How and Why We Avoid Conflicts of Interest: The Relevance of Conflict Checks in Turnaround Work

From its inception, the National Ethics Task Force [1] was charged with answering the question of whether there is a need for national ethics rules, standards and general practice guidance in the bankruptcy context. As the Task Force launched, several conflicts-related issues became apparent, including shifting allegiances that arise during the life of a case, the complexity of disclosure of “connections” when seeking approval of employment, the fleshing out of the duties of counsel for a debtor in possession, and the role of conflicts counsel in business reorganization cases. In the course of its review, the Task Force recognized that:

Sections 327 and 1103 of the Bankruptcy Code set forth specific standards that proposed that professionals must meet in order to be retained as an estate or committee professional. Each of these provisions requires the professional in question to meet certain standards relating to their independence from parties other than their client in a case . . . . As noted by several courts, “[t]he purpose of Rule 2014(a) is to provide the court and the United States Trustee with information to determine whether the professional's employment is in the best interest of the estate . . . . Rule 2014 disclosures are to be strictly construed, and failure to disclose relevant connections is an independent basis for the court to disallow fees or to disqualify the professional from the case.” [2]

The Task Force also recognized that:

FRBP 2014 does not limit the extent of disclosure of a professional’s connections with: (i) the debtor; (ii) any creditors of the debtor; (iii) other parties in interest; (iv) attorneys of the debtor, creditors, and parties in interest; (v) accountants for the debtor, creditors, and parties in interest; and (vi) the United States Trustee and persons employed by the U.S. Trustee’s office. Indeed, most courts that have addressed this issue have held that professionals have little, if any, discretion in determining whether a connection is “relevant” to their employment application. [3]

Additionally, the uncertainty surrounding the meaning of “connection” led professionals to attempt to argue that some important “connections” were immaterial. As a result of many hours of work, the Task Force proposed amendments to Rule 2014, although those amendments have not been adopted.

But was all this research and work really necessary? Were there really any problems with the earlier disclosure requirements for appointing professionals in reorganization cases? The example of a real-life case presenting troubling conflict and disclosure issues confirms that these should be critical areas of concern for insolvency professionals.

The impact of failing to properly disclose conflicts and the failure of making proper conflict checks can be seen in a receivership case that began in 2011 when the SEC investigated a business, accusing the owners of running a $220 million Ponzi scheme. Prosecutors alleged that the owners, through a complex web of more than 200 corporate entities, raised more than $200 million from 400 investors with “material and pervasive misrepresentation” starting in 2008. Allegedly, the owners told investors they would buy apartment complexes with low occupancy rates at discounted prices and then renovate and sell them within five years. However, the prosecutors alleged, the owners failed to disclose that they diverted the money to run numerous other entities.

Prior to charges being filed by the SEC in 2011, the owners hired a prominent forensic accountant to review their records to determine their potential exposure. The accounting firm reviewed the documents, then provided a report to the owners outlining potential weaknesses.

Ultimately, the SEC filed a civil case, and a receiver was appointed over the company. The receiver hired the same accountant who had done the review work for the owners to be the receiver’s accountant. When the receiver later stepped down from the case, at his request the court appointed the accountant as the new receiver. And when the State of Utah filed criminal charges against the owners in 2015, it hired the accountant as an expert witness.

At that point, the attorney for the owners stated, “In this case, the [owners] cannot get a fair trial.” He argued that the forensic accountant had tainted the case with the many roles he had played in the eight years the owners had been tied up in federal and state court. He indicated that investors testified at a preliminary hearing that there were no misstatements made, and that but for the accountant’s testimony, the owners would not have been bound over for trial. [4]

As of the date the article was published in the newspaper, the charges had not been dismissed, but the court had ruled that the accountant would not be allowed to testify at trial, stating, “He has literally worn every hat there is to be worn. I think that makes him a very odd person for both sides to deal with.” [5]

So How Did It Happen?

A review of the case docket [6] indicates that the forensic accountant had been approved by the court prior to 2013. But how was an accountant who had initially worked for the owners appointed as the receiver’s accountant? Shouldn’t that obvious conflict of interest have raised red flags? The AICPA Code of Professional Conduct states that “a member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance….” [7] The AICPA emphasizes the importance of avoiding even the appearance of impairment of objectivity. Because the forensic accountant was a CPA, the standards within his own profession should have indicated the impropriety of being employed as an accountant for the receiver after working for the owner, much less accepting the job as receiver over an entity for whom he had provided consulting services.

But what were the responsibilities of the original receiver? What role and responsibility did he have to avoid hiring an advisor who had previously provided consulting services for the owners? A receiver acts in a fiduciary role for the creditors, and as such, one of a fiduciary’s duties is to be impartial and hire or employ only those advisors who can also be impartial. If the forensic accountant had worked previously for the owner, could they then work without bias for the receivership?

And finally, what role should the court have played in reviewing the employment applications of the various individuals who would be working in a high-profile SEC case? Did the court take the necessary steps to ensure that individuals went through the proper procedures of making sure no conflicts were present by all parties who would be providing services, rather than relying on personal and business relationships? A general reading of the accountant’s employment application indicates that prior work for the owners may present some conflict; however, the court still approved the accountant’s employment, and later approved the appointment of the accountant as receiver. Could the court not foresee the handwriting on the wall of the accountant wearing “every hat there is to be worn”? [8]

Why Does It Matter?

The receivership case discussed in this article has now been closed, but what damage was done due to an alleged conflict of interest, and why does it matter to insolvency professionals in future cases? As accountant for the owners, the forensic accountant was privy to documents, analysis and legal strategy. Then, as accountant for the receiver, the forensic accountant had access to his prior knowledge of the opposing side’s legal analysis and strategy, and was even prepared to be an expert witness against the owners. Significant time and expense perhaps would not have been incurred if the court had ensured hiring a professional who was not tainted by potential conflicts of interest. Would the legal outcome have changed? We will never know, because the playing field was never really properly staged.

As professionals, each of us should be concerned about the potential implications the wearing of multiple hats has on our own professional lives. Most of us have strived hard to remove any blight or taint on our profession in the public’s eye. We have worked relentlessly to be seen as competent and worthy of the role given to us by the courts. Hence, it is in all of our best interests to ensure that conflicts of interest, whether in a receivership, bankruptcy or other matters in which we are engaged, do not override the main cause of action for which we have been engaged. We must ensure that we work together to protect the integrity of our profession, and that we never, ever, let a conflict of interest misdirect our actions. We are better than that!