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ABA Section of Business Law
Business Law Today
November/December 1998
Are you really disinterested?
Chapter 11 presents real problems in ethics
By CHRISTOPHER W. FROST
Frost is a professor at the University of Kentucky College of Law, in Lexington.
Who said being a business lawyer was easy? If you represent a family whose business is going south, can you
represent the shareholders and creditors at the same time?
Business reorganizations under Chapter 11 of the Bankruptcy Code present a number of unique ethical
problems for lawyers involved in the process.
A few large cases have attracted substantial attention from the bankruptcy bar. For example, in July 1997,
John Gellene, a former partner of Milbank, Tweed, Hadley and McCoy, was sentenced to 15 months in prison
for perjury for failing to disclose his firm's simultaneous representation of debtor Bucyrus-Erie Co. and a
controlling partner of one of the debtors' secured creditors. His firm faces a $100 million malpractice suit for its
role in the case.
A less costly example is the $1 million sanction paid by Weil Gotshal & Manges for its failure to disclose its
relationships with claimants and others interested in the bankruptcy of the Leslie Fay Companies. Bankruptcy
Judge Tina Brozman imposed the sanctions even though she agreed that Weil, Gotshal "rendered services
competently and loyally to the debtors, notwithstanding its derelictions in the area of disclosure." In re Leslie
Fay Cos., 175 Bankr. 525, 526 (Bankr. S.D.N.Y. 1994).
Conflicts are not exclusively a problem of big firms in big cases, however. Lawyers involved in small cases
involving closely held businesses face the same types of conflicts. In addition, small cases often generate subtle
conflicts that cannot be discerned until the case is well under way. Conflicts of this sort do not result from
direct client representation but instead arise from the structure of the bankruptcy process.
These structural conflicts have their roots in several unique features of Chapter 11. Chapter 11 is premised on
the continuation of the business operations while creditors and equity holders negotiate to restructure the
debtor's obligations. The Bankruptcy Code leaves pre-bankruptcy managers in control of the process through
the device referred to as the "debtor in possession." While their specific formulations of the rule vary, courts
uniformly hold that the fiduciary obligations of the debtor in possession, and the lawyer that represents it, run
to all of the creditors and equity holders in the business. Since the interests of these widely disparate groups
often conflict with the goals of the debtor's managers, the debtor in possession's lawyer is often placed in the
uncomfortable position of questioning the judgment of the business' decision-makers.
Chapter 11 has been subject to substantial criticism since its 1978 enactment. Critics often describe the
process as a means through which managers of failing businesses can avoid an inevitable liquidation while
milking the business and its creditors. Bankruptcy lawyers too are coming under increasing scrutiny by the
courts and the public for their role in the process and the fees they charge. In this environment, continued
public confidence in the system turns on the ability of the bankruptcy bar to negotiate the ethical quagmire
that Chapter 11 creates.
At the heart of Bankruptcy Code's ethical principles lies the "disinterestedness requirement" of Section 327.
That states that a lawyer for the trustee must not "hold or represent an interest adverse to the estate" and
must be "disinterested." Many courts apply the disinterestedness standard strictly, holding that any interest
adverse to the estate will disqualify a lawyer from representing the debtor in possession — without regard to
the materiality of that interest. This strict application and the unique nature of bankruptcy practice combine to
create three types of conflicts issues.
Two groups' views on being disinterested
Recently, both the American Law Institute and the National Bankruptcy Review Commission
have been sites of battle over the disinterestedness requirement.
Section 201 of the ALI's Restatement, Third, of the Law Governing Lawyers sets out a general
standard for conflicts of interest that requires consent when there is a "substantial risk that the
lawyer's representation of a client would be materially and adversely affected" by the lawyer's or
another client's interests. In contrast, Section 209(2) requires consent any time a lawyer
represents clients on opposite sides of litigation even if the matters are unrelated and without
regard to the materiality of the conflict.
Chapter 11 incorporates elements of both transactional and litigation practices as parties move
between plan negotiation and adversary proceedings. The hybrid nature of Chapter 11 practice has
led some bankruptcy lawyers to advocate the application of Section 201 with its materiality
standard in bankruptcy cases. In their most recent pronouncement, however, the drafters of the
Restatement have refused to take a position on the question.
The National Bankruptcy Review Commission considered and rejected incorporating a materiality
standard into the Bankruptcy Code's disinterestedness requirement. The commission was formed by
Congress in the Bankruptcy Reform Act of 1994 to study all aspects of the nation's bankruptcy
laws. Its 1,000-page report (available at http://_www.nbrc.gov) sets out more than 130
recommendations for revisions. The report rejected the distinction between the litigation and
administrative aspects of bankruptcy practice, noting, "The general adminis- tration of the estate
and particularly the development and confirmation of a plan frequently involve significant
controversies that can have the greatest practical impact on the outcome of claim."
