Bankruptcy of a Corporate Client Practical Problems of Privilege and Payment
In the context of an ongoing business enterprise, the interests of a corporation and the interests of its principal shareholders, directors, officers, and employees are often identical. Even where there is fastidious attention to detail in assuring the separateness of the corporate identity, the fact remains that corporations are often operated for the benefit of a small number of individuals who typically take a major role in running the firm.
This commonality of interest is not a problem for the prosperous corporation; indeed, it is the hallmark of a successful business. When a corporation is in financial difficulty, the common interest of the corporation and its principals may cause the principals to sacrifice salary, work harder, infuse new capital and take other personal financial risks, such as acting as a personal guarantor of the corporation's obligations. However, when the corporation's difficulties reach the critical stage, the common interests of the corporation and its control persons can diverge.2 This is most likely to happen when the control persons are divested of their control, by operation of law, in a chapter 7 liquidation proceeding.
A trustee in a chapter 7 case is required to make an examination into the affairs of the debtor firm,3 and this necessarily includes an examination into whether transactions between the corporation and its directors, officers and employees were done at "arm's length." The trustee must also determine whether the corporation made or suffered any fraudulent transfers or preferences. The potential friction between a trustee in bankruptcy and the principals of the corporation has significant consequences for the attorney who has represented the corporation prior to its demise.
In better times, counsel may have simultaneously represented both the corporation and individual directors or officers. But where a trustee is appointed for the corporation, it is, in effect, under new management. A bankruptcy trustee is provided wide latitude to obtain any facts pertaining to the corporation's conduct or property.4 Thus, to the extent that an attorney formerly retained by a corporation is in possession of information that would be useful to the trustee, the attorney is required to produce the information upon a proper demand.5 The corporation's attorneys still owe a duty of loyalty to the corporate entity, which is now under the control of the trustee. This can give rise to two interrelated problems for the firm's attorneys. The first problem relates to the attorney-client privilege. The second problem relates to payments for services that counsel has already received, or expects to receive. In both instances, counsel will discover that the trustee has a right to know what transpired in the past, even if it proves embarrassing to former officials of the debtor corporation—or to counsel.
The Privilege Problem: CFTC v. Weintraub
A trustee in bankruptcy controls the right to assert or waive the attorney-client privilege with respect to pre-bankruptcy communications, even over the objections of the former management. The Supreme Court so held in Commodities Futures Trading Commission v. Weintraub6 and noted that where a trustee is appointed, he or she assumes control of the business and the debtor's directors are "completely ousted."7 As the Court explained, unless the power to waive the attorney-client privilege regarding pre-bankruptcy communications is vested in the trustee, the debtor's pre-bankruptcy managers could use the privilege to conceal wrongfully diverted or otherwise misappropriated assets of the debtor, and thus could prevent the trustee from properly discharging his or her statutory duties to investigate the financial affairs of the debtor and to collect the property comprising the debtor's estate.8
Cases arising subsequent to Weintraub indicate that the lessons of the case have not been fully digested by the corporate bar. Former counsel for corporate debtors have often declined to cooperate with a trustee on the grounds that to do so would violate a privilege that counsel owes to individual clients who were simultaneously represented.9 Such resistance, which has not been successful, has frequently been based on a misapplication and misunderstanding of several distinct but closely related privileges—includingithe "joint defense" and "common interest" privileges—that arise from, and extend, the traditional attorney-client privilege. Typically, former corporate counsel asserts that the debtor corporation was party to a "joint defense" or "common interest" enterprise with former corporate insiders with regard to a suspicious transaction that the trustee seeks to investigate, and refuses to disclose information relating to that transaction on the ground that such information is protected by a "joint defense" or "common interest" privilege.10
While the law recognizes "joint defense" and "common interest" privileges, for several reasons, none of these privileges has any effect on a bankruptcy trustee's ability to compel disclosure of pre-bankruptcy communications to which the debtor corporation or its former managers were party.11 Frequently, for example, the party invoking one of these privileges cannot meet its burden to prove the elements of the privilege invoked; e.g., in the case of the "joint defense" privilege, the existence of a joint defense effort in furtherance of which the information sought by the trustee was communicated.12 Further, the privileges only protect against the disclosure of information to third parties, not to those who, like the trustee, step into the shoes of one of the parties sharing the putative "common interest."13 Without question, these privileges have no applicability when the interests of the trustee and former corporate insiders or managers become "adverse," which may occur prior to litigation when the trustee is engaged in fact-gathering in discharge of his duty to investigate the financial affairs of the debtor.14 Finally, by engaging in fact-gathering from corporate insiders and managers, the trustee waives any "joint defense" or "common interest" privilege that he, as successor in interest to the debtor corporation, might once have shared with them, and former corporate counsel, therefore, cannot cite such a privilege as a basis for the non-disclosure of the information sought by the trustee.15
