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Lawyers Should Check for Bankruptcy Early & Often Before Settling

A recent case from the U.S. Bankruptcy Court for the Middle District of Alabama reminds us that before we settle a claim on behalf of an individual plaintiff, lawyers should verify that the claimant has not filed for bankruptcy. According to the bankruptcy court, failure to do so can result in the lawyer being liable to pay converted estate assets to the bankruptcy estate.

Debtor Daryl McLemore submitted a Chapter 13 plan disclosing a personal injury claim. His plan was confirmed. Later, the Trustee learned that McLemore had settled his personal injury claim for $40,000.

$16,788 had been disbursed to McLemore rather than paid to the Trustee. McLemore filed a motion to modify the plan post-confirmation, proposing to pay $16,075 to unsecured creditors. The Trustee objected. McLemore then filed an application to employ his personal injury lawyer nunc pro tunc, requested attorney fees and expenses of approximately $13,500, and filed a motion to approve the $40,000 settlement, to which the Trustee and Bankruptcy Administrator objected.

After a hearing, the bankruptcy court denied the motion to employ special counsel nunc pro tunc, approved the settlement except for the attorney fees and expenses requested, and ordered McLemore’s counsel to pay $40,000 – the full amount of the settlement - to the Trustee.

The court determined this payment was warranted because McLemore’s lawyer waited two months after he learned that McLemore was in bankruptcy and three months after he settled the personal injury claim to seek approval of employment as special counsel. Noting that a simple PACER search would have revealed the bankruptcy, the court held that the law firm appropriately bore the responsibility to pay converted estate assets to the bankruptcy estate because the firm did not show excusable neglect.

On appeal, the U.S. District Court for the Middle District of Alabama found that, while case law supports the requirement that counsel disgorges the amount representing fees and expenses for failure to seek bankruptcy court approval of a settlement, those cases do not require that a lawyer’s disgorgement of fees extends to funds paid to parties other than the lawyer.

The bankruptcy court ruling here, thus, went beyond precedent for disgorgement. The Trustee argued that the order to pay the entire $40,000 should be viewed as a sanction. However, the opinion did not invoke its authority to sanction – it simply held that the law firm bore the responsibility to pay all converted assets to the bankruptcy estate. The District Court held that the record did not indicate that the bankruptcy court analyzed the lawyer’s conduct to determine whether sanctions were warranted. Therefore, the court remanded the case to consider the extent of sanctions, if any, to be imposed.

While we will have to wait to see whether the bankruptcy court makes findings to support payment of the entire settlement as a sanction, and whether those findings are ultimately upheld by the district court, we do not need to wait for the big takeaway here – ALWAYS check for bankruptcy before settling a lawsuit for an individual client. It is quick, inexpensive, and will save you, at the very least, a huge headache, not to mention avoiding a potential malpractice claim.

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