Straight & NarrowBy John C. hoard and Christopher M. trapp

The bankruptcy system is “self-policing,”2 especially when it involves retention of lawyers as special counsel. “In essence, the

bankruptcy system relies upon the integrity of pro-fessionals appearing in bankruptcy cases to make forthright, complete and candid disclosures to fulfill the spirit of the Bankruptcy Code, even where the professionals know that making these disclosures may result in a court’s determination that they may not be retained in the case.”3 The failure of special counsel to provide candid, honest and open disclo-sures can lead to disastrous results, including denial or revocation of retention, or reduction and/or dis-gorgement of fees. Retention of Special Counsel The standards for the retention of special coun-sel require a consideration of the counsel’s disin-terestedness, counsel’s prior representation of the debtor, the best interests of the estate and the lack of an adverse interest. As a threshold matter, an appli-cation for employment of special counsel must com-ply with Federal Rules of Bankruptcy Procedure 2014(a) and 11 U.S.C. § 327.

Disinterestedness The standard for the trustee’s retention of pro-fessionals is governed by § 327(a), and the retention of special counsel is governed by § 327(e). Section 327(a) governs the retention of counsel to handle general matters in the debtor’s bankruptcy case, and § 327(e) allows for the retention of attorneys to handle special matters. The key distinction between these two sections “is that the conflict of interest standard under Section 327(e) is more relaxed than the standard embodied in Section 327(a).”4 There is no requirement under § 327(e) that the attorney must be disinterested as there is under § 327(a).5

Prior Representation Section 327(e) requires that special counsel seeking retention “has [previously] represented the debtor.” There is disagreement among the courts whether this requirement acts as a prerequisite that will preclude employment of counsel.6

Best Interest of the Estate Whether the attorney’s retention is in the best inter-est of the estate is a factual determination tied directly to the role of counsel on behalf of the trustee. The best interest of the estate can be met if retention helps the trustee fulfill duties under § 704 of the Bankruptcy Code.7 Fulfillment of these duties has been found where special counsel has been retained to investigate legal malpractice claims,8 pursue fraudulent-convey-ance claims9 or handle state court litigation.10

Lack of Adverse Interest Although the lack-of-conflict standard is more relaxed under § 327(e), it does not go away alto-gether. Counsel cannot “represent or hold any interest adverse to the debtor or to the estate with respect to the matter on which such attorney is to be employed.11 “Section 327(e) requires that the spe-cial counsel have neither ‘an actual nor a reasonably probable conflict of interest.’”12 Thus, it is possible that even though the attorney has no conflict with the debtor, he or she may have a conflict with the estate.13

Special Counsel Standards AppliedRetention Denied or Revoked In Matter of Townson,14 the bankruptcy court grant-ed a creditor’s motion to disqualify special counsel because of a “potential conflict” even though the Court did not expressly find that special counsel held an inter-est adverse to the estate. The debtor, Townson, was a former director and officer of Frontier National Corp. and Frontier Bank (collectively, “Frontier”). The chapter

Christopher M. TrappRubin & Levin PCIndianapolis

Special Counsel Misgivings: Denials and Disgorgement1

1 On April 21, 2013, the ABI National Ethics Task Force released its Final Report, which includes a proposed amendment to Fed. R. Bankr. P. 2014 to address disclosure issues arising in bankruptcy cases. The Final Report also includes guidelines for the use of conflicts counsel in bankruptcy cases. The Final Report of the Ethics Task Force can be found at go.abi.org/FinalEthicsReport.

2 In re GSC GROUP INC., et al., Case No. 10-14653 (Bankr. S.D.N.Y.), Motion of the U.S. Trustee, for an Order Vacating Retention and Disgorging Professional Compensation, (Docket No. 1597, page 2).

3 Id.4 In re J.S. II LLC, 371 B.R. 311, 317 (Bankr. N.D. Ill. 2007); Tidewater Mem’l Hosp. Inc.,

110 B.R. 221, 227 (Bankr. E.D. Va. 1989). 5 See 11 U.S.C. § 101(14). Special counsel may also be retained pursuant to 11 U.S.C.

§ 327(c); however, the standards for disinterestedness under § 327(a) and Fed. R. Bankr. P. 2014 apply. See In re Champ Car World Series LLC, 411 B.R. 619, 623 (Bankr. S.D. Ind. 2008), for discussion of distinctions between § 327(c) and (e).

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John Hoard is a shareholder with Rubin & Levin PC in Indianapolis and is a member of ABI’s Ethics and Professional Compensation Committee. Christopher Trapp is an associate in the same office.

6 Compare Veluchamy v. Helm, No. 11 C 8263, 2012 U.S. Dist. LEXIS 72889 at *8 (N.D. Ill. May 24, 2012) (prior representation is not required), with In re J.S. II LLC, 371 B.R. at 319 (“[S]pecial counsel applicant must be found to have represented the debtor at some time prior to the bankruptcy case.”).

