SDNY decision protects and clarifies investment banker compensation in bankruptcy

Restructuring Alert


Reproduced with permission from BNA’s Bankruptcy Law Reporter, 29 BBLR 116, 1/26/17. Copyright  2017 by The Bureau of National Affairs, Inc. (800-372-1033)

In the Relativity Media Chapter 11 case in the Southern District of New York, Bankruptcy Judge Michael E. Wiles definitively shot down challenges brought by the fee examiner Robert Keach and Relativity Secured Lender LLC (together with the reorganized debtor, "RSL") to transaction fees earned by Houlihan Lokey Capital, Inc. and PJT Partners. Judge Wiles opined that not only did the fee examiner not have the power he thought he had to challenge the transaction fees earned by Houlihan Lokey and PJT in accordance with their retention by the debtors under Section 328 of the Bankruptcy Code, but he also called into question the efficacy of the so-called "Blackstone Protocol," which affords Section 330 "reasonableness" review to the Office of the United States Trustee. Bench Decision Regarding Objections to Final Fee Applications of PJT Partners L.P. and Houlihan Lokey Capital Inc., In re Relativity Fashion, LLC, et al., 2016 BL 419222, No. 15-11989 (MEW) (Bankr. S.D.N.Y. Dec. 16, 2016) [ECF No. 2194] (Op.).

On September 21, 2015, the bankruptcy court approved PJT’s retention under Section 328, nunc pro tunc to the petition date. On February 2, 2016, the bankruptcy court entered an order approving Houlihan Lokey’s retention under Section 328, nunc pro tunc to November 25, 2015. Both retention orders provided that "[t]he United States Trustee (...) retain[s] all rights to respond or object to (...) expenses on all grounds, including, but not limited to, reasonableness pursuant to section 330." Houlihan Lokey’s order also granted this right to the official committee of unsecured creditors by agreement of the parties.

At the suggestion of the plan sponsor, on April 5, 2016, Judge Wiles entered an order appointing the fee examiner, although he noted at the hearing that in doing so, he did not intend to change the standards that would govern the review and approval of any of the professionals’ fees. Accordingly, the court did not "so order" the stipulation appointing the fee examiner and instead entered a separate order reiterating the foregoing caveat and declining to make the fee examiner an officer of the court. The fee examiner subsequently contacted Houlihan Lokey and PJT to request additional detail regarding their work in the Chapter 11 case.

Houlihan Lokey and PJT provided the fee examiner with extensive and detailed documentation supporting their work. Nevertheless, the fee examiner filed objections to their final fee applications arguing that Houlihan Lokey and PJT should each be deprived of their entire transaction fee because they could not satisfy the "reasonableness" requirements of Section 330 by demonstrating a clear "nexus" between the work they performed and the Debtors’ restructuring. (RSL objected to Houlihan Lokey’s and PJT’s transaction fees on the same grounds as the fee examiner. The court found that they did not have standing to bring those challenges.)

After a hearing held on December 8, 2016, Judge Wiles roundly rejected the challenges to the transaction fees earned by Houlihan Lokey and PJT. In doing so, he distinguished between retention standards under Section 328 and Section 330 of the Bankruptcy Code, eloquently articulated the justification for treating negotiated transaction fees as an ordinary and important piece of investment bankers’ compensation, and described the history - and questioned the legitimacy - of the so-called Blackstone Protocol. He also brought to bear his own observations and experiences, including his "own sense of the results that were achieved and the role of the professionals in achieving [them]." Op. at 3.

First, the Court distinguished the standards that apply to Section 328 retention and Section 330 retention. Section 328 of the Bankruptcy Code is a prospective analysis in which a determination of reasonableness is made at the time of retention based upon the available information and there is no opportunity to revisit that determination unless it proves "improvident." "Reasonableness is judged in advance, and the issue is not revisited except in the very narrow circumstances permitted by the statue." Op. at 4.

Section 330 retention, on the other hand, approves reasonableness, "to some extent (...) after-the-fact" and enables the court to review "all ‘relevant’ factors, including time spent, rates charged, whether services were necessary or beneficial at the time such services were rendered, whether the services were performed in a reasonable amount of time, and whether the compensation is reasonable based on a customary compensation charged by comparably skilled practitioners in nonbankruptcy cases. 11 U.S.C. § 330(a)(3)(A-F)." Id.

Citing Donaldson Lufkin & Jenrette Securities Corp. v. National Gypsum Co. (In re National Gypsum Co.), 123 F.3d 861 (5th Cir. 1997), Judge Wiles went on to explain that "[s]ection 328(a) reflects the view that professionals are entitled to know what they are likely to be paid for their work." Op. at 4-5. Parties retained on a flat-fee or percentage-fee basis under Section 328 should have "some comfort that the [negotiated] compensation will be paid and that a court will not simply impose a new and different deal after all the work has been done." Id. at 5.

