Fairbanks attorney Barry Jackson represents L & C Development, an Alaska partnership, in its Chapter 11 bankruptcy. Jackson received a $19,500 retainer from L & C one day before he       3 ABR 140  filed L & C's petition under Chapter 11. The Federal Home Loan Mortgage Corporation (FHLMC), L & C's primary creditor, filed a motion in the bankruptcy court to recover the full amount of the retainer. Bankruptcy Judge Ross granted the motion and ordered Jackson to turn over the funds. Jackson appeals. The relevant facts are undisputed.

Factual Background

L & C's only significant asset is an apartment complex known as Sunrise East. FHLMC has a first deed of trust on the building in the amount of $5 million.⁽¹⁾ By November of 1987, L & C had defaulted on the loan and FHLMC began foreclosure proceedings. L & C raised certain defenses and counterclaims involving improper actions taken by United Bank Alaska, FHLMC's loan servicing agent.⁽²⁾

In the spring of 1988, FHLMC filed a petition for a preliminary injunction in the Alaska superior court. FHLMC wanted possession of the building and all of its rents and profits. FHLMC alleged that it was entitled to this relief pursuant to the rental assignment agreement in the deed of trust.⁽³⁾ After a hearing, Judge Souter denied FHLMC's petition for an injunction. He concluded that L & C might have valid defenses against FHLMC, and that FHLMC had       3 ABR 141  not sustained its burden of showing a likelihood of success on the merits.

Judge Souter's ruling allowed L & C to retain control of the rents from the building. By the fall of 1989, the rents had accrued in the amount of approximately $500,000.

In late September, 1989, FHLMC discovered that several hundred thousand dollars had been withdrawn from the account in which L & C had deposited the rents. These withdrawals were used to pay third parties for debts unrelated to the issues in this case. The attorney for FHLMC, Ann Liburd, wrote to L & C's attorney at that time, John Hendrickson, and made it abundantly clear that FHLMC objected to this use of the funds. She stated that the principals of L & C had no right to dispose of these funds without explicit permission from FHLMC.⁽⁴⁾

Nevertheless, on October 3, 1989, L & C paid $23,000 into attorney Hendrickson's trust account. The funds were disbursed as follows: $19,500 was paid to Jackson on October 3, 1989, $3,000 was paid to Hendrickson, and $500 was used to pay the filing fee in the bankruptcy court. The payment to Jackson was made by cashier's check so that the transfer would take place immediately before the petition for bankruptcy was filed on October 4, 1989. The $19,500 payment was made pursuant to a written attorney-client agreement       3 ABR 142  between Jackson and L & C, which was signed by the parties on October 3, 1989.⁽⁵⁾

On October 4, 1989, Jackson also filed an application to appear as counsel for L & C in the bankruptcy proceeding. Jackson's fee agreement with L & C was not, filed along with the application. Two days later, Liburd sent a letter to Jackson in which she asserted that FHLMC had a perfected security interest in all of the rents and revenues generated by the apartment complex. She told Jackson that FHLMC therefore objected to L & C's use of any of the cash collateral. (R. 218, Exhibit 2.) On October 10, Jackson wrote a letter to Liburd in which he contested FHLMC's assertion of a security interest in the rents. He stated that in his opinion FHLMC did not possess a perfected security interest in the rents and revenues, nor should the rents and revenues be characterized as cash collateral. (R. 218, Exhibit 3.) He did not mention in this letter that he had already received payment out of this fund.

On October 18, 1989, FHLMC moved to sequester the rents generated by the apartments. It also asserted a claim against all rents and revenues, both pre- and post-petition. (R. 17, 18.) On October 19, FHLMC objected to Jackson's motion to employ counsel to the extent that he would be paid out of the cash collateral.(R. 28.)

