A Weird New World Disinterestedness for Investment Bankers under New 11 U.S.C. 101(14)

Journal Issue

Feb 2006

Column Name

Straight & Narrow

Citation

ABI Journal, Vol. XXV, No. 1, p. 26, February 2006

Bankruptcy Code

101

327

Topic Tags

Financial Advisors

Investment Banking

Professional Compensation/Fees

Journal HTML Content

Happy New Year to all Straight & Narrow
readers. In celebration of the New Year, we will examine the new
issues facing investment bankers who have expanded opportunities to be
employed as professionals under 11 U.S.C.
§327(a).1 Lack of Interest Is the
Good News: Changes to the “Disinterested Person”
Definition of 11 U.S.C. §101(14) Among the numerous changes
made to the Bankruptcy Code by the Bankruptcy Abuse Prevention and
Consumer Protection Act of 2005 (BAPCPA) was an amendment to 11 U.S.C.
§101(14), which eliminated language that made investment bankers
“for a security of a debtor” and the investment
banker’s attorney statutorily “not
disinterested.”2 Revised 11 U.S.C.
§101(14) now reads: (14) The term “disinterested
per-son” means a person that— (A) is not a creditor, an
equity security-holder or an insider; (B) is not and was not,
within two years before the date of the filing of the petition, a
director, officer or employee of the debtor; and (C) does not have
an interest materially adverse to the interest of the estate or of any
class of creditors or equity security-hol-ders, by reason of any direct
or indirect relationship to, con-nection with or interest in, the
debtor or for any other reason. This change means that a
debtor-in-possession (DIP) or bankruptcy trustee could employ a
debtor’s pre-petition investment banker as an estate professional
if the investment bankers are otherwise disinterested and otherwise
meet the requirements of §327(a).3

And Now the Bad News: How Do I Meet the Disinterestedness Standard of
11 U.S.C. §101(14) and Employment Standard of 11 U.S.C.
§327(a)? The Statute Still Stands Initially, it is
important to note that investment bankers can still statutorily be a
“not disinterested” person if they are (1) creditors, equity
security-holders or insiders 4 of the
debtors 11 U.S.C. §101(14)(A), or (2) are within two years before
the filing a director, officer or employee of the debtor. 11 U.S.C.
§101(14)(B).5 The case law under 11
U.S.C. §101(14)(A) is fairly clear that this provision is
literally applied. Therefore any professionals, including investment
bankers, should divest themselves of all equity securities
6 of the debtor and waive all claims
7 they might otherwise have against the debtor
to qualify as disinterested persons. Further, investment bankers
employed under 11 U.S.C. §327(a) cannot acquire claims of
creditors or equity security-holders against their
debtor.8 Investment bankers should also take
care not to have any of their members or employees enter into any
arrangements with a debtor which could make them an insider of the
debtor.9 While there are cases that have
allowed certain professionals to maintain either small claims against
or equity interests in debtors,10 these
cases are a distinctly small minority and should not be relied upon.

Similarly, courts also strictly construe §101(14)(B) and refuse to
approve the employment of professionals who had partners or employees
act as officers, directors or employees of the debtor in the two years
prior to the bankruptcy filing under U.S.C.
§327(a).11 The only exception in this
area is that under certain circumstances, including the use of
confidentiality barriers or “Chinese
Walls,”12 some courts have refused to
impute that lack of disinterestedness of a member or employee to the
entire firm. Other courts have strictly imputed the lack of
disinterestedness of a single member or employee to the entire
firm.13 However, as discussed in more detail
later in this article, the existence of such officers, directors or
shareholders must be fully disclosed and any curative measures well
documented if the court is to consider the possibility of not imputing
a lack of disinterestedness to an entire
firm.14§101(14)(C): A Search for
Meaning The most litigation concerning a party’s
disinterestedness involves §101 (14)(C), which requires parties
not to have “an interest materially adverse to the interest of
the estate or of any class of creditors or equity security-holders, by
reason of any direct or indirect relationship to, connection with or
interest in the debtor, or for any other reason” in order to be
disinterested. While similar to the “not hold or represent an
interest adverse to the estate” standard of 11 U.S.C.
§327(a),15 it is a stricter standard
than §327(a)’s requirements. As the district court in In
re Glenn Electric Sales Corp.16 stated:

