CPR and Code 327 Harmonized in In re Mercury Part I

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Dec/Jan 2002

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The Code of Professional Responsibility is a major component of what distinguishes law
as a profession. The precepts set forth in the Code of Professional Responsibility
are not only aspirational, but are also mandatory. In bankruptcy cases, Bankruptcy
Code §327(a) mandates standards of conduct for professionals that are to be
employed by a bankruptcy estate. In In re Mercury,<a href="#1" name="1a">1</a> Judge Adlai S. Hardin Jr.

of the U.S. Bankruptcy Court for the Southern District of New York has written
an important decision concerning bankruptcy ethics that has ramifications not only for
bankruptcy cases, but also for corporate reorganization cases. Judge Hardin's analysis
of the interplay of the Code of Professional Responsibility and Bankruptcy Code
§327(a) merits discussion and thought by the bankruptcy community.

In Mercury, Mrs. Mercury was grievously injured in a slip-and-fall accident.
Thereafter, she and her husband commenced a personal injury action to recover damages.
The plaintiffs' retained counsel (PI counsel) and executed a retainer agreement under
which PI counsel would receive 33 percent of the personal injury award. During the
course of the personal injury litigation, the plaintiffs' financial situation
deteriorated, and they decided to file for chapter 7. The PI counsel received
$1,200 for preparing a chapter 7 petition; however, the debtors filed pro se.
Barbara Balaber-Strauss<a href="#2" name="2a">2</a> qualified as the permanent chapter 7 trustee, and she
prosecuted the personal injury claim for the benefit of the estate. Subsequently, in
January 2000 a mediation was conducted, and a settlement of a $190,000 was
reached with the insurance carrier. Trustee Balaber-Strauss accepted the settlement as
being in the best interests of the creditors. However, the plaintiffs/debtors were
dissatisfied with the settlement, and they informed the PI counsel of their desire
to reject the proposed settlement and to proceed to trial.

PI counsel made an ex parte application to be relieved as bankruptcy counsel, and
the application was granted. The debtors did not receive any notice of PI counsel's
application to be relieved as their bankruptcy counsel. In April 2000 an
application to retain PI counsel was made on behalf of the estate; however, the
application failed to disclose any potential conflict of interest between the debtors and
PI counsel. In May 2000, PI counsel sent the debtors a letter advising them
that their interests were adverse to Trustee Balaber-Strauss and that they should
retain new counsel. The debtors opposed the approval of the settlement, and they
appeared at the hearing on the settlement. Judge Connelly, the bankruptcy judge
initially assigned to the bankruptcy case, eventually approved the settlement. The PI
counsel filed an application for compensation.

Judge Hardin denied the application in its entirety because there were numerous
violations of the Code of Professional Responsibility and Bankruptcy Code §327(a).

The court noted that an attorney has a continuous professional duty to competently
represent a client and with proper care. Equally significant, an attorney must seek
the lawful objectives of a client, and he or she must not fail to effectuate a
contract for professional services. Only a client has the authority to make substantive
decisions concerning his or her case. Another important principle is that an attorney
must obtain authorization from the tribunal in which a matter is pending before he or
she is permitted to withdraw as counsel. A bedrock concept of professional ethics is
that an attorney is precluded from representing entities with conflicting interests.

Judge Hardin then proceeded to analyze the requirements for the retention of a
professional under §327(a). Judge Hardin stated:

<blockquote>
These provisions are very clear. Under subsection (a), to be retained to
represent the trustee the attorney must not "represent an interest adverse to the
estate" and must be "disinterested," and under subsection (e) an attorney that
has represented the debtor may represent the trustee only if "such attorney does
not represent...any interest adverse to the debtor or to the estate with
respect to the matter on which such attorney is to be employed." Section
101(14) defines a "disinterested person" as one that "(E) does not have
an interest materially adverse to the interest of the estate...by reason of any
direct or indirect relationship to, connection with, or interest in, the
debtor...." As stated in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Martin, 817 F.2d 175, 180
(1st Cir.1987)</a>, the "twin requirements of disinterestedness and lack of
adversity telescope into what amounts to a single hallmark." Both §§327(a)
and (e) require, at a minimum, that the attorney to be employed by the
estate hold no "adverse interest." 3 Collier on Bankruptcy ¶327.04[a] at
327-60 (Lawrence P. King, et al. eds., 15th ed. rev.2001).<a href="#3" name="3a">3</a>
</blockquote>

The concept of adverse interest is undefined in the Bankruptcy Code. Judge Hardin
adopted the following definition:

<blockquote>
Although "adverse interest" is not defined in the Bankruptcy Code, it has been
defined in the case law to mean for two or more entities (1) to possess or
assert mutually exclusive claims to the same economic interest, thus creating
either an actual or potential dispute between the rival claimants as to which,
if any, of them the disputed right or title to the interest in question
attaches under valid and applicable law, or (2) to possess a predisposition
or interest under circumstances that render such a bias in favor of or against
one of the entities.<a href="#4" name="4a">4</a> (citations omitted.)