On October 24, 1989, the bankruptcy court granted FHLMC's motion to sequester the rents from the apartments. The court ordered L & C to segregate all of the rents and profits from the property collected on or after October 18, 1989. The order provided for the payment of necessary operating expenses out of the fund. (R. 42.) The order did not cover pre-sequestration rents because FHLMC intended to resolve this issue by motion after further discovery. On March 8, 1990, the court entered an order which established that all rents collected after October 18, 1989, constituted cash collateral. The order stated that all such rents must be paid to FHLMC, minus reasonable and necessary operating expenses. (R. 149.)

On November 1, 1989, Jackson filed a statement of financial affairs on behalf of his clients. (R. 63.) Disclosure of all payments or agreements between L & C and its attorneys was required in the statement. On page 3.2 of the statement, Jackson disclosed that he had received a "$20,000 retainer and advance on fees and costs" on October 3, 1989. In addition, under the heading "Agreements with Attorneys", page 3.3 reads in part: "Barry W. Jackson, usual fees, subject to court review and approval, minimum fee $10,000, $20,000 advance, for Chapter 11 case, also see attorney disclosure statement." This statement is contrary to his present contention that he was entitled to use his pre-petition retainer without court approval.

On November 2, 1989, Jackson filed an "Attorney's Disclosure Statement". (R. 60.) The filing does not include a copy of       3 ABR 144  his agreement with L & C. The statement again assures that "all fees are subject to review and approval by this court." On December 12, 1989, Jackson filed an amended disclosure statement that indicated $3,000 of the $20,000 fee represented an "earned" retainer. The disclosure statement again asserted that all fees were subject to review and approval by the court. (R. 80.)

The adversary proceeding in bankruptcy court primarily involved the characterization of the pre-petition rents generated by the apartment complex. FHLMC maintained that paragraph 26 of the deed of trust operated as an "absolute assignment" of rents and, as such, FHLMC had a perfected security interest in all of the rents held by L & C. L & C contended that FHLMC's security interest in the pre-petition rents was not perfected. On August 2, 1991, the court entered a judgment which established that FHLMC had a perfected security interest in all rents and proceeds of the property, effective June 4, 1985, the date the deed of trust was recorded.⁽⁶⁾ This order, although it was entered as a final judgment under Rule 54(b), Federal Rules of Civil Procedure, was not appealed. The order identified, and ordered the turnover of, certain accounts as containing rents that were governed by FHLMC's assignment. The subject of FHLMC's claim against remaining funds was left open to subsequent motions.

In October of 1991, FHLMC moved to recover the pre-petition retainer paid to Jackson. (R. 208.) Shortly after FHLMC's motion to recover the retainer was filed, Jackson filed a second amended attorney's disclosure statement. (R. 217.) In this statement, Jackson for the first time asserted that [Ecourt] approval of pre-petition fees and costs is not required." After a hearing, the bankruptcy court granted FHLMCs motion. (R. 240.) The court signed an order prepared by the attorneys for FHLMC that directed Jackson to turn over the $20,000 retainer, plus interest from October 4, 1989. The order also stated "the $20,000 retainer was subject to the prior lien of FHLMC which was known or should have been known by the attorneys for the parties." This appeal followed.

Jackson has divided his arguments into four categories. He argues: first, that the funds paid to him were not collateral of FHLMC; second, that he was paid out of the interest on the rents, not the collateral; third, that FHLMC is barred from seeking reimbursement by the doctrine of laches; and, fourth, that the bankruptcy court failed to take into account the type of retainer used.

First, Jackson argues that the rental assignment clause of the deed of trust (paragraph 26) only created a security interest for FHLMC, and was not an absolute assignment of rents. This issue was litigated in the bankruptcy court, and on August 2, 1991, the court issued a decision in favor of FHLMC. The order stated that FHLMC had a perfected security interest in all of the rents and pro-       3 ABR 146  ceeds thereof, effective the date the deed of trust was recorded, June 4, 1985. FHLMC requested and obtained a Rule 54(b) judgment on this issue. Rule 54(b) allows a court to enter a final, appealable judgment on one issue in a case. L & C could have appealed this decision but it chose not to do so. Jackson cannot belatedly re-litigate the status of FHLMC's security interest in this court.

