In many complex debt restructurings, both lawyers and investment bankers have prominent roles in resolving the situation. Moreover, both are advocates for their clients. As professionals, their interests are usually aligned with client goals. Yet there can be distinct differences between lawyers and investment bankers in restructuring situations. Unlike lawyers, the investment banker often testifies as an expert witness on issues such as valuation, sale processes, interest rates, plan feasibility and the like, and may have a success fee dependent on an engagement's outcome. Another area of partial divergence involves the duties of, and options available to, investment bankers and lawyers when faced with unacceptable client behavior.

Lawyers are guided by ethical codes and rules and considerable case law (both bankruptcy and non-bankruptcy) when it comes to decisions about how to deal with difficult ethical dilemmas. Lawyers also must consider "privilege" issues as they relate to client confidences. Investment bankers, on the other hand, have neither canons of ethics nor privilege obligations, and there is little case law governing or guiding investment banker ethical behavior.

These distinctions were highlighted in an engagement several years ago, and it serves as a real-life example of the ethical dilemmas that investment bankers may face. Certain facts have been changed for privacy reasons.

The Facts

The client was a publicly traded manufacturer, with a line of credit secured by "eligible" accounts receivable. Every week its lender received a certificate from the client that set forth gross accounts receivable for the purpose of the borrowing base calculation as well as net (i.e., "eligible") accounts receivable. The lender would then advance funds based upon an agreed-upon formula.

The investment bank (IVB) was engaged when the client (not in chapter 11) was suffering liquidity problems and operational difficulties, and was in default on interest payments to its bondholders. The IVB's preliminary analysis was that the client and the bondholders should form an alliance to restructure the company, perhaps over the objections of the lender. The IVB believed that the lender had weaknesses in its documentation and perhaps other vulnerabilities as well.

Several weeks after the engagement commenced, and before the IVB discussed its proposed restructuring strategy with the company's key constituencies, the IVB's due diligence uncovered that the client was falsifying its borrowing base certificates. This situation, which resulted in "over-borrowing" from the lender, apparently had been occurring for some time. It was clear that as soon as the lender discovered the overborrowing, the company would be in material default on its credit line (among other things) and out of cash. Without financial assistance and cooperation from the lending institution, the company would likely have had to terminate operations and close its doors within days.

What were the IVB's choices in representing this client? In the heat of the crisis, the following options appeared to be available: (i) ignore the overborrowing and proceed with the engagement, (ii) advise the lender of the overborrowing, (iii) advise the client's board of the overborrowing and request that the company desist from further improper activities and/or inform the lender, or (iv) resign.

The first option was unacceptable to the IB, and it decided that it could pursue options two and/or four depending upon the outcome of option three—i.e., advise the board of the overborrowing and request that the company alter its behavior and advise the lender of such overborrowing.

After a board meeting, convened at the IVB's behest to inform the board of the transgressions, company management agreed to a meeting with the lender and the IVB shortly thereafter to discuss the overborrowing. After further discussions, company executives also agreed to cease further overborrowings in the interim.

In short order, the IVB and the company made a presentation to the lender describing the overborrowing and the company's immediate impending insolvency as a result of correcting the overborrowing, absent assistance from the lender. The IVB also presented its analysis to the lender of potential recoveries under various scenarios and concluded that there would be a steep discount from the face value of the loan if the lender elected not to support the company, as compared to a likely full recovery for the lender if it did support the company in the IVB's proposed financial restructuring program.

The lender ultimately accepted the IVB's analysis and supported the company's proposed game-plan. Through the ensuing financial restructuring, the company's constituencies achieved recoveries that both surpassed expectations and were deemed to be tremendous results in light of the pre-existing circumstances. And the IVB earned a substantial "success" fee.

Discussion

All's well that ends well, but what if the IVB's original recommendation to the board had been rejected? This was a very real possibility, given the "siege" mentality that can overcome a board's good sense during a crisis situation. The following are certain issues raised by this situation that merit reflection.

Issue: Did the IVB have the right—or the obligation—to demand that the company cease the overborrowing and disclose the matter to the lender, with an implicit "or else"? Put another way, what exactly was the "or else" at the IVB's disposal—resignation? Unilaterally advising the lender of the fraud? Anything else?
Response: It clearly was right to demand that the overborrowing cease and desist, and that the lender be apprised at once by the company. Not only was it the ethical thing to do, but to do otherwise could have subjected the IVB to legal liability if it continued its engagement without disclosing the overborrowing to the constituencies with which it was dealing. However, the IVB probably had limited flexibility if the client had declined to "fess up"; resignation may then have been the IVB's only viable option.

Issue: What if the company had ceased the overborrowing but somehow was not thereafter rendered illiquid? What would the IVB's duties and responsibilities have been at that juncture, given that no ongoing fraud would be occurring?
Response: The IVB concluded that, under such circumstances, it could not both remain engaged and fail to take action with respect to the overborrowing. Moreover, as a practical matter, it is difficult to conceive of circumstances where cessation of a major financial fraud (whose genesis had been lack of liquidity) could fail to render a company insolvent. Put another way, if a company is essentially stealing money to stay afloat, and then the pilfering stops, the company is quite likely going to have no financial liquidity whatsoever.

Issue: Is the investment banker potentially liable to a company and its shareholders for damages suffered after the investment banker has, without company approval, advised creditors that the client is committing fraud (i.e., damages suffered by the company arising from the creditor's subsequently terminating the company's liquidity)? Is the investment banker, on the other hand, liable to the company's creditors if it is aware of such fraud and does not inform anyone? How does it affect the dynamic if the investment banker resigns?
Response: This may be a classic "damned if you do and damned if you don't" conundrum. If the investment banker continues the engagement, it is exposed to potential liability whether it keeps silent or it unilaterally advises creditors of the existence of the fraud. Even if the investment banker resigns upon learning of the fraud (but without alerting anyone outside the company), it may still be subject to attack from creditors (and perhaps regulators).

Issue: Is the situation different if the company is operating under the protection of the bankruptcy court?
Response: Definitely. If a company is in chapter 11, it is difficult to see how apprising the court could be a bad course of action, particularly since the court is an in-place arbiter.

Conclusion

Experience indicates that client transgressions may increase as a result of insolvency or prospective insolvency, and the investment banker may find its clients balking when urged to "do the right thing." As a result, the investment banker giving advice to insolvent companies must be prepared to deal with the issues associated with inappropriate client behavior, and there appears to be little judicial or regulatory guidance through this ethical minefield.

Therefore, the investment banker needs to be experienced in difficult situations, advised by good counsel, possessed of a steady and firm moral compass and able to make important ethical decisions soberly and rationally in the midst of contentious events.