• Perils of Bankruptcy Practice: The Power of a Contract and Integration Clauses
  • May 6, 2003
  • Law Firm: Downs Rachlin Martin PLLC - St. Johnsbury Office
  • This issue features two cases: one that highlights the perils of bankruptcy practice, and the other that demonstrates how a well-written contract, that includes an integration clause, can provide a shield to litigation.

    In the first case, two law firms and an accounting firm were taken to task for their charges in connection with a bankruptcy proceeding. First, the Chapter 11 trustee objected to the fees charged by the firms, and opposed further payments to the firms. The firms and the trustee reached a settlement, by which some $260,000 would be refunded, and all of the professional firms would waive any further claim for payment for their services.

    Then the United States Trustee entered the scene, and objected to the settlement, claiming that the professional firms were not disgorging enough money, and that the Chapter 11 trustee did not adequately protect the interests of the creditors in agreeing to the settlement.

    In response, the firms and the Chapter 11 Trustee renegotiated their settlement, and the firms agreed to disgorge a total of $320,000.

    The United States Trustee continued to object, seeking disgorgement of more than 80% of the amounts the firms had been paid.

    The Bankruptcy Court upheld the settlement between the firms and the Chapter 11 Trustee, after commenting that such fee disputes are among the court's most distasteful work.

    So the law firms and the accounting firm "won." But their fee requests, the trustees' objections, and their settlement are on the public record. One wonders how the publicity of the case has impacted their clients' impressions. They have earned a (reduced) fee, but have they enhanced the value of their franchises?

    The Value of A Contract

    If you have ever wondered if the language in an engagement letter makes a difference, the second case should raise your eyebrows.

    Phelps v. PNC Bank, N.A. involves a dispute between a borrower, the borrower's builder, a bank, and an appraiser. Yet it has powerful lessons for accounting firms. In Phelps a borrower entered into a loan agreement to finance the construction of a building. As is customary with such financing, the loan was to be disbursed in accordance with a construction schedule, and individual loan disbursements were to be made only after an appraiser visited the property and certified that the corresponding stage of construction had been completed. You can probably see it coming. The appraiser certified that the building was on schedule, loan disbursements were made, and then the borrowers discovered that the construction was defective.

    First, consider the potential exposure of the appraiser. It is very much like the exposure of an accountant to anyone who relies upon the accountant's compilation, review or audit report and the accompanying financial statements. The appraiser is potentially liable for negligently inspecting the property, and for negligently misrepresenting that the construction stages had been met.

    But here, there was a bank involved. And when banks lend money, there are usually documents, that have been prepared by lawyers. In this case, not only were there agreements that provided the bank had no responsibility to the borrower to assure the correctness or completeness of the construction, but also there were agreements that the appraiser/inspector bore no such liability, that the appraiser/inspector performed his work solely for the bank's interests, and that each application by the borrower for additional funds represented the borrower's representation that the borrower had met the next stage of construction was entitled to the next disbursement of funds.

    Completing the loop, the agreements contained an 'Integration Clause." As described by the court, the integration clause provided that the agreement "constituted all the agreements between the parties relating to the project and superseded all other prior or concurrent oral or written agreements or understandings relating" to the construction of the Phelps's' residence. This Integration Clause precluded the court from hearing any evidence from the borrowers that the bank officials or appraiser had made oral promises to them that varied from the express terms of the contract.

    The bottom line: The borrower's case got thrown out of court. And the Summary Judgment was upheld on appeal. The lesson: draft your engagement letters well. Express that your services are provided only for your client and those about whose intended use and reliance upon the financial statements is disclosed to you before you begin your engagement. Add an integration clause saying that the engagement letter constitutes the sole agreement by the parties and cannot be modified by oral representations. And consider adding a footnote to your compilation, review, or audit reports that advises potential users of the financial statements that your report has been issued in accordance with, and is subject to, the terms of your engagement letter.

    As the Phelps case demonstrates, a contract can make the difference between getting a complaint thrown out of court, and years of litigation hell.