Teligent Allows Law Firm Defendant in Malpractice Action to Challenge Validity of Proceeds Assignment Contained in Settlement Previously Approved by Bankruptcy Court

A ruling that an entity lacks standing in a bankruptcy case is usually a frustrating development that means that the party will not have the opportunity to be heard on a matter that may have negative consequences for it. In Savage Associates PC v. K & L Gates LLP (In re Teligent, Inc.), [1] the absence of standing in the bankruptcy case actually produced a favorable outcome for a law firm that later had to defend a malpractice suit in another court.

Shortly before Teligent sought bankruptcy protection in 2002, it inked an agreement with Alex Mandl, its departing CEO, that ostensibly provided for forgiveness of a $15 million loan Teligent made to Mandl several years earlier. [2] Soon thereafter, the bankruptcy court appointed an unsecured claims estate representative (UCER), which filed suit against Mandl seeking to recover the balance of the loan. [3] Upon being sued, Mandl turned to K & L Gates LLP, the same law firm that had assisted him with the negotiation and drafting of the severance documents, to represent him in the litigation. [4] After a one-day trial, the Court ruled that Mandl was liable for the balance of the loan. [5] Thereafter, Mandl hired new counsel. [6]

Around the same time, the UCER filed a second action in Virginia against Mandl, his wife and an entity he controlled, alleging that Mandl had fraudulently transferred certain property through the entity to his wife in order to put it beyond the reach of his creditors. [7] As part of the Virginia suit, the parties participated in a mediation, which they agreed would be governed by the terms of a protective order routinely used for mediations in the U.S. Bankruptcy Court for the Southern District of New York (where Teligent’s bankruptcy was pending). [8] Mandl’s new counsel invited K&L Gates to participate in the mediation to address Mandl’s allegations of malpractice against it, but K&L Gates declined. [9]

Although this round of mediation did not produce a deal, the parties later reached a settlement on their own. In exchange for dismissal of the Virginia fraudulent-transfer action, Mandl agreed to pay the UCER $6.005 million and pursue in good faith a malpractice claim against K&L Gates. [10] Net proceeds, if any, from the malpractice action were to be shared between the CEO and the UCER. [11]

In May 2008, Mandl sued K&L Gates for malpractice, as contemplated by the settlement. [12] K&L Gates answered, asserting as a defense that Mandl’s claims were barred by the unlawful attempt to assign the proceeds of the malpractice action. [13] In further response, K&L Gates requested production of all of the parties’ mediation communications, arguing that they were critical to its ability to defend the malpractice lawsuit. [14] Initially, Mandl’s counsel complied but after objections from the UCER, further disclosures ceased. [15]

K&L Gates then moved the bankruptcy court to modify the confidentiality provisions of the protective orders to give it blanket access to the mediation documents and communications. [16] The UCER objected and cross-moved for an injunction to prevent K&L Gates from asserting as a defense in the malpractice action challenging the validity of the provisions of the settlement agreement which purported to assign an interest in the net proceeds of the malpractice action to the UCER. [17] On Sept. 24, 2009, Chief Judge Stuart M. Bernstein issued his decision. [18]

Judge Bernstein quickly disposed of K&L Gates’ motion to access the mediation materials and documents, holding that the law firm had not demonstrated such a compelling need for that information as would warrant an across-the-board lifting of the protective order. [19] However, the court was careful to limit its ruling, stating its decision was “not intended to foreclose [K&L Gates’] right to argue before the [D.C.] court that a specific communication is not covered by the confidentiality provisions of the Mediation Orders (e.g., it was not made ‘during the mediation process’), or that the court should nevertheless order disclosure of a specific communication under applicable law.” [20]

The bankruptcy court also denied the UCER’s injunction motion, holding that K&L Gates’ failure to object to the settlement did not preclude it from disputing the validity of the proceeds assignment provisions in the malpractice action. Specifically, the court ruled that K&L Gates could not be bound because it lacked standing to object to the settlement and the validity of the proceeds assignment provisions had not been adjudicated as part of the approval of the settlement. [21] The district court affirmed. [22]

On appeal from the district court, the Second Circuit likewise affirmed. It also found no error in the bankruptcy court’s determination that K&L Gates had not satisfied its burden to breach the mediation privilege. [23] It then turned to the question of whether K&L Gates was bound by the proceeds assignment provisions of the bankruptcy court approved settlement.