While the commission did not give the bankruptcy bar all of the relief from the stringent standards
that it desired, it did propose giving partial relief to lawyers with pre-bankruptcy claims and equity
interests. The recommendation, if implemented, would amend Section 327(a) to provide that a
person would not be disqualified from representation solely because they hold an insubstantial
unsecured claim against, or equity interest in, the debtor. The commission's report states that the
question of whether such claim or interest is insubstantial should be viewed from the perspective of
the estate, rather than the lawyer. Thus in a large estate, a court might view a pre-petition claim
for fees as insubstantial, even though it represents a large part of a particular firm's outstanding
billings.
— Christopher W. Frost
The first category of problems arises from the firm's client base and the multiple parties interested
in the bankruptcy case. A lawyer for the debtor in possession represents the estate and owes duties
to the entire creditor body. Because the bankruptcy process involves a competition among all of the
creditors and shareholders for a share of a limited pie, all of the creditors' interests are potentially
adverse to one another. Thus a firm representing the debtor in possession cannot represent a
single creditor, even on an unrelated matter, without running afoul of the disinterestedness
requirement. Because the chance of multiple representation is a function of the size of the case and
the size of the firm, client-based conflicts are more severe in large cases involving large law firms.
Disclosure is the lawyer's watchword when confronting such conflicts. Bankruptcy Rule 2014
requires that applicants for employment file a verified statement listing their "connections" with
the debtor and others involved in the case. Fed. Rule Bankr. Proc. 2014. The key word here is
"connection." The breadth of this term is intended to make clear that the lawyer filing the
statement should not make a determination of what types of relationships create a conflict. He or
she must disclose all connections so that the court may make a determination of the existence of a
conflict.
This duty of disclosure continues throughout the case. As the First Circuit noted, "as soon as
counsel acquires even constructive knowledge reasonably suggesting an actual or potential
conflict, a bankruptcy court ruling should be obtained." Rome v. Braunstein, 19 F.3d 54, 59 (1st Cir.
1994).
The bankruptcy case of the Bucyrus-Erie Co. demonstrates just how severe the sanctions for failure
to disclose can be. The fallout from John Gellene's failure to disclose his "connection" with one of
the secured creditors has left him with a perjury conviction and his firm with a loss of $1.8 million
in fees and a $100 million malpractice suit.
The second category of practical problems the disinterestedness requirement creates affects
lawyers in all sizes of firms that are engaged in debtor practice. To the extent that the lawyer for
the debtor in possession has a pre-petition claim for fees — even for fees for the preparation of the
petition itself — he or she is disqualified by the plain language of Section 101(14)(A) of the
Bankruptcy Code. In many instances a strict application of this provision would result in
disqualification of the debtor's pre-bankruptcy lawyer even though his intimate understanding of
the debtor and its business make the debtor's pre-bankruptcy lawyer the logical choice for debtorin-possession counsel.
Again, full disclosure of all outstanding fee claims, as well as fees paid or agreed to be paid within
one year prior to the filing, is the best insurance against accusations of impropriety. Such disclosure
is also statutorily required. Section 329 of the Bankruptcy Code requires lawyers for the debtor to
disclose all fees and fee agreements made in connection with the case within one year prior to the
commencement of the case. Lawyers representing debtors should also remember that fee
agreements and other arrangements with the debtor prior to bankruptcy constitute "connections"
with the debtor that must be disclosed under Rule 2014 even if the agreements are not made "in
connection with the case."
The third category of conflict that lawyers representing debtors in possession face is likely to be the
most dangerous because of its subtlety and because the structure of the Bankruptcy Code virtually
assures that the conflict is present in all bankruptcy cases. The structural conflicts that result from
the debtor in possession's fiduciary duties to creditors and shareholders often spill over and affect
the lawyer's conduct of the case.
These structural conflicts are worse in cases involving closely held businesses. In small Chapter 11
cases, the managers making the business decisions for the debtor often have a substantial equity
interest in the business themselves. Equity holders of insolvent companies often find that delay is
their best strategy because an immediate liquidation would result in an elimination of their
interests. In these cases, the lawyer for the debtor in possession may confront a difficult choice
between the desires of managers with whom the lawyer has a longstanding relationship and the
creditor's desire for an efficient resolution to the case. In re Kendavis Ind. Int'l Inc., 91 B.R. 742
(Bankr. N.D. Tex. 1988), provides an example of this problem of divided loyalties. In Kendavis, the
creditors' committee and certain individual creditors requested that the court order the firm
representing the debtor in possession to disgorge fees they had received during the case.
