A bankruptcy judge in Virginia disqualified a large firm from representing a chapter 11 debtor because the firm’s clients included an entity that controlled 43% of the debtor’s common stock and had two members on the board of 13. The shareholder was a $14 million dollar-a-year client.

A bankruptcy judge in New Jersey approved retention of a large firm to be the chapter 11 debtor’s counsel even though the firm’s clients included a creditor that held 79% of the debtor’s debt. The firm had only billed the creditor $2.4 million since the inception of the representation three years before.

Can the two decisions be reconciled? You decide.

The Engagement Approved in New Jersey

About a year before the chapter 11 filing, the debtor in New Jersey effected a transaction where a creditor became the debtor’s senior secured noteholder with 79% of the debtor’s debt. Several months later, the debtor engaged one of the country’s largest law firms that eventually put the debtor into chapter 11. The law firm had represented neither the debtor nor the secured noteholder in the prebankruptcy transaction.

The U.S. Trustee filed an objection to the retention, and the official creditors’ committee lodged a limited objection. The committee said that the prebankruptcy transaction would be a “central issue” in the case. In his May 16 opinion, Bankruptcy Judge Michael B. Kaplan of Trenton, N.J., said that the firm had made proper disclosure of the representation of the secured noteholder in unrelated matters.

Judge Kaplan said that retention was governed by Section 327(a), which says that a professional must “not hold or represent an interest adverse to the estate, and that [is] disinterested. . . .” In turn, Section 101(14)(C) defines a “disinterested person” as someone who “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, or for any other reason.”

Citing Section 327(c), Judge Kaplan said that a concurrent representation of a creditor is not an automatic disqualification. The subsection says that “a person is not disqualified for employment under this section solely because of such person’s employment by or representation of a creditor, unless there is objection by another creditor or the United States trustee, in which case the court shall disapprove such employment if there is an actual conflict of interest.”

Judge Kaplan concluded that the firm’s representation of the secured noteholder in “unrelated matters does not present a significant risk that its representation of the Debtors in this bankruptcy case will be in any way impacted or limited.” In addition, he gave “significant” weight to the forward-looking conflict waivers that the debtor and the secured noteholder had both signed with the firm that ended up representing the debtor.

Judge Kaplan focused on the “competing economic interests.” The firm had billed the secured noteholder $2.4 million since the inception of the representation (in other matters) a couple of years before. The billings to the creditor represented 0.03% of the firm’s revenue in 2023. He concluded that the firm was disinterested because “these sums are not insignificant [but] are relatively de minimis when considered in the context of the [firm’s] total annual . . . revenues” and “do not create any type of conflict or adverse interest that would warrant disqualification.”

Judge Kaplan identified “policy considerations” as justifying retention. Disqualifying the firm “would be detrimental” and “unworkable,” he said. Furthermore, barring the firm from working on matters involving the secured noteholder would be “impractical.”

Finding neither an actual nor potential conflict, Judge Kaplan approved the retention.

Disqualification in Virginia

The chapter 11 debtor in Virginia was a large manufacturing concern. Proposed co-counsel for the debtor was one of the country’s largest law firms. The U.S. Trustee objected to the retention.

In his May 30 opinion, Bankruptcy Judge Brian F. Kenney of Alexandria, Va., focused on the firm’s concurrent representation of an entity that controlled 43% of the common stock and two of the 13 seats on the board. Because lawyers at the firm were representing both the debtor and the controlling shareholders, he said that erecting an ethical wall was “impossible.”

In terms of billings, the $14 million in legal fees paid by the controlling shareholder represented 1.4% of the firm’s collections in 2023. Of course, the controlling shareholder had signed a waiver consenting to the firm’s representation of the debtor.

Judge Kenney found the firm had “satisfied” the disclosure requirements under Rule 2014(a). He also decided that possible preferences that the firm had received before filing were not grounds for disqualification.

Focusing on the clients’ consents and the representation of the controlling shareholder in “unrelated matters,” Judge Kenney said that while “consent may satisfy certain State bar rules on conflicts, it is not a substitute for disinterestedness under Section 327(a).”

There was a prepetition restructuring support agreement that earmarked 5% of the new equity to existing shareholders. Given that the controlling shareholder had 43% of the stock, he said it was “not an academic concern.” In fact, he said that “the Court cannot see how [the firm] could possibly negotiate a plan adversely to [the controlling shareholder’s] position.”

Judge Kenney rejected the idea of having conflicts counsel, saying that “it cannot be used as a substitute for general bankruptcy counsel’s duties to negotiate a plan of reorganization.”

Even if Section 327(c) were applicable, Judge Kenney found “an actual conflict of interest” because the firm “cannot be expected to negotiate a Plan that contravenes the interests of its $14 million dollar-a-year client.” Saying that the billings paid by the controlling shareholder were not de minimis, he distinguished the New Jersey case, discussed above, because billings for the secured creditor represented only 0.03% of the firm’s annual revenue.

Judge Kenney denied the retention application.

Observations

What about the appearance of impropriety from the viewpoint of creditors? How or when can creditors be confident that debtor’s counsel will not tip the scales in favor of a concurrent client who represents a major force in the case? Is the percentage of the firm’s revenues enough assurance?

Perhaps it’s a small client, but what if it’s a client landed by one of the firm’s biggest rainmakers? Would a bankruptcy lawyer avoid taking action to annoy a client of a big rainmaker?

As a matter of contract law, a client can presumably sign a forward-looking conflict waiver with unknowable effects years down the road. Even though the client-creditor may be bound by the waiver, why are other creditors bound by the effect of the waiver?

Prof. Nancy B. Rapoport is writing an article discussing the Virginia and New Jersey cases. She says,

The proportion of billings attributable to the client should be a factor in the court’s consideration, but it shouldn’t be the only factor.  [Debtor’s counsel in the New Jersey case] happens to be incredibly profitable, so should it get a pass because it rakes in so much that no one client is going to be a high percentage of its annual billings?

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We need to focus on fact-specific nuance here, rather than on the argument that Big Law firms are, well, really big and thus need to have the ethics rules applied in a way that benefits them to the detriment of their clients.

One of the country’s leading experts on ethics in bankruptcy cases, Prof. Rapoport is a UNLV Distinguished Professor and the Garman Turner Gordon Professor of Law at the University of Nevada, Las Vegas William S. Boyd School of Law.

The opinions are In re Invitae Corp., 24-11362 (Bankr. D.N.J. May 16, 2024); and In re Enviva Inc., 24-10453 (Bankr. E.D. Va., May 30, 2024).