Next, Jackson argues that on the day the petition was filed, the law of the case, per Judge Souters ruling, was that FHI.MC did not have a perfected security interest in the rents and proceeds. However, as FHLMC points out, the doctrine of the law of the case is invoked only where there is a final, appealable decision by a trial court. Wolff v. Arctic Bull, Inc., 560 P.2d 758, 763 (Alaska 1977). Denial of a motion for preliminary injunction is not such a decision. Haqberg v. Alaska National Bank, 585 P.2d 559, 560 (Alaska 1978). Judge Souter explicitly declined to rule on the merits of the case, and merely held that FHLMC had not sustained its burden of proving that it would be likely to succeed on the merits. At the time Jackson received the retainer, no court had conclusively determined the status of FHLMC's lien on the rents and proceeds of the apartment complex. The doctrine of the law of the case does not apply under these circumstances.

Lastly, Jackson argues that under the Uniform Commercial Code (UCC), the cash proceeds that were used to pay Jackson were not subject to any security interest held by FHLMC. He argues that cash proceeds in the hands of a third party (such as Jackson), obtained       3 ABR 147  in the ordinary course of business, are not subject to any security interest of a creditor. However, FHLMC is correct when it points out that, under AS 45.09.140(10), Alaska's version of the UCC does not apply to a security interest created by a deed of trust. Commercial law, as set out in Alaska's version of the UCC, does not apply in this context. FHLMC had a perfected security interest in the rents generated by Sunrise East long before Jackson was paid out of that fund. The bankruptcy court was correct in ruling in this manner.

Next, Jackson argues that even if FHLMC had a perfected security interest in the rental proceeds, he was paid from interest earned on the rents, not from the accumulated rents themselves. He cites UCC authority for the proposition that interest from a fund subject to a security interest is not automatically subject to the same security interest. He cites other authority which states that courts sometimes presume that payments made from a fund that is earning interest are made from the interest first, and that the security interest in the principal is eroded only as the balance in the account drops below the amount of the proceeds deposited.

FHLMC counters this argument by again pointing out that its security interest was created, and is governed by, a deed of trust on real property---a matter not governed by the UCC. AS 45.09.140(10). Paragraph 26 of the deed of trust gives FHLMC a security interest in all of the "rents and revenues" generated by       3 ABR 148  the apartment complex. The interpretation of the deed of trust is governed by state contract and real property law. Judge Ross was clearly of the opinion that the phrase "rents and revenues" included any interest generated by the rents. In his order of August 2, 1991, Judge Ross provided that all funds in a Dean Witter account of L & C was to be paid over to FHLMC. The Dean Witter account constituted investment of surplus rent in CD's and T-Bills, which included interest earned on those investments. The language of the order supports this conclusion. The order stated: "IT IS HEREBY ORDERED, ADJUDGED AND DECREED that the assignment of rents in favor of FHLMC under its first deed of trust has created a valid and perfected security interest in all rents and proceeds thereof for the Sunrise East Property effective upon June 4, 1985, the date the deed of trust was recorded."^>b>(7)This ruling was substantially correct and was not appealed. The language of the deed of trust and Judge Ross' ruling are consistent. Jackson has not asserted any reason why such a construction would be invalid. FHLMC's security interest extended not only to the rents, but also to the proceeds generated by those rents when they were deposited in an interest-bearing account.

Jackson also argues that FHLMC's delay in seeking repayment of his retainer was unreasonable. He states that the payment of the retainer was known to FHLMC no later than the first meeting       3 ABR 149  of creditors on November 3, 1989. Nevertheless, it did not pursue recoupment of the retainer for two years, when it filed its motion to recover funds in October 1991.

