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Ethical Trilogy Something Old Something New Something Borrowed

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Editor's Note:I am pleased to announce that one of the co-editors of this column, Michael Richman, has been selected as ABI's President-elect, proving once again the value of reading and writing for "Straight & Narrow."

This month's "Straight & Narrow" addresses the ethical implications of three recent decisions: (1) In re United Artists Theatres Co.2 (addressing professional indemnification agreements), (2) In re ICM Notes Ltd.3 (addressing whether a particular creditor can sue a chapter 11 debtor's counsel for malpractice) and (3) Grausz v. Englander4 (addressing issues of res judicata arising from approvals of final fee applications).

Something Old: Grausz v. Englander

In an article titled "When and Where: Limits on Malpractice Claims Against Debtor's Counsel," published in October 2000,5 "Straight & Narrow" addressed the developing doctrine of final fee awards barring subsequent malpractice suits against bankruptcy professionals. That article noted that courts in the Fifth Circuit6 were beginning to hold that the approval of a final fee application for a professional in a bankruptcy case was res judicata with regard to subsequent professional malpractice claims against that professional if the plaintiff knew or should have known of the malpractice case. Shortly after "When and Where" was published, the First Circuit adopted the Fifth Circuit's reasoning in the case of In re Iannochino.7

Recently, the Fourth Circuit joined the Fifth and First Circuits in holding that approval of final fee applications bars malpractice actions on res judicata grounds in its decision of Grausz v. Englander.8

In Grausz, a doctor filed a chapter 11 petition. Shortly after the filing, the debtor's counsel (initial counsel) negotiated a settlement agreement with the debtor's primary creditor that reduced that creditor's claim from $6.5 million to $4 million based on certain conditions, including: (1) the debtor's filing full and complete amended schedules, (2) an agreement that if those schedules were not complete, the creditor could pursue a dischargeability action against the debtor, and (3) the debtor's agreement that a breach of his warranty of the completeness of the amended schedules would constitute a post-petition breach of the settlement agreement.

The Grausz case represents the latest in what is becoming a well-established line of decisions holding that final fee orders centrally bar subsequent malpractice suits.

The initial counsel and debtor prepared amended schedules that were later determined not to be complete and that ultimately led to the denial of the debtor's discharge. The debtor accused the initial counsel of negligence in negotiating the settlement agreement and in advising the debtor about preparing his amended schedules. A trustee was appointed, and the debtor dismissed his initial counsel and retained new counsel to defend him in a suit seeking denial of the debtor's discharge. After the denial-of-discharge suit had been filed against the debtor, the initial counsel filed its interim and final fee applications for its work in the chapter 11, which were not objected to by the debtor.

Sometime after the fee applications were filed and approved, after losing his non-dischargeability suit, the debtor filed a malpractice suit against his initial counsel in state court.

The initial counsel removed the malpractice suit to the U.S. District Court for the District of Maryland, asserting bankruptcy jurisdiction as the grounds for removal. The initial counsel also moved for summary judgment or dismissal of the suit on the grounds of res judicata. The debtor moved for remand, arguing a lack of jurisdiction, and also disputed the res judicata effect of the final fee order. The district court granted the initial counsel's summary judgment motion and denied the remand motion as moot. The debtor appealed.

In affirming the district court's decision, the appeals court in Grausz initially held that malpractice actions based on alleged negligence in pre- and post-petition advice concerning a bankruptcy case are subject to bankruptcy jurisdiction and can be removed from state to federal court even if the claims are not property of the bankruptcy estate.9

After determining it had jurisdiction, the Fourth Circuit found that all elements of res judicata10 had been met in this case. However, the Grausz court held that even if all formal elements of res judicata are met, a malpractice action will still not be barred unless the court finds that (1) the plaintiff knew or should have known before the final fee application of the real likelihood of a malpractice claim and (2) the final fee application proceeding was an effective forum to litigate malpractice claims. Like the Fifth and First Circuits, the Grausz court found that (1) under the facts of its case, the debtor knew of the possible malpractice claim, and (2) final fee applications are an effective forum to litigate malpractice cases, even if the plaintiff has the right to a jury trial of its malpractice suit.11

The Grausz case represents the latest in what is becoming a well-established line of decisions holding that final fee orders centrally bar subsequent malpractice suits. It is particularly useful that it makes clear that even pre-petition advice related to a bankruptcy case is related to that case and that lawsuits based on it are removable to bankruptcy courts. These decisions are greatly reducing the threat of malpractice suits that might arise from representations of debtors in bankruptcy cases.

