Disinterestedness and Preferential Transfers Cant We Talk About This Later

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Dec/Jan 2002

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When seeking retention as a professional for a debtor-in-possession (DIP), it is
black-letter law that the proposed professional must be disinterested. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
U.S.C. §§101(14), 327(a)</a>. The timing and method of determining
disinterestedness is not as clear-cut. Indeed, it is common for courts to approve
the employment of a professional on an interim basis or final basis with a caveat that
the court may later rule on disinterestedness, particularly when the alleged interest
is more potential than actual at the outset.

Recently, however, the Third Circuit has addressed the need to determine
disinterestedness in the earliest stages of a case. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Pillowtex Inc.,
304 F.3d 246 (3d Cir. 2002)</a>. While the alleged conflict found in
Pillowtex—preferential transfers to a professional—is not new, the Third Circuit's holding
as to the timing of determining disinterestedness is a further complication to the early
stages of a bankruptcy case.

<h3>In re Pillowtex</h3>

In Pillowtex, the U.S. Trustee objected to the employment of proposed counsel for
the DIP based on counsel's alleged receipt of preferential transfers. After the
district court approved counsel's employment, with the caveat that if the court later
determined that counsel had received a preferential transfer, counsel would "promptly
return the same to [the bankruptcy] estate...and waive any unsecured claim it has
by virtue thereof," the U.S. Trustee appealed to the Third Circuit.

Meanwhile, the underlying bankruptcy proceeding moved forward, and the debtor
confirmed a reorganization plan, which would appear to have mooted the appeal.
Further, no party asserted a preference action against counsel, nor did any other
party object to counsel's employment. The Third Circuit, however, disagreed that
confirmation mooted the appeal. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Pillowtex, 304 F.3d at 250</a>; citing
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Venture Capital Ltd. v. Committee of Unsecured Creditors, 160 F.3d
982, 986 (3d Cir. 1998)</a>.

In considering the issues on appeal, the Third Circuit first examined the three
levels of conflict it had previously found: (1) an actual conflict of interest,
which requires disqualification; (2) a potential conflict of interest, for which
the district court has discretion to disqualify; and (3) the appearance of a
conflict, for which the district court may not disqualify without other basis. See

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Pillowtex, 304 F.3d at 251</a>; citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Marvel Entertainment
Group Inc., 140 F.3d 463, 476 (3d Cir. 1998)</a>. The Third
Circuit then reiterated its holding in First Jersey Securities that "[a] preferential
transfer to [debtor's counsel] would constitute an actual conflict of interest between
counsel and the debtor, and would require the firm's disqualification." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re
First Jersey Securities Inc., 180 F.3d 504, 509 (3d Cir.
1999)</a>. In First Jersey Securities, however, the court held that the record
demonstrated that counsel had received a preferential transfer, thereby creating an
actual conflict of interest, whereas no such evidence existed on the record in

Pillowtex.

Without such evidence, the Third Circuit could not rule on whether an actual
conflict existed. Indeed, the Third Circuit stressed that a record of such evidence
is important, despite counsel's assertions that such a hearing would be expensive and
unnecessary, because a preferential transfer can be, but is not always, an actual
conflict requiring disqualification. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Pillowtex, 304 F.3d at 250-52</a>;
citing Jackson, Thomas H., "Avoiding Powers in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 36 Stan. L. Rev.
725, 757 (1984)</a>.<a href="#1" name="1a">1</a> Thus, since counsel failed to proffer any evidence as
to the nature of the pre-petition fees received on or within 90 days prior to the
petition date, the Third Circuit could not determine what fees were preferential
transfers and what fees were for bankruptcy preparation. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Pillowtex, 304
F.3d at 253</a>. Consequently, since the record did not reflect such evidence, the
Third Circuit reversed and remanded the matter to the district court for a hearing
on whether the fees paid within 90 days of the petition date were preferential
transfers and whether an actual conflict existed.

<h3>Avoiding the Avoidance Conflict</h3>

Pillowtex's ruling does not change the conflicts analysis, only the timing of the
analysis. Indeed, Pillowtex mandates that a bankruptcy or district court resolve any
disinterestedness issues during the preliminary stages of a bankruptcy case. Although
prior to Pillowtex early resolution was achieved by the reservation of such objections
and/or waivers of claims resulting from avoidance actions, Pillowtex clearly states that
the mere promise to waive a claim resulting from the avoidance of a preferential
transfer is not sufficient. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 253</a>.

While it may be sufficient to waive past due fees and expenses prior to employment,
that waiver is quite different from the waiver suggested by counsel in Pillowtex. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;
A professional that has not waived pre-petition, antecedent fees, and has actually
received payments on account of such antecedent fees, may have liability to the
bankruptcy estate and may become a creditor. That situation is quite different from
a situation where a proposed estate professional has waived pre-petition, antecedent fees
prior to employment, and has not received payment for antecedent fees.

