The U.S. Bankruptcy Court for the Southern District of New York recently issued an opinion in an adversary proceeding (AP) in a chapter 11 bankruptcy case, In re Blue Dog at 399 Inc. v. BP 399 Park Avenue LLC, Adv. Pro. No. 15-01097-MEW (related to Main Case No. 15-10694) (Bankr. S.D.N.Y. July 21, 2017).[1] The court addressed the debtor-in-possession’s (DIP’s) special counsel’s motion to withdraw as counsel for the estate in the AP, and a related motion by DIP counsel to enforce an alleged settlement and to impose a retaining lien on the DIP’s litigation files held by DIP counsel.
DIP counsel was retained under 11 U.S.C. § 327(e) by an order dated June 13, 2016 (“retention order”), to represent the DIP in complex litigation against the DIP’s landlord concerning, among other things, the right to possession of the premises at which the DIP was to operate its restaurant and catering business. The terms of the retention were approved provided that DIP counsel would be paid solely and personally by the DIP’s equity owner, Elizabeth Slavutsky (principal),[2] and “at no cost to the Debtor’s estate.” Ten months later, and after mounting approximately $600,000 in unpaid fees and expenses, DIP counsel filed a motion to withdraw on April 14, 2017 (the “withdrawal”), and requested a retaining lien on the DIP’s and the principal’s files (together, the “files”) to secure payment of DIP counsel’s outstanding fees and expenses.[3] After mediation between the principal and DIP counsel, the parties announced tentative settlement terms in court on May 17, 2017 (the “announcement”), to be documented and submitted as a proposed amendment to the retention order, to add a term rendering the DIP liable to pay DIP counsel’s unpaid fees and expenses as an administrative expense of the estate pursuant to 11 U.S.C. § 330.
At the time of the announcement, the court declined to approve anything because such an arrangement was subject to notice and an opportunity to be heard by all creditors, and the U.S. Trustee objected to any settlement absent the immediate turnover of the files. Moreover, while attempting to finally document the settlement terms, and while DIP counsel continued to withhold the files, another (or the same) “serious rift” between the principal and DIP counsel caused the alleged settlement to fall apart.[4]
DIP requested, and the court approved, the retention of a second firm as replacement counsel in the AP by an order dated June 5, 2017 (the “additional counsel order”).[5] Three days later, DIP counsel filed an application to amend the retention order retroactively, to the date of its original retention, to hold the estate liable for DIP counsel’s fees and expenses (the “amendment motion”). At the same time, DIP counsel also filed a motion to approve and enforce the settlement terms allegedly memorialized by the announcement, proposing a release of DIP counsel’s alleged retaining lien and a turnover of the files in exchange for and conditioned upon approval of both the amendment motion and DIP counsel’s withdrawal (the “withdrawal and lien motion”).
The Blue Dog court took issue with every one of DIP counsel’s requests. First, the court opined that since it had approved exactly nothing at the announcement hearing, there could be no binding agreement or settlement of any kind. All bankruptcy settlements and DIP counsel retention and withdrawal terms must be approved or rejected by the court after a hearing on notice to all creditors.[6]
Second, the court cited Powell v. Omnicom[7] and two other precedential authorities for the well-settled contract law negating any intent to be bound, and therefore any binding contract, where parties make clear their intention to reduce a tentative agreement to writing, unless and until such writing is finalized. Because DIP counsel conceded at oral argument that the parties never did reach a full and complete agreement on the open-retention terms, the court characterized the amendment motion as “not really a legitimate effort to enforce an existing legally binding obligation. Instead, it is an effort to impose an obligation based on tentative and incomplete terms.”[8] The court denied the amendment motion and expressed disappointment that DIP counsel had advocated for the amendment motion notwithstanding the conceded facts, binding state contract law and bankruptcy rules directly negating DIP counsel’s “binding settlement” arguments.[9] Leaving no room for error, the court held that it would have denied the amendment motion as unreasonable and bad for the estate, even if the Blue Dog DIP had been legally bound and otherwise inclined to sponsor the amendment motion.
