Basketball Bet: Bad Bankruptcy Barrister

Randy Harris won our NCAA pool this year and has selected me to write an article in response to this hypothetical, which I present here with minor editorial changes from what Randy sent me:

Audrey was an employee at Major Health Insurer (MHI), through which she had health insurance coverage. She was a single parent with a troubled teenaged son. She checked her son into Calming Meadows Psychiatric Hospital. When MHI processed the insurance claim, they sent a $35,000 benefit check directly to Audrey rather than the Calming Meadows. Instead of signing the check over to Calming Meadows, Audrey got the idea to keep the money herself. She called an attorney named Brian, whose response was, “cash the check, bring me $10,000, and I’ll tell you how to spend the rest.” Which she did, then subsequently filed for bankruptcy.

Audrey had no problem getting the debt owed Calming Meadows discharged in bankruptcy. No criminal investigation was conducted. MHI took no employment action against Audrey.

1. Did Brian act ethically?
2. Did Audrey get off easy?

Delicious! This looks more than a little bit like a law school exam or a bar exam question. I think the melding of bankruptcy and legal ethics is not something that would likely come up in either format, but for those of you thinking about law school, this is a reasonable facsimile of the sort of thing you’d be doing there to earn your grades.

The answers are “no” and “no,” but maybe not for the reasons that seem immediately obvious.

Because the first question focuses on legal ethics, we need to understand the legal issues raised by the services Brian renders to Audrey. That means I have to answer question two before I can answer question one. We should also do a bit of filtering through facts at the threshold.

 

1. Sifting Through The Facts, With Tangents

MHI is both Audrey’s employer and her insurer. As her employer, MHI took no adverse action against Audrey. That means that we are not really concerned with the fact that MHI is Audrey’s employer.

Now, had adverse employment action been taken against Audrey, that would raise some interesting and murky issues. Audrey has a right, under Federal statutory law and likely also under the Constitution (Bankruptcy Clause of Article I and Petition Clause of the First Amendment), to seek bankruptcy relief. Can a private employer take an adverse employment action against an employee for the exercise of her legal rights? The answer, I think, is “It stinks if they do, but yes.” For a deeper exploration of those issues, I reference a prior post by Will Truman (originally here).

So, as an insurer, MHI owes Audrey a duty to promptly and objectively process all claims made of coverage, and to extend coverage where it actually applies. Here, the nature of the policy is such that MHI recognizes and extends coverage for Audrey’s son’s inpatient psychological care at Calming Meadows. So its duties as an insurer are discharged upon writing the check for Calming Meadows’ services. Calming Meadows is not a party to the contract of insurance; MHI as insurer owes Audrey these duties with respect to coverage and benefits, but in most states, it does not owe those duties to Calming Meadows. In some states, Calming Meadows is considered a third party beneficiary of the contract of insurance, and has a claim as a third-party beneficiary to the money. But I’ll follow the majority rule here, which is that Calming Meadows is a stranger to that contract and not entitled to money from MHI. Calming Meadows is entitled to money from Audrey, though.

So, as phrased, question two asks, “Did Audrey get off easy?” I interpret this to mean “Did Audrey benefit from this series of events?” The answer to that question is a matter of perspective, to some extent.

 

2. The Fruits of Audrey’s Bankruptcy

One of the first questions lawyers (in the U.S., at least) ask when bankruptcy comes up is “which chapter?”

Briefly, a bankruptcy under Chapter 7 is one in which the debtor’s assets are consolidated into what is called a bankruptcy estate, administered by a third-party trustee who is appointed by the court. The trustee assesses all of the debtor’s debts, liquidates the assets, and then proportionally uses the proceeds of the liquidation to pay down the debts, and then the balance on the debts are discharged, meaning the creditors may take no further action to enforce the debts (with a few exceptions). Under Chapter 7, certain kinds of debts like student loans are non-dischargeable, and certain assets are exempt from inclusion in the estate.

Chapter 11 is a bankruptcy in which the structure of debt repayment schedules are rewritten. Sometimes the bottom line of the debts are written down, but more typically what gets written down are ongoing obligations, interest rates, and the length and frequency of payments. Creditors in Chapter 11 cases usually get at least the bulk of the principal back. The debtor, not the trustee, remains in possession and control of the assets of the bankruptcy estate, although the court exercises a lot of supervision over how the estate’s assets are used. These are expensive procedures and often do not result in discharges.

