Ethical Trilogy Something Old Something New Something Borrowed

Journal Issue

Jun 2003

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Editor's Note:I am pleased to announce that one of the co-editors of this column, Michael Richman, has been
selected as ABI's President-elect, proving once again the value of reading and writing for "Straight & Narrow."

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This month's "Straight & Narrow" addresses the ethical implications of three recent decisions: (1) In re United
Artists Theatres Co.<a href="#2" name="2a">2</a> (addressing professional indemnification agreements), (2) In re ICM Notes Ltd.<a href="#3" name="3a">3</a> (addressing
whether a particular creditor can sue a chapter 11 debtor's counsel for malpractice) and (3) Grausz v. Englander<a href="#4" name="4a">4</a> (addressing issues of res judicata arising from approvals of final fee applications).

<h3>Something Old: Grausz v. Englander</h3>
In an article titled "When and Where: Limits on Malpractice Claims Against Debtor's Counsel," published in
October 2000,<a href="#5" name="5a">5</a> "Straight & Narrow" addressed the developing doctrine of final fee awards barring subsequent
malpractice suits against bankruptcy professionals. That article noted that courts in the Fifth Circuit<a href="#6" name="6a">6</a> were
beginning to hold that the approval of a final fee application for a professional in a bankruptcy case was res judicata
with regard to subsequent professional malpractice claims against that professional if the plaintiff knew or should
have known of the malpractice case. Shortly after "When and Where" was published, the First Circuit adopted the
Fifth Circuit's reasoning in the case of In re Iannochino.<a href="#7" name="7a">7</a>

Recently, the Fourth Circuit joined the Fifth and First Circuits in holding that approval of final fee
applications bars malpractice actions on res judicata grounds in its decision of Grausz v. Englander.<a href="#8" name="8a">8</a>

In Grausz, a doctor filed a chapter 11 petition. Shortly after the filing, the debtor's counsel (initial counsel)
negotiated a settlement agreement with the debtor's primary creditor that reduced that creditor's claim from $6.5
million to $4 million based on certain conditions, including: (1) the debtor's filing full and complete amended
schedules, (2) an agreement that if those schedules were not complete, the creditor could pursue a dischargeability
action against the debtor, and (3) the debtor's agreement that a breach of his warranty of the completeness of the
amended schedules would constitute a post-petition breach of the settlement agreement.

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<big><center>
The Grausz case represents the latest in what is becoming a well-established line of decisions holding that final fee
orders centrally bar subsequent malpractice suits.
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The initial counsel and debtor prepared amended schedules that were later determined not to be complete
and that ultimately led to the denial of the debtor's discharge. The debtor accused the initial counsel of negligence
in negotiating the settlement agreement and in advising the debtor about preparing his amended schedules. A trustee
was appointed, and the debtor dismissed his initial counsel and retained new counsel to defend him in a suit
seeking denial of the debtor's discharge. After the denial-of-discharge suit had been filed against the debtor, the
initial counsel filed its interim and final fee applications for its work in the chapter 11, which were not objected to
by the debtor.

Sometime after the fee applications were filed and approved, after losing his non-dischargeability suit, the
debtor filed a malpractice suit against his initial counsel in state court.

The initial counsel removed the malpractice suit to the U.S. District Court for the District of Maryland,
asserting bankruptcy jurisdiction as the grounds for removal. The initial counsel also moved for summary
judgment or dismissal of the suit on the grounds of res judicata. The debtor moved for remand, arguing a lack of
jurisdiction, and also disputed the res judicata effect of the final fee order. The district court granted the initial
counsel's summary judgment motion and denied the remand motion as moot. The debtor appealed.