In response, FHLMC argues that it was forced by Jackson to litigate the issue of whether FHLMC's assignment of rents applied to pre-petition rents and revenues. FHLMC was not in a position to recover the retainer until that issue had been decided by the court in August of 1991. In addition, Jackson concealed the nature of his agreement with L & C until November 12, 1991 (shortly after FHLMC filed its motion to recover the retainer), when he finally provided the court with a copy of the agreement. Until that time, Jackson had repeatedly maintained that "all fees are subject to review and approval by this court." It was not until his amended disclosure statement of November 12, 1991 (R. 217), that he took the position that the pre-petition retainer was exempt from court approval. FHLMC argues that, under these circumstances, its motion to turn over the funds was timely. The court agrees. The delay was caused by Jackson's concealment of the nature of his agreement and by his resistance to FHLMC's assertion of its security interest.

Type of Retainer

Thus, FHLMC had a perfected security interest, effective June 4, 1985, in all of the rents and proceeds of the apartment cornplex. When Jackson was paid out of this account, he was paid with FHLMC's cash collateral. Judge Ross ruled that Jackson's interest in the $20,000 retainer was subject to FHLMC's superior lien, and       3 ABR 150  he therefore ordered Jackson to turn over these funds to FHLMC. Judge Ross' ruling went no farther than that.

However, in his appeal brief, Jackson has discussed a case, In re McDonald, 114 B.R. 989 (Bankr. N.D.. Ill. 1990), that adds a new wrinkle to this analysis. In order to place the McDonald decision in context, it will be helpful to review the Code's provisions regarding attorney's fees. An attorney who wishes to represent a debtor must obtain permission to do so from the court. 11 U.S.C. § 327. Section 328 states that an attorney appointed under Section 327 is entitled to reasonable compensation. Section 329 requires a debtor's attorney to file with the court a statement of compensation paid or agreed to be paid, if the agreement was made "after one year before" (that is, in the year preceding) the filing of the petition for bankruptcy. The court has the authority to cancel or alter any such agreement to the extent that it finds the compensation to be excessive. Under Section 331, an attorney employed under Section 327 may apply to the court for interim compensation from the estate funds. After notice and a hearing, the court may allow whatever compensation it deems reasonable. Section 330 establishes the same procedure for compensation at the end of a bankruptcy proceeding.

In McDonald, an attorney for a debtor asked the bankruptcy court for permission to apply a pre-petition retainer to fees he had earned after the petition was filed. The court in McDonald disagreed with other courts which had concluded that a debtor's lawyers could       3 ABR 151  only use their retainers after notice and hearing pursuant to Sections 330 and 331. It concluded instead that the fee application procedure of Sections 330 and 331 must be followed when compensation is sought from tho estate, but not when compensation has been obtained from another source.

According to McDonald, the Code does not render all pre- petition retainers property of the estate, and thus not all retainers are subject to the fee application process. The court stated that the extent of the debtor's bankruptcy estate is determined in accordance with state property laws. The court then identified three types of retainer agreements: "classic" or "earned" retainers, "security" retainers, and "advance payment" retainers. The court looked to applicable Illinois law, and determined that money paid to a counsel pre-petition under the first and third types of agreement do not constitute property of the estate. It concluded that use of the retainer money under those agreements was not subject to the fee application procedures of Sections 330 and 331.

The court's conclusion was based on the differences it perceived between the three types of retainers. A "classic" or "earned" retainer is a sum of money that is paid by a client to secure an attorneys availability over a given period of time, so that the attorney is entitled to the money regardless of whether he actually performs any service for the client. An essential characteristic of the classic retainer is that it is entirely earned by the attorney upon payment, with the client retaining no interest in       3 ABR 152  the funds. Thus, since the client retained no interest in the funds after payment, such a payment made pre-petition is not part of the debtor's bankruptcy estate, and hence is not subject to the fee application requirements. McDonald, 114 B.R. at 997-999.