</blockquote>

Intimately connected to Bankruptcy Code §327(a) is <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Rule of Bankruptcy
Procedure 2014(a)</a>, which requires an attorney to disclose all the facts that are
pertinent to his or her retention, including those facts that relate to a potential
conflict of interest. The failure to disclose a fact that is germane to a bankruptcy
court's determination may result in an attorney's being subsequently disqualified in a
disallowance of the applicant's fees. The consequences for a violation of either
Bankruptcy Code §327(a) or <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Rule of Bankruptcy Procedure 2014(a)</a> are
significant. In addition, Bankruptcy Code §328(c) authorizes a bankruptcy court
to deny compensation if the professional was not disinterested or held or represented
an interest adverse to the estate. Judge Hardin wrote:

<blockquote>
The case law confirms what the statute expressly provides—that a professional
retained to represent the estate under §327 may be denied compensation and
reimbursement of expenses if he was not disinterested or was burdened by a
conflict of interest. "When a law firm is found not to be disinterested,
disallowance of fees is appropriate."<a href="#5" name="5a">5</a>
</blockquote>

The court found that PI counsel had violated his ethical obligations to the
debtors. The PI counsel never withdrew as personal injury counsel to the debtors;
therefore, it continued to have a duty to effectuate its professional obligations to
the debtors. Judge Hardin stated:

<blockquote>
As attorneys of record for the Mercurys in the personal injury action, F &

H owed to the Mercurys all of the ethical, contractual and legal obligations of
competence under Canon 6, zealous advocacy and fidelity under Canon 7 and
undivided loyalty under Canon 5 quoted in point I, above. Without reiterating
and juxtaposing the authorities and the acts and omissions of F & H set forth
above, it is perfectly plain that F & H violated their retainer agreement and
all of the ethical and legal rules discussed in point I.<a href="#6" name="6a">6</a>
</blockquote>

Equally significant was the conflict of interest that PI counsel had because of
the dual representation of both the debtors and the chapter 7 trustee. Judge Hardin
stated:

<blockquote>
In this case there was an actual, luminous conflict between the chapter 7
trustee and the Mercurys with respect to the settlement of their personal injury
action. The potential for that conflict was evident from the moment that the
Mercurys expressed their disinclination to participate in a mediation. The
conflict became patent during and after the mediation, not only because the
Mercurys made clear their rejection of settlement and their desire to go to
trial, but because the proposed settlement was palpably contrary to the debtors'
interests, although it was recommended to the trustee by F & H.<a href="#7" name="7a">7</a>
</blockquote>

The court noted that the conflict of interest was real, and the PI counsel was
under a fundamental duty to protect the interests of the debtors. Judge Hardin
remarked:

<blockquote>
At the Jan. 29, 2002, evidentiary hearing, Mr. Fellows and F &
H's counsel appeared to suggest that there was no conflict of interest because
after the bankruptcy filing F & H somehow became answerable to the trustee
and required to serve the best interests of the estate, rather than the
interests of the debtors (see, e.g., the Fellows testimony quoted in footnote
4), or perhaps because F & H's allegiance as counsel in the personal injury
action was to the claim, so that when the claim became part of the debtors'
estates, F & H's ethical and legal duties as counsel also were transferred
to the estate. Such arguments, if such were indeed their arguments, are
baseless. The attorney-client relationship exists between the attorney and his
client, and counsel's ethical, contractual and legal obligations are owed to the
client, not the client's claim and certainly not to a debtor-client's chapter
7 trustee, whose interests are fundamentally adverse to those of the debtor.<a href="#8" name="8a">8</a>

The consequence of counsel's apostasy was disastrous for the Mercurys. Had F
& H zealously urged the chapter 7 trustee to permit the Mercurys to go to
trial, as they were ethically required to do under the authorities in point
I(A)(1), above, it is quite likely that the trustee would have had no
alternative but to accede to the position of the debtors and their trial
counsel. If, nevertheless, the chapter 7 trustee moved to settle the personal
injury action, F & H were contractually and ethically bound to represent the
Mercurys in opposition. In addition, F & H had the ethical duty to advise
the Mercurys of their right to trump the chapter 7 trustee's attempt to settle
by the simple expedient of a motion to convert to chapter 11.<a href="#9" name="9a">9</a></blockquote>

PI counsel had a real conflict of interest because the debtors were adamantly
opposed to the proposed settlement. PI counsel refused to disclose the conflict of
interest in its retention affidavit, and the retention affidavit was materially false.
If PI counsel had disclosed that the debtors were opposed to the settlement, then
PI counsel would not have been retained as special counsel to the chapter 7 trustee.
Under these circumstances, the appropriate remedy was the denial of all compensation.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. 35 (Bankr. S.D.N.Y. 2002)</a>. <a href="#1a">Return to article</a>

<a name="2">2</a> Ms. Balaber-Strauss is a senior and respected chapter 7 trustee in the Southern District of New York. Ms. Balaber-Strauss is a
member of the Board of Directors of the National Association of Bankruptcy Trustees. <a href="#2a">Return to article</a>

<a name="3">3</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Mercury, 280 B.R. 35, 53 (Bankr. S.D.N.Y. 2002)</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 54</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 57</a>. <a href="#5a">Return to article</a>

<a name="6">6</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 60</a>. <a href="#6a">Return to article</a>

<a name="7">7</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; <a href="#7a">Return to article</a>

<a name="8">8</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 61</a>. <a href="#8a">Return to article</a>

<a name="9">9</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 62</a>. <a href="#9a">Return to article</a>

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Journal Authors

Carlos J. Cuevas

Theodore P. Kaplan

Journal Date

Sunday, December 1, 2002 - 12:00

Bankruptcy Rule

2002