How to Get Paid in a Bankruptcy Case Part I

New York Law Journal
October 15, 1999
By Paul Hollender

“This article is reprinted with permission from the lawnewsnetwork.com edition of New York Law Journal (c) 1999 NLP IP Company”

Bankruptcy lawyers are subject to more judicial control than lawyers in any other field.

This is based upon a statutory scheme in which assets belonging to a bankruptcy estate are marshaled and then divided among creditors, the concern being that such funds are primarily for the benefit of creditors and should not be consumed by professionals. The statutory control over attorneys fees is based upon a largely inaccurate historical perception that trustees and their professionals have a tendency to put their self interests before those of the creditors.

In addition, since business owners have a natural tendency to put their personal self-interest ahead of that of their creditors, the courts have a concern about conflicts of interest: is the attorney really representing the corporate debtor ; which, in bankruptcy, is actually a trustee for its creditors ; or the principals of the company?

Incentives to recover asset transfers or preferential payments for the benefit of the shareholders or their relatives, are theoretically small where the professionals charged with investigating and pursuing such transfers on behalf of the corporation are really working for the individuals who made and benefitted from such transfers. Accordingly, even if the source of payment of a professional retainer is not the corporation, the bankruptcy court wants to know about it, to determine whether the professional sought to be retained to represent the debtor is disinterested.

Justifiably or not, the fact is that attorneys, accountants and other bankruptcy professionals cannot get paid unless they undergo a two-step process. First they must be retained after full disclosure. Second, their fees are fixed upon application made subsequent to performing the services. Simply submitting a bill to a client for payment, pursuant to a contractual retainer agreement, just will not do.

This article, part one of a two-part series, will discuss how to get retained to represent debtors in Chapter 11 cases. Part two will discuss debtors’ counsel’s fee applications; as well as retention and fee applications when representing other professionals.

Chapter 11

To be retained to represent a Chapter 11 debtor, a professional must past two tests: he must be disinterested and he must neither hold, nor represent any adverse interest.

1. • The requirement of disinterestedness mandates that the proposed professional is not a creditor, equity holder, or insider.
2. • Thus a lawyer or accountant who is owed money for pre-petition services, is a creditor, and will be ineligible to represent the Chapter 11 debtor. The solution may be to simply waive payment of the pre-petition claim as a condition to court approval of retention in the Chapter 11 case.

   Likewise, a professional seeking to collateralize his future fees by taking a pre-petition mortgage on the debtor’s premises will be disqualified, since the taking of the mortgage requires the professional to schedule himself as a secured creditor.

   Furthermore, the professional cannot represent the company if, within two years, he or a relative has had an ownership interest in, or has been a director, officer or employee of the company.

   The standard of what constitutes an adverse interest was summarized by Bankruptcy Judge Tina Brozman in the Leslie Fay case if it is plausible that the representation of another interest may cause the debtor’s attorneys to act any differently than they would without that other representation, then they have a conflict and an interest adverse to the estate.

3. • In that case, well-known bankruptcy counsel was retained as debtor’s counsel, with court approval after cursory disclosure. Subsequent to performing substantial services, the firm made an application for interim compensation which was met by a motion by the U.S. Trustee to disqualify the firm on the grounds that it failed to disclose, either in its retention application, or subsequently, that the firm had significant ties to several possible targets of the fraud investigation the firm was overseeing.

   In particular, two board members who were potential targets were principals of large clients of the law firm. Also, an accounting firm which was a potential target was currently being represented by the law firm in a litigated matter. The court found an adverse interest because [debtor’s counsel] had an incentive to discount any possible liability so as to preserve its substantial client relationships with the firms of which the directors were principals.

   Although the court denied the disqualification motion, it required debtor’s counsel to reimburse the estate for the very substantial costs incurred to investigate the firm’s own investigation.

   The firm’s key problem was that it did not disclose enough information to the court upon its retention application. The point is, that in seeking retention, the applicant’s responsibility is to disclose everything, leaving it to the court, not the applicant, to decide whether the potential for conflicts exists, and if so, whether the firm should be completely disqualified, or whether certain protections can be structured to enable retention.

   Representation

   In Angelika Films, 57th, Judge Arthur Gonzalez ; who had been the U.S. Trustee in Leslie Faye ; denied all compensation to the debtor’s counsel and required the firm to disgorge its pre-petition retainer. Retention was initially allowed even though the firm was simultaneously representing the debtor’s principal in a matrimonial action, because the principal paid his personal, pre-petition debt prior to execution of the retention order. This is consistent with decisions which allow dual representation in very small businesses, where retention of separate counsel would impose a hardship.

4. • The court had initially acceded to the parties’ stipulation to allow retention notwithstanding;

   Counsel’s past and continuing concurrent representation of the principal in a matrimonial action, and;

   The fact that the initial bankruptcy retainer was paid by the principal’s mother.

   However, the court took umbrage at the fact that, in practice, counsel was unable to maintain that disinterestedness throughout the case.

   Notwithstanding a post-petition appraisal, presented by debtor’s counsel to the court showing a value of $500,000 to $750,000 for the debtor’s under-market lease to a movie theater it operated, debtor’s counsel moved to allow the debtor to assume and assign its lease to the debtor’s principal, for the sum of $100,000. Ultimately, after the appointment of a Chapter 11 operating trustee, the lease was sold for $1 million.

   Recognizing that there was often a gray area in which pre-existing counsel in a small business case will be allowed to represent the corporation in bankruptcy, even though it previously represented the principal or his family, the court noted when so allowed, counsel must be vigilant to the existence of the dividing line between representing the interests of the corporation and representing the individuals ; and know when not to step over the line.

