Comes now a Government Accountability Office report that analyzes an important question in bankruptcy law known as venue – where can a distressed company file for bankruptcy?  Under current practice, a business can file for bankruptcy far from its base of operations, in a state where it is legally incorporated (read: Delaware) or in a state where a subsidiary is already in bankruptcy (read: Manhattan).   For its report, the GAO interviewed attorneys and judges to determine how bankruptcy professionals select a venue.

Allowing companies to declare bankruptcy in a remote location raises serious questions about fairness for local creditors and customers. This debate is not new; even some bankruptcy judges have criticized the current rules.  As I have written previously, the debate in Congress over venue for corporate bankruptcies goes back to at least the late 1990s.  The current report stems from a request by Judiciary Committee Chairman Chuck Grassley (R-Iowa).

So, what does the GAO say about venue?  The GAO found that the current rules effectively concentrate large corporate bankruptcies in New York and Delaware for a variety of reasons.  The GAO stated that favorable prior court rulings and the familiarity of judges with complex financial arrangements are important factors driving the choice of venue.

Some judges and attorneys interviewed by GAO indicated that larger creditors are best situated to succeed in remote bankruptcy courts, to the detriment of small and mid-size businesses.  The current system “can disenfranchise” small businesses. One judge even stated that “people view the system as corrupt” because of the unfairness associated with venue selection.  Such sentiments are clearly corrosive to the idea that federal bankruptcy laws operate fairly and without preferential treatment for big business.

The GAO also analyzed efforts by the Department of Justice to provide transparency for fees charged by professional services firms in large bankruptcy cases where the assets of the bankrupt business exceed $50 million.   Bankruptcy law requires courts to approve the payment of professional fees as reasonable and necessary.  The DOJ transparency guidelines are undoubtedly intended to reduce what could be considered excessive fees in large bankruptcies.   For instance, as the GAO noted, professional fees in the American Airlines bankruptcy case exceeded $375 million.  The GAO also reported that some stakeholders viewed the guidelines as providing certainty and clarity, while most attorneys were critical and successfully watered down some key disclosure proposals.

It is fair to ask whether the questions of venue selection and excessive fees are related.  The GAO report notes several attorneys and judges stated that perceived court attitudes regarding professional fees could be a “significant factor” in choosing a venue for a corporate bankruptcy. The courts preferred by professionals representing large corporate debtors are apparently viewed as disinclined to reduce or limit professional fees.  The Manhattan bankruptcy court, for instance, has specifically declined to adopt the DOJ fee guidelines.  It is ironic, given DOJ’s laudable efforts to push for more transparency in corporate bankruptcy cases, that the Obama Administration specifically sought out New York bankruptcy courts for the automotive bankruptcy cases; there has been much press attention focused on the legal fees charged in these cases.

It is also fair to ask whether an attorney who counsels a financially troubled company to declare bankruptcy in a particular jurisdiction based, in part, on lax oversight of attorney’s fees is fully adhering to the legal duty to put a client’s interests first.

In responding to the GAO’s report, the Department of Justice stated its fee guidelines successfully uncovered some unusual billing arrangements.  For instance, DOJ states that some law firms charged companies more in bankruptcy than when providing legal services to the same companies prior to bankruptcy – a curious practice given that filing for bankruptcy should indicate a diminished ability to pay large legal bills.  DOJ notes that such “premium” billing may violate aspects of bankruptcy law.

What will be the effect of the GAO report?  Certainly it will add fuel to the fire for those in Congress who have historically sought to change the venue rules.  In addition, the GAO report could spur Congress to codify the DOJ fee guidelines.  Statutory limits on professional compensation could make New York and Delaware less attractive for corporate bankruptcies.  To the extent that companies are advised to declare bankruptcy in certain locations because of a perception that certain courts are more likely to approve higher professional fees, Congressional action could remove a potential conflict of interest that may distort the bankruptcy system for creditors and debtors.

McMickle is a former counsel to the Senate Judiciary Committee for bankruptcy issues.