Citing[10] CFTC v. Weintraub,[11] the court expressed extreme dismay at DIP counsel’s argument that a DIP should be held legally bound to a settlement or other proposed action, even one that is fully documented and still desired by the DIP or other parties in interest for whatever reason, if the DIP determined or became aware of information or forces revealing that such settlement or action is no longer a reasonable exercise of the DIP’s business judgment. DIPs, and by extension DIP counsel, have fiduciary duties to the estate.[12] As a result of that duty, and as officers of the court, DIP counsel should inform the court when shifting or newly discovered economic or other factors render a proposed action no longer beneficial to the estate.[13] The Blue Dog court equated DIP counsel’s “notion that a debtor should be forbidden to speak if it no longer thinks that a settlement is proper” with saying a debtor should be estopped from fulfilling its fiduciary duty and estopped from complying with its duty of candor to the tribunal. As officers of the court, lawyers generally, and especially DIP counsel, should never turn a blind eye to actions that are unfair or harmful to the estate.[14] To the Blue Dog court, any request to gag or tie the hands of the DIP is “absurd.” The DIP and its counsel do not just have the right to tell the court what they really think; they have an ongoing duty to do so.[15]
Of course, doing the right thing can be quite painful for attorneys, because it seems like an ethical lose/lose situation. Besides feeling stupid for proposing an action that turns out to be a bad idea, you must agonize over whether complying with this candor/officer of the court “duty to rat” might directly conflict with your duty to keep client confidences.[16] This is not a problem reserved to unfortunate lawyers. Judges face this same problem of sometimes having to eat their own words.[17]
Turning to the retaining lien, although the court acknowledged that retaining liens can be granted in some situations to secure a client’s obligation to pay fees, no such lien is possible when the client has no payment obligation. Even if the DIP had agreed up front that the DIP would grant a lien to secure a third party’s obligation (the principal’s), it failed to disclose any such term of retention pursuant to Fed. R. Bankr. P. 2014. To the contrary, DIP counsel repeatedly represented to the court in its retention application that its retention would be at no cost to the debtor’s estate. The court rejected the “preposterous” notion — argued by DIP counsel — that the Court should treat undisclosed terms as though they were not only disclosed as required, but also approved as reasonable under Bankruptcy Code § 328 when the stakeholders knew nothing about them. The court held that it would never allow DIP counsel to hijack the estate by holding the necessary files hostage for simple leverage against a nondebtor — especially when successful litigation was the only hope for the DIP’s reorganization.[18]
Attorney conduct is regulated to help keep the system fair. Because the DIP is run by people who, by definition, are not disinterested, it is the disinterested DIP counsel who must look beyond the wishes of the DIP’s management, and their own legitimate desire to get paid, to the overall needs of the estate and its ultimate residual stakeholders.[19]
Blue Dog should serve as a reminder to attorneys of the heightened disclosure and candor duties that DIP counsel must honor both as officers of the court and as fiduciaries of the DIP estate. It is also a reminder of the critical importance of the court’s role as gatekeeper when those duties are violated.
[1] See www.leagle.com/decision/inbco20170724481, visited on Oct. 20, 2017 (opinion not available at LEXIS or Westlaw as of the date of this writing).
[2] According to the principal’s declaration in support of the DIP’s bankruptcy petition, the principal was and is the sole director, manager and shareholder of the DIP. See Main Case Doc. No. 3.
[3] DIP counsel’s withdrawal papers further alleged that after defeating both a motion to dismiss and a motion for summary judgment and after mediation with the landlord, a final settlement was reached resolving the entire AP, after which the principal allegedly reneged on the deal. DIP counsel alleges “irreconcilable differences” due to its refusal to support a position inconsistent with the alleged settlement. See Motion to Withdraw (AP Doc. No. 62; Main Case Doc. No. 79).
[4] The principal’s account of the facts paints a polar-opposite picture, accusing DIP counsel of egregious personal and professional misconduct, of charging “outrageous” fees/expenses in excess of $1.7 million of which $1.2 million had already been paid, and of pushing premature settlements for improper purposes. See Retention Application for Replacement Counsel (AP Doc. No. 63; Main Case Doc. No. 81); DIP’s Objection to Retaining Lien (Main Case Doc. Nos. 81 and 108).
[5] See AP Docket No. 97. The additional counsel order did not authorize the original DIP counsel’s withdrawal, but included a provision prohibiting duplication of effort by the two firms. Id.
[6] See Fed. R. Bankr. P. 9019 (settlements); 11 U.S.C. §§ 327 and 328 and Fed. R. Bankr. P. 2014 and 2016 (retention and payment terms); S.D.N.Y. LBR 2090-1(e) (withdrawals).
[7] 497 F.3d 124, 129 (2d Cir. 2007).
[8] See Blue Dog, Slip Op., at p. 10.
[9] Although not mentioned in the Blue Dog opinion, attorneys advancing similar tenuous (and arguably frivolous) positions should be cognizant and appreciate the risk of monetary and other potential sanctions being imposed by the court that could be imposed sua sponte. Fed. R. Bankr. P. 9011.
[10] See Blue Dog, Slip Op., at p. 10.
[11] 471 U.S. 343, 355 (1985).
[12] Brown v. Gerdes, 321 U.S. 178 (1944) (counsel in bankruptcy cases seeking compensation from court are held to fiduciary standards); ICM Notes Ltd. v. Andrews & Kurth LLP, 278 B.R. 117, 126 (S.D. Tex. 2002), aff’d, 324 F.3d 768 (5th Cir. 2003) (DIP counsel does not hold fiduciary duty to specific creditors).
