Attorneys who represent chapter 11 debtors have become accustomed to voluminous conflict reports, negotiating waivers with current and former clients (as well as their partners) and continually submitting amended affidavits disclosing conflicts, relationships and connections in order to comply with the Bankruptcy Code and Rules. This disclosure proclivity derives from the potential consequences of nondisclosure. Indeed, too many bankruptcy practitioners have found themselves on the wrong end of motions to disqualify/disgorge due to incomplete and/or insufficient disclosures. See, e.g., In re Leslie Fay Cos., 175 B.R. 525, 531 (Bankr. S.D.N.Y. 1994).

The potential for disaster that can result from incomplete disclosures has made most debtors' counsel overly cautious. After all, most practitioners would rather address the issue in the beginning and take the chance of nonapproval of retention than address such matters in response to a motion to disqualify/disgorge after incurring hundreds of thousands, if not millions, of dollars worth of fees and expenses. Incurring such fees and expenses when a full and complete disclosure has not been made is foolish, as courts do not hesitate to issue harsh opinions and severe remedies for inadequate disclosures.

The same disinterestedness/disclosure requirements do not exist for all bankruptcy professionals, leaving some to wonder why debtor's counsel should have all the fun. One court has recently pondered that query and mandated certain new disclosure requirements that many would not otherwise consider necessary. See In re eToys Inc., Nos. 01-706 (MFW) to 01-709 (MFW), 2005 WL 2456255 (Bankr. D. Del. Oct. 4, 2005). As one of the busiest bankruptcy courts in the nation mandated this new disclosure requirement, it is important for all to take note.

Requirements for Disinterestedness and Disclosure

A debtor-in-possession (DIP), with the court's approval, may employ one or more attorneys, accountants, appraisers, auctioneers or other professional persons that do not hold or represent an interest adverse to the estate and that are disinterested persons to represent or assist the DIP. 11 U.S.C. §327(a). The term "disinterested" is relative and dependent upon the facts and circumstances of the case. See TWI Int'l. v. Vanguard Oil Serv. Co., 162 B.R. 672, 675 (S.D.N.Y. 1987). For example, the representation of a creditor in an unrelated matter does not necessarily disqualify a bankruptcy professional nor make him disinterested. 11 U.S.C. §327(b).

"Disinterestedness," however, is for the court to determine, thereby requiring full and complete disclosure, which requires a verified statement of all of the person's connections with the debtor, creditors, any other party in interest, their respective attorneys and accountants, the U.S. Trustee or any person employed in the office of the U.S. Trustee. Fed. R. Bankr. P. 2014(a).

Rule 2014's use of the word "connection" seemingly adds additional disclosure requirements in addition to relationships and interests. See 9 King, Lawrence P., Collier on Bankruptcy §2014.05 (15th ed. 2005); see, also, In re Filene's Basement Inc., 239 B.R. 850, 856 (Bankr. D. Mass. 1999). Based on the varying nomenclature used to describe the necessary level of disclosure, Rule 2014 affidavits have grown increasingly longer and now include personal friendships with creditor's counsel, informal relationships with the committee's financial advisors and the time that debtor's counsel bumped into the U.S. Trustee at the grocery store. While that last item is somewhat of an exaggeration, it demonstrates the thought process of prospective debtor's counsel in analyzing the necessary depth of a Rule 2014 affidavit.

However, Rule 2014, as well as §327, only addresses the retention and employment of bankruptcy professionals such as attorneys, accountants, etc. Though they are not expressly excluded, it is generally accepted that officers and directors of a bankrupt debtor are not "bankruptcy professionals." In re Ambric Group Inc., 2000 Bankr. LEXIS 552, *12 (Bankr. E.D. Pa. May 23, 2000); In re All Seasons Indus. Inc., 121 B.R. 822, 825 (Bankr. N.D. Ind. 1990); In re Phoenix Steel Corp., 110 B.R. 141, 142 (Bankr. D. Del. 1989).

As such, practitioners generally do not seek court authority to employ officers of a bankrupt debtor. See Phoenix Steel, 110 B.R. at 142; but, see In re Florida Airlines Inc., 110 B.R. 570, 571-72 (M.D. Fla. 1990). In addition, a bankrupt debtor's officers normally do not make disclosures regarding any relationship with creditors, attorneys, accountants or other bankruptcy professionals. In re Hooper, Goode Realty, 60 B.R. 328, 332 (Bankr. S.D. Cal. 1986). In fact, such a notion would be generally dismissed, and such a disclosure viewed with suspicion.

Although lacking precedents, the applicability of §327 and Rule 2014's employment and disclosure requirements to officers and directors of a bankrupt debtor recently arose in Delaware. Though somewhat novel in result, many a court has adopted procedures that were once mere trends in Delaware (i.e., "that's how they do it in Delaware").

The eToys Opinion and Standard

In 2001, eToys Inc. and certain of its affiliates filed for chapter 11 relief. Subsequently, the debtors appointed a new president and CEO. The CEO had certain relationships with debtors' counsel in that the CEO and one of debtors' counsel's senior partners were partners in a separate business venture, and debtors' counsel paid the CEO $30,000 a month for a four-month time period (two months prior to the petition date and two months after the petition date) for services provided to this separate business entity.

