Sophisticated Entities Need a Flexible Application of Disinterestedness

By Nicholas Lott

In recent years, big law firms have systematically leveraged their private-equity clients to secure additional bankruptcy clients.1 When a company within the private-equity firm’s portfolio confronts financial distress, counsel for the private-equity firm recommends a bankruptcy partner to act as the company’s counsel in bankruptcy.2 This pipeline was becoming increasingly commonplace — until In re Enviva.3

Enviva Inc. filed for bankruptcy and sought to employ Vinson & Elkins LLP (V&E) as debtor’s counsel.4 V&E had served as Enviva’s corporate counsel for 10 years before the bankruptcy.5 However, the court rejected Enviva’s application, citing V&E’s concurrent representation of Riverstone Holdings, a private-equity firm that owned 43 percent of Enviva’s equity.6 The Enviva decision exhibits a strict interpretation of the bankruptcy retention rules that is inappropriate in the context of large corporate debtors represented by large corporate law firms.

The bankruptcy retention rules and disinterestedness standards aim to preserve trust in the bankruptcy process.7 Bankruptcy participants and the public gain trust in the bankruptcy process when the retention rules balance (1) preserving fairness by ensuring that debtors’ counsel provides untainted loyalty to the debtor; (2) promoting efficiency by avoiding unnecessary disqualifications; and (3) protecting autonomy by extending deference to debtors to select trusted legal counsel.

For individual debtors, preserving fairness is the most important element. Principles of disinterestedness ensure that attorneys cannot exploit individuals who might be less sophisticated and less able to defend their interests. A rigid standard also is efficient because individual cases involve fewer parties, simpler financial structures and fewer potential conflicts.

Conversely, for large corporate debtors, the interests of autonomy should carry more weight. Large corporations are less exploitable due to their sophistication, elaborate governance structures and access to resources. They are more likely to run into attorney conflicts due to the complexity of prior financial dealings requiring legal assistance. They are also more likely to benefit from using counsel with an in-depth understanding of their previous dealings.

A more flexible standard of disinterestedness principles is thus preferable. Therefore, courts should adopt a more flexible interpretation of disinterestedness when dealing with bankruptcy petitions that involve large, sophisticated corporations as the debtor, and large corporate firms as the debtor’s counsel.

The Rules and Policy Objectives Governing the Retention of Debtor’s Counsel

State laws address conflicts of interest through Rule 1.7 of the Model Rules of Professional Conduct, which generally prohibits a lawyer from representing a client if there is a concurrent conflict of interest.8 However, the Model Rules permit lawyers to represent clients despite some concurrent conflicts of interest if the affected clients give informed consent in writing.9

In bankruptcy proceedings, the Bankruptcy Code establishes additional rules concerning conflicts of interest. For example, § 327(a) states, in relevant part, that debtors may only employ attorneys who “do not hold or represent an interest adverse to the estate, and that are disinterested persons.”10 Section 101(14) defines a “disinterested person,” in relevant part, as a person “that does not have an interest materially adverse to the interest of the estate.”11 Rule 2014 mandates that attorneys seeking employment as debtor’s counsel in a bankruptcy case must disclose “all of the person’s connections with the debtor, creditors ... [and] trustee.”12

Finally, § 328(c) allows the court to “deny allowance of compensation for services and reimbursement of expenses ... if ... such professional person ... holds an interest adverse to the interest of the estate with respect to the matter on which such professional person is employed.”13 In practice, courts have utilized this section to claw back fees, disqualify firms and even impose criminal sanctions.14

Congress enacted the retention rules and disclosure requirements to promote trust in the bankruptcy process.15 Trust in the bankruptcy system is linked to its ability to preserve fairness, promote efficiency and protect a debtor’s autonomy.

To preserve fairness, the disinterestedness requirements must give the debtor and creditors confidence that the employed counsel will “tender undivided loyalty and provide untainted advice and assistance in furtherance of their fiduciary responsibilities.”16 The fear of permitting conflicted law firms is that their legal advice is tainted by their economic ties to other parties in the case, such as a shareholder or creditors of the debtor.

