Mega-case Conflict Issues Enron Committee Counsel

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Sep 2002

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Consider the following hypothetical: A law firm wishes to be engaged as counsel to
the official committee of unsecured creditors. There are 14 members of the committee.

<ol>
<li>Two of the committee members were and remain significant clients of the firm.

</li><li>The firm currently represents numerous other creditors on matters unrelated to
the bankruptcy case.

</li><li>Another committee member, a surety, is a plaintiff in a suit alleging that
the two committee members who are clients of the putative committee counsel's firm
conspired with others to defraud the surety.

</li><li>Prior to the commencement of the chapter 11 case, the firm represented
certain institutions who arranged for a $1 billion structured finance offering on
behalf of a debtor affiliate, which included the issuance of debtor's stock and an
agreement to sell such stock.

</li><li>In the five years prior to the commencement of the chapter 11 case, the
firm represented certain of the debtors in 125 transactions, and collected nearly
$18 million in legal fees.

</li><li>Nearly $500,000 in fees were paid by the debtors to the firm during
the preference period. The firm did not voluntarily repay the putative preference.
</li></ol>

Indeed, this is not really a hypothetical. (The reference to Enron in the title
to the article was a bit of a giveaway.) The facts are based on the May 23,
2002, (unpublished) opinion of Bankruptcy Judge Arthur J. Gonzalez denying
a motion that sought to disqualify the law firm in question—Milbank, Tweed, Hadley
& McCloy LLP—from representing the official committee of unsecured creditors in the

Enron Corp. chapter 11 case pending in the U.S. Bankruptcy Court for the
Southern District of New York, and other publicly available information. In this
article, we examine the six issues, the general rules and principles for resolving
the question of whether any of them is a basis for disqualification generally, and
whether disqualification was appropriate under the particular facts and circumstances of
the Enron case. Incidentally, at this writing, the decision has been appealed by
the original movant to the U.S. District Court for the Southern District of New
York.

Issue 1: Committee counsel represents two committee members in unrelated matters.
The general statutory governance for employment of committee counsel is <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
U.S.C. §1103. Section 1103(a)</a> authorizes committees to employ professionals,
and §1103(b) requires that such professionals not "represent any other entity having
an adverse interest in connection with the case." However, §1103(b) goes on to
provide expressly that "[r]epresentation of one or more creditors of the same class as
represented by the committee shall not per se constitute the representation of an
adverse interest." As summarized by Judge Gonzalez:

<blockquote>
This section does not require an attorney to cease representing creditors in
matters that (1) are unrelated to the bankruptcy case [see <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Steel Co.
Ltd. v. Official Comm. of Unsecured Creditors, 178 B.R. 129, 131
(N.D. Ohio 1995)</a>], (2) are not adverse to the committee's interests
in the bankruptcy case [see <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Steel Co. Ltd. v. Official Comm. of
Unsecured Creditors, 178 B.R. 129, 132 (N.D. Ohio 1995)</a>],
or (3) pre-date the professional's employment by the committee. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re
Firstmark Corp., 132 F.3d 1179, 1181-83 (7th Cir.
1997)</a>.

</blockquote>

Therefore, on its face, the first issue seems to be a straightforward loser as a
basis for disqualification of committee counsel.

However, the statute says that representation of other creditors is not a per se
basis for disqualification. Therefore, it could be the basis for disqualification in
some cases. The movant, Exco Resources Inc., argued in substance that Milbank was
in thrall to its two significant clients on the committee (JP Morgan Chase and
Citibank) and that its advice and counsel to the committee would therefore be
inevitably biased toward the interests of those clients and against the interests of the
committee as a whole, and the general constituency of unsecured creditors. The court
was not impressed by this argument for two reasons. First, there was no evidence
of any such bias in fact. Second, the court found it implausible that a committee
of 14 members with claims ranging into the billions of dollars would permit itself
to be dominated by the views of two of them.<a href="#2" name="2a">2</a> The court also made clear that if
at any time in the future there was evidence of conduct inconsistent with the fiduciary
duties owed by the committee or its counsel, there were adequate remedies to deal with
it (i.e., disallowance of fees). There was thus no reason to disqualify. As
discussed below, the court was also satisfied with Milbank's use of conflicts counsel.