You may have heard a lot about Chapter 13 bankruptcies as “hybrids” between Chapter 7 and Chapter 11 filings. Chapter 13 bankruptcies only really work when the debtor has a reliable, steady source of income (that is, a regular job). The debtor, the creditors, and the court agree on a partial repayment schedule, usually between thirty to seventy cents on the dollar, and if the debtor completes the payment schedule, the remaining debts are discharged. As a matter of practical reality, a debtor who loses her job or other source of income will not be able to make payments under the plan, and something like two-thirds of all Chapter 13 filers never even submit a plan in the first place, with the result that over nineteen out of twenty Chapter 13 filings fail.

From the facts, it appears that Audrey got a discharge, meaning it’s not a Chapter 11, and she got it with no problem, which pretty much rules out a Chapter 13. So that means it was a liquidation bankruptcy, a Chapter 7. Chapter 7 cases can take one of two forms: assets and no-assets. In a debtor-with assets case, the total value of the bankruptcy estate exceeds the total debts, so there is money left over which (after the trustee’s fees) is returned to the debtor. As you might imagine, these are somewhat uncommon; if the debtor had sufficient assets to meet her debts, she wouldn’t be filing for bankruptcy in the first place. This sort of thing is useful if the debtor wants to retire her debts but her assets are locked up in some way that she can’t get at them easily, or a few other sorts of scenarios. A no-asset Chapter 7 bankruptcy is the much more typical scenario: the debtor owes more than she has or is likely to get. The creditors take pennies on the dollar and have to live with it.

Now, if this is an asseted bankruptcy, then all of Audrey’s non-exempt assets got thrown into the estate, liquidated, and the money was used to pay off all of her debts. The $35,000 insurance proceeds are, sure enough, an asset that would be difficult to exempt. The $35,000 owed to Calming Meadows is, sure enough, a debt that would be scheduled for payment out of the Chapter 7 estate.

If we’re in the world of an asseted bankruptcy, then there must have been more assets than the $35,000 in insurance proceeds that were liquidated. If it happened that after liquidation of all the assets and satisfaction of all the debts, there happened to be $25,000 left over, then good on for Audrey — she got $25,000 back out of her asseted Chapter 7 bankruptcy and everything is totally kosher. Such a scenario would not be particularly interesting from a legal, moral, or ethical perspective. Few people would argue in that circumstance that she ought to get the $25,000 back.

In order for the question to be interesting, and to meet the implied fact from the hypothetical that Calming Meadows wound up not getting its fee in exchange for its services, we’ve got to be in a no-asset situation. Audrey’s total assets, including the insurance proceeds, had to have been less than her total debts, including the bill from Calming Meadows. Note that in this situation, Calming Meadows gets more than nothing — possibly only pennies on the dollar, but it gets something.

Having not had its full bill satisfied, though, Calming Meadows almost certainly discontinues treatment of Audrey’s son. He will then be left without the mental health care that the hypo leads us to believe he actually needs. Add to the “debits” column of this transaction, then, Audrey having to either find and pay for an alternative source of mental health care for her son, or living with the fact that her son has an untreated mental health issue. That would be a big debit.

Also in the debit column would be the damage done to Audrey’s credit rating by the bankruptcy. Most credit bureaus stop reporting bankruptcies after seven years; at least one of the major bureaus has extended the reporting to ten years. Audrey is going to have a hard time getting a credit card with any substantial limits or interest rates below 20% for the next seven to ten years. She will have difficulty securing credit of any kind. It will not be impossible, though; some credit card companies like to issue cards to recent bankrupts because they can’t file again for seven years.

In the other column, we have $25,000. Remember, $10,000 of the $35,000 in insurance proceeds went to Brian. Presumably, that’s his fee for filing the bankruptcy (more about that below). The question to the floor becomes: “Does $25,000 in her pocket adequately compensate Audrey for allowing the mental health of her son to go untreated, and severely damaging her credit rating?”

Others might work the calculus differently and produce a different result.  But in my opinion, the answer is that this is a rather bad trade. I think that over the long haul, this is going to turn out to be rather expensive money for Audrey. Audrey should have known that going in to the transaction, and if she didn’t, her lawyer should have educated her. Which brings us to…

 

3. Brian’s Legal Ethics

 Turning our attention to the lawyer Brian, we must first distinguish between “ethics” and “morals.” As I define those terms, “ethics” are formal, described rules that govern the conduct of an attorney (or some other professional). “Morals,” by contrast address issues of right and wrong, good and evil, justifiable or unjustifiable behavior. Morals are calculated according to a calculus of utilitarianism, deontology, or as is becoming fashionable on these pages, a neo-Aristotelean sense of virtue ethics.

