In Travelers Casualty & Surety Co. v. Pacific Gas & Electric Co., 549 U.S. ___,127 S. Ct. 1199 (2007), the Supreme Court definitively overruled the Ninth Circuit’s decision in the case In re Fobian, 951 F. 2d 1149 (9th Cir. 1991), which held: “where litigated issues involve not basic contract enforcement questions, but issues peculiar to federal bankruptcy law, attorneys’ fees will not be awarded absent bad faith or harassment by the losing party.” In re Fobian, 951 F. 2d at 1153.

The Ninth Circuit’s rule is in direct conflict with a holding of the Fourth Circuit Court of Appeals in the case In re Shangra-La, Inc., 167 F. 3d 843, 848-849 (4th Cir. 1999). The Supreme Court granted Travelers’ petition for writ of certiorari to resolve the split in the circuits.

The issue of the extent to which attorneys’ fees are allowable in bankruptcy is significant to creditors in many different contexts. Loan documents and equipment leases almost invariably have attorneys’ fees clauses, and attorneys’ fees clauses are often found in most other written contracts, even form invoices and statements issued by trade creditors.

In addition, most states have statutes or common law addressing when attorneys’ fees may be recovered in litigation or other contexts. While the “American rule” states as a matter of general common law that the prevailing party in litigation is generally not entitled to recover its attorneys’ fees, the rule can be overcome by statute and by an enforceable contractual provision governing recovery of attorneys’ fees.

Pre-petition, Travelers had issued a surety bond on behalf of Pacific Gas & Electric (PG&E) guarantying PG&E would pay state workers compensation benefits to its injured employees. Travelers had indemnity agreements with PG&E, which included provisions where PG&E agreed to indemnify Travelers against any and all losses incurred by Travelers in connection with the bonds, including any attorneys’ fees Travelers incurs in “pursuing, protecting or litigating Travelers’ rights in connection with” the bonds. (Travelers, 127 S. Ct. at 1202.) This broad attorneys’ fees provision is thus not limited to actions for breach of the bonds or indemnity agreements, and is the type of contractual attorneys’ fees provision that can override the traditional “American rule” where each party is to bear its own attorneys’ fees.

PG&E filed bankruptcy and proposed a Chapter 11 plan. PG&E did not default under the bonds or the indemnity agreements. Travelers filed an unsecured claim in the bankruptcy asserting its right to recover against PG&E in the event of a future breach or default. PG&E agreed to add a provision to its plan and disclosure statement to address Travelers’ claim and its rights to indemnity and subrogation in the event of a future default.

Travelers later claimed that PG&E modified the agreed language in the plan and disclosure statement to substantially diminish Travelers’ rights. The parties were able to resolve this additional dispute through a stipulation approved by the bankruptcy court, which addresses the plan treatment of Travelers’ claim. It also provided that Travelers could assert a general unsecured claim for attorneys’ fees as part of its claim in the case, and PG&E reserved the right to object to that claim for fees.

Litigation in the bankruptcy court ensued over the allowability of Travelers’ claim for attorneys’ fees. PG&E defended the claim based on the binding Ninth Circuit precedent of In re Fobian. Based on the Ninth Circuit’s decision in Fobian holding that a claim for attorneys’ fees incurred by a creditor in connection with issues “peculiar to federal bankruptcy-law,” Travelers’ claim for attorneys’ fees must be denied since the fees were incurred exclusively in addressing federal bankruptcy issues concerning the treatment of Travelers’ claim under the plan and disclosure statement.

In so ruling, the lower courts concluded that the litigation initiated by Travelers against PG&E concerning the plan and disclosure statement were governed entirely by federal bankruptcy law and thus fell squarely within the Fobian rule. The Ninth Circuit affirmed the lower courts’ rulings in an unpublished opinion based on the authority of Fobian.

