Article

Why Bankruptcy Counsel Must Be Mindful of Ethics

Counsel and other professionals being engaged to represent a debtor in a restructuring will often face myriad thorny conflicts and conflict-related issues.

In the larger cases this is so, at least in part, because of complicated capital structures and interlocking interests.

The issues are even more complicated where an insider or affiliate offers to provide debtor-in-possession, or DIP, financing, offers to purchase the debtor or its assets, or seeks a third-party release.

Somewhat ironically, the conflict issues in the smaller cases often are more difficult because of the very nature of small and closely held businesses and the dollar amounts at stake in such cases.

For example, where a potential debtor is a single-member limited liability company, that single member may have guaranteed the debt of the small business, be its landlord, or have made a secured loan to the business. Additionally, small business ownership creates challenges for counsel when such entity's interests diverge from those of its owner, who may assume that she or he is the business.

To further illustrate how these issues arise similarly in the larger and smaller cases, retainers and fees regularly are paid on behalf of a debtor by an equity sponsor or an affiliate. In the smaller business cases, friends and family — who may have previously loaned money either to the debtor or its ownership — often pay the freight.

In matters large and small, Rule 1.8(f) of the American Bar Association's Model Rules of Professional Conduct must be consulted. A lawyer shall not accept compensation for representing a client from one other than the client unless:

• The client gives informed consent;
• There is no interference with the lawyer's independence of professional judgment or with the client-lawyer relationship; and
• Information relating to representation of a client is protected as required by Rule 1.6.

Section 327(a) of the Bankruptcy Code governs the retention of estate professionals, including general bankruptcy counsel. It states that the professional must not hold or represent an interest adverse to the estate and that the professional must be disinterested. Disinterestedness is defined in Section 101(14).

The Bankruptcy Code does not define "adverse" interest in any way. In contrast, the term "disinterested person" is defined in Section 101(14).

The term "disinterested person" means a person who:

• Is not a creditor, an equity security holder, or an insider;
• Is not and was not, within two years before the date of the filing of the petition, a director, officer, or employee of the debtor; and
• Does not have an interest materially adverse to the interest of the estate or of any class of creditors or equity security holders, by reason of any direct or indirect relationship to, connection with, or interest in, the debtor, for any other reason.

While Sections 327(a) and 101(14) seem straightforward, there is much room within their language for debate. The analysis is highly fact-specific, and there exist hundreds of reported decisions on the issue. For example:

• In re: Roberts in the U.S. Bankruptcy Court for the District of Utah in 1985, which defined the phrase "hold or represent an interest adverse to the estate."
• In re: Interwest Business Equipment Inc., in the U.S. Court of Appeals for the Tenth Circuit in 1994, which concluded that the bankruptcy court did not abuse its discretion in denying employment of a single law firm to simultaneously represent interrelated debtors; and
• In re: Kobra Properties in the U.S. Bankruptcy Court for the Eastern District of California in 2009, which upheld retention of former counsel for the unsecured creditors committee as counsel for the trustee, citing "dearth of suitable eligible counsel, the universal consent by creditors following full disclosure, and the general coincidence of economic interests of the unsecured creditors and of the trustee in optimizing the value of these estates."

In the In re: Black and White Stripes LLC case in the U.S. Bankruptcy Court for the Southern District of New York in November 2020, the Subchapter V debtors sought to retain general bankruptcy counsel under Section 327(a), who, at the time, was counsel to the debtors and its members, in a pending litigation.[1]

After the bankruptcies were filed, allegations were made that the members had received fraudulent transfers and wrongfully abused the corporate form.

The U.S. Trustee Program and a pair of creditors objected. The court explained that the decisive factor in considering the Section 327(a) retention before the court was whether counsel sought to be retained could proceed faithfully on behalf of the debtors and in the best interests of the estate.

The court found that counsel could not so proceed, leading to the conclusion the firm was not sufficiently disinterested. Therefore, the Section 327(a) application was denied.

Thus, when a third party, say an equity sponsor, selects bankruptcy counsel for a portfolio company and funds a retainer, counsel must consider ethical obligations and ask a variety of pointed questions, including:

• Can counsel act in accordance with the model rules on independence?
• Can counsel act in accordance with its obligations under Sections 327 and 101(14)) of the Bankruptcy Code?
• How motivated is counsel going to be to help the secured creditor obtain a predetermined result in this deal to ensure counsel is hired for the next deal?
• What is the extent of counsel's countervailing obligation to the bankruptcy process as an officer of the bankruptcy court?
• Is counsel too beholden to an insider secured creditor or its counsel or both? Who does debtor's counsel owe for the gig?
• Is counsel even clear who the client is for the purpose of the discharge of counsel's duty of loyalty, etc.?
• Does it matter which entity paid the retainer?
• Would disqualifying debtor's counsel accomplish anything? Could replacement counsel even be found without the ability to get a post-petition retainer in a case where administrative insolvency is avoided only by what is either a de jure or de facto surcharge of the secured creditor's collateral?

