Consider the following hypothetical: A law firm wishes to be engaged as counsel to the official committee of unsecured creditors. There are 14 members of the committee.

1. Two of the committee members were and remain significant clients of the firm.
2. The firm currently represents numerous other creditors on matters unrelated to the bankruptcy case.
3. Another committee member, a surety, is a plaintiff in a suit alleging that the two committee members who are clients of the putative committee counsel's firm conspired with others to defraud the surety.
4. Prior to the commencement of the chapter 11 case, the firm represented certain institutions who arranged for a $1 billion structured finance offering on behalf of a debtor affiliate, which included the issuance of debtor's stock and an agreement to sell such stock.
5. In the five years prior to the commencement of the chapter 11 case, the firm represented certain of the debtors in 125 transactions, and collected nearly $18 million in legal fees.
6. Nearly $500,000 in fees were paid by the debtors to the firm during the preference period. The firm did not voluntarily repay the putative preference.

Indeed, this is not really a hypothetical. (The reference to Enron in the title to the article was a bit of a giveaway.) The facts are based on the May 23, 2002, (unpublished) opinion of Bankruptcy Judge Arthur J. Gonzalez denying a motion that sought to disqualify the law firm in question—Milbank, Tweed, Hadley & McCloy LLP—from representing the official committee of unsecured creditors in the Enron Corp. chapter 11 case pending in the U.S. Bankruptcy Court for the Southern District of New York, and other publicly available information. In this article, we examine the six issues, the general rules and principles for resolving the question of whether any of them is a basis for disqualification generally, and whether disqualification was appropriate under the particular facts and circumstances of the Enron case. Incidentally, at this writing, the decision has been appealed by the original movant to the U.S. District Court for the Southern District of New York.

Issue 1: Committee counsel represents two committee members in unrelated matters. The general statutory governance for employment of committee counsel is 11 U.S.C. §1103. Section 1103(a) authorizes committees to employ professionals, and §1103(b) requires that such professionals not "represent any other entity having an adverse interest in connection with the case." However, §1103(b) goes on to provide expressly that "[r]epresentation of one or more creditors of the same class as represented by the committee shall not per se constitute the representation of an adverse interest." As summarized by Judge Gonzalez:

This section does not require an attorney to cease representing creditors in matters that (1) are unrelated to the bankruptcy case [see Daido Steel Co. Ltd. v. Official Comm. of Unsecured Creditors, 178 B.R. 129, 131 (N.D. Ohio 1995)], (2) are not adverse to the committee's interests in the bankruptcy case [see Diado Steel Co. Ltd. v. Official Comm. of Unsecured Creditors, 178 B.R. 129, 132 (N.D. Ohio 1995)], or (3) pre-date the professional's employment by the committee. In re Firstmark Corp., 132 F.3d 1179, 1181-83 (7th Cir. 1997).

Therefore, on its face, the first issue seems to be a straightforward loser as a basis for disqualification of committee counsel.

However, the statute says that representation of other creditors is not a per se basis for disqualification. Therefore, it could be the basis for disqualification in some cases. The movant, Exco Resources Inc., argued in substance that Milbank was in thrall to its two significant clients on the committee (JP Morgan Chase and Citibank) and that its advice and counsel to the committee would therefore be inevitably biased toward the interests of those clients and against the interests of the committee as a whole, and the general constituency of unsecured creditors. The court was not impressed by this argument for two reasons. First, there was no evidence of any such bias in fact. Second, the court found it implausible that a committee of 14 members with claims ranging into the billions of dollars would permit itself to be dominated by the views of two of them.² The court also made clear that if at any time in the future there was evidence of conduct inconsistent with the fiduciary duties owed by the committee or its counsel, there were adequate remedies to deal with it (i.e., disallowance of fees). There was thus no reason to disqualify. As discussed below, the court was also satisfied with Milbank's use of conflicts counsel.

Another reason why Milbank's current representations of committee members and other creditors did not give cause for disqualification is that Milbank used "conflicts counsel" to protect itself from actual conflicts of interest and conflicts of independence.³ This has become the trendy technique in megacases where large-firm resources (which come with large-firm conflicts baggage) are needed to administer cases. Given the realities of modern law practice, it is inconceivable to expect that any firm of size and adequate resources to handle the representation of a debtor or committee in a megacase would not have among its clients one or more of the thousands of parties in interest in such cases.⁴ The conflicts counsel, in this case the firm of Squire, Sanders & Dempsey L.L.P., is employed as a second law firm by the creditors' committee in order to investigate claims or otherwise handle matters involving Milbank clients or other situations in which Milbank might have a conflict of interest or independence. (Squire, Sanders & Dempsey prepared and filed the committee's opposition to the motion to disqualify.)