The committee complained that the firm represented both the debtor in possession and its
controlling shareholders and had filed plans of reorganization in the case that were unduly
generous to the shareholders The court agreed, noting that correspondence among the firm, the
shareholders and other professionals involved in the case showed that the shareholders believed
that the firm represented them. The court also concluded that the firm's conduct during the case
provided further evidence of that dual representation. The court awarded the firm only $2 million of
the $4 million in fees previously paid — requiring disgorgement of the balance.
Simply put, the lesson of Kendavis is that the debtor in possession's lawyer represents the debtor
in possession and not its decision-makers. Of course, most lawyers who represent business
organizations are familiar with the proposition that a lawyer representing a business entity owes
duties to the entity itself. As the following example demonstrates, however, identifying the
interests of an entity as complex as a debtor in possession presents unique problems.
Consider a hypothetical case involving XYZ Fabricators Inc., a small business that is owned
exclusively by members of the Jones family. XYZ produces specialty metal parts used in the
automotive industry. Recently, XYZ has encountered a drop in sales brought on by the increased
use of plastic in auto parts. The drop in sales has caused a short term cash-flow crisis and may
have implications for the long term survival of the company.
XYZ owes money to Big Bank and to Finance Company as well as to a number of suppliers. XYZ's
$300,000 obligation to Big Bank is secured by substantially all of the assets of XYZ and has been
guaranteed by John Jones, the president and principal shareholder of XYZ. The guaranty is further
secured by a mortgage on Jones' residence. XYZ owes Finance Company $100,000 and owes 25
suppliers, employees and other claimants $150,000, in total.
Lawyer Sara Smith is a long time friend of the Jones family and has represented both the family
and the corporation for years. She is extremely knowledge- able about Jones' financial situation
and XYZ's operations and finances. Jones, desperate to save the family business and his home,
asked Smith to assist him in working out the problems.
Smith attempted to negotiate a nonbankruptcy workout with XYZ's creditors for three months
during which time she billed XYZ more than $15,000. One week before Smith filed a Chapter 11
petition on behalf of XYZ, she received a payment for pre-bankruptcy services in the amount of
$5,000. Smith has filed a motion seeking approval of her appointment as lawyer for the debtor in
possession.
At this early point in the case, Smith is faced with two potential problems. First the debtor's prebankruptcy payment of her fee may be a preference under Section 547 of the Bankruptcy Code. This
section allows the trustee or the debtor in possession to recover pre-bankruptcy payments that
improve the recipient's position vis-a-vis other creditors of the estate. While Smith may raise a
number of defenses to a Section 547 action, it is clear that the potential claim by the estate against
her creates a conflict.
At a minimum, Smith must make full disclosure in her Rule 2014 affidavit and Section 329
statement of compensation. Whether the bankruptcy court will approve Smith's appointment is less
straightforward. While some courts are willing to countenance conflicts they find "de minimus,"
others strictly interpret the disinterestedness requirement. In such jurisdic- tions, the court may be
unwilling to allow her appointment unless she waives the unpaid amount of her pre-bankruptcy
claim and perhaps even repays the pre-bankruptcy payment she received.
In addition to the conflict created by Smith's fees, this hypothetical sets the stage for a potential
conflict of the more subtle variety. Because Smith has represented the Jones family and the
corporation for years and is a personal friend, the family may view her as their personal lawyer. Of
course her simultaneous representation of the Jones family and XYZ would create an impermissible
conflict because of the divergent interests of the family and the creditors of XYZ. At a minimum,
Smith must make clear to the Jones family that her duties as lawyer for the debtor in possession
will run to the corporation itself and not to the family. As the following extension of the
hypothetical shows, maintaining the separation between the entity and the decision-maker may be
easier said than done.
Assume that the bankruptcy court approved the application for Smith's appointment to represent
the debtor in possession and the parties commenced the case in earnest. Smith set to work drafting
and negotiating the plan of reorganization. The XYZ plan fixed the value of the bank's secured claim
at $325,000 ($300,000 principle plus interest and attorney's fees) and proposed to pay the entire
amount of the claim over five years with interest of 15 percent. The bank has approved its
treatment under the plan. The plan provides that the trade creditors will receive 90 percent of their
claims in cash. Finance Company, however, will receive only 50 percent of its claims paid over the
next five years without interest. The plan also provides that Jones will receive all of the equity of
the reorganized XYZ in return for his contribution of $10,000.