Confronted with these or similar facts, a bankruptcy court may be forced to consider a series of issues sounding in the ethical obligations of the lawyers, including:

• When a case looks like a fait accompli from the outset, how much should external issues — e.g., the interests of noncreditor parties-in-interests, employees, neighboring businesses, customers who love the product or service produced or provided by the DIP — be considered?
• Similarly, when a case looks like a fait accompli from the outset, how much should alternatives — dismissal, conversion, appointment of a trustee, or just disapproval of the DIP financing — weigh on a judge's decision making?
• How specialized is the business?
• How will the market, whatever that is, be harmed if the business fails?
• What interests in the integrity of the bankruptcy system are really at stake? Does it depend on the size of the case?
• How much evidence do you need to give the insider buyer the protections under Section 363(m) of the Bankruptcy Code? Is it even possible to grant them under these circumstances? Is it possible not to grant them?
• How badly does the court want to see a plan confirmed post-sale? See Delaware Local Rule 3017-2.
• What to do about the proposed third-party release?

Sections 327(b) through (e) of the Bankruptcy Code provide exceptions to the requirements of Section 327(a). These exceptions are applicable only in specific circumstances. For the purposes of this article, we only will focus on Sections 327(c) and (e).

Section 327(c) permits a trustee — or a debtor in possession — in a Chapter 7, 11 or 12 case to retain a professional that has been employed by, or has represented, a creditor absent an actual conflict of interest. This provision makes possible, among other things, representation of multiple debtors holding intercompany claims.

Section 327(e) authorizes the trustee or debtor in possession to appoint a firm as special counsel for a particular purpose.

The typical example would be the case where counsel is trial counsel regarding a specific matter, e.g., a patent case, when a Chapter 11 begins. Just as with respect to any professional being retained by a trustee or a DIP, counsel must have no adverse interest, but in the case of special counsel, the no-adversity requirement only is "with respect to the matter on which such attorney is to be employed."

There is also no disinterestedness requirement. Notwithstanding the express language of Section 327(e), many courts have allowed nonlawyers to be retained for a special purpose under Section 327(e).

Moreover, Section 327(e) has been used to employ counsel as special counsel for a debtor or trustee that were not previously employed by the debtor.

Another exception to Section 327(a), applicable to DIP and committee professionals, is contained in Section 1107(b) of the Bankruptcy Code, which provides that, "notwithstanding Section 327(a) of this title, a person is not disqualified for employment under Section 327 of this title by a debtor in possession solely because of such person's employment by or representation of the debtor before the commencement of the case."

The courts are divided as to what Section 1107(b) excuses. Most courts have held that Section 1107(b) is limited to excusing prior employment by the debtor and that a professional employed under Section 1107(b) must be disinterested and so may not retain any claim for prepetition fees.[2]

A minority of courts, on the other hand, have read Section 1107(b) more broadly and held that a professional employed thereunder may have a claim in the case.[3]

Conclusion

Mindfulness has been defined as the basic human ability to be fully present, aware of where we are and what we're doing, and not overly reactive or overwhelmed by what's going on around us.

When insiders, affiliates, friends and family show up all over a restructuring, it is a time for counsel to be mindful of the professional responsibilities as a lawyer practicing in an area of law that also has unique rules governing professional conduct.

Counsel's inquiry cannot start with an analysis of the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure.[4][5] Rather, the inquiry must start with the ethical rules found in the Model Code of Professional Conduct, including the duties of loyalty and independent judgment and to whom these duties are owed.

The consequences of failure to understand and abide by the rules of professional conduct may be dire for the bankruptcy professional who may be disqualified or denied compensation.

But a professional's misstep can have even more serious negative consequences for an affected client, as a debtor faced with the need to retain new counsel after a Chapter 11 filing has serious problems — not the least of which are credibility, continuity and the ability to be responsive to impatient stakeholders.

Doing the right thing may be hard, but not doing so can make things much harder than they need to be for counsel and clients alike.

“Why Bankruptcy Counsel Must Be Mindful of Ethics,” by Ira L. Herman was published in Law360 on July 11, 2022.

---

[1] In re Black and White Stripes, LLC , et al., 623 B.R. 34 (Bankr. S.D.N.Y. 2020).

[2] See, e.g., U.S. Tr. v. Price Waterhouse, 19 F.3d 138, 142 (3rd Cir. 1994) (holding that the bankruptcy court erred by authorizing the employment of an accounting firm because the firm's prepetition claim for services negated disinterestedness); Pierce v. Aetna Life Ins. Co.  (In re Pierce), 809 F.2d 1356, 1362 & n.18 (8th Cir. 1987) (holding that an attorney was not disinterested because his claim for prepetition legal services, which he had secured by a mortgage on the debtor's real estate, meant the attorney held an interest adverse to the estate).

[3] See, e.g., In re Talsma, 463 B.R. 908, 913–14 (Bankr. N.D. Tex. 2010) ("[F]or the words '[n]otwithstanding section 327(a) of this title' to have any effect, section 1107(b) must do more than exempt professionals from disqualification based on just the fact of prepetition employment by the debtor… . [T]he better (and the more practical) interpretation of section 1107(b) is that Congress intended to allow employment by a debtor in possession of its prepetition professionals 'in spite of' section 327(a) – i.e., regardless of whether they held claims against the debtor in possession so long as the otherwise disqualifying fact is necessarily coupled to the professional's prepetition employment.").

[4] 11 U.S.C. §§101 et seq. (2022) (the "Bankruptcy Code").

[5] See generally, Fed. R. Bankr. P.