Issue 2: Committee counsel representation of creditors (not committee members) in unrelated matters. The Issue 1 analysis governs and suggests strongly that there is no representational disability. Conflicts counsel can also be expected to play an important role in assuring that such relationships do not compromise the Milbank firm's representation of the committee.

Issue 3. Conflicts between committee members, including those represented by counsel in unrelated matter. There is nothing in the applicable rules and precedents that would mandate disqualification of a committee counsel on the basis of a conflict of interest (litigation adversity in this case) between the committee members who are counsel's clients in other matters, and other committee members. Intercreditor conflicts on committees are quite common. One would ordinarily expect such a conflict to be vetted by the committee members in the initial deliberations to select counsel (and one would also expect that in the case of a significant conflict between committee members concerning a particular law firm, that law firm would not be engaged). Thus, if the creditors' committee has selected the counsel notwithstanding the adversity between or among its members, that ought to be the end of it insofar as qualification to serve as committee counsel is concerned.

While the May 23 decision of the court does not discuss this particular issue at length, it appears from the opinion that the movant made this argument in order to buttress its assertion that Milbank was (or potentially could have come) under the undue influence of JP Morgan Chase and Citibank. Judge Gonzalez notes that Exco alleged (without presenting evidence) that Milbank and its two creditor clients were conspiring to keep important information away from other committee members. It was not enough to overcome the court's satisfaction with the conflicts counsel arrangement and the court's ability to resort to economic penalties to redress any prospective violation of fiduciary duties.

Issue 4: Counsel's representation of debtor's pre-petition structured finance transaction and related stock issuance. Under the Bankruptcy Code, §327 governs the employment of professionals by the debtor (as distinct from §1103, which applies to committee professionals). One of the basic distinctions between the two employment statutes is that §327 requires disinterestedness, while §1103 does not. The definition of "disinterested person" in §101(14) includes that the person "has not been, within three years before the date of the petition, an investment banker for a security of the debtor, or an attorney for such an investment banker in connection with the offer, sale or issuance of a security of the debtor." To take advantage of this potential basis of disqualification, Exco argued that committee counsel should be tagged with a disinterestedness requirement, and that the Milbank firm's representation of parties making structured finance monies available to the debtors, with related stock issuance features, was tantamount to serving as counsel to an investment banker in connection with the issuance of a security of the debtor.

An anomaly of the Bankruptcy Code is that §328 permits a court to deny compensation to a committee professional who holds an adverse interest and is not disinterested, even though §1103 does not require disinterestedness in order to be employed. Judge Gonzalez found that there was some precedent for reconciling this conflict by applying the §328 requirements as additional considerations for determining employment eligibility under §1103 (citing, in particular, In re Caldor Inc., 193 B.R. 165, 170-71 (Bankr. S.D.N.Y. 1996)).

Once conceding that Exco might have a disinterestedness point of relevance to Milbank's engagement, however, Judge Gonzalez felt strongly that the employment application was a most inappropriate context in which to consider significant transaction recharacterization issues. The structured finance transactions were loans on their face, and the represented parties were not investment bankers in the deal. In fact, the court noted that it was already a specified duty of Squire, Sanders & Dempsey, as conflicts counsel, to consider the transactions in question and their proper characterization. Thus, whether or not lack of disinterestedness could be a basis for disqualification, Judge Gonzalez found that Milbank was disinterested on the record before him.⁵

Issue 5: Firm's pre-bankruptcy representation of debtors in 125 transactions representing $18 million in fees. This issue sounds bad, but it is really quite simple and non-controversial. Regardless of the size of the prior work, assuming that Milbank does not continue to represent any debtor entities, this is a classic conflict of interest that can be solved with the debtor's consent and appropriate ethical walls to protect the debtors' confidences. The debtors did consent, and Milbank erected an ethical wall around every attorney who ever worked for Enron entities, including (at the behest of the U.S. Trustee) requiring such attorneys to sign confidentiality agreements.⁶