Something New: ICM Notes Ltd.

In ICM Notes, the Fifth Circuit clarified the duties that counsel for a chapter 11 debtor owes to parties in a bankruptcy case. A brief discussion of the facts of the case is important to an understanding of the ICM decision.

In October 1997, ICM Inc. filed a chapter 11 proceeding in the Southern District of Texas. Andrews & Kurth LLP (A&K) was approved by the court as debtor's counsel. As part of the bankruptcy, the pre-petition lender agreed to a cash collateral order that provided for payments of up to $200,000 in estate professional fees to be paid from the lender's cash collateral. During the case, an entity called ICM Notes Ltd. purchased the lender claims. In September 1998, the debtor obtained approval of a plan that provided for the sale of the debtor's assets for $530,000. Under the plan, $220,000 of the $530,000 would be used to pay professional fees. No professionals agreed to limit their fees to $220,000.

Ultimately, the plan fell apart when neither ICM Notes nor the debtor were willing to pay the court-approved administrative expenses, including professionals' fees in excess of $220,000. This impasse allowed the purchaser under the plan to withdraw from the purchase transaction. During these negotiations, A&K informed ICM Notes that the sale could not close unless all administrative expenses were paid in full or arrangements were made for the payment of these fees. After the sale fell through, ICM Notes obtained stay relief and purchased the debtor's assets at the foreclosure sale. ICM Notes then filed suit against A&K for breach of fiduciary duty and tortious interference with contract. A&K moved to dismiss the lawsuit on a number of grounds, including that (1) A&K did not owe a direct fiduciary duty to ICM Notes, (2) ICM Note could not assert a breach of fiduciary duty claim on behalf of the estate and (3) A&K did not breach any duties it might have owed ICM Notes.

Initially, the district court held, as a matter of law, that counsel for the debtor in a chapter 11 case did not have a fiduciary duty running to a particular creditor or party in interest. The district court noted that while the counsel owed a duty to the bankruptcy estate and to "both the client debtor-in-possession and the bankruptcy court,"12 it would be improper to extend that duty to individual creditors. The court's discussion of various cases concerning debtor's counsel's duties is particularly useful, as it demonstrates the subtle but important differences of opinion between courts concerning those duties owed by debtor's counsel.13

However, the case was not dismissed, as the district court found that genuine issues of material facts remained unresolved on the tortious interference issue, which precluded summary judgment. The Fifth Circuit affirmed, based on the reasoning of the district court's opinion.

The ICM decision is important because it represents one of the few circuit-level decisions concerning the scope of counsel for the debtor's duties in chapter 11 cases, as well as a clear statement that the debtor's counsel owes no fiduciary duties to specific creditors.

And Something Borrowed:14 In re United Artists

For a number of years, professionals have sought court approval of various terms of indemnification or exculpation with debtors and their committees. In January 2003, the Third Circuit became the first appeals court to address the important issue of whether such provisions are permissible under the Bankruptcy Code.15

In 2000, United Artists Theatre Co. and its affiliates filed chapter 11 bankruptcies in Delaware that were assigned to the U.S. District Court. In connection with their bankruptcy pleadings, the debtors sought to retain Houlihan Lokey Howard & Zukin (HL) as their financial advisors. As part of its retention agreement, HL sought to have the debtors indemnify it for all reasonable attorneys' fees and expenses, as well as all losses that could be incurred by HL related to the services that it was to provide the debtors, except for losses that were determined to have resulted solely from HL's "gross negligence, bad faith, willful misfeasances or duties."16 The U.S. Trustee objected to the indemnification provisions, arguing they were not authorized by the Code17 and were per se unreasonable under 11 U.S.C. §§328 and 330. The district court overruled the U.S. Trustee's objections. Shortly thereafter, the U.S. Trustee approved a pre-negotiated plan, and the U.S. Trustee timely appealed approval of the indemnity provisions in HL's retention agreement.

