- Success Fee Negotiated by Financial Advisor and Debtor Prepetition Reduced to Reasonable Fee for Services Provided
- June 1, 2005 | Author: Ronit J. Berkovich
- Law Firm: Weil, Gotshal & Manges LLP - New York Office
In In re XO Communications, Inc., the United States Bankruptcy Court for the Southern District of New York held that the $20 million "Transaction Fee" provided for in the engagement letter executed by the debtor and its financial advisor prior to the commencement of the debtor's chapter 11 case was not "reasonable" under section 330 of the Bankruptcy Code based upon the circumstances of the case. Instead, the court determined post-confirmation that $4 million represented a "reasonable" Transaction Fee.
Sections 328 and 330 of the Bankruptcy Code
Sections 328 and 330 of the Bankruptcy Code are the primary provisions governing the compensation of professionals retained by the debtor in a bankruptcy case. Section 328(a) provides in relevant part that the debtor "with the court's approval, may employ or authorize the employment of a professional person under section 327 . . ., on any reasonable terms and conditions of employment, including on a retainer, on an hourly basis, or on a contingent fee basis." Section 328(a) further provides that after the conclusion of such employment, "the court may allow compensation different from the compensation provided under such terms and conditions" only if "such terms and conditions prove to have been improvident in light of developments not capable of being anticipated at the time of the fixing of such terms and conditions."
Section 330(a)(1) of the Bankruptcy Code provides in relevant part that after notice and a hearing and subject to section 328, the court may award to a professional person employed under section 327 "reasonable compensation for actual, necessary services rendered by the . . . professional . . . and . . . reimbursement for actual, necessary expenses." Section 330(a)(3) provides that "[i]n determining the amount of reasonable compensation to be awarded, the court shall consider the nature, the extent, and the value of such services, taking into account all relevant factors, including -
(A) the time spent on such services;
(B) the rates charged for such services;
(C) whether the services were necessary to the administration of, or beneficial at the time at which the services were rendered toward the completion of, a case under this title;
(D) whether the services were performed within a reasonable amount of time commensurate with the complexity, importance, and nature of the problem, issue, or task addressed; and
(E) whether the compensation is reasonable based on the customary compensation charged by comparably skilled practitioners in cases other than cases under this title."
Thus, pursuant to section 328(a) of the Bankruptcy Code, the court may pre-approve the terms of a professional's employment as long as such terms are "reasonable," and the court will only change the pre-approved compensation if unforeseen events render the compensation improvident. In contrast, a professional seeking compensation under section 330(a) after providing services to the estate is only entitled to "reasonable compensation" for "actual, necessary services rendered." Moreover, under section 330(a), the court must consider whether such services were necessary or beneficial at the time they were rendered.
The distinction between these two provisions was critical in XO Communications, where allowance of a $20 million Transaction Fee sought by the debtor's financial advisor was at issue. After objections were filed at the outset of the chapter 11 case to approval of the fee under section 328(a) of the Bankruptcy Code, the financial advisor agreed to seek approval of the fee at a later date. After confirmation of the chapter 11 plan, the financial advisor sought allowance of the Transaction Fee in its final fee application and the court concluded that since the Transaction Fee at issue was never pre-approved, it must consider the reasonableness of the Transaction Fee pursuant to section 330 of the Bankruptcy Code.
Approximately six months prior to filing a chapter 11 petition, XO Communications, Inc. ("XO"), a telecommunications provider, entered into an engagement letter with its financial advisor to serve as XO's restructuring financial advisor. Under the terms of the engagement letter, as is typical in financial advisor engagement agreements, in addition to a monthly fee for services and reimbursement of expenses, the financial advisor was entitled to receive a "Transaction Fee" upon the closing of a "Transaction." The Transaction Fee was tied to the amount of debt and preferred stock obligations that were "restructured, modified, amended, forgiven or otherwise compromised" as part of a Transaction.
During its prepetition engagement, the financial advisor determined that XO required additional funding. To that end, the financial advisor and XO sought investors from multiple sources but received only one proposal, which was for an investment of $800 million. Although XO and the investors entered into a stock purchase agreement, the financial advisor was unable to secure the support of XO's noteholders for the proposed transaction. The noteholders subsequently secured an alternative investment proposal, but the financial advisor was unable to obtain the support of XO's senior secured lenders for the latter proposal. Although the financial advisor continued to seek investors, the process was unsuccessful, as the telecommunications market experienced a sharp decline in the months following the receipt of the initial proposal. During this time, the initial proposed investors indicated that they had experienced a change of heart, and it became apparent to all involved that the investment would not occur without substantial litigation.
XO subsequently commenced its chapter 11 case and on the same day filed a proposed plan of reorganization with two alternatives: Plan A (predicated on the $800 million investment) and Plan B (a stand-alone plan without the investment). As one of its first day motions, XO filed an application seeking approval to retain the financial advisor as its financial advisor on the terms and conditions of the prepetition engagement letter, including the Transaction Fee. Several major creditor groups objected to the retention application. After negotiations, XO, the financial advisor, and several objecting creditors entered into a stipulation whereby the fee application would be approved under section 328 of the Bankruptcy Code in all respects except for the Transaction Fee as it applied to Plan B. As a result, the court entered an order approving the retention application, other than the Transaction Fee with respect to Plan B, under section 328(a) of the Bankruptcy Code. The parties agreed that the reasonableness of the Transaction Fee for Plan B would be determined by the court at a later date.
