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In re Futuronics Corp.

decided: July 2, 1981.


Appeal and cross-appeal from judgments entered in the United States District Court for the Southern District of New York, Duffy, J ., denying any compensation to general counsel and special counsel for debtor-in-possession in a Chapter XI proceeding based upon counsel's violations of Bankruptcy Rules 215 and 219 and breaches of fiduciary obligations to bankruptcy court. Affirmed.

Before Oakes and Meskill, Circuit Judges, and Sand,*fn* District Judge.

Author: Meskill

Once again we are faced with the unsavory task of reviewing the propriety of an order imposing sanctions upon counsel for a party in a bankruptcy proceeding based upon attorney misconduct. Two law firms, Arutt, Nachamie & Benjamin (the "Arutt firm") and Israel & Raley (the "Israel firm"),*fn1 which represented the debtor-in-possession, Futuronics Corporation (Futuronics), in a proceeding under Chapter XI of the Bankruptcy Act, 11 U.S.C. §§ 701-99 (1976), appeal from judgments entered in the United States District Court for the Southern District of New York, Duffy, J., denying the Arutt and Israel firms compensation for any services performed as general counsel and special counsel for the debtor-in-possession and ordering the return to Futuronics of fees which had been paid with interest accruing from July 15, 1980. Judge Duffy's decision affirmed the order of the bankruptcy court, Lesser, J., except insofar as it had awarded the firms any compensation. The district court determined that Judge Lesser had abused his discretion in allowing the appellants any fees for their professional services in light of the two firms' violations of Bankruptcy Rules 215*fn2 and 219*fn3 and breaches of their fiduciary obligations as officers of the court. For the reasons set forth below, we affirm.*fn4


In January 1975, Futuronics filed its petition in bankruptcy under Chapter XI.*fn5 On the same day an order was entered authorizing the appointment of the Arutt firm as counsel for the debtor under a general retainer. The Arutt firm served as counsel for the debtor until September 1977. The action was originally assigned to Bankruptcy Judge Asa Herzog. Upon Judge Herzog's retirement, the action was reassigned to Bankruptcy Judge Stanley T. Lesser.

The Arutt firm quickly discovered that Futuronics' financial ill health in 1975 was largely attributable to trouble it had been experiencing with a series of substantial government contracts. Thus, the firm decided that special counsel should be retained who possessed the requisite expertise to handle complex government contract litigation. At the suggestion of Albert Blanck, the president of Futuronics, the Israel firm was contacted. The Israel firm was appointed as special counsel for the debtor by an order of Bankruptcy Judge Herzog dated March 11, 1975.*fn6 The order purported to fix the compensation to be given the Israel firm; it incorporated by reference an affidavit of Mr. Israel which listed a $15,000 retainer, various contingency fees for government contracts, and specific hourly rates for Mr. Israel and Mr. Raley. Although a creditors' committee and its counsel had already been selected, the March 11 order was entered ex parte.*fn7

The Israel firm succeeded in obtaining a settlement stipulation in January 1979 from the government, subject to the approval of the bankruptcy court, which provided that "(1) the Government would pay Futuronics.$4,650,000; (2) the Government would withdraw its $8,700,000 claim in the Futuronics' Chapter XI case; and (3) portions of filed and unfiled claims by subcontractors of Futuronics would be paid directly by the Government, relieving Futuronics of responsibility therefor, as if the prime contracts in question had been terminated for the convenience of the Government." A. 8-9. Judge Lesser approved the settlement after a hearing held in February 1979. Judge Lesser lauded the Israel firm for its work and noted in his opinion that the settlement would enable "the debtor ... to propose a plan paying a significant amount, possibly even 100%, to general creditors." A. 2.

Shortly after approval of the settlement of the government contract claims, the Israel firm submitted proposed orders seeking to have the bankruptcy court fix its compensation in accordance with the schedule incorporated by reference in Judge Herzog's order. Judge Lesser refused to sign the orders, reaffirming his previously expressed position that he was not bound by Judge Herzog's March 11 order. Instead, Judge Lesser on March 21, 1979 directed the Israel firm to seek allowances for compensation in a manner consistent with Bankruptcy Rule 219. In an affidavit sworn to April 9, 1979, the Israel firm presented a detailed "Statement of Services Rendered by Special Counsel." A. 10. The affidavit disclosed to the court for the first time that the Israel firm had paid the Arutt firm approximately $60,000 in fees in connection with the government contract litigation. Futuronics' present counsel, the Finley firm,*fn8 seized upon this disclosure and moved on behalf of Futuronics that all compensation to the Arutt and Israel firms be denied based upon the apparent fee-sharing arrangement that had been entered into between the firms in violation of Bankruptcy Rule 219(d). Judge Lesser stated: "What the Court had believed was to be a proceeding to assess the reasonable value of fees to be paid to the Israel firm for a job well done, and the binding effect, if any, of Judge Herzog's March 11, 1975 order, took a radically different turn." A. 11.

