The disqualification of a lawyer for a conflict in a bankruptcy case is governed by Section 327(a), the Third Circuit recently said. Absent an “actual conflict,” disqualification is discretionary and is not required under Section 327(a), even if there is a potential conflict.
The courts have discretion to apply the state’s rules of professional conduct when they are relevant and compatible with federal law and policy, Circuit Judge Thomas L. Ambro said for the Philadelphia-based appeals court in his opinion on May 24. Otherwise, the inquiry does not go beyond Section 327(a).
Boy Scouts’ Counsel
The Boy Scouts purchased primary insurance from an insurer that bought reinsurance from other insurers. The law firm at issue in the Third Circuit opinion was the primary insurer’s counsel in disputes with the Boy Scouts’ reinsurers. At about the same time the primary insurer retained the law firm, the Boy Scouts retained the same law firm to explore restructuring options in response to sexual abuse lawsuits.
In agreeing to represent the Boy Scouts, the firm told the organization that it would not give counsel on insurance coverage. The Boy Scouts retained another firm for insurance matters.
The primary insurer first learned that the firm was representing the Boy Scouts on reading an article in The Wall Street Journal about three months after hiring the firm for reinsurance disputes. The insurer did not object at the time.
As counsel for the Boy Scouts, lawyers from the firm attended some meetings with the primary insurer where the Boy Scouts was chiefly represented by the other firm. The insurer did not object at the time.
About 10 months after reading that the firm was also representing the Boy Scouts, the primary insurer told the firm that the dual representation was a conflict. The insurer also objected when the firm participated in mediation on the side of the Boy Scouts. The firm then responded by setting up a formal ethical screen between the firm’s bankruptcy and insurance lawyers.
The insurer refused to give the firm a waiver of the alleged conflict or to consent to the firm’s withdrawal. So, the firm withdrew unilaterally.
The firm filed the Boy Scouts’ chapter 11 petition in February 2020. The debtor filed an application to retain the firm as its bankruptcy counsel, but the primary insurer objected.
In an opinion that Judge Ambro called “well reasoned,” Bankruptcy Judge Laurie Selber Silverstein overruled the objection and authorized the firm’s retention. She saw no actual conflict and found that the firm’s two teams of lawyers had not shared the insurer’s confidential information. The district court affirmed, but the insurer appealed to the circuit.
In the meantime, the firm’s bankruptcy lawyers moved to a new firm, taking the Boy Scouts’ case with them. Consequently, the firm is no longer representing either the Boy Scouts or the insurer.
Jurisdiction and Standing
Arguably, the retention order was not a final order subject to appeal as of right. Much like the Second Circuit’s recent opinion in Alix v. McKinsey & Co. Inc., 20-2548 (2d Cir. Jan. 19, 2022), Judge Ambro said that retention of counsel implicates the integrity of the bankruptcy system and is extremely important to resolve. For ABI’s report on Alix, click here.
Although the firm no longer represents the Boy Scouts, Judge Ambro found constitutional and prudential standing because the possibility of disgorgement of fees gave the appeal “continuing implications” for the debtor and its creditors.
Section 327 Disqualification
Judge Ambro’s opinion is a tour de force on disqualification under Section 327 and the relationship between Section 327 and states’ ethics rules. He began analyzing the merits by laying out the fundamentals of Section 327(a).
To be eligible for employment, the professional may not “represent an adverse interest” and must be “disinterested.” Although the two prongs are “distinct,” Judge Ambro said, “they effectively collapse into a single test” in the case on appeal.
Conflicts under Section 327 are divisible into three categories, Judge Ambro said: (1) actual conflicts; (2) potential conflicts; and (3) appearances of conflict. If there is an actual conflict, counsel face per se disqualification, the judge said.
On the other hand, disqualification is discretionary if the conflict is potential, and an attorney is not disqualified on the appearance of a conflict alone, Judge Ambro said.
“Pragmatically,” Judge Ambro said, “a conflict is actual when the specific facts before the bankruptcy court suggest that ‘it is likely that a professional will be placed in a position permitting it to favor one interest over an impermissibly conflicting interest.’” In re Marvel Ent. Grp., Inc., 140 F.3d 463, 476 (3d Cir. 1998).
The bankruptcy court had found no actual conflict under Section 327. On appeal, the insurer “has not meaningfully challenged the Bankruptcy Court’s factual finding that [the firm] did not have an interest adverse to the estate,” Judge Ambro said. Therefore, the firm was not saddled with an actual conflict, for the purposes of the appeal.
The insurer argued that the bankruptcy court committed error by not also evaluating the dual representation under Rules 1.7 and 1.9 of the ABA’s Model Rules of Professional Conduct.
“We decline to do so,” Judge Ambro said, holding that “Section 327 and the Rules of Professional Conduct impose independent obligations.” He went on to say that “[p]rofessional conduct rules may be relevant and ‘consulted when they are compatible with federal law and policy . . . . In re Congoleum Corp., 426 F.3d 675, 687 (3d Cir. 2005).’”
Thus, the appeal at best presented a potential conflict, requiring the court to determine whether the potential conflict implicated the economic interests of the estate. In that regard, the Boy Scouts had other insurance counsel, and the Boy Scouts were not a party to the reinsurance agreement where the firm was counsel for the principal reinsurer. Given the facts, “the conflict alleged by [the insurer] was outside the scope of § 327(a),” Judge Ambro held.
Although ethics rules “may be informative in some cases,” Judge Ambro said, “We never stated that violations of the Rules of Professional Conduct are themselves sufficient to create a § 327 conflict.” Therefore, Judge Ambro concluded that the bankruptcy court “reasonably ruled” that the dual representation did not require disqualification under Section 327.
Judge Ambro went on to explain that disqualification is never automatic. “Even when an ethical conflict exists (or is assumed to exist) [under state ethics rules], a court may conclude based on the facts before it that disqualification is not an appropriate remedy.”
In the case on appeal, the bankruptcy court did not decide whether the firm had violated any state ethics rules but decided that disqualification was inappropriate. He found that the insurer could not have been adversely affected because the firm’s bankruptcy team had not received any confidential information.
To the contrary, the Boy Scouts would have been adversely affected had the firm been disqualified. Judge Ambro therefore ruled that the bankruptcy court’s decision was “nowhere close to an abuse of discretion.” He affirmed.
The disqualification of a lawyer for a conflict in a bankruptcy case is governed by Section 327(a), the Third Circuit recently said. Absent an “actual conflict,” disqualification is discretionary and is not required under Section 327(a), even if there is a potential conflict.
The courts have discretion to apply the state’s rules of professional conduct when they are relevant and compatible with federal law and policy, Circuit Judge Thomas L. Ambro said for the Philadelphia-based appeals court in his opinion on May 24. Otherwise, the inquiry does not go beyond Section 327(a).