a nondisinterested party is one who may have an economic or practical
interest that would tend to lessen the value of the bankrupt estate or
that would create either an actual or potential dispute in which the
estate is a rival. There is a significant split as to the nature of
an interest lender that might make a party not disinterested. The
majority of courts hold that a professional may only be disqualified
based on an actual or potential conflict of interest, and not on the
mere appearance of conflict.17 Other courts
hold that a professional may only be disqualified if there is an
actual conflict of interest.18 Finally, some
courts still consider the mere appearance of impropriety when analyzing
conflicts of interest.19 These
pronouncements, while useful, are extremely general and offer little
in the way of concrete guidelines. However, there are several decisions
that address certain common fact situations that can provide
investment bankers with guidance in this area. A Lost Map Found:
Key Disinterestedness Decisions 1. Prior Employment, No
Problem. 11 U.S.C. §1107(b) gives some protection for
professionals as it provides that the mere fact that the professional
was employed by the debtor prior to the bankruptcy does not disqualify
him or her for employment under 11 U.S.C.
§327(a).20 This small safe harbor
provision is limited as it does not protect professionals from being
held ineligible for employment by reasons of activities that occurred
pre-petition during that employment.21

2. Prior Payments, Possible Problem. Pre-petition payments
received from debtors are a frequent source of litigation under 11
U.S.C. §327(a). Full disclosure of pre-petition payments of
pre-petition fees and retainers is absolutely
required.22 Given the heavy negotiation that
sur-rounds investment bankers’ compensation package, investment
bankers should take care to ensure that their compensation is well
defined 23 and not
oppressive.24 Investment bankers must also
take care to ensure that any fee payments they receive within the
90-day preference period of 11 U.S.C. §547 are both timely
received and well documented. In the now infamous
Pillowtex25 decision, debtors’
counsel, who had received approximately $1 million in fees during the
90-day preference period and had agreed to disgorge any payments found
to be preferential and waive any claim for such
fees,26 had its fees and employment
challenged. The Third Circuit ruled that this arrangement did not
comply with the requirements of 11 U.S.C. §327(a). The circuit held
that if a professional received a preferential payment pre-petition,
the preference claim would make the professional a creditor and
disqualify it from being retained under 11 U.S.C. §327(a). The

Pillowtex court also held that a bankruptcy court had to
determine, prior to approving retention, whether the professional
received a preference.27 In light of this
issue, investment bankers must take care to ensure that their
pre-petition payments are timely and clearly earned
28 in order to eliminate the possibility of
a claim that would prevent their employment. 3. Retainers and
Payment Arrangements. Why Dollars Are Different from Operating
Assets. Another issue that causes problems in the disinterestedness
area is the payment of retainers. Questions have frequently arisen as
to both the nature and source of the retainer that have prevented
parties from being retained under 11 U.S.C. §327(a). Frequent
litigation has occurred where the retainer is given to the professional
in the form of property as opposed to cash. Although most courts

29 have held that retainers that are
security interests in property do not per se make a
professional not disinterested, these courts have imposed extremely high
standards for approving such
arrangements.30 The source of the retainer
has also led to professionals being found to be “not
disinterested.” Courts have generally held that where a
professional’s retainer is paid by a third party to a
professional, even when fully disclosed, that professional is not
disinterested and cannot be retained under 11 U.S.C.
§327(a).31 In rare cases, a court, with
full disclosure, might approve a third-party retainer, but even with
such disclosure, employment is not
assured.32 Therefore if an investment
banker intends to be retained by the debtor as a professional under 11
U.S.C. §327(a), any retainer should ideally be paid in cash from
the debtor or debtors. More creative retainers run a significant risk
of disqualifying the investment banker from meeting the
disinterestedness standard.