Issue 6: Firm's receipt of putative preference. The typical means of solving potential preference issues that might make a debtor or committee professional adverse to the estate, and therefore able to be disqualified, is to give the money back and waive the unsecured claim that would otherwise be available. In this case, Milbank kept the money, but only pending the outcome of an investigation by a court-appointed examiner (who was charged with covering a multitude of issues, including the question of whether the pre-petition payment to Milbank was a preference). Milbank agreed that it would not defend a preference action, but instead would abide by the examiner's findings and would therefore return the money and waive the unsecured claim if the examiner found it was a preference. The court thus found that "Milbank's agreement to waive any right to challenge the examiner's determination concerning any preference has the same effect as a professional waiver of a claim in order to satisfy the disinterested standard of §101(14)(A)—an accepted practice that has been employed in this case, and many other cases. See, e.g., In re Adam Furniture Indus. Inc., 158 B.R. 291, 297 (Bankr. S.D. Ga. 1993)."

Would the outcome have been different if the motion to disqualify had been promptly made? The discussion above attempts to describe the relevant issues and law with some degree of academic neutrality. However, no case is decided in a vacuum, and in this case there were some important reasons why the court may have been inclined to lean in Milbank's favor where it had discretion to do so. After covering the factual background, and before undertaking an analysis and discussion of the conflicts and ethics rules in question, the court's first discussion of substance concerned the movant's delay in seeking disqualification. Milbank's employment application was filed and served on Jan. 15, 2002, and was approved (unopposed) on Jan. 28, 2002. The Exco motion to disqualify was made on March 19, 2002.

Experienced practitioners may not regard the less-than-two-months' delay as undue, but Judge Gonzalez made clear why he considered it completely unreasonable in the circumstances of the case. Before he addressed the delay, he took care to note that as of the date of the decision in May (nearing the six-month mark for the case) there were already nearly 4,000 docket entries, dwarfing by many magnitudes the filing activity in every other recent large case. As of the date Milbank filed its employment application, there were 949 docket entries and 158 orders entered:

These numbers are an indicator of the degree of involvement of the committee (and its counsel). However, they do not tell the whole story. They do not address the numerous activities performed by the committee (and its counsel) that are not brought before the court, such as its interplay with management, its involvement in the business plan, etc. Nor do they provide detail of the contested nature of many of the proceedings before the court, including the billions of dollars of asset sales. But they do provide some insight into the level of activity in this case and the importance of addressing issues of disqualification of counsel in the early stages of any case—especially one that is as active and complex as this one.

But that was not all. Exco was an active party in the case from a very early stage. It filed its first pleading less than two weeks after the chapter 11 cases were commenced, on Dec. 13, 2001, and the court noted that Exco had joined a motion and participated in a hearing on Jan. 7, 2002. In addition, the court took note of Exco's hostility to the creditors' committee from an early stage. (Exco apparently alleged at an earlier time that the committee had breached its fiduciary duty to certain creditors.)

Judge Gonzalez pointedly referred to Exco's failure to object to Milbank's original application, and its further failure—once it did file its objection on March 19—to have its motion to disqualify heard with any expedition. "Exco was in no rush to have a hearing to rid the committee of its 'unqualified' counsel." Absent special cause, a hearing in the Southern District of New York could have been scheduled for 10 days' notice, or by March 29, and for cause shown that the bankruptcy court judges can be persuaded in appropriate cases to shorten that time. Judge Gonzalez had entered a case management order that also made April 16 available for a hearing. Here, for reasons not explained on the record, Exco scheduled the hearing for May 16, an unusually long two months from the date of its motion. From the court's perspective, this conduct was completely inconsistent with Exco's request for relief. On the one hand, Exco complained that Milbank had taken and was continuing to take actions as committee counsel adverse to the committee, suggesting a need for urgency. On the other hand, its actions in seeking relief were anything but urgent.

Thus, the court's decision to begin its opinion by discussing the movant's delay, prior to addressing the underlying merits, was clearly deliberate. "Delay in bringing any motion to disqualify counsel is generally frowned upon because of the disruption it would cause to the case. This is especially so in a bankruptcy reorganization in which a disruption, in addition to causing delay in getting a decision or a judgment or payment of money, causes a loss of value—value that cannot be regained." The court concluded the discussion by declaring that "the delay here would provide a separate ground to deny the relief sought."