Ultimately, I will leave evaluating the morality of what is going on to the Reader. In my opinion, nearly all reasonable moral calculi effectively strike a balance between the intent-driven analysis of deontology and the outcome-driven analysis of utilitarianism, but reasonable people may disagree on this point.

I’ll point out, though, that at least in my community there are people who think that bankruptcy is inherently immoral — one should pay one’s debts, one should make good on one’s promises, and bankruptcy offers a legally-sanctioned means to avoid those obligations, and the attorneys who make bankruptcy happen are, in the view of those who value these sorts of obligation-dessert calculations, aiders and abettors of that immoral conduct. As I point out below, though, while there may be some moral question on the individual level when it comes to bankruptcy, I think that when one steps away from the micro-analysis of an individual action, a society has an obligation to provide a reasonable measure of bankruptcy relief from both an intent and outcome perspective — and it benefits from so doing.

The question on the floor is not whether what Brian has done is “moral,” it’s whether what he has done is “ethical.” For this, we have more objective ways to evaluate Brian’s conduct. Ethics, being formal rules, are described in formal language. Most states in the United States have adopted variants on the ABA Model Rules of Professional Conduct (formerly called the “Model Code of Ethics”), and nearly all states look to the Model Rules for at least guidance when their own legal ethical codes are ambiguous.

Brian’s conduct raises two threshold ethical issues for me. First, in the hypo, he is depicted as at least partially initiating the scheme to use the bankruptcy to enable Audrey to pocket the insurance money. Second, he demands $10,000 for himself, which I presume to be his attorney’s fee for rendering services as Audrey’s legal advisor and representative in the Chapter 7 bankruptcy. I assume that neither Audrey nor Brian is cheating — they are not concealing assets or inflating debts in the mandatory schedules filed along with the Chapter 7 petition.

If that is true, I do not see that Brian is advising or assisting in a violation of the law. Audrey has a legal right to file bankruptcy, and Brian is advising her about how to go about exercising that right. Presumably, Brian is experience and competent enough to arrange things so that what I’m assuming is Audrey’s no-asset Chapter 7 bankruptcy winds up with her putting $25,000 in her pocket. As I’m about to explain, this is likely going to be a long game if that’s the result, so Brian’s expertise is a significant factor. But the intent, plan, and result are all legal — they all pass muster under the overseeing and likely skeptical eyes of the trustee and the judge, so the result is legal. Brian has advised Audrey in how to use the legal system to her best advantage, something that is not only not prohibited by most rules of legal ethics, but indeed encouraged as a hallmark of competence.

In order to get this result, Brian needs to be cognizant of at least two things. First, under the Bankruptcy Code, all transactions that occurred within the six months leading up to the bankruptcy filing are subject to scrutiny and reversal by the trustee. If Audrey cashed the insurance check within six months of her filing, then the bankruptcy trustee is going to look at it and try to figure out what happened to the money. If the trustee thinks the use of the money was untoward or improper, he will reverse the transaction, taking the money from whoever it was paid to. If Audrey used the $25,000 to pay a debt, the trustee will probably leave it alone.

If the money sat, unused, in Audrey’s bank account (or in Brian’s trust account on Audrey’s behalf) for more than six months, then the cashing of the check won’t be looked at but the disposal of the money will be. If it’s still sitting there, then it’s a liquid asset and will be confiscated by the trustee as part of the estate. So I can only assume that Audrey used the $25,000 to pay down other debts. Nothing else makes sense.

This is particularly interesting when considering that some debts are dischargeable and some not. If Audrey used the money to pay down or pay off a student loan, or certain kinds of tort judgments, then that’s a legitimate use of the money. After all, a debtor is entitled to favor one creditor over another. Rationally, a creditor might favor a creditor who gets higher rates of interest than those who charge lower rates (among other reasons to favor one creditor over another with limited funds), but if bankruptcy is in the picture, it makes more sense to pay down debts that are not dischargeable. There is nothing unethical about Brian advising Audrey to favor one creditor over another. Audrey could pay $25,000 to her student loan company and nothing to her revolving account credit card, for instance, and that would be pretty much OK.