<blockquote><blockquote><hr><big><center> Investment bankers,
given the relationship-driven nature of their profession, must
take special care in making their disclosures of
connections.</center></big><hr></blockquote></blockquote>

4. Who is the Client Again? Representing the Debtors’
Principals. Further, investment bankers must take care in defining
exactly who their clients are in their engagements with financially
distressed companies.33 One bright-line rule
would be for investment bankers never to take the ultimate equity owners
of an entity or group of entities as a client unless (1) its interests
are clearly and totally aligned with its subsidiaries, and (2) it will
be one of the debtors in a future bankruptcy
filing.34 Representing nonbankruptcy owners of
debtors simultaneously with debtors in bankruptcy is strictly
prohibited.35 Similarly, investment bankers
must take care to review the individual interests of even a group of
closely related entities in order not to run afoul of the
disinterestedness requirements of the Bankruptcy
Code.36 While investment bankers do not have
the same range of duties as the debtors’ bankruptcy counsel have
concerning related entities,37 conflicts could
still arise, and investment bankers should consider taking steps in
their engagement agreement to limit their duties in potential conflict
situations. 5. Well-Connected Blues: Represen-tation of Creditors
of the Debtor and 11 U.S.C. §327(c). Given the size of the
top tier of investment bankers as well as the scope of their clients
and contacts, it is inevitable that some, if not a significant number,
of any given debtors’ creditors will either be a client of or
otherwise doing business with 38 an investment
banker. Under §327(c), a professional is not disqualified from
being retained as a professional under 11 U.S.C. §327(a)
“solely because of such person’s employment by or
representation of a creditor” unless (1) there is an objection by
another creditor or the U.S. Trustee and (2) an actual conflict of
interest exists.39 In most cases, courts
have routinely held where a proposed professional represents a
creditor in an unrelated and non-material matter, that representation
would not preclude retention under 11 U.S.C.
§327(a).40 This is especially true
where the creditor has given a full waiver to the profession that will
allow it to represent the debtor adverse to the
creditor.41 However, if the creditor has a
material relation with the debtor and/or the professional has a material
relation with the creditor, courts will in all likelihood find that an
actual conflict of interest exists 42 and
either prevent the employment of the professional or, in the case of
an undisclosed relationship, order the disgorgement of
fees.43 Therefore, investment bankers must,
in all cases involving financially distressed entities, carefully
review the entities’ creditors and other parties with whom the
debtors have material relationships before accepting an engagement in
order to determine whether they could qualify to be retained as a
post-petition professional under 11 U.S.C. §327. Rule 2014:
Still Beating the Dead Horse One of the most important issues
facing investment bankers being retained under 11 U.S.C. §327(a)
is making appropriate disclosure under Bankruptcy Rule
2014.44 Rule 2014 provides: An order
approving the employment of attorneys, accountants, appraisers,
auctioneers, agents or other professionals pursuant to §327, 1103
or 1114 of the Code shall be made only on application of the trustee
or committee. The application shall be filed and, unless the case is a
chapter 9 municipality case, a copy of the application shall be
transmitted by the applicant to the U.S. Trustee. The application
shall state the specific facts showing the necessity for the
employment, the name of the person to be employed, the reasons for the
selection, the professional services to be rendered, any proposed
arrangement for compensation and, to the best of the applicant’s
knowledge, all of the person’s connections with the debtor,
creditors, any other party in interest, their respective attorneys and
accountants, the U.S. Trustee or any person employed in the office of
the U.S. Trustee. The application shall be accompanied by a verified
statement of the person to be employed setting forth the
person’s connection with the debtor, creditors, any other party
in interest, their respective attorneys and accountants, the U.S.
Trustee or any person employed in the office of the U.S. Trustee.