The question presented then is what might the court have done with the motion had it been made more promptly and urgently. Reviewing the six issues, it is not apparent that any of them would or should have been resolved any differently had an objection been raised to the original employment application. There is no apparent time aspect to the question of whether committee counsel can represent committee members or other creditors in unrelated matters, nor is there a time aspect to the question of whether conflicts among committee members are a basis of counsel disqualification. The prior debtor representations and the alleged preference payment are also issues, an analysis of which could not conceivably be affected by delay. On the question of whether Milbank was in thrall to its two committee member clients, the issue for the court was its hypothetical nature. A more prompt motion would not have adduced anything more concrete. This leaves the issue of whether Milbank should be disqualified as not disinterested by virtue of having served as underwriter's counsel.

It is possible that had objection to Milbank's retention been made at the outset, the court might have been more receptive to either conducting a mini-trial on the potential recharacterization of the structured finance transaction, or permitting time for further inquiry to be made by conflicts counsel or the examiner. While the court's concerns about the intensity of the case and potential loss of value would not have been eliminated, they might have been mitigated in comparison to having these issues raised for the first time after four months of Milbank's time had been spent in the cases.

On the other hand, in light of the fact that the asserted underwriter basis of disqualification was two steps removed from the employment statute, §1103 (distinterestedness has to be engrafted from §328, and the structured finance transaction has to be recharacterized), it is perfectly reasonable to assume that the court would have seen the issue the same way. Assuming for the sake of argument that Milbank could be considered a pre-petition underwriter's counsel, disqualification remains discretionary under the circumstances. There is thus no reason to believe that a more timely motion to disqualify would have led to a different result in this case.

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Footnotes

¹ This article expresses the author's opinions and is not by any means (nor intended to be) an exhaustive or definitive analysis of the relevant conflicts rules. Special thanks are due to Andrew Shaffer, a bankruptcy associate in the New York office of Mayer, Brown, Rowe & Maw, who assisted with the research. Return to article

² In fact, the creditors' committee—on authority of a unanimous vote—filed papers supporting Milbank and opposing disqualification. Return to article

³ Conflict of independence, as distinguished from conflict of interest, describes the situation in which firm clients on matters unrelated to the case-in-chief are substantial enough clients of the firm (measured in most cases by magnitude of fees) such that counsel might be influenced (perhaps not consciously or deliberately) to favor them in adverse dealings. Return to article

⁴ Conflicts counsel is an invention. The Code does not expressly permit or prohibit the employment of such counsel. Because it innoculates against conflicts disqualification a firm that might otherwise not be employable under the Code, and otherwise adds a second firm's expense (though one could argue that the fees of the two firms in the aggregate should not exceed what one firm would have incurred absent the conflicts), I presume (without having substantiated this with research) that the use of conflicts counsel has rarely, if ever, been approved in cases of modest size, or otherwise in circumstances where the rationale of few available firms for the job cannot be sustained. Return to article

⁵ What happens if Squire, Sanders & Dempsey finds that the transaction was a disguised securities underwriting, such that Milbank should be considered counsel to an underwriter and therefore not disinterested? It is highly unlikely that such a finding would be considered cause for disqualification. Section 328(c) is expressly precatory, and seems intended to apply to prospective adversity and disinterestedness—the type that might be expected to have a negative impact on the counsel's performance of duties—notwithstanding the fact that the §101 definition of disinterested person covers three years of history where investment bankers are concerned. Moreover, given the court's rather strong denunciation of Exco's position (for reasons of delay, as well as the merits, as discussed more fully below), it does not seem reasonable to assume that the court would give any great weight to prospective recharacterization of the structured finance transaction insofar as Milbank's eligibility to serve as committee counsel is concerned. Return to article

⁶ Exco observed that the firewalls had the effect of undermining representations that the Milbank firm made in order to win the committee counsel beauty contest. According to Exco, one of the selling points of the Milbank firm was its expertise in structured finance transactions. As a consequence of the firewalls, it is unlikely that Milbank can call on such expertise in the service of the committee. However, assuming this is true, it is still not a basis for disqualification. If anything, it is a matter that can and should be addressed, if at all, by the client committee, which of course retains the power to discharge its counsel if it believes it was misled. The committee's unanimous support of Milbank tends to show that it does not feel itself aggrieved by the firewalls. Return to article