The following is a case update written by the Adam A. Lewis, Senior Counsel at Morrison & Foerster LLP, analyzing a recent decision of interest:
In In re Black and White Stripes, LLC, ___ B.R. ___, 2020 WL 7090169, 2020 Bankr. LEXIS 3385 (Bankr. S.D.N.Y. Nov. 4, 2020) (“B&W”), a published opinion, the United States Bankruptcy Court for the Southern District of New York (the “Court”) denied a law firm’s application to represent affiliated debtors in the debtors’ bankruptcy cases under Subchapter V of Chapter 11 because of the firm’s prepetition representation of debtors and their principals as counsel in litigation with the debtors’ largest creditors. The Court based its decision on the potential significant claims by the debtors’ estates against the principals, potential conflicts of interest arising from the prior joint representation, and the firm’s lack of candor with the Court. To review the opinion, click here.
The two affiliated debtors are limited liability companies. They are essentially distributors of films. Both were owned by the same two principals. Certain of the operations were financed by loans from insiders who were relatives of the principals. Through a variety of transactions, the debtors also financed their activities via loans from their two main creditors (the “lenders”). In various ways, the debtors’ principals incurred secondary liability for the lender loans. There were also several intercompany agreements between the debtors.
The debtors defaulted on the loans. In separate state court actions, the two lenders sued the debtors and the principals. In one action, the defendants faced likely successful summary judgment motions by the lender. In the other, the defendants’ initial counsel withdrew after a year, to be replaced by another firm (the “Firm”) just in time to avoid a default deadline to respond set by the state court. The Firm received a $2,500 retainer accompanied by a letter that contemplated very broad services. As a discovery deadline approached, the Firm moved to withdraw based on alleged differences with the defendants. Facing this situation, the state court extended the discovery production deadline but made it clear the defendants risked a default judgment if they failed to meet it. The Firm subsequently purported to produce some documents for the defendants, but the production proved woefully inadequate. Proceedings followed with the state court eventually issuing an order requiring full compliance by a date certain on pain of default. Next, the state court granted the Firm’s motion to withdraw. At virtually the same time, one of the principals paid the Firm just over $10,000 for preparation and filing of bankruptcy petitions for both debtors, which then filed Subchapter V petitions. Far and away, the lenders were the main claimants in the bankruptcies. Upon the bankruptcy filings, the state court actions were stayed as to the debtors, but not as to the other defendants. The state court issued yet another order requiring discovery compliance by the remaining defendants by a new date, again at the risk of a default.
The debtors immediately brought an adversary proceeding in the bankruptcy cases against the lenders, seeking to enjoin the state court prosecution of their claims against the principals for 180 days by extension of the automatic stay. After granting the debtors a temporary restraining order, the Court, upon a more developed record, dissolved the TRO and denied any injunctive relief, finding that the bankruptcy filings were aimed not at reorganization of the debtors but at protecting the principals in the state court litigation.
Contemporaneously, the Firm applied to be employed to represent the debtors in the bankruptcies. Its supporting declarations did not initially disclose the Firm’s past representation of the debtors and principals in the state court litigation against the lenders. When it was later disclosed, the Firm asserted that there was no conflict arising from the prior joint representation. The lenders and the United States Trustee (the “UST”) objected based on the Firm’s prior entanglement with and among the debtors, the principals, and the lenders in the state court litigation. In that vein, they noted that the debtors had potential claims against the principals for avoidance actions and breaches of duty to the debtors. The UST made essentially the same arguments and also pointed to various other inaccuracies in the application and related materials – such as the Firm’s original attribution of its retainer to the debtors but subsequent correction of the source as one of the principals — as cause for concern. The Firm replied that its work in the state court action was both very brief and limited in scope to dealing with the pending discovery issues. It also asserted that the Firm’s withdrawal was due to severe injuries suffered by one of its attorneys, lawyer Cushner, in a bicycle accident (a different reason for the withdrawal than given to the state court). The court denied the Firm’s application for employment as the debtors’ bankruptcy counsel.
The opinion contains a long and painstaking review of the applicable law on retention of professionals. This e-bulletin attempts to boil the discussion down to its essentials. The Court began by stating that “[t]o be retained under [Bankruptcy Code] section 327(a), professionals must be both disinterested and not hold or represent any interest adverse to the estate.” (Citations omitted.) The ultimate concern is whether there is any reason to believe that the bankruptcy estate (and with it the estate’s creditors) will have any reason to doubt that the estate will have counsel’s undivided loyalty.
On the facts before it, the Court concluded there well could be such doubt in light of the Firm’s ties to the debtors, its past representation of debtors’ principals, the litigation with the lenders, the estates’ potential significant claims against the principals, and the potential for claims between the debtors. It did not help that the Firm first failed to disclose those relationships at all in its employment application, gave different stories to the state court and the Court on why it withdrew from the state court action, tried to steer the Court away from the broad scope of its prepetition engagement, and seemed willing to lend itself to a scheme by the debtors to forestall progress in the state court action against the principals (capped by the debtors’ attempt to stay the state court actions against the principals virtually the moment the debtors filed their bankruptcies). These facts reflect an apparent willingness by the Firm to elevate the interests of the principals above all else. This concern was underscored by the corrected disclosure that the bankruptcy retainer came not from the debtors, but one of the principals. The Court concluded, therefore, that the Firm met neither the adversity nor the disinterestedness tests of section 327(a).
This decision is not controversial. Even putting aside the technical disinterestedness and adversity considerations of section 327(a), counsel’s unsavory conduct in assisting the debtors and principals to delay the state court action, its shifting explanation for its withdrawal, and its downplaying of the scope of its prepetition engagement, among other things, bespeak a Firm that is not to be entrusted with fiduciary duties to the debtors and their creditors. It was a credible concern that the Firm would continue to promote the principals’ interests above all others. In any event, the involvement of the Firm in the claims between the debtors and the lenders, possible claims by the debtors against the principals, and possible claims between the debtors patently violates both disinterestedness and adversity. Indeed, it is a wonder that the Firm even bothered to apply to represent the debtors.
These materials were authored by Adam A. Lewis, Senior Counsel at Morrison & Foerster, LLP. Editorial contributions were made by Ed Hays of Marshack Hays LLP.