While courts are somewhat divided in the language they use to describe
the term “connections,”45 they
have all consistently held that any connection that may be in any way
pertinent to a court’s determination as to retention of a
professional must be fully disclosed.46
Investment bankers, given the relationship-driven nature of their
profession, must take special care in making their disclosures of
connections. In light of the EToys47
and Filene’s Basement48
decisions, particular care must be given to disclosing any form of
business relationships with the parties covered by the dictates of
Rule 2014. In light of the increasing complexity of the extent and
nature of these disclosures, as well as related issues concerning the
retention of investment bankers,49 investment
bankers should seriously consider retaining counsel to represent their
interests in being retained and having their fees paid in any
significant engagement. However, please note that in a typical
Catch-22 situation, investment bankers should exercise care in selecting
this counsel, as their retention of counsel will itself be a
connection which will have to be disclosed and reviewed in other
bankruptcy proceedings. Conclusion: The Beginning This
article represents an effort to provoke serious thought about some of
the issues that will arise as a result of the changes to the
disinterestedness standard made by BAPCPA. The true impact these
provisions will have on bankruptcy practice will, unfortunately, not
be resolved until judges, the U.S. Trustee and other parties in
interest formally address these issues in litigation. Until then, I
hope these unauthoritative musings have entertained and informed
you.<hr><h3>Footnotes</h3>1 11 U.S.C. §327(a) provides: Except as
otherwise provided in this section, the trustee, with the court’s
approval, may employ one or more attorneys accountants, appraisers,
auctioneers or other professional persons, that do not hold or represent
an interest adverse to the estate, and that are disinterested persons,
to represent or assist the trustee in carrying out the trustee’s duties
under this title. 2 In re Eagle-Picher Industries Inc., 999 F.2d
969 (6th Cir. 1993) (investment banker disqualified from case despite
factual finding by bankruptcy court that investment banker was a
“disinterested person”); In re Federated Department Stores Inc.,
44 F.3d 1310 (6th Cir. 1995); In re Capital Metals Co. Inc., 228
B.R. 724 (9th Cir. CAP) (financial advisor’s principal who served
pre-petition as debtor’s CFO was statutorily not a “disinterested
person”). 3 Investment bankers cannot be employed “for a specified
special purpose” under 11 U.S.C. §327(e), as that provision only applies
to attorneys. 4 See 11 U.S.C. §101(31). 5 See In re Capitol Metals
Co. Inc., 228 B.R. 724 (9th Cir. BAP). 6 See In re Daig
Corp., 799 F.2d 1251 (8th Cir. 1986); In re Intech Capital
Corp., 87 B.R. 232 (Bankr. D. Conn. 1988). 7 U.S. Trustee v.
Price Waterhouse, 19 F.3d 138 (3rd Cir. 1994); In re CIC Inv.
Corp., 175 B.R. 52 (9th Cir. BAP). However, if debt is owed by a
related nondebtor entity, a professional might not be statutorily not
disinterested. See In re Bendlers Inc., 106 B.R. 480 (Bankr. N.D.
Ohio 1989). 8 See Gray v. English, 30 F.3d 1319, 1321, 1324 (10th
Cir. 1994). 9 11 U.S.C. §101(31) The categories of insiders set forth in
11 U.S.C. §101(31) is an illustrative rather than exclusive list, and
determinations of who is an insider will be made on a case-by-case
basis. Matter of Krehl, 86 F.3d 737 (7th Cir. 1996). 10 See In re
O’Connor, 52 B.R. 892 (Bankr. D. Okla. 1985) (ownership by member of
debtor’s law firm of 1,000 shares out of approximately 13,000,000 shares
of debtor’s stock did not disqualify law firm under 11 U.S.C. §327(a));

In re Jaimalito’s Cantina Associates Ltd. Partnership, 114 B.R. 1
(Bankr. D. Col. 1990). 11 In re United Color Press Inc., 129 BR
143 (Bankr. S.D. Ohio 1991) (managerial consultant who served on
debtor’s board pre-petition solely to ensure adequate number of
directors existed was not disinterested); In re GHR Energy Corp.,
60 BR 52 (Bankr. S.D. Tex. 1985). See, also, Bowles,
Getting Paid: Retention and Compensation in Bankruptcy Cases—A Guide for
Non Attorney Professionals (ABI, 2005) for a discussion of the
possibility of retention under 11 U.S.C. §363. 12 See In re Chicago
South Shore and South Bend R.R., 101 BR 10 (Bankr. N.D. Ill. 1989);
see, also, In re Capen Wholesale Inc., 184 B.R. 547
(N.D. Ill. 1995). 13 See In re Michigan Interstate Ry. Co. Inc.,
32 B.R. 327 (Bankr. E.D. Mich. 1983) (where law firm disqualified in
part for failing to disclose that “special partner” of firm was former
director, president and general counsel of debtor). 14 See In re
Essential Therapeutics Inc., 295 B.R. 203 (Bankr. D. Del. 2003);

