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The Problem With “Zero Down” Chapter 7 Bankruptcies

There is no shortage of attorneys advertising on the internet and on television their willingness to file Chapter 7 bankruptcy cases under “zero down,” “low money down,” or “file now, pay later” fee agreements. And it is no mystery why large numbers of financially strapped individuals find the assurance that they can “file now and pay later” for bankruptcy relief irresistible. However, there are many reasons why people should approach choosing a lawyer with greater care than they might choosing a plumber or electrician, and why they are entitled to expect more from their lawyer than they might from non-professionals with whom they do business.

Attorney and Client: A Fiduciary Relationship

Under Minnesota law a lawyer stands in a fiduciary relationship with his or her client, meaning a lawyer is under the legal and ethical obligation to act in the best interest of a client. Because of this fiduciary relationship, Minnesota law imposes on lawyers the highest obligation of good faith, loyalty, fair dealing and full disclosure with respect to all matters affecting the interests of their clients.

Rules of Professional Conduct and Conflicts of Interest

Precisely because lawyers stand in a fiduciary relationship with their clients, they are all bound by rules of professional conduct that prohibit them from doing things that are allowed in many other kinds of business relationships; those same rules require lawyers to do things that are not required in many other kinds of business relationships.

Thus, every lawyer knows that he or she is prohibited from representing a client whenever a conflict of interest exists that could significantly hinder the lawyer’s ability to effectively represent the client. And while a lawyer may choose to represent a client despite a conflict of interest if the lawyer reasonably believes that he or she will be able to provide competent and diligent representation, the rules of professional conduct require in such situations that the lawyer undertake the representation only if the client gives informed consent, confirmed in writing. And consent is informed only if the lawyer has explained fully the material and reasonably foreseeable ways that the conflict could have adverse impacts on the interests of the client. Attorney/client conflicts of interest are governed by Rule 1.7 of the Minnesota Rules of Professional Conduct.

Zero Down Bankruptcy: When Your Chapter 7 Attorney Is A Creditor

When you file a Chapter 7 bankruptcy case you have an undeniable conflict of interest with all of your pre-bankruptcy creditors; your creditors want to be paid, and you want to discharge your liability to them in bankruptcy.

And if, before you file your Chapter 7 case, you enter an agreement with the attorney who files the case for you that obligates you to pay them after the case is filed, then that attorney becomes your creditor. In fact, most courts that have considered this question have concluded that pre-petition debts for legal services are dischargeable in the debtor’s Chapter 7 case just like any other unsecured debt, and have also held that post-petition attempts by the attorney to collect on such debts would be improper.

If you or someone that you know entered a fee arrangement with an attorney who agreed to file a Chapter 7 bankruptcy case and collect any portion of his or her legal fees after the case was filed, that attorney, in accordance with their fiduciary duties, should have disclosed that the promise to pay the attorney’s legal fees would be discharged in the bankruptcy case, and that attempts to collect the fee from the debtor after the discharge was granted would be prohibited by law.

Conflict of Interest Workaround: Unbundling Chapter 7 Legal Services

Some attorneys in Minnesota, and around the country, try to avoid these consequences by filing “no money down” and “low money down” Chapter 7 bankruptcy cases for clients under so-called bifurcated fee arrangements. Under such arrangements, the full scope of legal services necessary for a client to secure the benefit of a Chapter 7 discharge are “unbundled” and covered under two separate fee agreements:

  1. One fee agreement that is signed pre-petition and covers only services essential to get the case filed; and
  2. A second fee agreement signed post-petition that covers the additional services necessary to conclude the Chapter 7 case, including preparing the actual schedules and statement of financial affairs, appearing with the client at the meeting of creditors, and other services as may be required to conclude the Chapter 7 case and secure the discharge.

Because no fees are owed to the attorney at the time the Chapter 7 case is filed the attorney is not a creditor in the client’s bankruptcy case; and because the client signs a second agreement with the attorney after the Chapter 7 petition is filed, the client’s obligations to pay the attorney for the legal services provided in that second fee agreement is not discharged in the Chapter 7 case.

Some courts in other jurisdictions have concluded that these bifurcated fee arrangements in Chapter 7 cases are permissible, but only when subject to a host of conditions. Foremost among those conditions is that a bifurcated fee arrangement must be in the best interests of the client and that the agreement for pre-petition services and the agreement for post-petition services be genuinely separate agreements and the debtor is fully informed before signing either agreement that they have the right to handle the balance of the bankruptcy case themselves, hire another attorney to represent them, or enter a second agreement with the original attorney to conclude the bankruptcy case. The scope of disclosures (to both clients and the court) necessary for getting such agreements approved is considerable; and, of course, the resulting fee arrangement must always be reasonable.

