J. CRAIG WHITLEY, Bankruptcy Judge.
This matter presents the question of whether a Chapter 7 debtor's attorney may take a security interest in the debtor's property prior to filing bankruptcy to secure both pre- and post-petition professional fees. On the facts presented, the attorney in this case may not for at least two reasons. First, because the attorney failed to comply with the applicable state rules of professional conduct, he may not retain a security interest in his debtor's property to secure fees incurred pre-petition. Second, and as for post-petition fees or fees unearned at the time of filing, debtor's legal and equitable interests in the liened property became property of the bankruptcy estate at filing and the Code Section 362 stay became effective. Thus, counsel was not authorized to encumber the property after bankruptcy pursuant to Sections 541 and 362. As more fully explained below, debtor's attorney is therefore ordered to cancel his promissory note, release his liens on debtor's property, and terminate his related UCC-1 Financing Statement.
The facts are undisputed and were all fully and voluntarily disclosed by debtor's attorney, R. Keith Johnson. Debtor, James Pace, Jr., first met with Johnson in March 2015 to obtain information and to explore whether filing bankruptcy would be beneficial. Pace is the sole owner of a small company that files separate tax returns. To better advise Pace of his options, Johnson reviewed both Pace's personal and business's financial statements and tax returns. Sometime after initially consulting with Johnson, but before deciding to file bankruptcy, Pace experienced several hardships that further strained his financial situation: his wife lost her job; his mother required nursing care; and his business slowed. In mid-June 2015, Pace again consulted with Johnson regarding his bankruptcy options. At this point, Johnson began a more in depth analysis of Pace's finances and Pace's business and began preparing bankruptcy schedules.
By June 23, 2015, it became apparent that Pace did not have the ability to pay to file this case. Johnson estimated his fees would be $6000 and expenses would be $500. According to Johnson, as he had done with other clients, he advised Pace to discuss borrowing money from relatives possibly in exchange for a lien on property. Pace, however, had no source to borrow funds. At Johnson's request, Pace obtained valuations on his motorcycle and boat. Johnson then suggested that Pace grant Johnson a lien on both the motorcycle and the boat to secure Johnson's fees. Pace executed a promissory note on June 26, 2015 for $6500 in favor of Johnson that required all principal and interest be paid by December 26, 2015. That same day, Pace signed a security agreement granting a security interest in the boat and motorcycle to Johnson. Pace signed the lien recording application for the motorcycle on June 30, 2015. That same day, Johnson filed Pace's Chapter 7 bankruptcy case. According to the North Carolina Department of Secretary of State, Johnson filed a UCC financing statement for the boat approximately two weeks later on July 17, 2015.
Upon reviewing Pace's petition, which lists Johnson as a secured creditor based on his liens on the boat and motorcycle,
Johnson argues that but for Pace's granting him the liens, Pace would not have been able to afford filing bankruptcy. Johnson believes he was doing his client "a favor by agreeing to defer payment." Had Johnson not extended these terms, to raise funds to file bankruptcy, he believes Pace would have had to sell the boat and motorcycle at a distress sale that would have netted much less than the actual value. Johnson asserts that the terms of the agreement were fair and equitable and that his fee rate was in keeping with his thirty years of experience as a bankruptcy specialist.
This Court has no reason to question the sincerity of counsel's statements. However, it cannot agree with his conclusion 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?
Given this, while the Code does not expressly prohibit the practice, taking liens in favor of a Chapter 7 debtor's counsel to secure pre-petition fees is strongly discouraged and subject to "heightened scrutiny of the propriety of this type of fee agreement." In re Alfieri, 468 B.R. 414, 417 (Bankr. M.D. Fla. 2011) (quoting In re Parkhurst, No. 01-40744, 2002 WL 33939708, at *5 (Bankr. D. Idaho Mar. 22, 2002)).
Even if permitted by the Code, attorneys who choose to take a security interest in their client's property must comply with applicable state bar rules. Alfieri, 468 B.R. at 417 ("Certainly, the attorney must demonstrate compliance with the applicable bar rules."); Parkhurst, 2002 WL 33939708, at *4 (requiring compliance with Idaho Rule of Professional Conduct 1.8). North Carolina Rule of Professional Conduct 1.8 (Rule 1.8) permits an attorney to take such a lien but establishes safeguards to protect against exploitation. Rule 1.8 provides in relevant part:
We need not weigh each requirement of Rule 1.8 in this case. Johnson admits he did not advise Pace in writing of the desirability of seeking independent legal counsel on the transaction, and he thus did not comply with the rule. Instead, Johnson argues the interest acquired is not directly adverse to Pace's making Rule 1.8 inapplicable. Johnson asserts:
In all fairness, Johnson was likely acting with his client's best interests at heart. But, by taking these liens, Johnson obtained rights against the collateral appurtenant to being a secured creditor. In Chapter 7, debtors and their secured creditors are adversaries. Accordingly, Rule 1.8 applies. See Parkhurst, 2002 WL 33939708, at *2 (rejecting arguments that counsel "was simply doing his clients a favor by allowing them to sign a promissory note rather than requiring them to pay his fees and costs `up front' primarily because they could not afford to do so" and that the arrangement was no different than if the clients had to sell the collateral at a "`fire sale' price to pay his fees in cash before filing for relief"). Because Johnson admittedly failed to meet the high standards required by Rule 1.8, he must release his secured interests for pre-petition fees.
While pre-petition fees may in limited circumstance be secured via liens on debtor property provided that the applicable ethical rules are followed, the Bankruptcy Code does not permit a Chapter 7 debtor's attorney to be paid for post-petition services out of estate property. Nor does it allow him to do indirectly what he cannot do directly under the guise of taking a lien on a Chapter 7 debtor's property to secure post-petition fees. As we all know, a bankruptcy estate consists of all legal and equitable property interests of the debtor as of the commencement of the case. 11 U.S.C. § 541(a)(1). After filing bankruptcy, a debtor is no longer able to transfer or encumber property of the bankruptcy estate absent court approval. The automatic stay prohibits it. 11 U.S.C. § 362(a)(4).
Johnson claims that the $1350 in fees incurred post petition are secured by his security interest in Pace's boat and motorcycle. However, because Johnson's fees were not yet earned at the time of filing, Pace's property was not yet encumbered by his debt owed for post-petition fees. In re Equip. Servs., Inc., 290 F.3d 739, 746 (4th Cir. 2002) ("[I]f the relationship is a trust arrangement in which the attorney holds the retainer for the client as security for the payment of future fees, then the retainer so held, less any fees charged against it, constitutes the property of the client.") aff'd sub nom. Lamie v. U.S. Tr., 540 U.S. 526 (2004). Consequently, upon filing this case, Pace's property interests were transferred to the bankruptcy estate. In re Mahendra, 131 F.3d 750, 756 (8th Cir. 1997) ("The debtor's equitable interest in the unearned portion of the retainer becomes property of the estate upon the filing of the bankruptcy petition."); Indian Motocycle Assocs. III Ltd. P'ship v. Mass. Hous. Fin. Agency, 66 F.3d 1246, 1255 (1st Cir. 1995) (noting that a debtor's interest in any unearned portion of a retainer becomes property of the bankruptcy estate). Thus, there is no property interest in the boat and motorcycle outside the bankruptcy estate remaining to secure Johnson's post-petition fees, and Johnson is not entitled to compensation from estate funds. Lamie, 540 U.S. at 538 ("Adhering to conventional doctrines of statutory interpretation, we hold that § 330(a)(1) does not authorize compensation awards to debtors' attorneys from estate funds, unless they are employed as authorized by § 327.").
Therefore, it is