Another reason why Milbank's current representations of committee members and other
creditors did not give cause for disqualification is that Milbank used "conflicts counsel"
to protect itself from actual conflicts of interest and conflicts of independence.<a href="#3" name="3a">3</a>

This has become the trendy technique in megacases where large-firm resources (which
come with large-firm conflicts baggage) are needed to administer cases. Given the
realities of modern law practice, it is inconceivable to expect that any firm of size
and adequate resources to handle the representation of a debtor or committee in a
megacase would not have among its clients one or more of the thousands of parties in
interest in such cases.<a href="#4" name="4a">4</a> The conflicts counsel, in this case the firm of Squire,
Sanders & Dempsey L.L.P., is employed as a second law firm by the creditors'
committee in order to investigate claims or otherwise handle matters involving Milbank
clients or other situations in which Milbank might have a conflict of interest or
independence. (Squire, Sanders & Dempsey prepared and filed the committee's
opposition to the motion to disqualify.)

Issue 2: Committee counsel representation of creditors (not committee members)
in unrelated matters. The Issue 1 analysis governs and suggests strongly that there
is no representational disability. Conflicts counsel can also be expected to play an
important role in assuring that such relationships do not compromise the Milbank firm's
representation of the committee.

Issue 3. Conflicts between committee members, including those represented by
counsel in unrelated matter. There is nothing in the applicable rules and precedents
that would mandate disqualification of a committee counsel on the basis of a conflict
of interest (litigation adversity in this case) between the committee members who are
counsel's clients in other matters, and other committee members. Intercreditor conflicts
on committees are quite common. One would ordinarily expect such a conflict to be
vetted by the committee members in the initial deliberations to select counsel (and
one would also expect that in the case of a significant conflict between committee
members concerning a particular law firm, that law firm would not be engaged). Thus,
if the creditors' committee has selected the counsel notwithstanding the adversity between
or among its members, that ought to be the end of it insofar as qualification to
serve as committee counsel is concerned.

While the May 23 decision of the court does not discuss this particular issue at
length, it appears from the opinion that the movant made this argument in order to
buttress its assertion that Milbank was (or potentially could have come) under the
undue influence of JP Morgan Chase and Citibank. Judge Gonzalez notes that Exco
alleged (without presenting evidence) that Milbank and its two creditor clients were
conspiring to keep important information away from other committee members. It was not
enough to overcome the court's satisfaction with the conflicts counsel arrangement and
the court's ability to resort to economic penalties to redress any prospective violation
of fiduciary duties.

Issue 4: Counsel's representation of debtor's pre-petition structured finance
transaction and related stock issuance. Under the Bankruptcy Code, §327 governs
the employment of professionals by the debtor (as distinct from §1103, which
applies to committee professionals). One of the basic distinctions between the two
employment statutes is that §327 requires disinterestedness, while §1103 does not.
The definition of "disinterested person" in §101(14) includes that the person "has
not been, within three years before the date of the petition, an investment banker
for a security of the debtor, or an attorney for such an investment banker in
connection with the offer, sale or issuance of a security of the debtor." To take
advantage of this potential basis of disqualification, Exco argued that committee counsel
should be tagged with a disinterestedness requirement, and that the Milbank firm's
representation of parties making structured finance monies available to the debtors, with
related stock issuance features, was tantamount to serving as counsel to an investment
banker in connection with the issuance of a security of the debtor.

An anomaly of the Bankruptcy Code is that §328 permits a court to deny
compensation to a committee professional who holds an adverse interest and is not
disinterested, even though §1103 does not require disinterestedness in order to be
employed. Judge Gonzalez found that there was some precedent for reconciling this
conflict by applying the §328 requirements as additional considerations for determining
employment eligibility under §1103 (citing, in particular, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Caldor Inc.,
193 B.R. 165, 170-71 (Bankr. S.D.N.Y. 1996)</a>).

Once conceding that Exco might have a disinterestedness point of relevance to
Milbank's engagement, however, Judge Gonzalez felt strongly that the employment
application was a most inappropriate context in which to consider significant transaction
recharacterization issues. The structured finance transactions were loans on their face,
and the represented parties were not investment bankers in the deal. In fact, the
court noted that it was already a specified duty of Squire, Sanders & Dempsey, as
conflicts counsel, to consider the transactions in question and their proper
characterization. Thus, whether or not lack of disinterestedness could be a basis for
disqualification, Judge Gonzalez found that Milbank was disinterested on the record
before him.<a href="#5" name="5a">5</a>

Issue 5: Firm's pre-bankruptcy representation of debtors in 125 transactions
representing $18 million in fees. This issue sounds bad, but it is really quite
simple and non-controversial. Regardless of the size of the prior work, assuming that
Milbank does not continue to represent any debtor entities, this is a classic conflict
of interest that can be solved with the debtor's consent and appropriate ethical walls
to protect the debtors' confidences. The debtors did consent, and Milbank erected an
ethical wall around every attorney who ever worked for Enron entities, including (at
the behest of the U.S. Trustee) requiring such attorneys to sign confidentiality
agreements.<a href="#6" name="6a">6</a>

