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Discretion and Indiscretions The Seventh Circuit Rules on 328(c)

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On January 8, 1998, the United States Court of Appeals for the Seventh Circuit decided In re Crivello, __ F.3d __, 1998 U.S. App. LEXIS 268 (7th Cir. 1998), holding that a bankruptcy court has discretion under §328(c) of the Bankruptcy Code to deny a professional’s fees when it subsequently learns that the professional never should have been employed because he or she did not satisfy the dual requirements of §327(a). At the same time, the Seventh Circuit counseled that if "any evidence exists to support an inference of intent," bankruptcy courts should apply that discretion by punishing "as severely as an attempt to put forth a fraud upon the court" a professional’s failure to disclose his or her connections as required by Bankruptcy Rule 2014.

In Crivello, the debtor-in-possession, Frank Crivello, sought to employ Kravit, Gass & Weber (the "law firm") as bankruptcy counsel in his chapter 11 case. In connection with the application to employ the law firm, a partner in the firm prepared an affidavit attesting that neither he nor the firm held or represented any interest adverse to the debtor or the estate, and disclosing the receipt of a $10,000 retainer from NMI, a corporation wholly owned by the debtor’s cousin, Joseph Crivello. Shortly thereafter, the U.S. Trustee demanded that the law firm disclose the source of all funds that it obtained from or on behalf of the debtor as well as the scope of the law firm’s representation of the debtor. Although the law firm never provided the additional information requested by the U.S. Trustee, the bankruptcy court authorized the debtor to retain the law firm as his bankruptcy counsel.

The Seventh Circuit stated that the law firm failed to disclose in its employment application numerous connections between the firm and the debtor. The firm had represented the debtor and his cousin in numerous civil and criminal matters, including several pending federal criminal investigations. It also had agreed to represent numerous companies affiliated with the debtor in defense of any criminal investigation of the debtor. Moreover, the law firm failed to disclose its pre-petition claims against the debtor, or a series of payments it received from the debtor’s cousin and companies he controlled, some of which it applied to fees incurred in its criminal representation of the debtor and to the debtor’s post-petition legal fees.

In October 1993, the law firm applied for interim compensation in the amount of $169,825 pursuant to §330. Over the U.S. Trustee’s objection, the bankruptcy court awarded the law firm interim compensation in the amount of $80,000. In June 1994, the law firm applied for final compensation in the amount of $334,484 pursuant to §331, and pending a determination on its application for final compensation, filed a second application for interim compensation in November 1994. The U.S. Trustee objected in each instance, claiming that the law firm was not disinterested and had failed to disclose all of its connections.

In response to the U.S. Trustee’s objections, the law firm filed supplemental affidavits revealing some details of the NMI payments to the law firm for services it rendered on behalf of the debtor. The law firm also filed an amended affidavit pursuant to Rule 2014 explaining that its original affidavit failed to mention the firm’s pre-petition representation of Joseph Crivello because his name did not appear in the creditor mailing matrix when the firm reviewed its records in preparing the employment application.

In March 1995, the bankruptcy court revoked the law firm’s employment order and denied in its entirety the law firm’s application for final compensation. In re Crivello, 194 B.R. 463, 469 (Bankr. E.D. Wis. 1996). The bankruptcy court specifically held that the law firm was not disinterested and that it had "willfully failed to disclose critical facts and connections with" the debtor. The district court affirmed the bankruptcy court on appeal. In re Crivello, 205 B.R. 399, 403-04 (E.D. Wis. 1997). Although the district court found no support in the record for the bankruptcy court’s findings that the law firm had willfully failed to disclose its connections with the debtor, it declined to reverse because the bankruptcy court’s decision to deny compensation to the law firm under §328(c) was based on the independent finding that the law firm was not disinterested.

The Seventh Circuit first reviewed the professional employ-ment requirements of §327(a) of the Bankruptcy Code that applicants "not hold or represent an interest adverse to the estate" and be "disinterested persons." 11 U.S.C. §327(a). These dual requirements, the court stated, "serve the important policy of ensuring that all professionals appointed pursuant to §327(a) tender undivided loyalty and provide untainted advice and assistance in furtherance of their fiduciary responsibilities." Id. at 11-12 (quoting Rome v. Braunstein, 19 F.3d 54, 58 (1st Cir. 1994)). Next, the court considered Rule 2014, the procedural mechanism to enforce the professional employment requirements of §327(a), and commented that a professional’s failure to disclose his or her connections is sufficient grounds to revoke an employment order and to deny compensation. Id. at 12. Finally, the court reviewed the professional compensation provisions of the Bankruptcy Code. Once employed, a professional must apply to the bankruptcy court for compensation, and the court may award "reasonable compensation for actual, necessary services" rendered by the professional. 11 U.S.C. §330(a)(1). Furthermore, a bankruptcy court may deny allowance of compensation for services rendered by "a professional person employed under §327" if, at any time during the professional’s employment, he or she "is not a disinterested person, or represents or holds an interest adverse to the interest of the estate with respect to the matter on which such professional person is employed." 11 U.S.C. §328(c).