Initially, the United Artists court rejected the U.S. Trustee's position that professional indemnity provisions were not categorically prohibited by the reasonableness standard of 11 U.S.C. §328(a). In reaching this conclusion, the court noted that (1) there was no clear prohibition against such provisions in 11 U.S.C. §328; (2) such agreements are becoming more common in the general marketplace; (3) the majority of recent case law has determined that indemnity provisions can be approved as reasonable on a case-by-case review of the circumstances of the case and the terms of the agreement; and (4) that the financial advisors were not ethically or legally prohibited from seeking such indemnification provisions.18

Of special importance in this case is that federal law should govern the determination of whether indemnity provisions are appropriate and that Delaware law should be applied by analogy to determine that issue. The United Artists majority then discussed in detail the duty financial professionals owe estates and determined, somewhat surprisingly, that financial professionals do not owe fiduciary duties to bankruptcy estates. The court stated:

[t]hough directors and officers are fiduciaries of the corporations they serve, we do not hold financial advisors like Houlihan Lokey to be fiduciaries. Still, in the bankruptcy context they may owe a higher level of care than in ordinary practice [citations omitted]. The upshot for this case is that, to the extent that fiduciaries may obtain indemnity for their negligence, financial advisors in bankruptcy (who may or may not be fiduciaries) may do the same.
315 F.3d 217, 231, n.14 (emphasis added).

Notwithstanding the court's intention to indicate the appropriateness of financial advisors' seeking and obtaining indemnity provisions in their retention agreements, the "statement" that financial advisors employed by a debtor may or may not be fiduciaries of a debtor's estate calls into question this: What standard of care do financial advisors employed by a bankruptcy estate owe that estate?19

Although United Artists answered the question of whether indemnification provisions were not per se prohibited under the Code, it has raised many new issues, including (1) the duty of care owed to chapter 11 debtors by financial professionals hired by those debtors, (2) the role of state law in determining whether financial professionals can ethically seek indemnification provisions and (3) the ability of attorneys who are generally prohibited under applicable state law from limiting their liability for malpractice in their retention agreements to attempt to seek such limitations without court approval if a federal standard governs the permissibility of indemnity provisions. The answer to the last question is most likely "no," given that such provisions are not ordinarily obtained or sought in non-bankruptcy situations, and that state ethical rules often prohibit such agreements. On the other hand, with United Artists ruling that federal law, not state law, governs what terms are permissible in an employment or retention agreement, it is arguably an open issue. Therefore, while the final credits on United Artists have rolled (at least at the circuit court level), bankruptcy professionals will have to wait for sequels before they learn the true impact of this decision.


These decisions demonstrate that ethical issues in bankruptcy cases are gaining more appellate attention, and that it is likely that the law of bankruptcy ethics will increasingly be made by appeals courts rather than bankruptcy courts.


1 Board-certified in business bankruptcy by the American Board of Certification. Return to article

2 315 F.3d 217 (3rd Cir. 2003). Return to article

3 2003 WL 956231 (5th Cir. March 11, 2003,) aff'g. ICM Notes v. Andrews & Kurth, 278 B.R. 117 (S.D. Tex. 2002). Return to article

4 321 F.3d 467 (4th Cir. 2003). Return to article

5 19 Am. Bankr. Inst. J. 8 (Oct. 2000). Return to article

6 In re Intelogic Trace Inc., 200 F.3d 382 (5th Cir. 2000); In re Southmark, 163 F.3d 925 (5th Cir. 1999). Return to article

7 242 F.3d 36 (1st Cir. 2001). Return to article

8 321 F.3d 467 (4th Cir. 2003). Return to article

9 321 F.3d at 472. Return to article

10 Under res judicata, a claim will be precluded when (1) the prior judgment was final and on the merits, and rendered by a court of competent jurisdiction in accordance with the requirements of due process; (2) the parties are identical, or in privity, in the two actions; and (3) the claim in the second matter [is] based upon the same cause of action involved in the earlier proceeding. Citing In re Varat Enters. Inc., 81 F.3d 1310, 1315 (4th Cir.1996). Id. at 321 F.3d at 472. Return to article

11 Id. at 474. Return to article

12 278 B.R. at 122. Return to article

13 Id. at 123-126. Return to article

14 This portion of the article is based on a more in-depth article that is scheduled to be published in the May issue of Norton Bankruptcy Law Advisor. Return to article

15 In re United Artists Theatre Co. v. Walton, 315 F.3d 217 (3rd Cir. 2003). Return to article

16 This limitation was later reduced by the Third Circuit, which struck down the "sole cause" exception to the indemnity provisions. Return to article

17 See "Interview with EOUST Director Lawrence Friedman," 22 ABI Journal (February 2003). Return to article

18 The United Artists court, however, was badly divided as to how the indemnification agreement should be interpreted. Such a discussion is beyond the scope of this article. Return to article

19 315 F.3d at 230, n. 14 (citations omitted). Return to article

Journal Date: 
Sunday, June 1, 2003

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