By Lisa M. Goolik, J.D.
An attorney was not permitted to take a security interest in a debtor’s property prior to the debtor’s filing for bankruptcy protection to secure both pre- and postpetition professional fees. The U.S. Bankruptcy Court for the Western District of North Carolina determined that because the attorney failed to comply with the applicable state rules of professional conduct, he could not retain a security interest in his debtor’s property to secure fees incurred pre-petition, and as for post-petition fees or fees unearned at the time of filing, the debtor’s legal and equitable interests in the property became property of the bankruptcy estate at filing (In re Pace, Nov. 2, 2015, Whitley, C.).
Background. The debtor met with the attorney to obtain information and to explore whether filing bankruptcy would be beneficial. Sometime after initially consulting with his attorney, but before deciding to file bankruptcy, the debtor experienced several hardships that further strained his financial situation. It became apparent that the debtor did not have the ability to pay the estimated $6,500 to file his case. The attorney then suggested that the debtor grant him a lien on the debtor’s motorcycle and boat to secure the attorney’s fees. The debtor executed a promissory note on June 26, 2015, for $6500 and signed a security agreement granting a security interest in the boat and motorcycle to the attorney. The debtor signed the lien recording application for the motorcycle on June 30, 2015. That same day, the attorney filed the debtor’s Chapter 7 bankruptcy case. The attorney filed a UCC financing statement to perfect his lien on the boat approximately two weeks later.
Ethical issues. While the court did not doubt the attorney’s claims that but for the promissory note and lien, the debtor could not afford to file bankruptcy, it could not agree that such transactions are permissible.
“For obvious ethical and practical reasons, an attorney taking a lien on his debtor’s property is not common. It takes little imagination to hypothesize how the interests of counsel and client could collide. For instance, what would happen if a debtor failed to satisfy the terms of an applicable promissory note? Would the attorney be able to foreclose on the encumbered property? Would the attorney need to move for relief from stay? If so, who would represent the debtor in a defense of the motion?, " questioned the court.
Accordingly, North Carolina’s Rule of Professional Conduct permits an attorney to take such a lien but establishes safeguards to protect against exploitation. The rule provides in relevant part: “(a) A lawyer shall not enter into a business transaction with a client or knowingly acquire an ownership, possessory, security, or other pecuniary interest directly adverse to a client unless: . . . (2) the client is advised in writing of the desirability of seeking and is given a reasonable opportunity to seek the advice of independent legal counsel on the transaction; . . . "
It was undisputed that the attorney did not comply with the rule—he failed to notify the debtor in writing of the desirability of seeking independent legal counsel on the transaction. As a result, the court ordered the attorney to release his secured interests for pre-petition fees.
Moreover, after filing bankruptcy, a debtor is no longer able to transfer or encumber property of the bankruptcy estate absent court approval. As a result, there was no property interest in the boat and motorcycle outside the bankruptcy estate remaining to secure the attorney’s post-petition fees.
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