The debtors confirmed a liquidating plan in November 2002, for which the CEO was named as plan administrator. Approximately two years later, a shareholder and an administrative claimant filed motions seeking disqualification, disgorgement, sanctions and the commencement of a criminal investigation against the CEO, debtors' counsel and other bankruptcy professionals. At the heart of certain of these pleadings was the lack of disclosure of the relationship, both pre- and post-petition, between the CEO and debtors' counsel.

Court's Jurisdiction Two Years after Confirmation

In analyzing the pleadings and the relationships at issue, the court undertook a thorough and well-reasoned review of the law and practicalities of disclosure and disinterestedness. For example, the court first undertook a thorough analysis of its limited jurisdiction based on timing and the two years that had passed since confirmation. eToys, 2005 WL 2456255 at *3-6.

Although two years had passed, the court found that the pleadings suggested willful actions on the part of the CEO and certain bankruptcy professionals. Such a willful act of nondisclosure "goes to the heart of the integrity of the bankruptcy system," which compelled the court to address the merits irrespective of time. eToys, 2005 WL 2456255 at *5 (citing In re B.E.S. Concrete Prods. Inc., 93 B.R 228, 236 (Bankr. E.D. Ca. 1988)).

Further, the allegations implicated the provisions of Federal Rule of Bankruptcy Procedure 9024, which adopts Federal Rule of Civil Procedure 60 and creates an exception to the prohibition of reviewing otherwise time-barred matters if "extraordinary circumstances suggest the [moving] party is faultless in the delay." eToys, 2005 WL 2456255 at *6 (citing In re Benjamin's-Arnolds Inc., No. 4-90-6126, 1997 WL 86463 at *10 (Bankr. D. Minn. Feb. 28, 1997)). The court determined that such extraordinary circumstances existed because of the alleged failure to disclose certain relationships on the part of the bankruptcy professionals involved, and the public policy interests related thereto. Id. (citing In re Southmark Corp., 181 B.R. 291, 295 (Bankr. N.D. Tex. 1995)).

The Mandate of Officer/Director Disclosure

Upon determining that jurisdiction existed, the court focused on allegations of undisclosed relationships. The flaw in such allegations was the fact that the CEO was an officer, not a bankruptcy professional. As such, the court determined that the CEO had no duty to disclose, as a corporate officer is not a bankruptcy professional retained under §327(a). eToys, 2005 WL 2456255 at *20.

Nonetheless, the court appears to have announced a new requirement in the District of Delaware, which requires that officers, and presumably directors, of a debtor in bankruptcy disclose any relationship that an officer has with creditors, professionals and other parties in interest in the case. Id. The court based this edict on its power to supervise and deny compensation to officers of a corporation under certain circumstances, and because relationships that could affect an officer's loyalty (and the failure to disclose those relationships) are factors that the court should consider in supervising officers of the debtor. Id.

A similar decision was rendered in Phoenix Steel, in which the court held that while salaried officers retained to replace resigning officers were not "professional persons" as contemplated by §327, their compensation was nevertheless subject to court approval under §330 after full disclosure of all relevant information, though not predicated upon the satisfaction of the "technical requirements" applicable to fee applications. Phoenix Steel, 110 B.R. at 143. Phoenix Steel, however, implies that only officers that are appointed post-petition are subject to this disclosure requirement, making the timing of appointment a crucial matter.

While the court found that no actual conflict of interest existed in the case at hand, nor that the CEO had committed any act that harmed the estate or that otherwise provided a basis for reducing the CEO's compensation, the court demonstrated concern that "without a disclosure requirement, much mischief can occur." See eToys, 2005 WL 2456255 at *20 (citing In re Coram Healthcare Corp., 271 B.R. 228, 236 (Bankr. D. Del. 2001)). Based on this concern, officers, and presumably directors, of a bankrupt debtor in Delaware now must file a disclosure or risk subsequent remedial measures.

Unfortunately, the court gave little guidance as to the appropriate form for such disclosures. It would appear that a Rule 2014 affidavit would be appropriate, despite the fact that Rule 2014 addresses the employment of professional persons under §§327, 1103 or 1114. The inapplicability of Rule 2014 may provide the basis for a local rule clarifying and giving guidance as to the appropriate form. Such clarification and guidance is necessary, as counsel for the debtor does not represent the officers and/or directors of the bankrupt entity, and the amount of guidance and advice that debtor's counsel can give to an officer/director regarding their duty to disclose and the depth of such disclosure is, at best, limited. Such a disclosure requirement may very well require the need for such officers and directors to hire independent counsel to represent them in the disclosure process.

Conclusion

eToys set forth a new level of disclosure with which officers/directors of a debtor in bankruptcy must comply. Compliance would appear easy for most officers/directors, though not necessarily true for restructuring professionals that are retained as officers or directors. Restructuring professionals, however, should be accustomed to the level of disclosure and the routine nature of it.

Many might consider eToys guidance to be unnecessary, as other protections and remedies exist to address a situation where an officer/director is not disinterested. Indeed, disgorgement may be a small penance when compared to the potential liability for damages, and perhaps punitive damages, for an officer/director's willful breach of fiduciary duty. Although most confirmed reorganization plans include exculpatory clauses and releases, most courts, including the eToys court, refuse to approve plans containing such provisions unless gross negligence and willful misconduct are expressly excluded.

Irrespective of other remedies and the novelty of its holding, eToys comes from one of the busiest bankruptcy courts in the nation, which often sets the standard for other courts to follow. In this day of corporate scandal and distrust of corporate officers, eToys' disclosure requirements may well become the norm in other courts across the country.