Chapter 7 Debtor’s Counsel Permitted to Defend Creditors in Avoidance Suits

Is a lawyer disqualified from representing defendants in avoidance actions brought by a chapter 7 trustee if the lawyer briefly served as counsel for the debtor before and after filing?

According to Bankruptcy Judge Carol A. Doyle of Chicago, the debtor’s former counsel is not disqualified, at least if the lawyer was not representing the debtor when the transactions took place that the trustee is later attempting to avoid.

The Lawyer’s Limited Role

Using another counsel, a corporate debtor filed a chapter 11 petition. Within a month, a secured creditor filed a motion for appointment of a chapter 11 trustee. The debtor then hired the lawyer in question to assist its original counsel. Within two weeks, the new counsel consented to the appointment of a chapter 11 trustee, having concluded that the debtor would have difficulty prosecuting preference suits against insiders for transfers within a year of bankruptcy.

The trustee converted the case to chapter 7 and filed a chapter 7 petition for an affiliate. After creditors filed an involuntary chapter 11 petition against another affiliate, the “new” lawyer consented to an order for relief and converted the case to chapter 7. The cases were jointly administered in chapter 7.

The trustee filed 440 almost identical preference and fraudulent transfer suits. The debtors’ “new” lawyer appeared as counsel for 52 defendants but not as counsel for any insiders. The trustee moved to disqualify the lawyer, contending that the lawyer had a statutory duty and a duty of loyalty to the trustee and to the estates.

In her 23-page opinion on August 14, Judge Doyle denied the disqualification motion, holding that the lawyer had no duty to the trustee or the estates, only a duty to his clients to assist them in carrying out their limited duties to the trustee.

The Limited Duties of a Chapter 7 Debtor’s Counsel

To disqualify a lawyer, Judge Doyle said there must be an ethical violation, and the remedy of disqualification must be appropriate. On the question of an ethical violation, Judge Doyle divined the duties that a debtor’s lawyer owes to the estate or to a chapter 7 trustee.

Judge Doyle said that the lawyer has a duty of loyalty to the debtor corporation but “does not owe any direct duty to the estate.”

In chapter 7, the debtor’s only duties are laid out in Section 521(a)(3) and (a)(4). Those duties are to cooperate with the trustee in the performance of the trustee’s duties and to surrender the property, books, and records of the estate.

On the other hand, Judge Doyle said, the Bankruptcy Code imposes no similar duties on a chapter 7 debtor’s counsel. Instead, she said that the debtor’s counsel’s duties are imposed by the rules of professional conduct.

Significantly, Judge Doyle said that the “lawyer represents only the debtor, not the trustee or the estate.” Consequently, a chapter 7 debtor’s lawyer has no fiduciary duty to the estate.

Judge Doyle explained that on appointment of a trustee, fiduciary duties shift from the debtor in possession to the trustee, “leaving the debtor with only its statutory responsibilities under the Code.” Because the debtor cannot exercise the duties of the chapter 7 trustee, she said that the debtors “therefore do not owe the fiduciary duty to the estate that goes along with those powers.”

The only role of a chapter 7 debtor is to cooperate and produce records. In chapter 7, only the trustee has power to pursue avoidance actions.

A debtor may therefore assert its own interests and come into conflict with the trustee “without violating any statutory or other duty to the estate,” Judge Doyle said. For example, a debtor and its counsel may argue that property is not property of the estate. Or, a debtor and its counsel can oppose a fraudulent transfer suit.

Having concluded that the lawyer had no “direct duties” to the estate with regard to the 52 avoidance actions, Judge Doyle next inquired whether the lawyer had impermissible concurrent representations.

Concurrent representations are governed by ABA Model Rule 1.7, adopted in Illinois. Under that rule, Judge Doyle said there might be “some risk” of adversity were the trustee to request information from the debtor regarding the 52 suits. Because the lawyer agreed to withdraw as counsel for the debtor, she said there would be no risk of conflict arising from concurrent representations.

Still, the trustee contended that the lawyer’s prior work for the debtors and his new representations of the defendants would be “substantially related.” In that regard, Judge Doyle analyzed Model Rule 1.9. She concluded that the new and former representations were not “substantially related” because the debtors were not parties, and the lawyer’s former representation was not a representation of the trustee.

In addition, the old and new representations were not substantially related because the lawyer was not counsel for the debtors when the transactions took place, and he “had no involvement in anything relating to the preference claims” or noninsider fraudulent transfers. Furthermore, the lawyer had no access to confidential information that was not public or discoverable in litigation.

Of significance, Judge Doyle explained how the new version of Rule 1.9 narrowed the prior federal common law notion of “substantial relationship.” The new rule, she said, abandoned the idea that the actual receipt of confidential information was irrelevant. Now, she said, “there is no presumption at all, let alone an irrebuttable presumption, that [the lawyer] obtained confidential information relevant to the adversaries.”

Judge Doyle found no ethical violation and thus no ground for disqualification because there was no risk, “let alone a substantial risk,” the lawyer would have had confidential information to assist in the defense of the 52 defendants.

Judge Doyle ended her opinion by noting how the lawyer’s representation of 52 defendants would provide “an important counterweight to the enormous power wielded by chapter 7 trustees.” Because the lawyer could provide representation at a low cost, she said that the trustee could not “force settlements from parties who should not be paying anything.”

What About Counsel for Chapter 11 Debtors?

What about attorneys for chapter 11 debtors? Do they owe fiduciary duties to the estate?

Susan M. Freeman of Lewis Roca Rothgerber Christie LLP in Phoenix told ABI that she believes “the same is true of chapter 11 debtors’ attorneys. Courts, she said, “err when saying that DIP lawyers also owe fiduciary duties to the estate. The better reasoning is that DIP lawyers must proactively counsel their client DIPs on compliance with the DIPs’ fiduciary duties and also owe duties to the court under professional conduct rules, as explained in Hansen, Jones & Leta v. Segal, 220 B.R. 434 (D. Utah 1998).”

For further analysis, see Freeman, “Are DIP and Committee Counsel Fiduciaries for Their Clients’ Constituents or the Bankruptcy Estate? What Is a Fiduciary, Anyway?,” 17 Amer. Bankr. Inst. L. Rev. 291 (Winter 2009).