The Payment Problem: Counsel Fees Paid at the Eleventh Hour
Attorneys who have received funds from a corporation that subsequently enters a bankruptcy proceeding may find themselves in the same boat as many other creditors. That is, they may have received a transfer that is recoverable by the trustee. The Bankruptcy Code and Rules enable and require bankruptcy courts to scrutinize these payments carefully. Under §329(a) of the Bankruptcy Code, for example, an attorney representing the debtor must file a statement with the bankruptcy court detailing, among other things, the compensation paid to the attorney in connection with the representation within the year prior to the filing of the petition placing the debtor in bankruptcy proceedings.16 Importantly, every affected attorney must make this filing, regardless of whether or not the attorney is seeking an award of additional compensation in the debtor's bankruptcy proceeding.17 As "[p]ayments to a debtor's attorney provide serious potential for overreaching," the bankruptcy court will review these payments, and the underlying services, carefully.18 Attorneys can expect that the bankruptcy court will take a broad view of the services subject to review under §329, and will review services not directly connected to an impending bankruptcy filing.19
The court may examine payments to attorneys and related services from several angles. Under Bankruptcy Code §329(b) and Bankruptcy Rule 2017, it may inquire whether a payment exceeds the reasonable value of the related services, and may cancel the relevant compensation agreement or order the return of the payment if it is so finds.20 In conjunction with §329, bankruptcy courts also regularly inquire as to whether payments to attorneys are void or voidable as fraudulent transfers.21 Counsel must be able to demonstrate that the services paid for by the corporation were performed for the corporation—not for the benefit of the individuals who owned or ran the corporation prior to the bankruptcy petition.22 While the courts recognize that there are many benefits that may accrue from the same legal services to both the corporation and its shareholders, particularly in the case of a closely-held corporation, they will not allow compensation to counsel for services that are of primary importance to shareholders or other corporate insiders and of only secondary importance to the corporation.23 In the same vein, the bankruptcy court may not consider legal services rendered to resist an involuntary bankruptcy petition to be compensable.24
Practice Points for Trustees
As soon as is practicable, a newly designated bankruptcy trustee should notify any attorneys who have represented the debtor that the trustee expects that:
- counsel will fully inform the trustee of any information that is relevant to securing assets for the estate. The trustee should specifically note that it will be necessary to investigate "insider" transactions that may require the trustee to demand the reversal of any transactions that would be deemed preferential or fraudulent. Absent voluntary compliance, the trustee may seek a court order to compel the examination of counsel and the production of records under Bankruptcy Rule 2004.
- counsel will refrain from accepting future engagements that might prove adverse to the debtor. The trustee should note the potential conflicts that may arise if counsel represents former control persons.
- counsel will comply with §329 and Bankruptcy Rules 2016 and 2017. The trustee should explain that it is necessary to ascertain that services were performed for the benefit of the debtor rather than for the former control persons.
Practice Points for Corporate Counsel
Counsel should head off this potential conflict problem at the very inception of the relationship. A well-crafted retainer agreement should explain that where the corporation is the client and paying the attorney's fees, it is sometimes possible to represent the principals of the corporation as well, but that, in the event of a conflict, the corporation will remain as the attorney's client and conflicted individuals must retain their own counsel.
Counsel must recognize—and point out to the control persons of the corporation—the possibility that counsel will be required to disclose all information concerning the affairs of the corporation when new management takes control of the corporate entity. Counsel should make it clear that even where there is personal loyalty to the principals of the firm, counsel will be compelled to disclose information adverse to those principals by virtue of serving as corporate counsel. The simple rule is this: "Attorneys in all cases are required to clarify exactly whom they represent, and to highlight potential conflicts of interest to all concerned as soon as possible."25
Counsel should prepare to demonstrate that pre-petition services rendered during the year preceding the bankruptcy petition were rendered exclusively for the corporate entity, since fees for services that are of primary benefit to individuals must be returned to the debtor's estate. In this regard, descriptive, contemporaneous time records may be critical. While a corporate client may not have required detailed records of billings, the bankruptcy court, which will review those payments, will hold counsel to a rigorous standard.