On the other hand, a "security" retainer provides that the retainer will be held by the attorney to secure payment of fees for future services that the attorney is expected to render. The retainer remains the property of the debtor until the attorney applies it to charges for services actually rendered; any unearned funds are returned to the client. Since these funds continue to be owned by the client, in order for an attorney to draw against this retainer, he must obtain permission from the bankruptcy court under Sections 330 and 331. Id. at 999-1000.

An "advance payment" retainer is one in which the debtor pays, in advance, for some or all of the services that the attorney is expected to perform on the debtor's behalf. This type of retainer differs from the security retainer in that ownership of the retainer is intended to pass to the attorney at the time of payment, in exchange for the commitment to provide the legal services. Thus, an attorney does not have to obtain permission of the court before using these funds to satisfy his fees. Id. at 1000-1001.

Jackson contends that $3,000 of his retainer was a "classic" earned retainer, and that the balance of $16,500 was an advance payment retainer. He argues that since L & C did not retain an interest in the funds once payment was made, the $19,500 retainer       3 ABR 153  was not a part of L & C's bankruptcy estate. Thus, the retainer was his to use as he pleased, without having to obtain permission from the court and without interference from any of L & C's creditors. FHLMC has not responded to this argument.

There are several things wrong with Jackson's position. First, the court does not believe that this line of reasoning can be used when an attorney takes a pre-petition retainer, of any kind, out of funds that are subject to an under-secured creditor's perfected security interest. There is no indication in McDonald that the funds out of which the attorney was paid were subject to a prior lien by a creditor. The court believes that this distinction is dispositive. Bankruptcy courts have long held that, as a general rule, a debtor cannot use property in which a creditor has a security interest to pay the administrative expenses (such as attorney's fees) of his bankruptcy case. In re Flagstaff Food Service Corp., 739 F.2d 73 (2d Cir. 1984); In re Cascade Hydraulics & Utility Service, Inc., 815 F.2d 546 (9th Cir. 1987) ⁽⁸⁾ McDonald did not indicate that the attorney in that case was paid out of an encumbered fund. Thus, even if this court accepted the reasoning of McDonald, the facts in this case are distinguishable on an important point. A non-refundable transfer of funds to an attorney in the form of an       3 ABR 154  "earned retainer" does not avoid a security interest in the same funds created by a deed of trust.

Next, the Code defines the bankruptcy "estate" as containing all of the property in which the debtor has an interest. 11 U.S.C. § 541. Several of the courts that have considered the treatment of pre-petition retainers have noted that a debtor has an equitable interest in the retainer that his attorney holds in a trust account. See,e.g. In re Lilliston, 127 B.R. 119 (Bankr. D. Md. 1991); In re Leff, 88 B.R. 105 (Bankr. N.D. Tex. 1988). It doesn't matter how Jackson characterizes the retainer in this case because he did in fact deposit L & C's retainer in his trust account.⁽⁹⁾ Under Section 541, therefore, the retainer was part of L & C's bankruptcy estate. Jackson violated Section 331 by drawing against the retainer without court approval.

In addition, at least one court has held that when an attorney receives a retainer to ensure payment of fees, the attorney becomes a secured creditor as to the funds in his trust account. In re Burnside Steel Foundry, 90 B.R. 942 (Bankr. N.D. Ill. 1988), citing U.C.C. ¶ 9-305 (perfection by possession). In this case, the security interest that Jackson had in the L & C funds in his trust       3 ABR 155  account was junior to FHLMC's security interest which was perfected four years prior to the creation of Jackson's interest.

Furthermore, although some courts have followed McDonald without questioning its reasoning,⁽¹⁰⁾ other courts have rejected McDonald as creating a loophole for attorney compensation that is contrary to the Code. In re NBI. Inc., 129 B.R. 212 (Bankr. D. Colo. 1991); In re Dixon, 143 B.R. 671 (Bankr. N.D. Tex. April 21, 1992). The court in NBI noted that under Sections 327 and 328 of the Code a bankruptcy court may approve employment of debtors counsel only when it finds that the terms of employment are reasonable. The court held that "classic" and "advance payment" retainers that are purportedly earned in full on payment are inherently unreasonable in bankruptcy cases. The court reasoned that earned retainers in bankruptcy cases impermissibly circumvent the explicit requirements of the Code because:

The Code provides for such compensation [for debtor's counsel] only for actual and necessary legal services and related costs. Absent specific authorization by the court, such compensation is allowed only after such services have been provided and such costs incurred, not before.