So, while bifurcated fee arrangements are not per se improper in all courts, attorneys and their clients are well advised to exercise extreme caution when using them even in those jurisdictions where they are not prohibited.

Unbundling Chapter 7 Legal Services – Minnesota

As of late December 2021 (when this blog is being written), we do not know whether the judges of the Minnesota Bankruptcy Court will approve the use of “file now and pay later” fee arrangements in Chapter 7 cases filed here. But there is compelling evidence that our local bankruptcy judges are concerned that such fee arrangements are improper, and every reason to conclude that bifurcated fee arrangements run afoul of the Local Rules of Bankruptcy Procedure.

Bifurcated fee arrangements in Chapter 7 cases are premised on the notion that a lawyer can enter a fee agreement with a client under which the lawyer agrees to provide only those pre-petition services sufficient to get the bankruptcy case filed, and then provide the additional legal services necessary to conclude the Chapter 7 case if and only if the client signs a post-petition fee agreement promising to pay for those additional services. However, in any Minnesota Chapter 7 bankruptcy case in which the debtor is represented by an attorney, the debtor and attorney must sign and file Local Form 1007-3-1(7). That form specifies that upon filing a Chapter 7 petition for a client, the attorney is expected to perform a host of enumerated duties, including specifically:

  • ensuring that the debtor is represented by an attorney at the meeting of creditors;
  • preparing, filing and serving any necessary amendments to the petition, schedules, and statements;
  • fully advising the debtor of the legal effect and consequences of proposed reaffirmation agreements;
  • advising the debtor in motions for relief from the automatic stay, filing objections when appropriate, and appearing when required at any hearing;
  • preparing, filing and serving responses to motions for dismissal of the case; and
  • representing the debtor in bringing and defending any and all other matters or proceedings in the bankruptcy case as necessary for the proper administration of the case.

Simply stated, attorneys who file Chapter 7 cases for debtors in Minnesota are required to provide all of the post-petition legal services listed in Local Form 1007-3-1(7), and it is improper for those attorneys to ask their clients to sign any fee agreement that purports to relieve them of those responsibilities.

These obligations of Minnesota attorneys in Chapter 7 cases are not new, going back to a rule that was adopted in 2010. What is new is that, pursuant to a recent order signed by all of the Minnesota Bankruptcy Judge, in every Chapter 7 bankruptcy case filed in the United States Bankruptcy Court for the District of Minnesota, where some or all of the attorney’s fees are to be collected after the bankruptcy case is filed, an application must be filed for the court to review and approve the fee arrangement. That application must be filed within 14 days after the bankruptcy case is filed

The reasons for this new application requirement are made clear in the court’s order:

  1. First, the court noted that a decision recently issued by the Eighth Circuit Bankruptcy Appellate Panel found a post-petition fee arrangement of a Chapter 7 attorney to be “unreasonable.”
  2. Second, the order stated: “The Court is also concerned that post-petition attorney’s fee arrangements may present several ethical concerns under the Minnesota Rules of Professional Conduct.”

Unless local attorneys who file Chapter 7 cases for clients cease using “file now and pay later” fee arrangements entirely, it is reasonable to expect to see further guidance from the Minnesota Bankruptcy Court in the coming months.

Some Conclusions

Attorneys stand in a fiduciary relationship to their clients. Clients have a right to expect from their attorneys not merely that the attorney be completely honest and always put the interests of the client first, but also that they be thorough and meticulous about disclosing to the client anything and everything the client should know concerning matters affecting the interests of the client. That includes matters related to any fee agreement the lawyer asks the client to make.

No attorney should be offering “zero down bankruptcy” or “file now and pay later” fee arrangements to Chapter 7 clients without making comprehensive disclosures about how this might create a conflict of interest between the client and the attorney, and about the ways in which that conflict could adversely impact the client’s interests.

Especially in light of the burdens on debtor’s counsel imposed by the new application required by the recent order issued by the United States Bankruptcy Court for the District of Minnesota, Chapter 7 clients whose attorneys offer “file now and pay later” fee arrangements will likely pay more for their bankruptcy cases than if they had paid the entire fee up front; and attorneys who offer such fee arrangements should be telling clients that.

Given the potential for conflicts with their own attorney and/or disapproval of “file now and pay later” fee arrangements by the court, debtors considering filing for Chapter 7 relief should explore options that may allow them to pay their attorney in full before filing, including halting payments to unsecured creditors or delaying payments to secured creditors, or selling property (especially non-exempt assets), to raise money to pay the legal fee for their Chapter 7 case.

In Minnesota, more guidance on this topic from our Bankruptcy Court is almost certainly coming soon. Stay tuned!

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