Counsel should never perform post-bankruptcy legal services for the corporate debtor, or the trustee for the corporate debtor, without specific court appointment. To do so is to act as an unauthorized—and uncompensated—volunteer.26
1 SIPC, as a matter of policy, disclaims responsibility for any private publication by any of its employees. The views expressed herein are those of the authors and do not necessarily reflect the views of SIPC or of the authors' colleagues upon the staff of SIPC.
2 See Boss-Bicak, Shira, "Feeling a Pinch on Payday; Putting the Business First," New York Times, Aug. 19, 2004.
3 11 U.S.C. §704(a)(4).
4 See, e.g., Brannon v. Gay, 527 F.2d 799,802 (7th Cir. 1976); Freeman v. Seligson, 405 F.2d 1326,1333 (D.C. Cir. 1968); Chereton v. United States, 286 F.2d 409,413 (6th Cir.), cert. denied, 366U.S. 924(1961); In re Federal Copper of Tennessee Inc., 19 B.R. 177,179 (Bankr. M.D. Tenn. 1982); In re Ratmansky, 7 B.R. 829, 833 (Bankr. E.D. Pa. 1980). See, also, Fed. R. Bankr. P. 2004(b).
5 Absent voluntary compliance, a trustee may seek a court order to compel disclosure of the information. See Fed. R. Bankr. P. 2004, 9016; Fed. R. Civ. P. 45.
6 471 U.S. 343 (1985).
7 Weintraub, 471 U.S. at 353.
8 See Weintraub, 471 U.S. at 353-54; 11 U.S.C. §§704(a)(1) and (4). Weintraub is consistent with the majority of prior cases. See OPM Leasing Services Inc., 670 F.2d 383 (2d Cir. 1982); Citibank N.A. v. Andros, 666 F.2d 1192 (8th Cir. 1981); In re Smith, 24 B.R. 3 (Bankr. S.D. Fla. 1982); In re Blier Cedar Co., 10 B.R. 993 (Bankr. D. Me. 1981); In re Investment Bankers Inc., 30 B.R. 883 (Bankr. D. Colo. 1983).
9 See SIPC v. Stratton Oakmont Inc., 213 B.R. 433 (Bankr. S.D.N.Y. 1997). See, also, In re Bevill, Bresler and Schulman Inc., 805 F.2d 120 (3d Cir. 1986).
10 See Stratton Oakmont, 213 B.R. at 434; Bevill, 805 F.2d at 122-23.
11 The joint defense privilege is applicable in the context of litigation and serves to protect the confidentiality of communications between parties, and their counsel, who have agreed upon and undertaken a joint litigation effort. See, e.g., Lugosch v. Congel, 219 F.R.D. 220, 236 n. 10, 237 (N.D.N.Y. 2002). The common-interest doctrine extends the underlying premise further and protects communications that occur outside the context of litigation between parties and counsel to a common enterprise with a legal purpose. Id. All of these "common interest" privileges are premised upon the existence of a common enterprise or arrangement with a legal, not merely commercial purpose, uniting several parties and their counsel. Id. at 237-38. They are all designed to facilitate communication between the parties to such an enterprise, and their counsel, by protecting confidential communications made in the course of the enterprise from disclosure to third parties. Id. at 237. Accordingly, they may be applicable only if there is a genuine commonality of interest between the members of the joint, legal enterprise and if each party to the enterprise reasonably understands that communications made within the enterprise group are confidential. Id.
12 See, e.g., Bevill, 805 F.2d at 126. See, also, Stratton Oakmont, 213 B.R. at 436.
13 See Stratton, 213 B.R. at 439-40 ("Just as a former joint client would expect to be able to use the information previously acquired about the other joint client in a subsequent and related litigation, the expectations of a former member to a joint defense agreement should be no different"). See, also, In re Hechinger Inv. Co. of Del., 285 B.R. 601, 612 (D. Del. 2002) ("Generally, where the same lawyer jointly represents two clients with respect to the same matter, the clients have no expectation that their confidences...will remain secret from each other..."); Bass Pub. Ltd. Co. v. Promus Cos. Inc., 868 F.Supp. 615, 620 (S.D.N.Y. 1994) ("Where there is a joint attorney-client privilege, there is no expectation that confidential information will be withheld from joint clients").
