CPR and Code Section 327 Harmonized in In re Mercury Part II

Journal Issue

Mar 2003

Column Name

Journal HTML Content

Editor's Note:

Part I of this article appeared in the December/January 2003 issue, Vol. XXI, No. 10.

</blockquote>

In a prior Code to Code
column, we discussed Judge Adlai S. Hardin Jr.'s
decision in In re Mercury,<a href="#1" name="1a">1</a> which concerned the
disallowance of all fees for a law firm that acted as special counsel to a
chapter 7 trustee. The Mercury decision is
important because of its comprehensive examination of the Code of Professional
Responsibility, Bankruptcy Code §327(a), Federal Rule of Bankruptcy Rule
of Procedure 2014(a) and bankruptcy. In Mercury,
the court reaches the correct conclusion; however, there are other compelling
grounds concerning the violation of professional ethics that warranted the
disallowance of all fees.

It must be borne in mind that PI counsel, a personal
injury firm with no bankruptcy expertise, rendered legal advice concerning the
preparation of the debtors' bankruptcy case, and it received a $1,200
retainer. The debtors had been represented by counsel at the inception of the
bankruptcy case. However, during the middle of the bankruptcy case, the debtors'
counsel obtained an ex parte order relieving
them as counsel to the debtors. PI counsel became the debtors' bankruptcy
counsel and permitted the debtors to file their bankruptcy case pro se—which they did after their bankruptcy counsel was
relieved—even though the debtors had a major personal injury claim. There
are two consequential issues concerning the personal injury claim that are
fundamental to the attorney-client relationship: (a) the exemption of the
personal injury claim and (b) the settlement of the personal injury claim.
Given the nature of the injury to Mrs. Mercury, it was possible that Mrs.
Mercury might claim that all of the proceeds were exempt under New York law.
There would be litigation between the debtors and the chapter 7 trustee
concerning the propriety of the exemption, and the dual representation of the
debtors and chapter 7 trustee would constitute a conflict of interest for PI
counsel.

Equally significant is the potential conflict of
interest concerning the settlement of the personal injury claim. The debtors
needed legal representation throughout the bankruptcy case because of the
resolution of the personal injury claim. It was incumbent upon PI counsel not
to oppose the debtors' legal position in the bankruptcy case because it
had previously represented the debtors in the same matter concerning the same
legal issues. Trustee Strauss had a duty to all of the unsecured creditors, and
her duty was to act in the best interests of the bankruptcy estate. PI counsel
could not simultaneously advise Trustee Strauss to accept the proposed
settlement while advocating a position that is contrary to the debtors'
interests.

PI counsel was also the debtors' bankruptcy counsel
through the period of the mediation. The adversary system failed because the
debtors lacked bankruptcy counsel to advise them and advocate for them at
critical junctures of the bankruptcy case. Judge Hardin wrote:

<blockquote>
It was F & H's obligation to clearly and unambiguously
advise the Mercurys that a "downside risk" of proceeding to
mediation was that the chapter 7 trustee was legally in control of their
personal injury claim and might be successful in persuading the court to
approve a mediation settlement despite their opposition. F & H not only
failed to do so, but advised the Mercurys that there was no risk in going to
mediation because, if the proposed settlement were not acceptable to them, they
could always proceed to trial. F & H had the obligation to advise the
Mercurys as to the conflict between their interests and those of the chapter 7
trustee with regard to the question of settlement, to explain to the Mercurys
what steps they might take if the trustee were to apply to the court for
approval of the settlement, and to act with competence and zeal to protect the
Mercurys' right to a trial notwithstanding the trustee's desire to
settle the action. F & H acted in defiance of all of these obligations.
They repudiated their contractual, ethical and legal duties as counsel for the
Mercurys by abandoning their clients and joining in the trustee's
application to retain F & H as special counsel to the trustee for the
precise purpose of moving for court approval of the settlement which their
clients had rejected.<a href="#2" name="2a">2</a>
</blockquote>

Another important point is that PI counsel also failed
to notify the court that it had acted as bankruptcy counsel for the debtors. PI
counsel was under a duty to disclose its relationship as bankruptcy counsel to
the debtors. There is an inherent tension between a chapter 7 debtor and a
chapter 7 trustee. As Mercury demonstrates, a
debtor might think that a settlement is imprudent, while a chapter 7 trustee
thinks that the same settlement is beneficial because it will ensure a prompt
and significant payment to the unsecured creditors. PI counsel's failure
to disclose all of the underlying relationships was detrimental to the
bankruptcy process. Under prior case law, the failure to disclose material
facts pertaining to its retention is a basis for not only disqualification, but
also for the denial of all compensation.

