The Bankruptcy Code generally restricts the trustee’s employment of professionals to those “that do not hold or represent an interest adverse to the estate, and that are disinterested.”[1] Broadly speaking, “disinterested” persons are those who do not have a pre-petition interest in or relationship with the debtor.[2] The Code does not define “adverse interest,” but generally a party holds an adverse interest if he or she (1) holds or asserts an economic interest that would reduce the value of or give rise to an actual dispute with the estate, or (2) possesses a bias against the estate.[3] These requirements are “stringent.”[4] The purpose of these restrictions is to ensure that professionals hired by trustees “tender undivided loyalty and provide untainted advice and assistance in furtherance of their fiduciary responsibilities.”[5]
Legal bankruptcy circles, however, are notoriously tight-knit, thus sometimes making it difficult for trustees to find attorneys meeting these two standards. Section 327 therefore provides for two important exceptions.[6] First, counsel is not disqualified “solely because of such person’s employment by or representation of a creditor, unless … there is an actual conflict of interest.”[7] Second, a trustee may employ an attorney that previously represented the debtor for a special prosecution “if [it is] in the best interest of the estate; and if such attorney does not represent or hold any interest adverse … with respect to the matter on which such attorney is to be employed.”[8]
The Second Circuit provides a framework for how to determine when the appearance of a conflict is an actual conflict in the context of when a trustee seeks special counsel. In In re AroChem Corp., the chapter 7 trustee sought to retain counsel to pursue a derivative cause of action on behalf of the estate.[9] The trustee’s derivative complaint was very similar to a derivative cause of action brought by a creditor named Wells.[10] When the trustee attempted to find outside counsel to pursue the litigation, he could not find anyone who would do so on terms beneficial to the estate except for Wells’s counsel.[11] The trustee therefore applied to appoint Wells’s counsel as special counsel in an adversary proceeding.[12] The other creditors objected to the application, arguing that Wells had “hijacked” the bankruptcy and was using the chapter 7 trustee to pursue his own personal vendetta.[13]
The bankruptcy court rejected this argument, and the Second Circuit agreed with the bankruptcy court. The Second Circuit noted that the exceptions to the general restrictions on employment of professionals in bankruptcy are found in § 327(c) and (e).[14] Although the bankruptcy court had reasoned that the representation was proper under § 327(e), the Second Circuit rejected this analysis as improper because counsel was creditor’s counsel rather than debtor’s counsel.[15] Despite this error, the court agreed that because the employment was for special counsel, the analysis should “reason by analogy to 372(e),” and only consider whether employment was appropriate with regards to “the services which are to be performed by that attorney.”[16]
The court then examined whether counsel had an adverse interest.[17] The court held that when the interests of the estate and the special counsel are “identical with respect to the matter for which special counsel is retained,” the interests are not adverse.[18] The fact that the parties’ relationship in the underlying bankruptcy is adversarial did not necessarily mean that there was an adverse interest with regards to representation in the specific matter.[19] Because the trustee presented proof that there was nothing more than “raw speculation to support a claim that a conflict might develop” during the course of the adversary proceeding, representation was appropriate.[20]
The Third Circuit provides a complementary framework for analyzing when appointment of creditor counsel as general counsel is appropriate despite the appearance of counsel being interested or adverse. In In re Marvel Entertainment Group, the trustee sought to employ as general counsel a firm that had an existing relationship with one of the secured creditors in the case.[21] The court held that the standard for disqualification of attorneys is best summarized by three rules: (1) § 327(a) and (c) per se require disqualification of counsel with an actual conflict; (2) when the conflict is only a potential conflict, these Code sections provide courts with the discretion to disqualify counsel; and (3) disqualification is not permissible on the appearance of conflict alone.[22] It is therefore impermissible to disqualify a firm “for a mere ‘appearance of impropriety.’”[23]