7 The trustee has duties to “collect and reduce to money the property of the estate” and to “close such estate as expeditiously as is compatible with the best interests of parties in interest.” 11 U.S.C. § 704(a)(1).

8 In re Potter, 2009 Bankr. LEXIS 2900 (Bankr. D.N.M. June 12, 2009).9 Veluchamy v. Helms, 2012 U.S. Dist. LEXIS 72889, *10 (N.D. Ill. May 24, 2012). 10 In re Cockings, 195 B.R. 735 (Bankr. E.D. Ark. 1996).11 11 U.S.C. § 327(e). 12 Veluchamy, 2012 U.S. Dist. LEXIS 72889 at *11 (citing In re J.S.II LLC, 371 B.R. at 321). 13 Centrue Bank v. Sampson (In re Thompson), 2010 U.S. Dist. LEXIS 109883 (S.D. Ill. Oct.

15, 2010). 14 In re Townson, No. 12-03027, 2013 Bankr. LEXIS 853 (Bankr. N.D. Ala. March 7, 2013).

John C. HoardRubin & Levin PCIndianapolis

7 trustee filed an action against Frontier and several of its offi-cers and directors, hiring Heninger Garrison Davis LLC (HGD) as special counsel. In his complaint, the trustee maintained that Townson agreed to reduce a monetary entitlement from Frontier. In exchange, Frontier agreed to sell 15 shares of Frontier pre-ferred stock to Townson for $1 per share and Townson could, once per year after he reached the age of 55, redeem each share for $175,000. While the trustee alleged that Frontier’s directors approved the agreement with Townson, the shares were never issued and Townson’s employment with Frontier was terminated. HGD also represented another client, Brown, in a counter-claim against Frontier in state court, which was similar to the alle-gations in the trustee’s complaint against Townson. In response to the motion to disqualify, HGD filed its amended application to employ and disclosed its representation of Brown.15 Notwithstanding this disclosure, the court found that whether or not an actual conflict exists, the appearance that HGD represents an interest possibly adverse to the estate presents a potential conflict and is a problem.16 The court ended its opinion criticizing HGD for its initial failure to dis-close its representation of Brown based on HGD’s claim that “it did not see a need to do so.”17 The court noted that HGD should not have unilaterally made the decision that the rep-resentation of Brown had no bearing on the representation of the trustee, but rather the court and interested parties should have had an opportunity to evaluate the potential claims.18 In a related case decided pursuant to the standards for conflict of interest under § 327(c),19 the failure to disclose actual conflicts arising after orders permitting retention of special counsel disqualified two law firms from serving as special counsel to the trustee, one of whom had been retained about two years prior to disqualification. In Forizs & Dogali PA v. Siegel,20 the U.S. District Court for the Middle District of Florida affirmed the bankruptcy court’s ruling granting a creditor’s motion to disqualify special counsel. The chapter 7 debtor allegedly operated a Ponzi scheme.21 The trustee hired two lawyers from the law firm of Forizs & Dogali PA (F&D) as special counsel to pursue avoidance actions against the debtor’s investors, including what the court described as “net winners” (those receiving transfers from the debtor in an amount greater than the principal invested with the debtor).22 The trustee took a strict position regarding creditors that filed proofs of claim against the estate in excess of their lost prin-cipal investment. The court noted that the trustee objected to each creditor claim that allegedly “assert[ed] a claim for illegal profits of a Ponzi scheme.”23 In its Fed. R. Bankr. P. 2014 disclosure affidavit, F&D acknowledged that it represented a bankruptcy creditor “who was a victim of [the debtor] in connection with the alleged Ponzi scheme.”24 The affidavit further stated that “upon information and belief, [the creditor] did not receive any distribution or

proceeds from [the debtor].”25 Thereafter, the bankruptcy court approved the application to employ F&D as special counsel. Less than three months later, another attorney for F&D filed an unsecured proof of claim in the sum of $117,206 for the creditor. For unclear reasons, the creditor filed another proof of claim on his own six months later for approximately $288,000. A few years after the proofs of claim were filed, one of the two F&D attorneys hired as special counsel, Ewusiak, formed his own law firm, Ewusiak and Roberts PA (E&W), and continued to represent the creditor in the bankruptcy. The trustee filed a motion to retain E&W as special counsel, to which a creditor objected in the creditor’s motion to dis-qualify both E&W and F&D as counsel. The bankruptcy court granted the motion to disqualify, iden-tifying an actual conflict of interest on the grounds that “E&W must argue, on the one hand for the estate, that a Ponzi scheme investor is entitled to no money in an amount greater than the principal invested with the debtor and, on the other hand for [the creditor], that a Ponzi scheme investor is entitled to money in an amount greater than the principal invested with the debtor.”26