Issue 6: Firm's receipt of putative preference. The typical means of solving
potential preference issues that might make a debtor or committee professional adverse
to the estate, and therefore able to be disqualified, is to give the money back and
waive the unsecured claim that would otherwise be available. In this case, Milbank
kept the money, but only pending the outcome of an investigation by a court-appointed
examiner (who was charged with covering a multitude of issues, including the question
of whether the pre-petition payment to Milbank was a preference). Milbank agreed that
it would not defend a preference action, but instead would abide by the examiner's
findings and would therefore return the money and waive the unsecured claim if the
examiner found it was a preference. The court thus found that "Milbank's agreement to
waive any right to challenge the examiner's determination concerning any preference has
the same effect as a professional waiver of a claim in order to satisfy the
disinterested standard of §101(14)(A)—an accepted practice that has been employed
in this case, and many other cases. See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Adam Furniture Indus.
Inc., 158 B.R. 291, 297 (Bankr. S.D. Ga. 1993)</a>."

Would the outcome have been different if the motion to disqualify had been promptly
made? The discussion above attempts to describe the relevant issues and law with some
degree of academic neutrality. However, no case is decided in a vacuum, and in this
case there were some important reasons why the court may have been inclined to lean
in Milbank's favor where it had discretion to do so. After covering the factual
background, and before undertaking an analysis and discussion of the conflicts and
ethics rules in question, the court's first discussion of substance concerned the
movant's delay in seeking disqualification. Milbank's employment application was filed and
served on Jan. 15, 2002, and was approved (unopposed) on Jan. 28,
2002. The Exco motion to disqualify was made on March 19, 2002.

Experienced practitioners may not regard the less-than-two-months' delay as undue,
but Judge Gonzalez made clear why he considered it completely unreasonable in the
circumstances of the case. Before he addressed the delay, he took care to note that
as of the date of the decision in May (nearing the six-month mark for the case)
there were already nearly 4,000 docket entries, dwarfing by many magnitudes the
filing activity in every other recent large case. As of the date Milbank filed its
employment application, there were 949 docket entries and 158 orders entered:

<blockquote>
These numbers are an indicator of the degree of involvement of the committee
(and its counsel). However, they do not tell the whole story. They do not
address the numerous activities performed by the committee (and its counsel) that
are not brought before the court, such as its interplay with management, its
involvement in the business plan, etc. Nor do they provide detail of the
contested nature of many of the proceedings before the court, including the
billions of dollars of asset sales. But they do provide some insight into the
level of activity in this case and the importance of addressing issues of
disqualification of counsel in the early stages of any case—especially one that
is as active and complex as this one.
</blockquote>

But that was not all. Exco was an active party in the case from a very early
stage. It filed its first pleading less than two weeks after the chapter 11 cases
were commenced, on Dec. 13, 2001, and the court noted that Exco had joined
a motion and participated in a hearing on Jan. 7, 2002. In addition, the
court took note of Exco's hostility to the creditors' committee from an early stage.
(Exco apparently alleged at an earlier time that the committee had breached its
fiduciary duty to certain creditors.)

Judge Gonzalez pointedly referred to Exco's failure to object to Milbank's
original application, and its further failure—once it did file its objection on March
19—to have its motion to disqualify heard with any expedition. "Exco was in no
rush to have a hearing to rid the committee of its 'unqualified' counsel." Absent
special cause, a hearing in the Southern District of New York could have been
scheduled for 10 days' notice, or by March 29, and for cause shown that the
bankruptcy court judges can be persuaded in appropriate cases to shorten that time.
Judge Gonzalez had entered a case management order that also made April 16
available for a hearing. Here, for reasons not explained on the record, Exco
scheduled the hearing for May 16, an unusually long two months from the date of
its motion. From the court's perspective, this conduct was completely inconsistent
with Exco's request for relief. On the one hand, Exco complained that Milbank
had taken and was continuing to take actions as committee counsel adverse to the
committee, suggesting a need for urgency. On the other hand, its actions in
seeking relief were anything but urgent.

Thus, the court's decision to begin its opinion by discussing the movant's delay,
prior to addressing the underlying merits, was clearly deliberate. "Delay in bringing
any motion to disqualify counsel is generally frowned upon because of the disruption it
would cause to the case. This is especially so in a bankruptcy reorganization in which
a disruption, in addition to causing delay in getting a decision or a judgment or
payment of money, causes a loss of value—value that cannot be regained." The court
concluded the discussion by declaring that "the delay here would provide a separate
ground to deny the relief sought."

