NBRC Struggles with the Problem of Disinterestedness

Journal Issue:

Dec/Jan 1997

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Editor's Note: A future column will explore the treatment of pre-petition debts owed by the debtor to counsel denied employment as counsel for the estate.

The freedom to choose counsel is particularly important to a debtor contemplating filing for chapter 11 protection. As a company faces the struggle to survive as a going concern, it needs the guidance of trusted and experienced advisors to negotiate the complexities of the bankruptcy process. Bankruptcy courts have long recognized that "[t]he relationship between attorney and client is highly confidential, demanding personal faith and confidence in order that they may work together harmoniously."¹ Sometimes, however, just as a debtor enters into the confusing world of a chapter 11 reorganization, a court determines that the counsel whom the debtor has selected is disqualified from representing it.

While some courts have recognized that "[o]nly in the rarest of cases should a debtor-in-possession under chapter 11 be deprived of the privilege of selecting counsel,"² in practice, a debtor-in- possession is only afforded the privilege of selecting its own counsel if that counsel satisfies the often arbitrary application of the Code's "disinterestedness" requirements.³ As a result, a debtor-in- possession who has developed a trusting relationship with an attorney may be deprived of that attorney's counsel just as the debtor-in-possession faces the most critical time. Disruption of an established professional relationship as the debtor-in-possession faces so many other problems and upheavals is counter-productive to the efficient administration of a chapter 11 reorganization, may decrease the likelihood that a debtor-in-possession will be able to reorganize successfully and, most importantly, interferes with the vital attorney-client relationship.

The Current Standard

The Bankruptcy Code provides that professionals employed by a debtor-in-possession must be "disinterested persons" and may not hold or represent an interest adverse to the estate.⁴ An attorney is disinterested if, among other things, she does not have an interest materially adverse to the estate.⁵ With respect to professionals to be employed by a debtor-in-possession, the requirement that such professional be disinterested is strictly construed by many courts.⁶ Courts have disqualified counsel for reasons including the existence of pre-petition claims for unpaid fees,⁷ prior service as an officer of the debtor-in-possession,⁸ prior representation of the officers and directors of the debtor-in-possession ⁹ and service as an escrow agent from a trans-action between the debtor-in-possession and a creditor.¹⁰ As a result, the counsel that a debtor-in-possession has selected may be disqualified solely based on connections or interests that a court perceives may become a conflict at some point in the future.¹¹ For instance, attorneys have been disqualified due to the fact that the counsel's retainer was paid by a creditor of the debtor-in-possession, for which payment the creditor received a promissory note from the principal of the debtor-in-possession.¹² As a result, an attorney may be disqualified from representing a debtor-in-possession based on relationships that would not violate any state ethical rules or guidelines.

Both courts and commentators have recognized the difficulty that the strict application of the disinterestedness requirement places upon a debtor-in-possession.¹³ Some courts have attempted to work around the Code's requirements to allow a debtor-in-possession some choice in its professionals.¹⁴ However, some of those efforts have been over-turned by higher courts that have stressed the rigid application of the disinterestedness standards.¹⁵

NBRC Action and Reversal

In an effort to address this problem, the National Bankruptcy Review Commission initially adopted a recommendation to amend the Bankruptcy Code to remove the disinterestedness requirement with respect to professionals employed by a debtor-in-possession.¹⁶ Instead, a professional employed by a debtor-in-possession would be disqualified only if it was shown that such professional held an interest that was materially adverse to the estate. This recommendation was adopted to address a number of concerns identified by the Commission, including that the amendment would protect a debtor-in-possession's freedom to choose its counsel and would allow debtors-in-possession to draw upon a larger pool of specialized counsel with sufficient resources for undertaking complex representation.¹⁷