But the hypo suggests that Audrey pockets the money, rather than using it to pay off debts. That means that when creating the mandatory schedules of assets and debts, Brian is working the Chapter 7 exemptions aggressively on behalf of his client. Recall that above, I indicated that some assets go into the Chapter 7 estate and some do not. Some exemptions are standard nationwide, but the bulk of those exemptions vary from state to state, because they derive from the kinds of assets that the particular state’s law protects from enforcement of judgments. Now, the hypo does not indicate which state the filing occurs in, and I’m not aware of any state that allows a liquid asset exemption of $35,000, which is what would seem to be needed here.

So somehow, Brian has learned how to navigate and structure things such that $35,000 of liquid assets are either subject to an exemption and exclusion from the bankruptcy estate, or as permissible expenses from the estate. I guess he’s just that good. Hard for me to believe, but one of the rules of lawyers dealing with hypos is that you can’t change the given facts. And the given facts are that at the end of the bankruptcy, $10,000 goes to Brian and $25,000 goes to Audrey.

Even the relatively generous exemptions of states like California and New York would not seem to allow this result — but this is out of my area of expertise and maybe Brian is just that good. So is $10,000 a reasonable fee for an attorney who is that good? Because a $10,000 fee for filing a Chapter 7 seems like it’s way too much — by a factor of at least five. Most bankruptcy attorneys I know charge between $1,500 and $2,000 for a no-asset Chapter 7. They must declare their fee on the petition, and they are paid out of estate funds. A fee above the market rate for the area is almost certain to elicit close scrutiny by both the trustee and the judge. So if Brian declares a fee of $10,000 for filing a no-asset Chapter 7, he’s going to need to justify that fee, which raises the ethical issue that takes us to Model Rule 1.5.

That rule tells us that Brian may not charge an “unreasonable” fee. Factors to be considered in evaluating the reasonableness of Brian’s fee are, along with my analysis of each in italics:

(1) the time and labor required, the novelty and difficulty of the questions involved, and the skill requisite to perform the legal service properly; (Chapter 7’s are so routine they are administered by paralegals, and the exemptions are very standardized. Brian may be very, very clever, though; but all the same, this suggests the fee is too high.)
(2) the likelihood, if apparent to the client, that the acceptance of the particular employment will preclude other employment by the lawyer (Again, the bulk of the work is done by paralegals and the most time-consuming thing Brian will have to do will likely consist of a single hearing before the trustee, so this fee seems too high to me.);
(3) the fee customarily charged in the locality for similar legal services (I’m not aware of attorneys anywhere charging more than a third of this fee for this service, although I suppose that it’s possible I’m ignorant of what’s going on in other parts of the country than Southern California.);
(4) the amount involved and the results obtained (Audrey walking away with $25,000 liquid in her pocket is an almost unimaginably fantastic result to a no-asset Chapter 7, meriting a higher fee than is otherwise indicated.);
(5) the time limitations imposed by the client or by the circumstances (None present in the hypo, so no factor suggesting a higher fee based on time pressure);
(6) the nature and length of the professional relationship with the client (Chapter 7 cases are ones involving little client contact and the hypo indicates that there was no previous professional relationship between Audrey and Brian, suggesting a lower fee is appropriate);
(7) the experience, reputation, and ability of the lawyer or lawyers performing the services (As indicated above, apparently Brian is a really, really good lawyer to work through the schedules and exemptions to produce this result, potentially justifying a higher-than-standard fee.); and
(8) whether the fee is fixed or contingent (Brian’s fee is fixed, and pre-negotiated, with both parties knowing the stakes; a contingent fee is variable and since the variability of a fee represents financial risk to the attorney, higher fees are justified in a contingent-fee situation).

The only fact suggesting a higher-than-usual fee is Brian’s unbelievably good result; this is relevant to two of the eight Rule 1.5 factors. With six factors suggesting adherence to the market rate of about $2,000 and two factors suggesting a higher rate, I doubt that if I were the judge I would approve a fee of more than about twice the regular rate. Brian would have to be very, very persuasive indeed in justifying his $10,000 fee to me.

I conclude that Brian has charged an unreasonably high fee in violation of Rule 1.5, notwithstanding the concededly fantastic result he’s obtained for his client.