The question presented then is what might the court have done with the motion
had it been made more promptly and urgently. Reviewing the six issues, it is not
apparent that any of them would or should have been resolved any differently had
an objection been raised to the original employment application. There is no apparent
time aspect to the question of whether committee counsel can represent committee
members or other creditors in unrelated matters, nor is there a time aspect to the
question of whether conflicts among committee members are a basis of counsel
disqualification. The prior debtor representations and the alleged preference payment
are also issues, an analysis of which could not conceivably be affected by delay.
On the question of whether Milbank was in thrall to its two committee member
clients, the issue for the court was its hypothetical nature. A more prompt motion
would not have adduced anything more concrete. This leaves the issue of whether
Milbank should be disqualified as not disinterested by virtue of having served as
underwriter's counsel.

It is possible that had objection to Milbank's retention been made at the outset,
the court might have been more receptive to either conducting a mini-trial on the
potential recharacterization of the structured finance transaction, or permitting time
for further inquiry to be made by conflicts counsel or the examiner. While the
court's concerns about the intensity of the case and potential loss of value would
not have been eliminated, they might have been mitigated in comparison to having
these issues raised for the first time after four months of Milbank's time had been
spent in the cases.

On the other hand, in light of the fact that the asserted underwriter basis of
disqualification was two steps removed from the employment statute, §1103
(distinterestedness has to be engrafted from §328, and the structured finance
transaction has to be recharacterized), it is perfectly reasonable to assume that the
court would have seen the issue the same way. Assuming for the sake of argument
that Milbank could be considered a pre-petition underwriter's counsel, disqualification
remains discretionary under the circumstances. There is thus no reason to believe that
a more timely motion to disqualify would have led to a different result in this
case.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> This article expresses the author's opinions and is not by any means (nor intended to be) an exhaustive or definitive analysis of the
relevant conflicts rules. Special thanks are due to Andrew Shaffer, a bankruptcy associate in the New York office of Mayer, Brown, Rowe
& Maw, who assisted with the research. <a href="#1a">Return to article</a>

<a name="2">2</a> In fact, the creditors' committee—on authority of a unanimous vote—filed papers supporting Milbank and opposing disqualification. <a href="#2a">Return to article</a>

<a name="3">3</a> Conflict of independence, as distinguished from conflict of interest, describes the situation in which firm clients on matters unrelated
to the case-in-chief are substantial enough clients of the firm (measured in most cases by magnitude of fees) such that counsel might be
influenced (perhaps not consciously or deliberately) to favor them in adverse dealings. <a href="#3a">Return to article</a>

<a name="4">4</a> Conflicts counsel is an invention. The Code does not expressly permit or prohibit the employment of such counsel. Because it innoculates
against conflicts disqualification a firm that might otherwise not be employable under the Code, and otherwise adds a second firm's expense
(though one could argue that the fees of the two firms in the aggregate should not exceed what one firm would have incurred absent the
conflicts), I presume (without having substantiated this with research) that the use of conflicts counsel has rarely, if ever, been approved
in cases of modest size, or otherwise in circumstances where the rationale of few available firms for the job cannot be sustained. <a href="#4a">Return to article</a>

<a name="5">5</a> What happens if Squire, Sanders & Dempsey finds that the transaction was a disguised securities underwriting, such that Milbank should
be considered counsel to an underwriter and therefore not disinterested? It is highly unlikely that such a finding would be considered cause
for disqualification. Section 328(c) is expressly precatory, and seems intended to apply to prospective adversity and disinterestedness—the
type that might be expected to have a negative impact on the counsel's performance of duties—notwithstanding the fact that the §101 definition
of disinterested person covers three years of history where investment bankers are concerned. Moreover, given the court's rather strong denunciation
of Exco's position (for reasons of delay, as well as the merits, as discussed more fully below), it does not seem reasonable to assume
that the court would give any great weight to prospective recharacterization of the structured finance transaction insofar as Milbank's eligibility
to serve as committee counsel is concerned. <a href="#5a">Return to article</a>

<a name="6">6</a> Exco observed that the firewalls had the effect of undermining representations that the Milbank firm made in order to win the committee
counsel beauty contest. According to Exco, one of the selling points of the Milbank firm was its expertise in structured finance transactions.
As a consequence of the firewalls, it is unlikely that Milbank can call on such expertise in the service of the committee. However, assuming
this is true, it is still not a basis for disqualification. If anything, it is a matter that can and should be addressed, if at all,
by the client committee, which of course retains the power to discharge its counsel if it believes it was misled. The committee's unanimous
support of Milbank tends to show that it does not feel itself aggrieved by the firewalls. <a href="#6a">Return to article</a>

Journal Authors

Michael P. Richman

Journal Date

Sunday, September 1, 2002 - 12:00

Bankruptcy Rule

2002