In affirming the district court's decision, the appeals court in Grausz initially held that malpractice actions
based on alleged negligence in pre- and post-petition advice concerning a bankruptcy case are subject to bankruptcy
jurisdiction and can be removed from state to federal court even if the claims are not property of the bankruptcy
estate.<a href="#9" name="9a">9</a>

After determining it had jurisdiction, the Fourth Circuit found that all elements of res judicata<a href="#10" name="10a">10</a> had been
met in this case. However, the Grausz court held that even if all formal elements of res judicata are met, a
malpractice action will still not be barred unless the court finds that (1) the plaintiff knew or should have known
before the final fee application of the real likelihood of a malpractice claim and (2) the final fee application
proceeding was an effective forum to litigate malpractice claims. Like the Fifth and First Circuits, the Grausz court
found that (1) under the facts of its case, the debtor knew of the possible malpractice claim, and (2) final fee
applications are an effective forum to litigate malpractice cases, even if the plaintiff has the right to a jury trial of its
malpractice suit.<a href="#11" name="11a">11</a>

The Grausz case represents the latest in what is becoming a well-established line of decisions holding that
final fee orders centrally bar subsequent malpractice suits. It is particularly useful that it makes clear that even
pre-petition advice related to a bankruptcy case is related to that case and that lawsuits based on it are removable to
bankruptcy courts. These decisions are greatly reducing the threat of malpractice suits that might arise from
representations of debtors in bankruptcy cases.

<h3>Something New: ICM Notes Ltd.</h3>

In ICM Notes, the Fifth Circuit clarified the duties that counsel for a chapter 11 debtor owes to parties in a
bankruptcy case. A brief discussion of the facts of the case is important to an understanding of the ICM decision.

In October 1997, ICM Inc. filed a chapter 11 proceeding in the Southern District of Texas. Andrews &

Kurth LLP (A&K) was approved by the court as debtor's counsel. As part of the bankruptcy, the pre-petition lender
agreed to a cash collateral order that provided for payments of up to $200,000 in estate professional fees to be paid
from the lender's cash collateral. During the case, an entity called ICM Notes Ltd. purchased the lender claims. In
September 1998, the debtor obtained approval of a plan that provided for the sale of the debtor's assets for
$530,000. Under the plan, $220,000 of the $530,000 would be used to pay professional fees. No professionals
agreed to limit their fees to $220,000.

Ultimately, the plan fell apart when neither ICM Notes nor the debtor were willing to pay the
court-approved administrative expenses, including professionals' fees in excess of $220,000. This impasse allowed
the purchaser under the plan to withdraw from the purchase transaction. During these negotiations, A&K informed
ICM Notes that the sale could not close unless all administrative expenses were paid in full or arrangements were
made for the payment of these fees. After the sale fell through, ICM Notes obtained stay relief and purchased the
debtor's assets at the foreclosure sale. ICM Notes then filed suit against A&K for breach of fiduciary duty and
tortious interference with contract. A&K moved to dismiss the lawsuit on a number of grounds, including that (1)
A&K did not owe a direct fiduciary duty to ICM Notes, (2) ICM Note could not assert a breach of fiduciary duty
claim on behalf of the estate and (3) A&K did not breach any duties it might have owed ICM Notes.

Initially, the district court held, as a matter of law, that counsel for the debtor in a chapter 11 case did not
have a fiduciary duty running to a particular creditor or party in interest. The district court noted that while the
counsel owed a duty to the bankruptcy estate and to "both the client debtor-in-possession and the bankruptcy
court,"<a href="#12" name="12a">12</a> it would be improper to extend that duty to individual creditors. The court's discussion of various cases
concerning debtor's counsel's duties is particularly useful, as it demonstrates the subtle but important differences of
opinion between courts concerning those duties owed by debtor's counsel.<a href="#13" name="13a">13</a>

However, the case was not dismissed, as the district court found that genuine issues of material facts
remained unresolved on the tortious interference issue, which precluded summary judgment. The Fifth Circuit
affirmed, based on the reasoning of the district court's opinion.