In re Rusty Jones Inc., 134 B.R. 321 (Bankr. N.D. Ill. 1991). 15
“[T]he twin requirements of disinterestedness [of 11 U.S.C. §101(14)]
and lack of adversity telescope into what amounts to a single hallmark.”
In re Martin, 817 F.2d 175, 180 (1st Cir. 1987). 16 99 B.R. 596,
aff’g., 89 BR 410 (Bankr. D. N.J. 1988). 17 In re Marvel
Entertainment Group Inc., 140 F.3d 463, 476 (3d Cir. 1988). 18
See General Electric Co. v. Industra Products Inc., 683 F. Supp.
1254 (N.D. Ind. 1988). 19 See In re Granite Partners L.P., 219
B.R. 22 (Bankr. S.D.N.Y. 1988) (applying the appearance of impropriety
standard with respect to the requirements of Bankruptcy Code §327(a)).
20 In re Pillowtex, 304 F.3d 246, 251 (3rd. Cir. 2002). 21 See
In re Federated Department Stores Inc., 44 F.3d 1310, 1318 (6th Cir.
1995) (noting that the 11 U.S.C. §1107(b) exception is extremely
narrow). See, also, In re Prince, 40 F.3d 356, 360 (11th Cir.
1994) (attorney disqualified from representation for assisting debtor in
transferring $600,000 in property to debtor’s wife). 22 See In re
Vann, 136 B.R. 863, (D. Colo. 1992), aff’d., 986 F.2d 1431 (10th
Cir. 1993) (full direct and comprehensive disclosure about fees is
required). 23 See In re Farmland Industries Inc., 397 F.3d 647
(8th Cir. 2005); In re eToys, 331 B.R. 176 (Bankr. D. Del. 2005)
24 See In re Prudhomme, 152 B.R. 91 (Bankr. W.D. La. 1993)
(debtors’ counsel). 25 In re Pillowtex, 304 F.3d 246 (3rd Cir.
2002). 26 This procedure has been used in other courts to eliminate the
conflict problem. See In re Enron Corp., 2003 U.S. Dist. Lexis
1442 (S.D.N.Y. 2003). 27 In re Pillowtex, 304 F.3d at 255. 28

See, generally, In re eToys Inc., 331 B.R. 176 (Bankr. D. Del.
2005) (issue arose as to pre-petition investment bankers’ right to
certain pre-petition payments). 29 In re Martin, 817 F.2d 175
(1st Cir. 1987) (no per se disqualification). But see In re
Escalera, 171 B.R. 107 (Bankr. E.D. Wash. 1994) (per se
disqualification). 30 In re Martin, 817 F.2d at 182-183 (setting
forth list of requirements to retain security interest retainer and be
disinterested). 31 In re Park-Helena Corp., 63 F.3d 877 (9th Cir.
1995) (debtors’ counsel disqualified for accepting retainer from
debtors’ president and failing to disclose source of retainer). 32
See In re BBQ Resources Inc., 237 B.R. 639 (Bankr. E.D. Ky.
1999). 33 In re Occidental Financial Group Inc., 40 F.3d 1059,
1062-63 (9th Cir. 1994) (retainer agreement identified owners as
client). However, even if owners are not technically listed as clients,
professionals can have their fees rejected and employment revoked if
they in fact act for the owners of a debtor. See In re Kendavis
Industries Intern Inc., 91 B.R. 742 (Bankr. N.D. Tex. 1988)
(totality of circumstances indicated the debtor’s counsel represented
interests of equity owners). 34 See Matter of Wiredyne, 3 F.3d
1125, 1128 (7th Cir. 1993) (noting that attorney not required to
disgorge fees for pre-petition representation of owners and debtors
where interests aligned). In re Wheatfield Business Park LLC, 286
B.R. 412 (Bankr. C.D. Cal. 2002) (“reputable presumption of lack of
disinterest when representing related parties”); In re Global Marine
Inc., 108 B.R. 998 (S.D. Tex. 1987) (no per se