F&D argued that it did not have a present conflict of interest, ostensibly because the creditor was then represented by E&W at the time that the motion to disqualify was filed. The district court found that “F&D misses the issue, which is whether Section 327(c) protects from disqualification special counsel who acquire an actual (or potential) conflict of inter-est and fail to disclose the conflict to the bankruptcy court.”27 The court found that the duty of disclosure on counsel is a “continuing one,” and when F&D filed a proof of claim for “accretions in excess of the principal invested, the repre-sentation materially changed and F&D needed to notify the Court.”28 The court further held that inadvertence does not excuse the failure to disclose a conflict of interest.29

Fee Disgorgement Courts may deny all compensation to professionals who fail to make adequate disclosure, and “counsel who fail to disclose timely and completely their connections proceed at their own risk because failure to disclose is sufficient grounds to revoke an employment order and deny compensation.”30 “Absent the spontaneous, timely and complete disclosure required by sec-tion 327(a) and [Fed. R. Bankr. P.] 2014(a), court-appointed counsel [must] proceed at their own risk.”31 In determining an appropriate sanction, an important consideration is whether the failure was intentional. As one court noted, “a bankruptcy court should punish a willful failure to disclose the connections ... as severely as an attempt to put forth a fraud on the court.”32

In Matter of Sundance Self Storage-El Dorado LP,33 the only asset owned by the debtor, Sundance, was a self-storage facility. After a two-year failed attempt to obtain confirma-tion of a reorganization plan, the mortgagee obtained relief from the automatic stay to foreclose on its collateral, and the

15 Id. at *8-9. 16 Id. at *15. 17 Id. at *19. 18 Id. at *20.19 11 U.S.C. § 327(c) provides an exception to § 327(a) that professionals that represented a creditor may

be employed provided there is no actual conflict of interest. In re Champ Car World Series LLC, 411 B.R. 619 (Bankr. S.D. Ind. 2008).

20 Forizs & Dogali PA v. Siegel, No. 8:12-cv-253-T-23, 2012 U.S. Dist. LEXIS 136052 (M.D. Fla. Sept. 24, 2012).

21 Id. at *1. 22 Id. at *2-3. 23 Id. at *3. 24 Id. at *1.

25 Id. 26 Id. at *7. 27 Id. at 8. 28 Id. at 9. 29 Id. 30 In re West Delta Oil Co., 432 F.3d 347, 355 (5th Cir. 2005). 31 Rome v. Braunstein, 19 F.3d 54, 59-60 (1st Cir. 1994). 32 In re Crivello, 134 F.3d 831, 839 (7th Cir. 1998). 33 In re Sundance Self Storage-El Dorado LP, 482 B.R. 613, 618 (Bankr. E.D. Cal. 2012).

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U.S. Trustee filed a motion to convert or dismiss the case. Counsel for the debtor then filed a fee application, and the court set a hearing date on the U.S. Trustee’s motion and the lawyer’s fee application. Six days before the hearing, Sundance, without request-ing permission from (or even notifying) the court, gave a deed to the storage facility to another entity, West Coast, which was recorded the day before the hearing. West Coast then filed its own chapter 11 petition six days after the hear-ing in the Sundance case. West Coast is a corporation wholly owned by Smith, a major player in the Sundance bankruptcy. Smith signed the schedules and statements filed in the case and appeared on behalf of the debtor at the meeting of credi-tors. Sundance filed an initial status report in the case stat-ing that Smith had been hired to “oversee reorganization of the business, increase income, decrease expense and play a hand’s-on role in the day-to-day business activities.” Smith signed most of the declarations in the case. In the Sundance case, the court, sua sponte, issued an order to show cause as to Sundance’s counsel out of a concern that counsel may have played a role in the unauthorized transfer of property to West Coast. The order to show cause requested that counsel file a declaration detailing his knowledge and involvement of the transfer of property from Sundance to West Coast and the filing of the West Coast case. In response, the

lawyer filed several declarations with the court and appeared and testified at the hearing on the matter. After the order to show cause was issued, the court first found (through its own investigation) that Sundance’s lawyer represented Smith in Smith’s personal chapter 13 filed prior to his application to employ the same lawyer in the Sundance case. The court further found that the lawyer represented the debtor in a previous chapter 11 case and was still owed money by Sundance for his services. Although the court determined that it had no direct evi-dence that counsel was involved with, or had knowledge of, the transfer to West Coast, it found numerous wrongful acts and omissions of Sundance’s counsel, including the failure to make adequate disclosures under Fed. R. Bankr. P. 2014, and ordered all fees ($57,270) and cost reimbursements ($4,631) disgorged. The court noted that as a “last-ditch” effort to justify this omission, counsel stated that he under-stood that Smith was an independent contractor consultant with Sundance and he did not see this as a connection to the debtor that had any relevance to the case. The court found that regardless of whether that assertion was genuine, the attorney “defied the fundamental rule that the attorney does not get to pick and choose what connections to disclose based on his or her own perceptions of their relevance.”34 abi

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34 Id. at 634.

Copyright 2013 American Bankruptcy Institute. Please contact ABI at (703) 739-0800 for reprint permission.