After Finance Company rejected the plan, Smith attempted to obtain court approval for confirmation
notwithstanding its objections. Smith claimed that the plan's treatment of Finance Company was
appropriate and that, because of the $10,000 contribution by Jones, the plan met the requirements
of the absolute priority rule. After a protracted battle, the court denied confirmation of the plan.
Smith appealed the denial but her arguments were rejected by the district court and the court of
appeals. Over two years after the case was filed, the court granted Finance Company's motion to
convert the case to a Chapter 7. Smith filed her final fee request totaling $50,000 for the entire
case.
Most bankruptcy lawyers would consider Smith's actions fairly routine. The Bankruptcy Code allows
plans to be confirmed over the objections of creditors and, while the courts are split over the issue,
many courts permit so-called new value plans under which the shareholders of an insolvent
corporation may purchase a continued equity interest in the corporation on a contribution of
"money or money's worth." Under this view, Smith seems to have discharged her duties and, if her
fees are reasonable for the services she rendered, she should have her fee request approved.
Objecting creditors may raise two issues in this case, however. First, under Section 328(c) of the
code, these creditors might attack the fee application on the basis that Smith failed to remain
disinterested throughout the case. Like the Kendavis case, Smith's filing of the new value plan
might provide some evidence that she really represented the interests of the family rather than the
interests of all the participants in the case. The objecting creditors are also likely to point to the
generous treatment of the secured creditor (whose debt was guaranteed by Jones) as further
evidence of a conflict. Unlike Kendavis, however, the facts of the hypothetical offer only her actions
as evidence of a conflict. Some courts have been reluctant to find a conflict based solely on
lawyer's actions that are permitted under the code or court decisions. See In re Office Products of
America, 136 B.R. 983 (Bankr. W.D. Tex. 1992).
Even if the court denies the creditors' claim of a conflict, the creditors can make a separate
objection under Section 330(4)(A)(ii) that Smith's services were not "reasonably likely to benefit
the debtor's estate." In an increasing number of cases, courts have reduced the fees of the debtor
in possession's lawyer where the lawyer's work has prolonged an attempted reorganization that the
lawyer should have known was doomed to failure.
For example in Office Products of America, the court held that the debtor's lawyer's filing of an
unconfirmable plan of reorganization in an effort to stave off the debtor's liquidation did not
warrant a finding of disinterestedness. The court noted, however, that the fee application filed in
the case showed "that there was a point in time when the debtor knew or should have known that
the pursuit of [the] plan flew in the face of the [plan confirmation standards]." Id. at 990-91. The
court denied the lawyer's request for some $10,000 in fees for work that the court believed "served
primarily to maintain then-current management in control of the enterprise, at significant risk to
the creditor body." Id. at 991.
Cases like Office Products of America speak volumes about the unique nature of debtor-inpossession practice. A lawyer representing a debtor in possession is not only an advocate for the
interests of the managers and shareholders of the business. In addition, the lawyer must exercise
independent judgment regarding the best course of action from the perspective of the creditors as
well as the shareholders. At some point, he or she will be called on to decide whether continued
attempts at reorganization are futile, and continued efforts past this point place the lawyer's fees at
risk. Futility is not simply a legal concept, however. The likelihood that a reorganization will
succeed is more a judgment about the business, its value and the negotiating positions of the
parties in the case, than it is an evaluation of legal arguments.
The need to make such business judgments is what separates lawyers in bankruptcy from corporate
lawyers outside the process. Outside the confines of Chapter 11, corporate lawyers can look to
management for business judgments unless managers' decisions threaten serious harm or are
illegal. The comments to Rule 1.13 of the Model Rules of Professional Conduct state that "Decisions
concerning policy and operation, including ones entailing serious risk, are not as such in the
lawyer's province." In bankruptcy, however, courts often make clear that "the duty to advise the
client goes beyond responding to the client's request for advice. It requires an active concern for
the interests of the estate and its beneficiaries." In re Wilde Horse Enters. Inc., 136 B.R. 830, 840
(Bankr. C.D. Cal. 1991).
Courts' requirements that lawyers for the debtor in possession exercise independent judgment
about the business prospects of the debtor and exhibit active concern for those interested in the
outcome of the case reveals a fundamental truth about the Chapter 11 process. The framework that
Congress intended to govern companies in the throes of bankruptcy has proved to be largely
unworkable — particularly in small cases. Strained by ever increasing dockets and limited
resources, bankruptcy judges have turned to the lawyer representing the debtor in possession for
assistance in constraining the behavior of managers who may be using the process to further their
own interests rather than the interests of the creditors.
Reforms that may alleviate some of the pressures on the system, and the lawyers practicing within
it, seem a distant hope. In the meantime, bankruptcy lawyers will continue to face a treacherous
ethical path that requires an extra measure of candor and judgment.
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