disqualification for representation of multiple debtors). 35 See In
re Occidental Financial Group Inc., 40 F.3d at 1059 (law firm
disqualified and ordered to disgorge all fees where it represented the
debtor’s nonbankrupt owners and their various subsidiaries. Law firm
also failed to disclose conflict). 36 See In re Interwest Business
Equipment Inc., 23 F.3d 311, 316-18 (10th Cir. 1994), and In re
BH&P Inc., 949 F.2d 1300 (3rd Cir. 1991), where professionals were
disqualified due to conflicts between the various bankruptcy estates. 37
It is important to note that investment bankers, being primarily
concerned with obtaining the highest and best dollars for the debtors
for their assets from a business standpoint, generally do not have the
same conflict-of-interest problems as debtor’s counsel or a turnaround
management firm would have in a similar situation. 38 See In re eToys
Inc., 331 B.R. at 195-97 (discussing business partnership between
debtor’s CEO and committee counsel). 39 See In re Marvel
Entertainment Group Inc., 140 F.3d at 463 (there must be either a
potential or actual conflict of interest from the creditor
representation for professional to be disqualified as debtor’s
professional). 40 See, generally, In re Marvel Entertainment Group
Inc., 140 F.3d 463 (3rd Cir. 1998); In re Klregl Bros. Universal
Stagelighting Co. Inc., 189 B.R. 874 (Bankr. E.D.N.Y. 1995). 41
See In re Marvel Entertainment Group Inc., 140 F.3d at 482
(unconditional waiver by creditor of debtor demonstrated
disinterestedness of law firm). But see In re Joe Corp., 298 B.R.
703 (Bankr. D. Mont. 2003) (incomplete and improperly disclosed waiver
did not make professional disinterested). 42 See In re Granite
Partners L.P., 219 B.R. 22 (Bankr. S.D.N.Y. 1998); In re Lee Way
Holding Co., 100 B.R. 950 (Bankr. S.D. Ohio 1989). 43 In re Lee
Way Holding Co., 100 B.R. at 950 (chapter 11 debtor’s counsel
disqualified and ordered to disgorge fees when it failed to disclose
conflicts). 44 For a recent article discussing Rule 2014 disclosures in
more detail, see Bowles, “The Revenge of the Dot Coms: In re
eToys Inc. and In re Smart World Technologies,” LLC 24 ABI LJ
16 (December/January 2006). 45 Compare In re BH&P Inc., 119 B.R.
35, 44 (D. N.J. 1990), aff’d., 949 F.2d 1300 (3rd Cir. 1991). (“[Rule
2014] may not be so generous as to require the party to raise with the
court every imaginable conflict which may occur in bankruptcy”) with

In re Park-Helena, 63 F.3d 877, 881 (9th Cir. 1995) (“the duty of
professionals is to disclose all connections with the debtor,
debtor-in-possession, insiders, creditors and parties in interest...
They cannot pick and choose which connections are irrelevant or
trivial... No matter how old the connection, no matter how trivial it
appears, the professional seeking employment must disclose it”). 46
In re Park-Helena, 63 F. 3d at 882. 47 In re eToys Inc.,
331 B.R. at 176. 48 In re Filene’s Basement Inc., 239 B.R. 845
(Bankr. D. Mass. 1999). 49 See In re Commercial Financial Services
Inc., 427 F.3d 804 (10th Cir. 2005) (discussing a $1 million
reduction in a financial advisors’ fees).

Journal Authors

C. R. Bowles

Journal Date

Wednesday, February 1, 2006 - 12:00

Bankruptcy Rule

2006

2014