As members of this committee all know, the extent of disclosures required under Rule 2014 of the Federal Rules of Bankruptcy Procedure is somewhat vague, as its key term “connections” is very broad.[1] Recently, three new cases have provided fresh insight into this issue.
In re Miners Oil Company Inc.: You May Know Who Your Real Client Is, but Does Your Client’s Owner Know That?[2]
Miners Oil shows why divorce and chapter 11 bankruptcy cases often do not mix well. In November 2011, Miners Oil (the debtor) filed its chapter 11 case and the debtor’s law firm filed an application for employment. As part of its Rule 2014 disclosures, the law firm disclosed that the debtor’s sole owner was represented by separate counsel. The law firm’s retention agreement also expressly stated that it was not representing the owner in any way in the case. The law firm’s 2014 disclosure did not disclose that the law firm had any other connections to the owner.
The owner at the time of the debtor’s filing was involved in a highly acrimonious divorce case whereby the debtor had to make various payments to the owner’s estranged wife. Further, the debtor was owed more than $2 million by other entities owned by the owner, as well as approximately $2.4 million owed by the owner himself.
Shortly after the debtor’s bankruptcy was filed, the debtor filed an adversary proceeding against the owner’s estranged wife, with the stated purpose or preventing the estranged wife from draining the debtor’s estate of funds. Shortly thereafter, the owner was removed from all management positions with the debtor. The reorganization effort ultimately failed, the debtor’s assets were sold, and the case was converted into a chapter 7 proceeding.
After the conversion, the law firm moved for allowance of its final fees. The owner objected, saying that the law firm had failed to disclose its connections and conflicts with the owner and arguing:
[The law firm] knew that at the time of filing the [debtor’s] bankruptcy petition that [the debtor] was owed nearly $2.4 million from [the owner], that [the debtor] would likely be the largest creditor in [the owner’s] personal bankruptcy, and that he [the lead attorney at the law firm] would have to take legal positions adverse to the owner’s stated legal goals to retain ownership of [the debtor] and to negotiate settlement with his wife ... and his former attorney and business partner....
After significant litigation, the court found that the law firm failed to adequately disclose the actual nature and circumstances of the law firm’s relationship with the owner. These failures included failing to disclose in its application that the owner was not only the debtor’s “principal,” but was its largest creditor, and that the owner was involved in a very disagreeable divorce. Further, the law firm had failed to disclose in its application that it had had several discussions with the owner concerning his situation prior to obtaining separate counsel. The court found that such detailed and candid disclosures were necessary to fully comply with Rule 2014. The court also questioned whether the adversary proceeding against the owner’s wife was beneficial to the estate or the owner. Ultimately, it reduced the law firm’s fees by approximately $12,000.
Analysis: This case is a “must read” (and scary) as to what, at least in the eyes of one court, professionals are required to detail in making a Rule 2014 disclosure for a closely held debtor. Not only is the professional required to note that a connection exists, it must also outline the debtor’s owner’s connections with the debtor and whether and to what extent the professional had discussions with the principal prior to bankruptcy.
While it is clear that Rule 2014 is designed to identify possible divided-loyalty issues, the extent of disclosure required by this opinion is rather troubling. It seems equally likely, however, that what the court was truly troubled by was the filing of the adversary proceeding against the owner’s estranged wife, a suit that the court found had little value to the debtor’s estate but did have value to the owner.
In re RAJ Kamal Corp.: Remember That You Need to Disclose Your Connections with Other Professionals[3]
The facts of this case are, for a change, rather straightforward. On June 30, 2011, the debtor, Raj Kamal Corp. (RKC), filed a chapter 11 petition and applied to have C. Anthony Hughes (the attorney) appointed as RKC’s chapter 11 counsel. At the same time, RKC also filed a motion to retain an accountant to assist RKC with its various accounting and business operations. The attorney failed to make any Rule 2014 disclosures in connection with his employment application. In the accountant’s application, he represented that he had no connections with RKC or its counsel, but he also failed to make any Rule 2014 disclosures in his declaration in support of his application.
After the accountant filed his only fee application, the bankruptcy court independently discovered that the attorney and accountant had acted together as professionals for debtors in other cases, including one in which the accountant and the attorney had been sanctioned for failing to disclose their connections as each other’s clients and where the accountant had taken a post-petition “transfer,” without court approval, of all of the debtor’s assets, which were placed in a new entity that had filed yet another chapter 11.[4] The bankruptcy court ultimately disallowed all fees to both the attorney and the accountant.