Judge Rosemary S. Pooler, writing for the panel, held that K&L Gates could not be bound by the settlement because it “lacked both Article III and prudential standing to object to the order, and was not a ‘party in interest’ under 11 U.S.C. § 1109(b).” [24] The panel allowed that “[a]lthough parties in interest typically have a financial stake in the outcome of the litigation, under certain limited circumstances, courts have recognized that a party with a legal (as opposed to financial) interest may appear.” [25] The Second Circuit did not attempt to define the boundaries of what those “certain limited circumstances” are, but instructed that “[w]hether or not someone is a party in interest must be read against the purposes of Chapter 11, which are to ‘preserv[e] going-concerns and maximize[e] property available to satisfy creditors.’” [26]

Against this backdrop, the Second Circuit opined that there was “no question…that K & L Gates had too remote an interest in the settlement agreement to have been considered a party in interest for the purposes of being heard before the bankruptcy court on the agreement’s approval.” [27] It “was not a creditor of Teligent; it was merely a potential debtor of Teligent’s debtor (i.e., Mandl).” [28] K&L Gates had no “financial stake” in either the bankruptcy case or the settlement motion. [29] The Second Circuit did not separately consider whether K&L Gates had a “legal interest” sufficient to confer party in interest status.

Thus, based on the outcome of these proceedings, K&L Gates presumably considered the decision not to attempt to dispute the validity of the settlement’s proceeds assignment provision before the bankruptcy court has, at least in the near term, paid off for it. K&L Gates remains free to argue in the malpractice action that the attempted assignment of the malpractice litigation proceeds defeats the CEO’s claims against it.

One is left to wonder whether there might have been a different outcome had the case been decided in another circuit (or even another panel of the Second Circuit). For example, one day before the Teligent decision was issued, the Third Circuit released its opinion in In re Global Indus. Tech. Inc. [30] In this appeal arising out of an asbestos bankruptcy case, the Third Circuit reversed the bankruptcy court’s denial of standing to insurers who sought to object to the chapter 11 plan’s creation of a trust for asbestos claimants to be funded by proceeds of insurance policies issued by the insurers. On appeal, it was undisputed that the plan was facially insurance neutral (i.e., it did not purport to change the insurer’s contractual obligations), but the record was clear that the prospect of the trust being created had produced a staggering 27-fold increase in claims against the insurers’ policies. [31]

Although initially citing too much of the same law relied upon by the Teligent court, the Third Circuit then appeared to embrace a more permissive standing standard. Noting that “Article III standing and standing under the Bankruptcy Code are effectively coextensive,” the Third Circuit stated that to establish standing the insurers need only “demonstrate…some injury-in-fact, i.e., some ‘specific, identifiable trifle of injury,’…or ‘personal stake in the outcome of [the] litigation.’” [32] Here, despite the fact that the insurers’ legal rights were left unimpaired, the potential economic impact on them of confirmation of a plan containing this particular asbestos trust was vastly different than their prepetition experience. [33]

A similar point could be made about the effect of the settlement approved by the bankruptcy court in Teligent. The court’s approval of the settlement dictated that K&L Gates would be sued for malpractice, something that might not have occurred without the settlement. K&L Gates still had its defenses to the malpractice claims but, at minimum, it would have to incur the legal expense of defending against the malpractice lawsuit. Under the Third Circuit’s analysis, at least, this fact pattern suggested that K&L Gates could have been deemed to have standing and hence possibly been more limited in what defenses it could later interpose in the malpractice action. Although K&L Gates prevailed, the approach it took was not without risk and should not necessarily be replicated in every scenario where litigation is pending or contemplated in another forum.

In an interesting postscript to the Teligent litigation, UCER and K&L Gates are yet again back before the bankruptcy court squabbling over many of the same matters seemingly resolved by the Second Circuit’s opinion. The UCER is seeking to enjoin K&L Gates’ renewed efforts to obtain more limited discovery in the malpractice action concerning the mediation and settlement, and also is seeking a declaration from the bankruptcy court that approval of the settlement resulted in a valid assignment of the malpractice claim proceeds under New York law. At the time this article was written, K&L Gates had not yet responded substantively to these motions.