I also question whether he’s provided complete enough advice to his client. As I noted above in analyzing whether Audrey “got off easy,” the lasting impact of a bankruptcy filing is significant and real, in this case she’s looking at leaving her son’s mental health issue (one serious enough to need inpatient care) without treatment. Model Rule 2.1 describes Brian’s duties in rendering advice to his client:

In representing a client, a lawyer shall exercise independent professional judgment and render candid advice. In rendering advice, a lawyer may refer not only to law but to other considerations such as moral, economic, social and political factors, that may be relevant to the client’s situation.

I should hope that it is beyond debate that the issue of discontinuing her son’s mental health treatment is a “moral, economic and social factor” that is relevant to Audrey’s situation. Now, the rule says that Brian “may” refer to this in rendering advice, not that he “must” do so. So a good argument exists that if Brian doesn’t say, “Audrey, you know this means that your son’s mental health issue is going to go without professional therapy from here on out,” then maybe he hasn’t behaved unethically. But mandatory language applies to the first sentence of the rule requires that he give Audrey “candid advice” about the lasting effects of bankruptcy, something that an attorney in his position could not help but at least be aware of. This is particularly true after the 2005 bankruptcy reform legislation, requiring that the attorney and the debtor both certify in their filing that the debtor has obtained counseling about credit, which must include a discussion of what bankruptcy does to one’s credit. Brian must also assess the situation and render advice “independently,” meaning from a point of view that is not self-interested (that is, aimed at maximizing his fee) and one that is not driven by Audrey’s subjective concerns (maybe one of her creditors is her ex-husband or some other enemy).

As I indicate above, in my opinion, filing a Chapter 7 bankruptcy for the purpose of pocketing $25,000 is not a very good idea for the typical client. I suppose someone whose credit is already totally shot, someone who is under a mountain of other debt, someone whose future financial prospects are dim without the bankruptcy, that might be someone for whom such a maneuver might be within the realm of reason. But we know that Audrey has a good job with MHI, so her financial prospects are at least fair-to-moderate. In the hypo, Brian advises the bankruptcy anyway, and seemingly for the purpose of charging a fee for his services which (as demonstrated above) is unconscionably high. This is not independent and candid advice.

Model Rule 7.3, which addresses when and under what circumstances an attorney may approach a prospective client regarding legal services, is not implicated here because Audrey initiated the contact with Brian, not the other way around. Having received an inquiry about his services, rather than solicited Audrey as a client, Brian is free to propose to Audrey such services as he believes he is competent to render. Competence is not Brian’s problem — indeed, it seems to me Brian is some kind of super-lawyer to get a result like this without cheating. His problem is that his fee is too high and it’s possible his client didn’t really understand what she was doing when she agreed to his plan — although it could be that she never really cared, having decided before calling Brian that she was going to try to pocket the insurance money.

 

4. Conclusion

I find it interesting in passing that we are concerned about the practical effect of this chain of events to the debtor Audrey (did she succeed?), but as to the attorney Brian, we are concerned about his ethics (did he do the right thing?).

In answering these questions, I have assumed that both Audrey and Brian have been truthful and complied with the black letter of the law. If either of them lied to the court, all bets are off — and if they get caught, they’ll be in all kinds of big trouble. Nothing in the hypo suggests that such a thing has happened and if it did, it wouldn’t be a very interesting hypo.

So did Brian the lawyer act unethically? No, because he charged Audrey an unconscionably high fee for his service and it appears that there is a serious possibility that he did not render Audrey complete enough advice to enable her to reach a good decision. The decision to file Chapter 7 and escape the debt owed to Calming Meadows is Audrey’s, not Brian’s, so Brian is not responsible for the either ethics or morals of that decision. Also, Brian giving Audrey advice enabling her to game the bankruptcy system and pocket the $25,000, if it actually works, is not unethical; I see no evidence that Brian has advised or facilitated committing a fraud upon the court (although if that did happen, we’re dealing with a very different sort of animal). Whether it is moral for either Audrey or Brian to do this is an open question.

Now, did Audrey get off easily? Well, she gets a short-term gain of whatever is left over from the $25,000 after taxes; let’s rough that out at about $20,000 net. But in exchange for this, she gets to see her troubled son kicked out of a mental health program that presumably was doing him some good, and shouldering seven to ten years of a Chapter 7 bankruptcy clouding her credit. I certainly wouldn’t make that trade for a net of $20K. It only makes sense for Audrey to file Chapter 7 if there is a lot of other unpayable, dischargeable debt that also goes away with the discharge — in which case, her primary motive for the bankruptcy is discharging the other debt.

Congratulations again, Randy; see you in the NCAA pool next year.