   Here, the firm had failed to keep that line in mind. In seeking approval of a sale of the key corporate asset to the principal, for a discount price, there was a clear dichotomy between the interests of the individual and those of the estate. By failing to respect that line, counsel forfeited its right to payment by the estate.

   When counsel is representing the debtor’s principal, it is, in the first instance, better to refer the Chapter 11 case to outside counsel.

   If the decision is made, notwithstanding the potential for future conflicts, for the same firm to seek retention as bankruptcy counsel to the debtor corporation, then counsel must be aware that it will be held to a higher standard of scrutiny as to such future conflicts. It must be constantly aware of the potential for such conflicts, during the course of the Chapter 11 case, and be sensitive of the need to have the principal retain separate counsel for post-petition transactions.

   As a rule of thumb, debtor’s counsel should remember the maxim: Pigs get fat but hogs get slaughtered.

   Affiliates of the Debtor

5. • Where the firm is also representing affiliates of the debtor, the courts tend to allow the firm to be retained for Chapter 11 purposes, for administrative convenience, unless an actual conflict exists.
6. • The Bankruptcy Rules require an applicant for professional retention to disclose all connections that would impact upon its disinterestedness.
7. • In this regard it is well to keep in mind the view stated by Judge Gonzalez that the court should not have to rummage through files or conduct independent fact-finding investigations. Mere boilerplate disclosure may cover an inadvertent failure to disclose an insignificant connection, but does not suffice for known connections with parties presenting a significant risk of adversity.

   Disclosure to Court

8. • In Granite Partners L.P., 8 Harrison J. Goldin was appointed Trustee with a charge of;

   Investigating the collapse of a company that sold collateralized mortgages through Merrill Lynch and other broker-dealers, and;

   Commencing suits against those determined to be responsible.

   The proposed law firm disclosed to the trustee that the firm would not sue the auditor in question for two reasons: the law firm used that same accounting firm as its own auditor, and the law firm represented the American Society of Certified Public Accountants. Notwithstanding this limitation, the Trustee still desired to retain this law firm. This information, however, was not disclosed to the court in the retention application. This flaw, plus another discussed below resulted in a total denial of fees for investigatory work, a penalty reduction of other legal and trustee fees.

   Bankruptcy Judge Stuart Bernstein found that the mere disclosure to the Trustee of the law firm’s representation of the ASCPA, of which Price Waterhouse was a member, was insufficient to avoid the risk of tainted judgment in the limited task of identifying claims, but not suing on them.

   The professional must disclose all facts that bear on its disinterestedness and cannot usurp the court’s function by choosing, ipse dixit, which connections impact disinterestedness and which do not. The existence of an arguable conflict must be disclosed, if only to be explained away.”9 Had counsel disclosed these facts to the Court, retention would have been denied.

   Ongoing Disclosure

   Also paramount in the court’s Granite Partners’ decision was the applicant’s reliance upon boilerplate clauses in making disclosure, and in failing to make ongoing disclosure of radically different information which developed during the course of the case.

   The court, in denying compensation relating to claims investigation, faulted counsel’s failure to disclose the ongoing and increasing level of new business it was performing for Merrill Lynch from the time of retention through the time of the fee application three years later. A one year pre-petition $225,000; two-and-a-half years during case $9 million.

   In fact, the firm took on new Merrill Lynch business while the retention application was pending, and failed to disclose it.

   Further, although counsel represented in its retention application that it would be obtaining letters from its existing broker-dealer clients waiving any potential conflict of interest, it failed to disclose to the court that Merrill Lynch had failed to provide such a written waiver letter.

   The court emphasized the need for ongoing disclosure of changed circumstances, rather than waiting for fee applications.

   Had the court known of the relationship with Merrill Lynch, it would not have authorized retention. No Matter how thoroughly or fairly [the firm] conducted the investigation, the question will always linger whether it held back, or failed to bite the hand that feeds it quite as hard as the circumstances warranted.

9. The court concluded that the firm intentionally failed to make additional disclosures because It feared the adverse consequences of full disclosure.

   Conclusion

10. • When seeking to represent a debtor in a Chapter 11 case, a law firm must first engage in some serious soul searching as the potential for divided loyalties. If the firms’ long-term loyalties are to the principals of the company and the corporate entity itself, and if it is likely that the need to choose between the two will arise during the course of the Chapter 11 case, the firm should not get involved in the Chapter 11 case.

    On the other hand, if potential conflicts can be avoided, they should be disclosed, and procedures suggested for minimizing the risks.

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    1. • 11 USCA ¤327(a).
    2. • 11 USCA ¤101(14).
    3. • Leslie Fay Cos. Inc, et al 175 B.R. 525, 533 (Bankr. SDNY 1994)).
    4. • See Conflicts, the Appointment of Professionals, and Fiduciary Duties of Major Parties in Chapter 11 cases cited at 8 Bankr. Dev J. 349, 362-366. (Wide range of decisions ranging from absolute prohibition, to authorization where Òmom and pop nature of business would impose severe hardship on shareholders to retain separate counsel.
    5. • See In re Hassett v. McColley (In re O.P.M. Leasing Services Inc., 16 B. R. 932 (Bankr. SDNY 1982).
    6. • Bankruptcy Rule 2014(a): The application shall be accompanied by a verified statement of the person to be employed setting forth the person’s connections with the debtor, creditors, or any other party interest, [and] their respective attorneys.
    7. • Granite Partners, 219 B.R.22, 34.
    8. • Granite Partners L.P., 219 B.R. 22,33 (Bankr. SDNY 1998).
    9. • Granite Partners, 219 B.R. 22, 34.
    10. • 212 B.R. 22, 38.
    11. • 212 B.R. 22, 39.

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        Paul Hollender is a partner at Corash & Hollender PC in Staten Island, N.Y

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