"Earned retainers" are unreasonable in bankruptcy because they effectively nullify the protections afforded the estate and its creditors by the Code and Rules. Parties in interest and the Court have the right, if not the duty, to monitor the conduct of the case and related expenditures which have potential impact on the assets of the estate. Parties in       3 ABR 156  interest are entitled to notice and an opportunity to be heard on matters which affect them in advance, not after the fact.

"Earned retainers" also allow debtor and counsel to impermissibly usurp the Court's authority under the Code and Rules. They propose to substitute the discretion of counsel and debtor for that of the Court. The administrative convenience urged by counsel as justification for allowing "earned retainers" without prior fee applications does not absolve the Court of its statutory obligations.

For all of these reasons, the proper course for Jackson to have taken would have been to deposit the retainer in his trust account, immediately disclose the terms of his agreement with L & C to FHLMC and the court, and then apply to the court for a draw against the trust funds under Section 331 as he needed them. Although at the time he entered into his fee agreement with L & C, no court had yet ruled that FHLMC had a perfected security interest in the funds, Jackson was indisputably on notice that FHLMC claimed such an interest and that it would oppose any transfer of funds to Jackson or any other third party. Given FHLMC's assertion of a superior lien on the funds, and the court's subsequent confirmation       3 ABR 157  of that claim, the court's decision to order Jackson to return the funds is hereby affirmed.⁽¹¹⁾

DATED at Anchorage, Alaska, this 20^th day of January, 1993.

M. Russell Holland

United States District Judge

N O T E S:

      3 ABR 140  1. See Multifamily Deed of Trust dated June 3, 1985, attached as exhibit 1 to FHLMC memorandum in support of motion for sequestration of rents R. 18).

      3 ABR 140  2. L & C's amended disclosure statement (R. 152).

      3 ABR 140  3. See paragraph 26 of the multifamily deed of trust.

      3 ABR 141  4. Letter of September 28, 1989, attached as exhibit 1 to FHLMC's reply brief (R. 218).

      3 ABR 142  5. Memorandum to clients, dated October 3, 1989, attached as exhibit C to L & C's opposition to motion to recover funds (R. 216).

      3 ABR 144  6. Judgment dated August 2, 1991, attached as exhibit A to FHLMC motion to supplement record (Clerk's Docket No. 7).

      3 ABR 148  7. Judgment dated August 2, 1991 (emphasis added), attached as exhibit A to FHLMC motion to supplement record (Clerk's Docket No. 7).

      3 ABR 153  8. In 11 U.S.C. § 506(c), Congress codified an exception to this general rule. Under Section 506(c), the court may allow reasonable and necessary administrative expenses to be paid out of a secured creditor's collateral, but it may do so only to the extent that the expenses benefit the secured creditor. The attorney's fees in this case clearly were not spent for the benefit of FHLMC, so this exception does not apply.

      3 ABR 154  9. In his opposition brief in the bankruptcy proceeding, Jackson stated that he deposited the entire amount of the retainer in his trust account immediately after he received payment. He stated that because there was so much early activity in the case, he moved all of the money from his trust account to his personal operating account within the first couple of months of the case. (R. 210 at 4-7). It is undisputed that he did not obtain court approval before removing the money from his trust account.

      3 ABR 155  10. See In re Montgomery, 121 B.R. 32 (Bankr. E.D. Cal. 1990); In re D.L.I.C. Inc., 120 B.R. 348 (Bankr. S.D.N.Y. 1990).

      3 ABR 157  11. The court in no way expresses an opinion on the merits of any request for attorney's fees that Jackson may make in the future.