Second, the court clarified some misconceptions "regarding investment banker compensation in general, and in particular about so-called transaction fees, because there is often a lot of confusion about just what they represent." Id. Noting that "[i]nvestment bankers’ main compensation is through transaction fees" both in and out of bankruptcy, the court wrote to address "a problem of labels that are loosely applied." Id. at 6. The court emphatically distinguished the cases in which a party was seeking "a discretionary fee enhancement or success fee which is equivalent to a bonus" from "cases in which ordinary transaction fees are sought. Transaction fees are part of the standard, negotiated, base compensation for the investment banker." Id. at 7 (emphasis added). Cases like In re Residential Capital, LLC and In re Northwest Airlines (which were relied upon by the objectors) "address requests for extra compensation, beyond what is provided for in the retention agreement, [and] really deal with entirely different matters." Op. at 7 (discussing In re Residential Capital, LLC. 2014 BL 32411, 504 B.R. 358, 366 (Bankr. S.D.N.Y. 2014), and In re Northwest Airlines, 2009 BL 24155, 400 B.R. 393, 400 (Bankr. S.D.N.Y. 2009)). In no uncertain terms, the court stated that "the transaction fee is not a bonus, and there is no reason why allowance of the transaction fee should be subject to the same standards as a request for payment of a bonus." Id. at 8 (emphasis added). The court further rejected as "wrong" the suggestion that an investment banker cannot be paid its transaction fee "unless it makes the same showing that a professional would have to make in order to receive a discretionary extra-contractual bonus." Id. Thus, "[c]ourts that consider applications for the payment of transaction fees should not be confused by the labels that people apply and should instead look at exactly what compensation is sought and the terms under which it is being sought." Id. at 8-9. The court also rejected "this same misunderstanding" in the context of attempting to calculate an investment banker’s compensation based on inferred hourly rates from monthly fees alone. Id. at 9.

Third, the court offered some history and commentary on the so-called Blackstone Protocol because the fee examiner relied on it heavily in his objection. Id. The Blackstone Protocol developed as a "negotiated truce" between investment banks and the Office of the U.S. Trustee for the Southern District of New York. In effect, the Blackstone Protocol "creates a hybrid situation" in which Section 330 "reasonableness" standards apply only to an objection made by the U.S. Trustee; others are bound by Section 328(a)’s "improvident" standard. Id. at 11.

However, "it is not at all clear that Congress contemplated this kind of hybrid approach." Id. In Judge Wiles’s view, Section 328 approval and Section 330 approval cannot co-exist, as such a scenario "would completely undermine Section 328(a)." Id. at 12. "A court cannot after-the-fact change the standards that apply to objections filed by other parties (...) Once the arrangement is approved and becomes part of the approved terms of employment, it is locked in." Id. (discussing Riker, Danzig, Scherer, Hyland & Perretti v. Official Committee of Unsecured Creditors (In re Smart World Techs., LLC). 2009 BL 1076, 552 F.3d 228 (2d Cir. 2009) (emphasis added). Thus, "[e]xactly what it means for the United States Trustee to reserve rights to object under Section 330 is, frankly, not clear." Op. at 12.

Turning to the fee applications at issue, the court rejected the fee examiner’s view that he had succeeded to the U.S. Trustee’s right to review the reasonableness of the investment bankers’ fees under Section 330, which was contained in the Section 328(a) retention orders. Id. at 15. First, the court noted that it had specifically declined to so-order the stipulation among the debtors, the official committee of unsecured creditors and the United States Trustee appointing the fee examiner and had instead added a paragraph to a separate order stating that the stipulation would not change the standard of review to which the professionals previously were subject. Id. In the court’s view, granting additional rights of review to parties other than the U.S. Trustee impermissibly would change the standard of review. Id. Second, it would not be fair to the investment bankers to allow the fee examiner to assume this mantle pursuant to a stipulation to which neither banker was a party. Id. at 16. In sum, under the terms of Section 328(a) and Smart World, the court believed it "had no power to give anyone else the right to assert objections based on Section 330 standards. Doing so, in effect, would have changed the retention from a Section 328(a) standard to a Section 330(a) standard, which Smart World [prohibits]." Id.

The fee examiner and RSL conceded at the hearing that if the Section 328 standard applies, there would be "no issue" with Houlihan Lokey’s transaction fee. Id. at 18. With respect to PJT, however, the objectors contended that even if Section 328 applies, there remained a question whether PJT had met the terms of its approved retention agreement that would entitle it to a transaction fee. Id. The court ultimately found that PJT had met the terms of its agreement and was contractually entitled to its transaction fee. Id. at 18-21.

The recent Relativity decision provides important and well-reasoned clarification in the area of professional retention and compensation. It ameliorates a persistent "problem of labels," eliminates the misconception that a negotiated transaction fee is a success fee or a bonus and emphasizes that transaction fees are in fact commonplace and "standard" in investment banker compensation. Judge Wiles’s position with respect to the continuing viability of the "hybrid" Blackstone Protocol is also noteworthy. It will be interesting to see this decision put into practice in the new year.

NOTE: The authors successfully defended Houlihan Lokey Capital, Inc. in the subject litigation.