The United States Supreme Court granted certiorari to resolve the narrow issue of whether attorneys’ fees incurred in connection with post-bankruptcy litigation involving issues of federal bankruptcy law are categorically disallowed in bankruptcy. The court’s unanimous decision determined that nothing in the Bankruptcy Code categorically disallows such fees, and that instead the allowance of attorneys’ fees as part of a claim in bankruptcy is governed by state law unless a specific provision of the Bankruptcy Code limits or alters the allowance of such fees.

In so ruling, the court noted the basic and long-standing rule in bankruptcy is that state law determines the nature and scope of creditors’ claims just as state law governs the nature and scope of property rights or interests except to the extent an express provision of the Bankruptcy Code alters those rights and claims. The court’s analysis of the issue focused on §502(b) of the Bankruptcy Code, which sets forth the general rule governing the allowance of claims in bankruptcy. That statute provides that the court “shall allow” a claim “except to the extent that” the claim is subject to one of nine enumerated exceptions to allowance set forth in the subparts to §502(b). Those exceptions include the very broad exception that the claim is not allowable to the extent that the claim is “unenforceable against the debtor … under any agreement or applicable law.” The only “applicable law” cited by the lower courts, including the Ninth Circuit, in disallowing the Travelers’ claim was the Ninth Circuit’s ruling in Fobian.

The Supreme Court noted that the Ninth Circuit did not find the claim to be “unenforceable” under applicable nonbankruptcy law and also did not conclude that any provision of the Bankruptcy Code itself rendered the claim unenforceable. Rather, in the Supreme Court’s word, the Ninth Circuit rejected Travelers’ claim “based solely on a rule of that court’s own creation.” Travelers, 127 S. Ct. at 1205.

Reminiscent of the court’s unanimous decision in Union Bank v. Wolas, 502 U.S. 191, 112 S. Ct. 527 (1992), also involving a reversal of the Ninth Circuit and its imposition of an unwritten “short-term” or “trade credit” limitation on the ordinary course of business defense to preferences, the Supreme Court examined the Bankruptcy Code independently and found no support for the Ninth Circuit’s Fobian rule anywhere in the Bankruptcy Code, concluding that “the absence of textual support is fatal for the Fobian rule.” Travelers, 127 S. Ct. at 1206.

Most noteworthy perhaps is that PG&E in fact did not attempt to defend the Fobian rule. Rather, PG&E argued that Bankruptcy Code §506(b) categorically disallows attorneys’ fees incurred post-petition to a creditor whose claim is unsecured or undersecured. That statute provides that interest, attorneys fees, costs and other charges are allowed to a creditor whose allowed secured claim is secured by property with a value as of the petition date that exceeds the amount of the claim (i.e., an oversecured creditor.)

However, the Supreme Court refused to consider the argument or express an opinion on the effect of Bankruptcy Code §506(b) on Travelers’ claim for fees because PG&E failed to raise the argument in the lower courts or in its opposition to the Travelers’ petition for certiorari. Whether Travelers can persuade the lower courts that §506(b) is not a limitation on the allowance of attorneys’ fees incurred post-petition by an unsecured creditor remains to be determined.

The Travelers decision is one of several Supreme Court decisions in bankruptcy cases in which the court has steadfastly enforced the plain language of the Bankruptcy Code and refused to read into the Bankruptcy Code conditions or limitations not expressed in that language. The overruling of the Fobian decision is helpful to creditors and clarifies an area of conflict in reported bankruptcy law that created a basis for litigation where none should have existed.

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Lesley Anne Hawes is a partner with McKenna Long & Aldridge, LLP, a full-service law firm of 400 lawyers and public policy advisors with offices in Atlanta, Brussels, Denver, Los Angeles, Philadelphia, San Diego, San Francisco and Washington, DC. The firm provides business solutions in the areas of corporate law, government contracts, intellectual property and technology, complex litigation, public policy and regulatory affairs, international law, real estate, environmental, energy and finance as well as bankruptcy and creditor’s rights. To learn more about the firm and its services, visit www.mckennalong.com.