14 See Stratton, 213 B.R at 439-40. Cf., In re Mirant Corp., 326 B.R. 646, 649-50 (Bankr. N.D. Tex. 2005) ("It is well established that, in a case of joint representation of two clients by an attorney, one client may not invoke the privilege in litigation against the other client in litigation between them arising from the same subject matter in which they were jointly represented").
15 See Stratton, 213 B.R. at 439-40.
16 See 11 U.S.C. §329(a).
17 Fed. R. Bankr. P. 2016(b).
18 H.R. Rep. No. 95-595, 95th Cong., 1st Sess. 329 (1977); Sen. Rep. No. 95-989, 95th Cong., 2d Sess. 39-40 (1978).
19 See, e.g., In re Dixon, 143 B.R. 671, 676 (Bankr. N.D. Tex. 1992) ("[C]ourts interpreting §329 and B.R. 2017, along with their statutory predecessors, leave no doubt that it was Congress' intent to permit the courts to reexamine the reasonableness of fees within the one-year look back period, irrespective of the nature of the services rendered").
20 See 11 U.S.C. §329(b); Fed. R. Bankr. P. 2017(a).
21 See, e.g., In re Investment Bankers Inc., 136 B.R. 1008 (D. Colo. 1990), aff'd., 4 F.3d 1556 (10th Cir. 1993); In re Stein, 261 B.R. 680, 694-95 (Bankr. D. Ore. 2001); Dixon, 143 B.R. at 675-81. See, also, In re Peninsula Roofing & Sheet Metal Inc., 9. B.R. 257, 262 (Bankr. W.D. Mich. 1981). See, also, In re Wilson, 6 B.R. 333 (Bankr. M.D. Fla. 1980), aff'd., 16 B.R. 870 (M.D. Fla. 1982), rev'd. on other grounds, 694 F.2d 236 (11th Cir. 1982).
22 See, e.g., In re Sullivan's Jewelry Inc., 226 B.R. 624 (BAP 8th Cir. 1998); In re Wilde Horse Enterprises Inc., 136 B.R. 830 (Bankr. C.D. Cal. 1991). See, also, In the Matter of Wiredyne Inc., 3 F.3d 1125 (7th Cir. 1993).
23 See Sullivan's Jewelry, 226 B.R. at 626-27; In re Clayton Grain Elevator Inc., 30 B.R. 760, 762 (Bankr. W.D. La. 1983); In re Delk, 27 B.R. 86 (Bankr. W.D. Okla. 1983); In re Pajarito American Indian Art Inc., 11 B.R. 807, 811 (Bankr. D. Ariz. 1981); In re ISC Financial Corp., 16 B.R. 7 (Bankr. W.D. Mo. 1980).
24 In re Evenrod Perfumes Inc., 67 F.2d 878 (2d Cir.1933); cert. den., 291 U.S. 671 (1934); SEC v. Capital Counselors Inc., 512 F.2d 654 (2d Cir. 1975); SEC v. Alan Hughes Inc., 481 F2d. 401 (2d Cir. 1973). See, also, In re Lake Region Operating Corp., 238 B.R. 99 (Bankr. M.D. Pa. 1999); In re Posadas Assoc., 127 B.R. 278 (Bankr. D. N.M. 1991).
25 United States v. Int'l Brotherhood of Teamsters, Chaffeurs, Warehousemen and Helpers of America, AFL-CIO, 119 F.3d 210, 217 (2d Cir. 1997).
26 See Lamie v. U.S. Trustee, 540 U.S. 526, 539 (2004) ("If the attorney is to be paid from estate funds unless §330(a)(1) in a chapter 7 case, he must be employed by the trustee and approved by the court"); In re WHET Inc., 33 B.R. 443 (Bankr. D. Mass. 1983); In re Idak Corp., 26 B.R. 793 (Bankr. D. Mass. 1982); In re Photon, 26 B.R. 693 (Bankr. D. Mass. 1982). But see In re Triangle Chemicals Inc., 697 F.2d 1280 (5th Cir. 1983).