Although the court confirmed Plan A, XO was unable to consummate Plan A. Consequently, the court thereafter confirmed Plan B, and Plan B was consummated. Immediately prior to confirmation of Plan B, as a result of an agreement with certain entities that had prior to and during the chapter 11 case acquired 85% of XO's senior secured debt (the "Senior Debt Entities"), XO withdrew the portion of the retention application that sought approval of the Transaction Fee as it applied to Plan B. The financial advisor objected to XO's withdrawal of the retention application and after consummation of Plan B, the financial advisor filed a final fee application seeking approval of the Transaction Fee. Based on the formula provided in the engagement letter, the financial advisor sought approximately $20 million, of which $18 million was the Transaction Fee. XO and the Senior Debt Entities filed objections to the fee application, arguing that the Transaction Fee was not "reasonable" under section 330 of the Bankruptcy Code.
The Bankruptcy Court's Decision
The bankruptcy court first noted that a bankruptcy judge has "broad discretion" in determining whether to allow or disallow professional fees. The court then compared sections 328 and 330 of the Bankruptcy Code. The court noted that section 328 limits the court's ability to revisit fees already approved under that section. Thus, the court had little difficulty allowing the portion of the financial advisor's final fee application that sought approval of fees already approved under section 328(a), including the monthly fee and reimbursement of expenses.
By contrast, because the Transaction Fee with respect to Plan B was never approved under section 328(a), the court held that its reasonableness must be determined under the standards of section 330. According to the court, in the case at bar, the most relevant factors of those set forth in section 330(a)(3) were (i) whether the financial advisor's services were necessary and beneficial to the estate at the time they were rendered and (ii) whether the requested fee is commensurate with compensation awarded for comparable services outside of bankruptcy.
To support its fee application, the financial advisor provided evidence of the services it rendered in connection with Plan B and argued that such services were instrumental in the reorganization. In contrast, the Senior Debt Entities argued that Plan B was a disaster and was caused in part by the financial advisor's failure to consummate successfully one of the investment proposals received initially or a similar transaction. The court held that although an unsuccessful effort by a professional does not necessarily result in the professional being denied compensation for its services, the record before it did not support a success fee of the magnitude sought by the financial advisor or one that would be appropriate if Plan A had been confirmed. While Plan A would have provided secured creditors with 100 cents and unsecured creditors with 8.5 cents on the dollar, Plan B provided only 88 cents to secured creditors and 1.5 cents to unsecured creditors. Moreover, the unsecured creditors' recovery under Plan B, which was 80% less than under Plan A, was possible only as a result of a "gift" from the secured creditors.
Importantly, the court noted that while the financial advisor's services were "necessary and beneficial" to some degree, such services must be viewed in the context of Plan B and the circumstances that existed at the time they were rendered, not at the time the engagement letter was signed. In light of the rapidly deteriorating value of XO at the time the financial advisor performed the services in connection with Plan B, as well as the minimal impact the financial advisor had on the recovery to unsecured creditors, the court refused to approve the fee as requested. While the court concluded that approval of a $20 million Transaction Fee with regard to Plan B was not reasonable, it recognized that the benefits and assistance the financial advisor provided in connection with a recovery to unsecured creditors under Plan B entitled the financial advisor to reasonable compensation. The court stated that to determine what fee would be "reasonable" for the services actually performed by the financial advisor, it would look at the comparable market rate for such services in similar cases.
The court noted that courts in the Second Circuit utilize a "market-driven" approach in considering the reasonableness of professionals' fees, consistent with courts in other circuits, which also determine reasonableness by reference to prevailing market practices. Under the market-driven approach, courts must consider the cost of comparable services.
The court recognized that it is common and generally within the range of reasonableness for financial advisors to earn a transaction fee calculated as a percentage of outstanding debt. The court did not believe, however, that the market would support such a formula in cases where a large portion of the outstanding debt is out of the money such that it is clear at the outset that no financing would be available to fund a restructuring of unsecured debt. The court held that the reasonableness of the financial advisor's fee was, therefore, properly calculated as a percentage of the debt that the financial advisor helped restructure under Plan B -- the secured debt. The $20 million Transaction Fee requested by the financial advisor was clearly over-market as a percentage of the secured debt and according to the court, outside the range of reasonableness. After accepting (without explanation) the formula posited by the Senior Debt Entities and applying the formula to the secured debt, the court determined that a $4 million Transaction Fee was reasonable for the services rendered by the financial advisor with respect to Plan B.
On the one hand, the decision in XO Communications can be seen as a check on what some have decried as excessive success fees; however, the decision could also be criticized as denying financial advisors the bargained-for consideration they would have received absent chapter 11. The decision also under scores the importance of having success fees approved at the beginning of a chapter 11 case under section 328(a) of the Bankruptcy Code. Given, however, the recent reluctance of United States Trustees in many important jurisdictions to allow pre-approval of success fees, it appears that financial advisors may have to await the outcome of chapter 11 cases to learn if their pre-negotiated success fees will be approved. As a result, financial advisors may begin to require upfront initiation fees or higher monthly fees when dealing with distressed companies to compensate for the uncertainty in obtaining their normal success fees.
In re XO Communications, Inc., No. 02-12947 (AJG), 2005 WL 548037 (Bankr. S.D.N.Y. Mar. 9, 2005).