Thus, under the facts of that case, the lower court’s disqualification of the law firm was inappropriate.[24] Although counsel had represented the creditor and was still representing the creditor when the trustee filed the application to employ, counsel had never represented the creditor on bankruptcy matters.[25] In addition, during the time period between when the trustee filed his application to employ and the court’s hearing on the application, the firm separated itself from the secured creditor.[26] Disqualifying a firm under those circumstances would result in it being nearly impossible for a law firm that ever had a relationship with a secured creditor to be employed by a trustee.[27] Furthermore, disqualification solely on this sort of “‘appearance of impropriety’ … would allow ‘horrible imaginings’ alone to carry the day.”[28] This was clearly not what the structure of § 327 envisioned.[29]
Both Marvel and AroChem approved the trustee’s choice of counsel, finding that the “imagined” conflicts were not likely enough to be actual and adverse. Other cases, utilizing these same principles, provide examples of when facts support disqualification. A Connecticut bankruptcy court held that disqualification was appropriate when counsel represented a principal of the debtor whose interest in the litigation was ensuring that any settlement amount would provide the debtor with a surplus.[30] In another case, when a trustee sought to retain counsel that was currently representing the largest unsecured creditor in the case, and the retention was for the trustee to determine whether to pursue an objection to a large priority claim, an actual conflict existed because the trustee, who is tasked with representing all creditors, would be inappropriately favoring the unsecured creditor.[31] Likewise, in the Fifth Circuit, debtor’s special counsel was denied their fees due to an adverse interest when, as part of the negotiations of the sale of the debtor, the attorneys engaged in conversations indicating that they were willing to finance the debtor, although they ultimately did not end up consummating the deal.[32] In each of these cases, although the conflict itself had not yet manifested, the potential was severe and real enough for courts to find that it hampered the attorney’s ability to represent the interests of the estate — i.e., it was actual and adverse.
These cases show that the requirements of § 327 are strict; however, with some creativity, flexibility and full disclosure to the court, attorneys whose current or previous representations may appear adverse or lack disinterestedness need not forgo representing the trustee when doing so would be beneficial to both their client and the estate. A solid understanding of these exceptions will not only assist trustees in administering their estates, but also provide creditor and debtor attorneys with additional avenues for representing the interests of their existing clients.
[1] 11 U.S.C. § 327(a).
[2] A disinterested person:
(A) is not a creditor, an equity security holder, or an insider;
(B) is not and was not, within 2 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 holders, by reason of any direct or indirect relationship to, connection with, or interest in, the debtor, or for any other reason.
11 U.S.C. § 101(14).
[3] Johnson v. Richter, Miller & Finn (In re Johnson), 312 B.R. 810, 819, n.7 (E.D. Va. 2004) (collecting cases).
[4] Johnson, 312 B.R. at 819.
[5] In re Leslie Fay Companies, 175 B.R. 525, 532 (Bankr. S.D.N.Y. 1994) (quoting Rome v. Braunstein, 19 F.3d 54, 58 (1st Cir. 1994)).
[6] Section 1107(b) provides that the attorney who represented the debtor-in-possession prior to the filing of the petition is also not disqualified solely on account of the previous representation. The interpretation of that section, although similar to the interpretation discussed here, is worthy of its own consideration and therefore not addressed in this article.
[7] 11 U.S.C. § 327(c).
[8] 11 U.S.C. § 327(e).
[9] AroChem Corp., 176 F.3d at 616, 620-22.
[10] Id.
[11] Id.
[12] Id. at 616.
[13] Id.
[14] Id. at 622.
[15] Id.
[16] Id.
[17] Id. at 623.
[18] Id. (emphasis original).
[19] Id.
[20] Id. at 626. Importantly, too, the trustee and counsel in AroChem attempted to engage in a pooling agreement that would eliminate any conflicts for fees. When that agreement fell through, Wells’s counsel elected to terminate its representation of Wells absent approval from the court in favor of pursuing the derivative cause of action.
[21] 140 F.3d 463, 476 (3d Cir. 1998).
[22] Marvel, 140 F.3d at 476.
[23] Id.
[24] Id. at 477.
[25] Id.
[26] Id.
[27] Id.
[28] Id., citing BH & P, 949 F.2d 1300, 1313 (3d Cir. 1991) (quoting In re Martin, 817 F.2d 175, 181-83 (1st Cir. 1987)).
[29] See id.
[30] Daly v. Konover Constr. Corp. (In re Homesteads Cmty. at Newtown, LLC), 390 B.R. 32 (Bankr. D. Conn. 2008).
[31] In re First State Bancorporation, No. 7-11-11916-JA, 2013 Bankr. LEXIS 873, 2013 WL 823414 (March 6, 2013).
[32] I.G. Petroleum, LLC v. Fenasci (In re W. Delta Oil Co.), 432 F.3d 347, 358 (5th Cir. 2005).