After a full hearing, Judge Lesser determined that any work performed by the Arutt firm with respect to the government contract litigation had been done without court approval and thus in direct violation of Rule 215(a). Furthermore, Judge Lesser noted that the proposed order submitted in March 1975 for the appointment of the Israel firm as special counsel "did not contain the affirmation of Blanck as president of Futuronics"; "did not reveal the connections between the Israel and Arutt firms"; and falsely stated that "no prior application for the relief sought" had been made. A. 17. Judge Lesser discovered in the course of the hearings that contrary to the statement contained in the application for the March 11 order, a prior application had indeed been presented to and rejected by Judge Herzog in February 1975. The previous application had included an affidavit which Judge Lesser determined embraced "a bald fee-splitting agreement, (which had been) foisted on the Israel firm by the Arutt firm, but accepted by the Israel firm with full knowledge of its implications." A. 12. Samuel Arutt of the Arutt firm conceded below that Judge Herzog had rejected the proposed February order "because of the 1/3 - 2/3 " fee-sharing arrangement contained in it.*fn9 Judge Lesser discovered that after Judge Herzog had rejected the initial application, another was submitted which deleted the objectionable language concerning fee sharing. The bankruptcy judge determined that the parties decided nevertheless to maintain their fee-sharing arrangement as evidenced by a letter dated March 3, 1975, without disclosing the agreement to the court. Thus, Judge Lesser concluded that Judge Herzog had signed the March 11 order without knowledge of the underlying agreement that had been entered into between the Arutt and Israel firms.

The record reveals that between March 1976 and April 1977, the Israel firm received approximately $190,000 in interim advances,*fn10 and that between May 1976 and May 1977 the Israel firm paid the Arutt firm approximately $60,000, or nearly one-third of its receipts. Judge Lesser noted that the Israel firm applied for interim compensation from the court on "perhaps a dozen occasions" and that each time "the Arutt firm participated in and urged the approval" of the applications. A. 14. On one occasion in 1977, Judge Lesser explained to the parties that he was denying interim allowances because the Israel firm had been paid fully up to date. The two law firms responded only with the contention that Judge Lesser was bound to the terms of the March 11 order that provided for interim allowances. The parties never once disclosed to the court that the Israel firm's financial hardship resulted from its payment of one-third of its interim advances to the Arutt firm, and never informed the court of the retainer agreement between the two firms. Judge Lesser stated in his opinion:

It is inexplicable, and totally inconsistent with the Israel firm's present position that it never doubted the propriety of its arrangement with the Arutt firm, that neither Mr. Israel nor Mr. Raley disclosed to the Court the precipitating cause of its financial hardship in the case, to wit, that it had paid the Arutt firm approximately one-third of the funds that had been received from Futuronics.

A. 15. Judge Lesser concluded that the Arutt and Israel firms had entered into an illicit fee-sharing arrangement in violation of Bankruptcy Rule 219(d). A. 24.

Judge Lesser noted his authority to withhold compensation entirely, A. 25-26, but chose to limit the sanctions against the firms. He directed the Arutt firm to return to Futuronics the $60,000 in unauthorized fees received from the Israel firm and to reduce the "reasonable compensation" that otherwise would be allowed to the Israel firm by approximately $190,000.*fn11 The Israel firm was allowed $850,000 in fees (which included a $200,000 "bonus") less the $218,380 already paid, or $631,620. The Arutt firm was allowed $36,635 as compensation for 470 hours of professional services performed on behalf of Futuronics, less the $10,000 retainer already paid, or $26,635. A. 27-32.

The parties appealed to the district court pursuant to § 39(c) of the Act, 11 U.S.C. § 67(c) (1976). Judge Duffy affirmed the bankruptcy court's decision to the extent that it denied compensation to the Israel and Arutt firms but reversed insofar as the order granted either of the firms any compensation. He determined that the bankruptcy court had abused its discretion in ...

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