The law firm conceded that it was not disinterested. Therefore, the issue before the Crivello court was—simply stated—whether a bankruptcy court must deny fees when it subsequently learns that a professional never should have been employed under §327 in the first place, or whether it has discretion to deny fees. Id. at 14.

In its main holding, the Crivello court decided that a bankruptcy court does have discretion in denying the fees of a professional who never should have been employed under §327. Id. at 18. Relying on Michael v. Federated Dep’t Stores Inc. (In re Federated Dep’t Stores Inc.), 44 F.3d 1310 (6th Cir. 1995), the U.S. Trustee had argued that "a bankruptcy court’s decision to deny compensation under §328(c) clearly requires a valid professional appointment under §327(a) as a prerequisite to an award of compensation." Id. at 15. By the U.S. Trustee’s reasoning, because the law firm never was disinterested, it never was "validly" appointed under §327(a), and because the law firm was never "validly" appointed, the bankruptcy court could not exercise the discretion given to it in §328(c). Id. at 15-16.

The court rejected the U.S. Trustee’s reasoning as being against the plain language of §328(c):

The trustee believes that §328(c) applies only when a professional who previously satisfied the dual requirements of §327(a) becomes either not disinterested or represents or holds an interest adverse to the interest of the estate after a bankruptcy court has correctly approved a professional as employable under §327(a). To reach this result, the trustee interprets the word "is" in §328(c) to mean "becomes" and inserts the word "valid" before "employment."

A reviewing court may not insert additional language into the Code to conform it with the court’s view of bankruptcy law. If a bankruptcy court has the capacity to deny compensation when "at any time during such professional person’s employment" that person is not disinterested, then only explicit language in the Code may limit this grant of discretion. Since the Code contains no such language, the bankruptcy court has discretion even if "at any time during ... employment" refers to the onset of employment.

Id. at 17-18.

Although the Crivello court decided that bankruptcy courts do have discretion to deny professional fees under §328(c), it gave the bankruptcy courts very explicit instructions how to exercise that discretion in order to minimize any incentive not to disclose conflicts fostered by its decision. Before a bankruptcy court awards any fees to an improperly employed professional:

[I]t should consider whether the professional’s failure to disclose was intentional. If any evidence exists to support an inference of intent, then the court should not fall prey to the professional’s story of confusion, miscommunication or negligence. We believe a bankruptcy court should punish a willful failure to disclose the connections required by Fed. R. Bankr. P. 2014 as severely as an attempt to put forth a fraud upon the court.

Id. at 24. (Emphasis added.)

This aspect of the Crivello opinion is consistent with the principle stated in numerous other cases that a professional’s intentional failure to disclose his or her conflicts justifies complete denial of compensation or, where compensation already has been awarded, complete disgorgement. See, e.g., In re Lewis, 113 F.3d 1040, 1045 (9th Cir. 1997); In re Park-Helena Corp., 63 F.3d 877, 882 (9th Cir. 1995), cert denied, 116 S.Ct. 712 (1996); Matter of Futuronics Corp., 655 F.2d 463, 471 (2d Cir. 1981), cert denied, 102 S.Ct. 1435 (1982); In re Benjamin’s-Arnolds Inc., (Bankr. D. Minn., Feb. 28, 1997) (1997 WL 86463 at 8). Indeed, the Seventh Circuit’s guidance on the bankruptcy court’s exercise of its discretion to deny fees to or order disgorgement of fees from professionals who fail to fully disclose their conflicts not only permits complete denial or disgorgement, but virtually requires those remedies where there is "any evidence" of intentional non-disclosure.1 Nonetheless, noting that "bankruptcy courts have been given wide latitude in connection with fact-intensive matters," the court expressly declined to carve out an exception to the discretion given bankruptcy courts under §328(c) that would require full denial of fees where non-disclosure is intentional. Be that as it may, the Crivello opinion suggests that, in the Seventh Circuit, convincing a bankruptcy court to exercise its discretion to award even partial fees or order less than complete disgorgement will be difficult if there are any indicia suggesting that a professional’s non-disclosure was intentional.

Speculation regarding how bankruptcy courts will exercise their discretion in light of the Seventh Circuit’s opinion in Crivello may prove to be unnecessary. The court concluded its opinion by remanding the case to the U.S. Bankruptcy Court for the Eastern District of Wisconsin "for a new hearing on whether [the law firm] merits any compensation under 11 U.S.C. §328(c)." Presumably, the bankruptcy court will receive the benefit of a more complete record regarding whether the non-disclosures were willful, and thus will be in a position to exercise its discretion as directed by the Seventh Circuit.


1In its general discussion of a bankruptcy court's exercise of discretion to award fees under §328(c), the Crivello court mentions the possibility that "even an interested professional may provide services which are beneficial to the estate." In guiding the "appropriate application" of a bankruptcy court's discretion, however, the Seventh Circuit plainly implies that benefit to the estate and other equities should become irrelevant if the non-disclosure of conflicts was intentional: "Before a bankruptcy court elects to award partial payment to a law firm or other professional that was improperly employed, it should consider whether the professional's failure to disclose was intentional." In re Crivello, 1998 U.S. App. LEXUS 268, at 23 (7th Cir. 1998) (emphasis added). Return to Text
Journal Date: 
Sunday, March 1, 1998

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