The issue of dual representation as PI counsel is more
complex. Under Bankruptcy Code §541(a), the filing of a bankruptcy
petition creates a bankruptcy estate. Unless exempted, the bankruptcy estate
succeeds to all of the debtor's interests in property. The personal
injury claim was property of the estate. Conceptually, it is as if the debtors
assigned the personal injury claim to the creditors so that they could receive
a discharge of the creditors' claims. Trustee Strauss, as the qualified
permanent chapter 7 trustee, was the manager of the Mercury estate, including
the personal injury claim. PI counsel owed a duty to the Mercury bankruptcy
because it was the bankruptcy estate that controlled the claim. Otherwise, a
debtor could file for bankruptcy and still control the outcome of a major asset
of the estate.

This analysis is consistent with the Supreme Court's
holding in Commodity Futures Trading Commission v. Weintraub.<a href="#3" name="3a">3</a> Here, the Supreme Court ruled that a bankruptcy trustee controls
the attorney-client privilege when a corporation files for bankruptcy.<a href="#4" name="4a">4</a> The
filing of a bankruptcy petition effects a change in management, and it is
current management that controls the attorney-client privilege. In a bankruptcy
case, it is a trustee that acts as current management. Justice Marshall,
writing for a unanimous Court, stated:

<blockquote>
The powers and duties of a bankruptcy trustee are extensive. Upon
the commencement of a case in bankruptcy, all corporate property passes to an
estate represented by the trustee. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
U.S.C. §§323, 541</a>. The trustee is
"accountable for all property received," §§704(2),
1106(a)(1), and has the duty to maximize the value of the estate. See §704(1); <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=4…
re Washington Group Inc., 476 F.Supp. 246, 250
(M.D.N.C. 1979)</a>, aff'd. sub nom., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=6…
v. Gilbert, 636 F.2d 1213 (CA4 1980), cert.
denied, 452 U.S. 940, 101 S.Ct. 3084, 69 L.Ed.2d
954 (1981)</a>. He is directed to
investigate the debtor's financial affairs, §§704(4) [and]
1106(a)(3), and is empowered to sue officers, directors and other insiders to
recover, on behalf of the estate, fraudulent or preferential transfers of the
debtor's property. §§547(b)(4)(B), 548. Subject to court
approval, he may use, sell or lease property of the estate (§363(b)).<a href="#5" name="5a">5</a>

</blockquote>

Under the Supreme Court's analysis of the powers
of a bankruptcy trustee, the debtors lacked the authority to control the
settlement of the personal injury claim because it is a bankruptcy trustee who
has authority under the Bankruptcy Code to control the assets of a bankruptcy
estate. This is consistent with the practice of substituting a bankruptcy
trustee as the plaintiff in a pending personal-injury action.

Judge Hardin is correct that the retention of a
debtor's bankruptcy counsel as special counsel by a bankruptcy trustee
represents a problem of a potential conflict of interest. As witnessed by the Mercury< decision, a debtor and bankruptcy trustee might have divergent
views concerning the resolution of a personal-injury claim in a bankruptcy
case. The PI counsel might be compelled to oppose a former client on a matter
that he or she represented the former client. The PI counsel might be compelled
to testify against a former client as to why a settlement is beneficial and why
a 9019 motion should be approved over the objections of a debtor. This is a
recurring problem in chapter 7 cases that involve personal-injury claims.

Under Judge Hardin's analysis, special counsel has
a continuing professional duty to a debtor. If so, then special counsel cannot
represent a bankruptcy estate because of the potential that he or she might
have to take a position that is contrary to the debtor's interest. There
is always the possibility that a debtor will think that a settlement is
inadequate, while a bankruptcy trustee might think that a settlement is
prudent.

Disclosure of the potential of interest for special
counsel might be insufficient to satisfy the requirements of the Code of
Professional Responsibility. The threat of a disallowance of all compensation
might make it impractical to retain special counsel that represented a debtor
in a personal-injury case. Therefore, Mercury
will have an impact on the retention of special counsel and the prosecution of
personal injury claims in a bankruptcy case.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
B.R. 35 (Bankr. S.D.N.Y. 2002)</a>. <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=2…; at 61-62</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=4…
U.S. 343 (1985)</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> The
Court did not address the issue of control of the attorney-client privilege
when an individual files for chapter 7. <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=4…
U.S. 343, 352 (1985)</a>. <a href="#5a">Return to article</a>

Journal Authors

Carlos J. Cuevas

Theodore P. Kaplan

Journal Date

Saturday, March 1, 2003 - 12:00

Bankruptcy Rule

2003