On appeal, the attorney argued that (1) he could not disclose his representation of the accountant due to attorney/client privilege, (2) he was a disinterested person under 11 U.S.C. § 101(14), and (3) the total disallowance of fees was too severe. The BAP rejected all of these arguments, holding that there is no violation of attorney/client privilege when an attorney discloses the fact that he represented another professional.[5]
The BAP also ruled that the issue of whether the attorney was disinterested was not the reason for the sanctions. Instead, it was the attorney’s undisputed failure to comply with the disclosure requirement of Rule 2014 by failing to disclose the nature and extent of his connections with the accountant that caused his sanctions. The BAP noted that professionals employed or seeking employment “cannot pick and choose which connections are irrelevant or trivial.... No matter how old the connections, no matter how trivial it appears, the professional seeking employment must disclose it.”[6]
Finally, the BAP ruled that the bankruptcy court can deny all fees and sanction professionals even if a professional’s failure to disclose was inadvertent. The BAP noted that this penalty was within the bankruptcy court’s discretion because, among other reasons, the attorney had previously been admonished on this same issue in the Sundance case.
Analysis: The important element of this decision is its reminder that failure to disclose connections to other professionals in a bankruptcy case can be fatal to a professional employment application and/or his or her pocketbook. The facts are rather extreme and might have resulted in a far harsher result in other circuits.[7]
In re Rental Systems LLC: Closely Held Entities Equal Lots of Connections That Must Be Disclosed — Including Source of Retainer[8]
In this case, proposed counsel for a chapter 11 debtor (proposed counsel) filed an application for its employment and a supporting Rule 2014 declaration. The proposed counsel did disclose that it received approximately $143,000 in pre-petition payments and held a retainer in the amount of $11,315.82. It did not, however, disclose the source of the retainer until several weeks after its initial application. As part of its “Supplemental Declaration,” the proposed counsel disclosed that the source of the payments and the retainer was a non-debtor affiliate that was listed as having a $45 million claim against the debtor and, due to the intercompany transfers, could be liable for numerous avoidance actions by the debtor.
The bankruptcy court found that the failure to disclose of the source of the retainer, as well as the proposed counsel’s relationship with the debtor’s non-debtor affiliates, violated Rule 2014. The court noted that while approval of its employment was pending, the proposed counsel had advocated several positions that were favorable to the non-debtor affiliate. While the court found that proposed counsel’s advocacy was neither in bad faith, nor even wrong, it held that only a disinterested counsel, without the taint of involvement of non-debtor affiliates, could make these advocacy decisions and denied proposed counsel’s application for employment.
Analysis: This case shows that the old adage “follow the money” is just as critical in bankruptcy as it is in journalism. Here, the debtor operated as a central cash-management entity that had control over all transactions between affiliates. The proposed counsel testified that it did not know where its retainer came from, even though it had helped the debtor prepare its schedules. Further, the evidence showed that non-debtor affiliates were likely to be the only source of further payments to the proposed counsel during the chapter 11 proceedings.
The bankruptcy court’s finding that the close relationship between the proposed counsel and the debtor’s affiliates raised serious concerns was well supported by the proposed counsel’s serious failure to disclose the source of its retainer under Rule 2014. It highlights the problems that can be created when representing chapter 11 debtors that have had significant financial transactions with affiliates controlled by the debtor’s principals.
[1] See, e.g., In re Arlan’s Dep’t Stores Inc., 615 F.2d 925, 930-31 (2d Cir. 1979) (discussing underlying reason full disclosure of connections were required).
[2] In re Miners Oil Company Inc., 502 B.R. 285 (Bankr. W.D. Va. 2013).
[3] Raj Kamal Corp. v. Fukushima (In re Raj Kamal Corp.), 2013 Bankr. LEXIS 5305 (B.A.P. 9th Cir. Dec. 17, 2013).
[4] See In re Sundance Self Storage-El Dorado LP, 482 B.R. 613 (Bankr. E.D. Cal. 2012).
[5] In an ironic twist, the attorney represented the accountant in the accountant’s own chapter 13 case.
[6] 2013 Bankr. LEXIS 5305 at *13 (quoting In re Parks-Helena Corp., 63 F.3d 877, 882 (9th Cir. 1995)).
[7] See, e.g., In re Federated Department Stores, 44 F.3d 1310 (6th Cir. 1995) (denial of all fees because professional was statutorily not disinterested, even though professional gave massive benefit to the estate); U.S. v. Gellene, 182 F.3d 578 (7th Cir. 1999) (upholding criminal conviction of attorney who deliberately failed to disclose certain connections).
[8] In re Rental Sys. LLC, 2014 Bankr. LEXIS 1057 (Bankr. N.D. Ill. Mar. 17, 2014).