[13] In re JLM Inc., 210 B.R. 1926 (B.A.P. 2d Cir. 1997) (holding both management and DIP counsel have fiduciary duties to estate when DIP counsel disobeyed management directions and objected to attempt to dismiss case where management was unperfected secured creditor seeking to secure its position to detriment of bankruptcy estate).
[14] Model Rule of Professional Conduct 3.3 (Candor to the Tribunal), available at www.americanbar.org/groups/professional_responsibility/publications/mod…, last visited on Oct. 31, 2017.
[15] DIP counsel “owe[s] a broad-based duty of care, candor, and undivided loyalty to the chapter 11 debtor.” In re Mushroom Transportation Co. Inc., 366 B.R. 414, 440 (Bankr. E.D. Pa. 2007); ICM Notes Ltd. v. Andrews & Kurth LLP, 278 B.R. 117, 123 (S.D. Tex. 2002) (“[I]t is undisputed that counsel of a debtor in possession owes certain fiduciary duties to both the client debtor in possession and the bankruptcy court.”); In re Wilde Horse Enterprises Inc., 136 B.R. 830, 840 (Bankr. C.D. Cal. 1991) (“[C]ounsel for a corporate [DIP] owes a fiduciary duty to the corporate entity estate — the client — and represents its interests, not those of the entity’s principals.”)
[16] Model Rule of Professional Conduct 1.6 (Confidentiality), available at www.americanbar.org/groups/professional_responsibility/publications/mod…, last visited on Oct. 31, 2017. As Brown v. Gerdes above, supra n. 7, explained, DIP management is not DIP counsel’s client, so the attorney/client privilege should rarely be a problem. See also Model Rule of Professional Conduct 1.13 (organization as client), available at www.americanbar.org/groups/professional_responsibility/publications/mod…, last visited on Oct. 31, 2017, confirming separation between the organization as client and the individuals through whom it acts, and explaining up-the-chain “duty to rat” when a lower-level corporate officer insists on violating legal obligations. In the uncommon event of an irreconcilable conflict between these competing disclosure and confidentiality duties, DIP counsel should consider making a “noisy withdrawal.” See generally C.R. “Chip” Bowles, “Noisy Withdrawals: Urban Legend or Invaluable Ethical Tool?,” 20 Am. Bankr. Inst. J. 26 (Oct. 2001). Even here, tread softly — and remember that Blue Dog is a good example of a too-noisy withdrawal.
[17] This is why bankruptcy judges almost never “preapprove” the terms of a professional’s retention under Bankruptcy Code § 328(a). See, e.g., In re National Gypsum Co., 123 F.3d 861, 862 (5th Cir. 1997) (bankruptcy court could only change terms and conditions of employment if they proved “to have been improvident in light of developments not capable of being anticipated at the time of the fixing of such terms and conditions.”) (quoting Bankruptcy Code § 328(a)); In re Smart World Technologies LLC, 552 F.3d 228, 234 (2d Cir. 2008) (when fee had been preapproved under § 328(a), bankruptcy court erred in reducing fee because of developments that were unforeseen, because correct standard is “not capable of being anticipated”).
[18] The imbalance of the means overwhelming the desired end is palpable — potentially sinking a multimillion-dollar business in exchange for simple leverage to get paid. Similar is the practice of colleges holding transcripts hostage from grads with loan defaults. Since most employers require a degree as a prerequisite to hire, this practice may prevent some students from getting jobs, thereby ensuring nonpayment of the loan.
[19] See also Vining v. Ward (In re Ward), 894 F.2d 771, 776 (5th Cir. 1990) (had DIP counsel known of the existence of an unscheduled judgment against estate, “as an officer of the court, [the attorney] would certainly have had a duty to inform the court”); In re Rivers, 167 B.R. 288, 300 (Bankr. N.D. Ga. 1994); In re Wilde Horse Enterprises Inc., 136 B.R. at 847 (recognizing that DIP counsel faced with management’s persistence in breaching fiduciary obligation must alert the court through withdrawal motion or otherwise). In re Swansea Consol, Resources Inc., 155 B.R. 28, 38 n.14 (Bankr. D. R.I. 1993) (as officer of the court, DIP counsel “had absolutely no choice but to disclose” unauthorized diversion of debtor in possession funds to foreign bank); Agresti v. Rosenkranz (In re United Utensils Corp.), 141 B.R. 306, 309 (Bankr. W.D. Pa. 1992) (“If the debtor is not fulfilling its fiduciary duty to the estate, it is the responsibility and duty of DIP counsel to bring such matters to the attention of the court.”).