The ICM decision is important because it represents one of the few circuit-level decisions concerning the
scope of counsel for the debtor's duties in chapter 11 cases, as well as a clear statement that the debtor's counsel
owes no fiduciary duties to specific creditors.

<h3>And Something Borrowed:<a href="#14" name="14a">14</a> In re United Artists</h3>

For a number of years, professionals have sought court approval of various terms of indemnification or
exculpation with debtors and their committees. In January 2003, the Third Circuit became the first appeals court to
address the important issue of whether such provisions are permissible under the Bankruptcy Code.<a href="#15" name="15a">15</a>

In 2000, United Artists Theatre Co. and its affiliates filed chapter 11 bankruptcies in Delaware that were
assigned to the U.S. District Court. In connection with their bankruptcy pleadings, the debtors sought to retain
Houlihan Lokey Howard & Zukin (HL) as their financial advisors. As part of its retention agreement, HL sought to
have the debtors indemnify it for all reasonable attorneys' fees and expenses, as well as all losses that could be
incurred by HL related to the services that it was to provide the debtors, except for losses that were determined to
have resulted solely from HL's "gross negligence, bad faith, willful misfeasances or duties."<a href="#16" name="16a">16</a> The U.S. Trustee
objected to the indemnification provisions, arguing they were not authorized by the Code<a href="#17" name="17a">17</a> and were per se

unreasonable under <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… U.S.C. §§328</a> and 330. The district court overruled the U.S. Trustee's objections. Shortly
thereafter, the U.S. Trustee approved a pre-negotiated plan, and the U.S. Trustee timely appealed approval of the
indemnity provisions in HL's retention agreement.

Initially, the United Artists court rejected the U.S. Trustee's position that professional indemnity
provisions were not categorically prohibited by the reasonableness standard of <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… U.S.C. §328(a)</a>. In reaching this
conclusion, the court noted that (1) there was no clear prohibition against such provisions in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… U.S.C. §328</a>; (2)
such agreements are becoming more common in the general marketplace; (3) the majority of recent case law has
determined that indemnity provisions can be approved as reasonable on a case-by-case review of the circumstances of
the case and the terms of the agreement; and (4) that the financial advisors were not ethically or legally prohibited
from seeking such indemnification provisions.<a href="#18" name="18a">18</a>

Of special importance in this case is that federal law should govern the determination of whether
indemnity provisions are appropriate and that Delaware law should be applied by analogy to determine that
issue. The United Artists majority then discussed in detail the duty financial professionals owe estates and
determined, somewhat surprisingly, that financial professionals do not owe fiduciary duties to bankruptcy
estates. The court stated:

<blockquote>
[t]hough directors and officers are fiduciaries of the corporations they serve, we do not hold financial advisors like
Houlihan Lokey to be fiduciaries. Still, in the bankruptcy context they may owe a higher level of care than in
ordinary practice [citations omitted]. The upshot for this case is that, to the extent that fiduciaries may obtain
indemnity for their negligence, financial advisors in bankruptcy (who may or may not be fiduciaries) may do the
same.
</blockquote>

<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3… F.3d 217, 231, n.14</a> (emphasis added).

Notwithstanding the court's intention to indicate the appropriateness of financial advisors' seeking and
obtaining indemnity provisions in their retention agreements, the "statement" that financial advisors employed by a
debtor may or may not be fiduciaries of a debtor's estate calls into question this: What standard of care do financial
advisors employed by a bankruptcy estate owe that estate?<a href="#19" name="19a">19</a>

Although United Artists answered the question of whether indemnification provisions were not per se

prohibited under the Code, it has raised many new issues, including (1) the duty of care owed to chapter 11 debtors
by financial professionals hired by those debtors, (2) the role of state law in determining whether financial
professionals can ethically seek indemnification provisions and (3) the ability of attorneys who are generally
prohibited under applicable state law from limiting their liability for malpractice in their retention agreements to
attempt to seek such limitations without court approval if a federal standard governs the permissibility of indemnity
provisions. The answer to the last question is most likely "no," given that such provisions are not ordinarily
obtained or sought in non-bankruptcy situations, and that state ethical rules often prohibit such agreements. On the
other hand, with United Artists ruling that federal law, not state law, governs what terms are permissible in an
employment or retention agreement, it is arguably an open issue. Therefore, while the final credits on United Artists
have rolled (at least at the circuit court level), bankruptcy professionals will have to wait for sequels before they
learn the true impact of this decision.