In April, however, the Commission reconsidered its approval of the elimination of the disinterestedness requirement,¹⁸ and in July, it reversed its original recommendation and instead suggested a far more limited amendment that only addresses dis-qualification due to pre-petition claims.¹⁹ In moving away from its original proposal, the Commission dismissed the reasons offered it originally in favor of protecting the perception of the bankruptcy system, arguing that perceived conflicts undermine the confidence of observers of the bankruptcy system.²⁰

Specifically, the Commission stated that providing debtors-in-possession with greater freedom to choose their counsel was "inconsistent with the reality of bankruptcy practice" due to the fiduciary obligation that a debtor and its counsel owe to the estate and its creditors.²¹

As a result of the duty owed by debtors-in-possession and its counsel, the Commission stated that "debtors should not be free to retain counsel—even their own pre-petition counsel—when those counsel will be required to serve conflicting interests." ²²

This statement by the Commission is correct as far as it goes. No one would suggest that bankruptcy attorneys should be exempt from state ethical obligations that prevent attorneys from undertaking representation that results in the counsel having to serve two separate masters. However, one of the purposes of chapter 11 is the rehabilitation of honest debtors.²³ As these honest debtors serve as debtors-in-possession, they need access to rep-resentation and counsel that they have confidence in during their darkest hour. This need is even more acute for small family-owned or closely held companies. Forcing small family-owned or closely held companies to switch counsel while on the brink of disaster without a very good reason is unreasonable and counter-productive.

This is not to say that full disclosure of any relationships the chosen counsel may have is inappropriate. Disclosure is necessary in order to enable a court to fully evaluate the propriety of the approval of counsel selected by the debtor-in-possession; however, the court's review of the relationships or connections between the debtor-in-possession, its counsel and the estate should be done with the presumption that a debtor-in-possession should be allowed to employ the counsel of its choice and not with a view towards setting up unnecessary hurdles for the qualification of the debtor-in-possession's counsel.

The Commission reasons that focusing on a debtor-in-possession's right to choose counsel is misguided because "a debtor's attorney is not free to act only to advance his client's interests; rather, he must serve the policy and goals of the bankruptcy system as diligently as he serves his client."²⁴ However, if these qualifications for debtor-in-possession's counsel are strictly applied, small debtors-in-possession would have no representation available as only King Solomon would be able to negotiate these divided loyalties. As a result, debtors-in-possession are un-necessarily and unreasonably deprived of the counsel of their choice. This deprivation may be instigated by a creditor or other constituency attempting to gain an advantage over the debtor-in-possession. Due to the strict application of the disinterestedness requirement, parties in interest can use the threat of raising possible or potential conflicts as a threat to prevent the debtor-in-possession from retaining the counsel of its choice.

While the Commission refused to do away with the disinterestedness requirement, it has attempted to address some of the more egregious bases for disqualifying debtor-in-possession's counsel. The Commission recommended that the Code be amended to provide that "a person should not be disqualified for employment under §327 solely because such person holds an insubstantial unsecured claim against or equity interest in the debtor."²⁵ This amendment constitutes a step in the right direction. If adopted, it will avoid having a debtor-in-possession deprived of the counsel that has worked with it prior to bankruptcy in formulating a reorganization plan simply because some of the attorney's invoices remain outstanding. The debtor-in-possession should not be deprived of the counsel of an attorney that prior to the filing of a chapter 11 petition has demonstrated a commitment and loyalty to the debtor-in-possession by continuing to work with the debtor and not pressing for payment during difficult financial times.

Conclusion

The Commission's current proposal does not address the need for a more fundamental change regarding the approval of counsel to a debtor-in-possession. The overriding policy should be to allow debtors-in-possession, particularly small debtors-in-possession, relatively broad discretion in selecting their counsel, especially when no creditor objects to that choice. Anyone who has represented small- and mid-sized companies understands the terrible stress and strain that a chapter 11 case places on the lives of the people involved in the case and understands that the financial strain that these companies face makes impractical the hiring of a multitude of lawyers to look out for the stockholders. All parties in interest involved in an operating chapter 11 case should be given as much discretion as possible in choosing the professionals to guide them through these troubled waters.