To promote efficiency, the disinterestedness standards must be clear to the public so that prospective law firms do not expend time and money on cases where they will be unexpectedly disqualified and denied compensation. Moreover, the court’s process for identifying conflicts must be streamlined and timely to avoid unnecessary litigation expenses, which increases the participants’ trust that the estate will be maximized for their benefit.17

Finally, to preserve debtors’ autonomy, the disinterestedness standard must comply with the legal maxim that “only in the rarest cases will the [debtor] be deprived of the privilege of selecting qualified counsel since the relationship between them is highly confidential, demanding personal faith and confidence in order that they may work together harmoniously.”18 The balance between these countervailing policy considerations is delicate but necessary to ensure maximum confidence in the bankruptcy process.

Application of the Retention Rules

Courts have regularly declined to apply a bright-line interpretation of “disinterested,” but have since disagreed on where to draw the line of disinterestedness. For example, In re Invitae is notable for its flexible application of the disinterestedness standards. Invitae, a medical genetics company, sought to retain Kirkland & Ellis LLP (K&E) as debtors’ counsel.19 However, the U.S. Trustee objected because K&E concurrently represented Invitae’s largest secured creditor — Deerfield Partners — in unrelated matters.20

Deerfield held 79 percent of Invitae’s debt and paid K&E $2 million for legal work in 2023.21 The court concluded that K&E was disinterested because the potential conflicts of interest were waived by “detailed waivers,” no actual conflict of interest existed because K&E’s annual fees from Deerfield were “de minimis,”22 and the parties were “sophisticated entit[ies].”23

Conversely, In re Enviva exhibited an example of the court applying a strict interpretation of “interest adverse to the estate” and “disinterestedness.”24 Enviva filed for chapter 11 and applied to employ its corporate counsel — V&E — as debtor’s counsel.25 The U.S. Trustee contended that V&E’s concurrent representation of Riverstone Holdings — a private-equity firm owning 43 percent of Enviva’s equity — amounted to an “interest adverse to the estate.”26 The court concurred and found that V&E receiving 1.4 percent of its annual revenue from Riverstone was not “de minimis in any sense of the term,” making it an actual conflict.27 The Invitae ruling reflects a better balance of the principles underlying the disinterestedness standards — fairness, efficiency and autonomy — than the Enviva ruling.

Fairness

A flexible interpretation of the retention rules maintains sufficient fairness in large corporate bankruptcies. A primary objective of the retention rules is to ensure that bankruptcy attorneys can provide untainted legal advice to the debtor.28 In a bankruptcy case where the debtor is a large corporation and the creditors are typically large financial institutions, the retention rules can be more relaxed because the parties are sophisticated and less vulnerable to exploitation. Moreover, courts can substantially achieve the objective of undivided loyalty through methods that are more narrowly tailored than outright disqualification. For example, courts can ensure that law firms raise ethical walls if the law firm must take an adverse position against another client.29

In addition, courts can ensure that law firms generate comprehensive Rule 2014 conflict reports so that sophisticated debtors are fully informed of the adverse interests and are capable of defending their rights.30 Thus, the court can achieve sufficient fairness in these bankruptcy cases without an overly strict interpretation of the retention rules.

Efficiency

Second, a looser application of “disinterestedness” is more efficient in large corporate bankruptcies. With conflict-based disqualifications, debtors must divert finite resources toward retaining new bankruptcy counsel at a time when management should be solely focused on corporate survival. The newly appointed attorneys need many billable hours to familiarize themselves with the intricate reorganization plans set forth by large corporate debtors, which causes delays in the case and reduces both the likelihood of reorganization and the funds available to repay creditors.

Some may argue that a harsh interpretation of “disinterestedness” is more efficient because it forces conflicted law firms to self-select out of bankruptcy representation. However, this self-selection would reduce the pool of available high-end legal expertise, and for debtors, fewer options for legal counsel means higher costs and less-effective representation.

Although due process should not be generally sacrificed in the name of economic efficiency,31 a rigid approach to disinterestedness in large corporate bankruptcies serves no one. In bankruptcy, the task is primarily to preserve and efficiently distribute resources. Creditors are best served when the debtor’s counsel can quickly get up to speed on the facts of the case, incorporating institutional knowledge about the debtor’s financial situation.