<h3>Conclusion</h3>

These decisions demonstrate that ethical issues in bankruptcy cases are gaining more appellate attention,
and that it is likely that the law of bankruptcy ethics will increasingly be made by appeals courts rather than
bankruptcy courts.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Board-certified in business bankruptcy by the American Board of Certification. <a href="#1a">Return to article</a>

<a name="2">2</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3… F.3d 217 (3rd Cir. 2003)</a>. <a href="#2a">Return to article</a>

<a name="3">3</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… WL 956231 (5th Cir. March 11, 2003,) aff'g. ICM Notes v. Andrews & Kurth, 278 B.R. 117 (S.D.
Tex. 2002)</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3… F.3d 467 (4th Cir. 2003)</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… Am. Bankr. Inst. J. 8 (Oct. 2000)</a>. <a href="#5a">Return to article</a>

<a name="6">6</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Intelogic Trace Inc., 200 F.3d 382 (5th Cir. 2000)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… re Southmark, 163 F.3d 925 (5th Cir. 1999)</a>. <a href="#6a">Return to article</a>

<a name="7">7</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… F.3d 36 (1st Cir. 2001)</a>. <a href="#7a">Return to article</a>

<a name="8">8</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3… F.3d 467 (4th Cir. 2003)</a>. <a href="#8a">Return to article</a>

<a name="9">9</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3… F.3d at 472</a>. <a href="#9a">Return to article</a>

<a name="10">10</a> Under res judicata, a claim will be precluded when (1) the prior judgment was final and on the merits, and
rendered by a court of competent jurisdiction in accordance with the requirements of due process; (2) the parties are
identical, or in privity, in the two actions; and (3) the claim in the second matter [is] based upon the same cause of
action involved in the earlier proceeding. Citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8… re Varat Enters. Inc., 81 F.3d 1310, 1315 (4th Cir.1996)</a>. Id. at
<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3… F.3d at 472</a>. <a href="#10a">Return to article</a>

<a name="11">11</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3…; at 474</a>. <a href="#11a">Return to article</a>

<a name="12">12</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… B.R. at 122</a>. <a href="#12a">Return to article</a>

<a name="13">13</a> Id. at 123-126. <a href="#13a">Return to article</a>

<a name="14">14</a> This portion of the article is based on a more in-depth article that is scheduled to be published in the May
issue of Norton Bankruptcy Law Advisor. <a href="#14a">Return to article</a>

<a name="15">15</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3… re United Artists Theatre Co. v. Walton, 315 F.3d 217 (3rd Cir. 2003)</a>. <a href="#15a">Return to article</a>

<a name="16">16</a> This limitation was later reduced by the Third Circuit, which struck down the "sole cause" exception to the
indemnity provisions. <a href="#16a">Return to article</a>

<a name="17">17</a> See "Interview with EOUST Director Lawrence Friedman," 22 ABI Journal (February 2003). <a href="#17a">Return to article</a>

<a name="18">18</a> The United Artists court, however, was badly divided as to how the indemnification agreement should be
interpreted. Such a discussion is beyond the scope of this article. <a href="#18a">Return to article</a>

<a name="19">19</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3… F.3d at 230, n. 14</a> (citations omitted). <a href="#19a">Return to article</a>

Journal Authors

C. R. Bowles

Journal Date

Sunday, June 1, 2003 - 12:00

Bankruptcy Rule

2003