debtor's obligations under 11 U.S.C. § 363(c)(2), which requires creditor consent or court approval. Grasso diverted over $377,000 in distributions, including payments for personal expenses, without authorization. (5) Unauthorized Post-Petition Payment to Firm: Winterhalter requested and received a $30,000 payment from Curtis Investors, L.P. (which constituted estate property and cash collateral) without court approval, in direct violation of his firm's Rule 2016(b) disclosure. (6) Services for Debtor Individually: Services provided solely for Grasso's personal benefit (e.g., defending discharge litigation, assisting non-debtor entities) were deemed not compensable from the estate. (7) Breach of Duty of Candor: Winterhalter knew that Grasso's testimony regarding the WSFS Claim transaction was false and misleading (e.g., stating he was not involved, unaware of the price, and that Sansom Street Partnership solely controlled the purchase) but failed to correct the record, thereby breaching his duty of candor under Pa. R.P.C. 3.3 and as an officer of the court. The cumulative effect of these failures, fostering client misconduct and lack of candor, demonstrated no net benefit to the estate, and in fact caused substantial harm. Therefore, all compensation was denied, and all fees received were ordered disgorged. The court also referred the matter to the District Court and appropriate disciplinary boards.
Analysis:
This case serves as a powerful reminder of the stringent requirements for professional compensation in bankruptcy, underscoring that attorneys must do more than simply perform services; they must ensure those services genuinely benefit the estate and adhere to the highest ethical and professional standards. The ruling clarifies the serious consequences for attorneys who fail in their duties of competence, diligent factual inquiry, and absolute candor to the court, particularly when representing debtors-in-possession who hold fiduciary obligations to their creditors. It sets a precedent for aggressively denying fees and ordering disgorgement in situations where attorneys participate in or fail to report client misconduct, highlight the judiciary's commitment to protecting the integrity of the bankruptcy process and estate assets.