As a professional employed by the DIP, that someone with such potential liability
would have an interest in discouraging the investigation and pursuit of avoidance
actions, particularly if the potential distribution to unsecured creditors is minimal,
if expected at all. And in the Third Circuit, only the DIP or a chapter 11
trustee can bring avoidance actions. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Committee of Unsecured Creditors of
Cybergenics Corp. vs. Chinery, 304 F.3d 316 (3d Cir. 2002)</a>. Due
to the Cybergenics holding, the protection previously provided by committee investigation
of avoidance actions appears to be gone.<a href="#2" name="2a">2</a>

Thus, "when there has been a facially plausible claim of a substantial preference,
the district court and/or the bankruptcy court cannot avoid the clear mandate of the
statute by the mere expedient of approving retention conditional on a later determination
of the preference issue." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 304 F.3d at 255</a>. Pillowtex, therefore,
mandates an early resolution to potential conflicts.

Moreover, early resolution is important to the professional to prevent the
potential for great economic loss. After all, if an appellate court finds that a
professional must be disqualified because of an actual conflict of interest, then that
professional may be subject to the total disgorgement of all fees and expenses incurred
during the bankruptcy, as well as the subsequent disgorgement of the preferential
transfer, regardless of the success of the case.

Thus, professionals would be wise to resolve potential conflicts early in a
bankruptcy case. To resolve allegations of actual conflict due to preferential
transfers, a professional must proffer evidence that the alleged preferential
transfers were payment for pre-bankruptcy services, or that subsequent new value
was otherwise provided. Such evidence may be introduced at the hearing on the
employment application as opposed to a full-blown adversary proceeding. Indeed,
the Third Circuit did not hold that an adversary proceeding and trial were
necessary, and implied that a hearing was needed to determine whether the U.S.
Trustee could establish a prima facie case that preferential transfers were made.

If, however, the transfers were on account of an antecedent debt and meet the
elements of §547, with none of the defenses therein, the professional must face
the inevitable: He or she is the recipient of preferential transfers. But it is
better to determine and address the conflict before thousands or millions of dollars in
fees are incurred.

Upon a finding that a preferential transfer was made, the district court must
determine whether such transfer created an actual conflict for the proposed
professional. Indeed, such conflict might be avoided by the retention of special
conflicts counsel to investigate and pursue preferential transfers against estate
professionals. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Air South Airlines Inc., No. 97-07229-W, 1998 WL 34020727, *5 (Bankr. D. S.C.
Jan. 16, 1998)</a>. With the employment of special conflicts counsel, the
professional is no longer in actual conflict as that professional is not employed or
authorized to investigate and/or advise a DIP on such issues. In fact, many
courts have analyzed §327(c) and held that there is no conflict of interest where
counsel represents or is a creditor of the debtor, but is employed for certain
purposes in the case for which no conflict exists. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Hoffman Associates
Inc., No. 90-02419-W, 1996 WL 33340782, *3 (Bankr. D.
S.C. Sept. 10, 1996)</a>; citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re RPC Corp., 114 B.R. 116
(M.D.N.C. 1990)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Fondiller, 15 B.R. 890, 892 (9th
Cir. B.A.P. 1981)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of Lorandos, 58 B.R. 519 (Bankr.
S.D. Ohio 1986)</a>. While special conflicts counsel would be employed by the
DIP, the conflict is removed from the conflicted professional, and an effective
investigation of potential avoidance actions against other estate professionals may
occur.

Proposed professionals could also avoid conflicts by introducing evidence of special
circumstances in the particular case. For example, if the debtor had filed a
"pre-pack" bankruptcy that provided for payment in full of all creditors, there would
be no need to avoid any preferential transfers. Presumably, other such circumstances
could also exist.

Alternatively, the conflict can be avoided by having such a hearing and complying
with the findings. If the court finds a preference that creates an actual conflict,
counsel has the opportunity to withdraw or remit the preference and waive their claim,
thereby avoiding the conflict. As painful as this result would be, professionals are
not excepted from the provisions of §547.

<h3>Conclusion</h3>

The conflict discussed in Pillowtex is not a new issue. Requiring resolution of the
conflicts issue in the earliest stages of a bankruptcy case, however, is not the
common practice in many courts. For quite some time, professionals have delayed such
issues with promises to waive and/or reservations of the right to pursue such actions.

Certainly, many such determinations will be resolved favorably and create some
unnecessary delay and additional expense. However, the delay and expense need not be
large, as the issues are certainly capable of resolution in a summary proceeding.
Absolute proof through an adversary proceeding is not the intended result. Instead,
courts need to determine whether a prima facie case exists that preferential transfers
were made to which the proposed professional cannot rebut or demonstrate a defense.

Granted, this will prevent many proposed professionals from serving as estate
professionals. However, for a professional with the potential for disgorgement and
the always-present ethical issues, is waiting really worth the risk?

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> In stating that a preferential transfer to a proposed professional could be an actual conflict, the Third Circuit appears to be
backing away from its affirmative holding in First Jersey Securities that this "would be an actual conflict." <a href="#1a">Return to article</a>

<a name="2">2</a> Currently, there is a split in Second and Third Circuit authority as to the standing of a creditor and/or committee to bring
avoidance actions. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Committee of Unsecured Creditors of Cybergenics Corp. vs. Chinery, 304 F.3d 316 (3d Cir.
2002)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Nationale de Paris vs. Murad (In re Housecraft Industries USA Inc.), No. 01-7998, 2002 WL
31388883</a>, -- F.3d -- (2d Cir. Oct. 24, 2002). <a href="#2a">Return to article</a>

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Sunday, December 1, 2002 - 12:00

Bankruptcy Rule

2002