Autonomy

Finally, a looser interpretation of “disinterestedness” in cases involving sophisticated parties respects the debtor’s autonomy. In the modern business environment, many law firms represent numerous private-equity firms. For example, K&E advertises that it currently represents more than 800 private-equity clients.32 In turn, private-equity firms typically engage many law firms to advise on their complex operations. Kohlberg Kravis Roberts & Co. LP (KKR), a large private-equity firm, has employed dozens of the world’s largest professional firms within only the past few years.33

When the extensive connections between law firms, private-equity and funded companies in distress are layered together, the result is an entangled network of relationships that limits the pool of truly disinterested parties. Hence, a strict interpretation of the disinterestedness standards severely restricts the pool of sophisticated large law firms that are available for retention by debtors. As a result, many corporate debtors would have to prioritize identifying and retaining an unconflicted counsel rather than selecting a renowned firm that it already trusts.

Although debtors have the option to employ smaller law firms or specialist boutiques as bankruptcy counsel,34 giant corporate debtors are better served by law firms with vast resources, who can advise on matters before and after a bankruptcy filing. These debtors should have the autonomy to select law firms with which they have a relationship of trust.

A Guide to Applying the Disinterestedness Rules Flexibly

Materiality

The language of the relevant statutory provisions permits a flexible approach to identified conflicts of interest. A good starting point is a strict interpretation of the term “material” when identifying an “interest materially adverse to the estate” in § 101(14)(c).35 For example, in In re Invitae, K&E represented Invitae as debtor’s counsel while billing one of K&E’s creditors $2 million per year for unrelated matters.36 The court expressly concluded that this economic interest did not rise to the level of “material adversity.”37 Other courts have ruled similarly.38

Because the term “material” is undefined by the Bankruptcy Code,39 courts should consider how the term is employed in other relevant sectors of the law.40 For example, the term “material” is frequently utilized in securities regulation for public companies. Under the Sarbanes-Oxley Act, public companies must obtain an audit to assure that their financial statements are free from material misstatements,41 defined as 5 to 10 percent of the company’s revenue or income.42 In addition, public companies are required to disclose all material contracts, defined as 10 to 15 percent of the company’s assets.43 In In re Enviva, V&E received 1.4 percent of its annual revenue from Riverstone, which fell substantially short of either the 5 to 10 or 10 to 15 percent threshold, and thus could have been deemed not materially adverse.

Adverse Interests with Respect to the Proceeding

Further, the statute only requires bankruptcy courts to police adverse interests that pertain to matters related to the bankruptcy case. Section 328(c) specifies that attorneys may not hold adverse interests that arise “with respect to the matter on which such professional person is employed.”44 As debtor’s counsel, “the matter on which such person is employed” is the present bankruptcy proceeding. Therefore, bankruptcy courts should avoid penalizing adverse interests that are unrelated to the bankruptcy proceeding.

Adverse interests that pertain to matters related to the bankruptcy case are the conflicts that truly threaten to prevent a big law firm from “tender[ing] undivided loyalty”45 and are substantially easier to identify than an adverse interest in any unrelated matter. Thus, courts should concentrate their analyses on adverse interests that pertain to matters related to the bankruptcy case when dealing with cases that involve sophisticated corporate debtors.

Again, courts already apply this approach.46 In Invitae, the court determined that a disqualifying adverse interest was not present because K&E’s “representation of [the debtor’s creditor] in other, unrelated matters does not present a significant risk that its representation of the Debtors in this bankruptcy case will be in any way impacted.”47

The Model Rules permit courts to allow waivers for adverse interests that pertain to unrelated matters,48 as does applicable case law.49 While some assert that an attempt to waive conflicts in bankruptcy is against public policy, the Bankruptcy Code’s text does not prohibit waivers. Furthermore, many bankruptcy scholars have concluded in recent years that economic theory actually supports informed, consensual bankruptcy waivers in business cases where the involved parties are all sophisticated.50

Conclusion

The rules governing the retention of debtor’s counsel are designed to increase confidence in the bankruptcy system.51 Trust in the bankruptcy process is maximized when the disinterestedness standards preserve fairness by ensuring that a debtor’s counsel provides untainted loyalty to the debtor, promote efficiency by creating a workable standard that avoids unnecessary and costly disqualifications, and protect autonomy by extending reasonable deference to debtors to select legal counsel that they trust.52 A looser interpretation of the retention rules and the disinterestedness requirements best balances these objectives in bankruptcy cases involving sophisticated corporate debtors.

Nick Lott is in his final year of a J.D./M.A.cc degree at Brigham Young University in Provo, Utah. His degrees reflect his passion for the intersection of legislation and business, and bankruptcy is often the venue for this intersection. Upon graduation, he will join Vinson & Elkins LLP in Houston.