Comment 1 to Rule 1.7 of the ABA Model Rules of Professional Conduct (Model Rules) makes it clear: "[l]oyalty and independent judgment are essential elements in the lawyer's relationship to a client." Courts have explained that these and other rules governing professional conduct "are often viewed as even more necessary in bankruptcy cases than in other contexts."¹ In In re Meridian Automotive Systems-Composite Operations, Inc. (MASCO),² the U.S. Bankruptcy Court for the District of Delaware disqualified a prominent law firm (the law firm) from representing a client because the representation conflicted with the duties that the law firm owed to a former client. This column will explore (1) the facts and analyses of the bankruptcy court in MASCO and (2) some of the arguments raised by the law firm.

Facts

Stanfield Capital Partners LLC (Stanfield) was a pre-petition secured creditor of MASCO and its affiliates (the debtors) who possessed first- and second-priority liens on the debtor's assets. Stanfield hired the law firm to analyze the credit agreements between the first and second lenders. The purpose of the engagement was for the law firm to identify provisions "that might affect the second-lien lenders' plan to provide additional financing to the debtors secured by first-priority liens in accounts receivable."³

Immediately before the bankruptcy filing, the debtors obtained a commitment for a debtor-in-possession (DIP) credit facility that would have allowed the debtors to pay off the first lienholders in full. The first lienholders, who also held second-lien claims, formed an informal committee (FLC). The FLC hired the law firm "to advise it with respect to intercreditor issues that might arise if the [DIP credit facility] was not approved by the [c]ourt."

After the debtors filed for bankruptcy, the court entered interim orders approving the DIP credit facility. But the debtors failed to meet the conditions necessary to obtain a final order. This forced the debtors to seek other financing that would leave intact and prime the first- and second-priority debt. The court approved this financing, and the law firm continued to represent the FLC on the "intercreditor issues after entry of the final DIP order."

Stanfield filed a motion to disqualify the law firm from representing the FLC, arguing that (1) since it was a current client of the law firm, the law firm was prohibited from representing the FLC under Model Rule 1.7(a), and (2) even if it was not a current client of the law firm, the law firm violated a duty owed to Stanfield as a former client under Model Rule 1.9(a). Stanfield asserted that "the intercreditor issues for which it retained [the law firm] are the same as those arising in these cases since the collapse of the [DIP credit facility]."

Stanfield Terminated the Firm and Is Not a Current Client

As stated above, Stanfield argued that the law firm was prohibited from representing the FLC because of a conflict of interest with a current client. Generally, and relevant here, Model Rule 1.7(a) prohibits a lawyer from representing "a client if the representation involves a concurrent conflict of interest. A concurrent conflict of interest exists if...the representation of one client will be directly adverse to another client...."

Stanfield argued that the law firm continued to represent it because it did not terminate the law firm and the law firm did not withdraw its representation. However, the court quickly dispensed with this argument and concluded that Stanfield terminated the law firm approximately two months before the law firm began its representation of the FLC. Specifically, the court looked at an exchange of e-mails between Stanfield and an attorney at the law firm in which the attorney asked the fund manager in charge of Stanfield's Meridian investments whether Stanfield intended to utilize the law firm for the debtors' upcoming bankruptcy. The fund manager replied that "[t]he consensus was that [the law firm] was going to be too busy...so we really just decided to move on."⁴ The court concluded that this was enough evidence of Stanfield's termination of the law firm because if the fund manager "intended to utilize [the law firm], he naturally would have said so in response to [the attorney's] open-ended inquiry. Thus, the law firm did not violate Model Rule 1.7(a).⁵

Law Firm Violates Duty to Former Client

Even though Stanfield was not a concurrent client of the law firm, the law firm could still violate the Model Rules if the law firm violated its duties to Stanfield as a former client. Model Rule 1.9(a) prohibits a lawyer who has formerly represented a client in a matter from "thereafter representing another person in the same or a substantially related matter in which that person's interests are materially adverse to the interests of the former client unless the former client gives informed consent, confirmed in writing."

The law firm conceded that Stanfield's interests and the interests of the FLC were materially adverse and that the law firm did not seek informed written consent from Stanfield before representing the FLC. Instead, the law firm argued that the Stanfield and FLC representations did not involve the same or substantially related matters. But even if it did, the law firm argued, Stanfield consented to its representation of the FLC.⁶

Same or Substantially Related Matter Defined and Applied

As the court pointed out, the Model Rules do not define what constitutes "the same or substantially related matter" for purposes of Model Rule 1.9(a). However, the court looked to the comments to Model Rule 1.9 for guidance in defining the "matter" involved:

The scope of a "matter" for purposes of this Rule depends on the facts of a particular situation or transaction. The lawyer's involvement in a matter can also be a question of degree. When a lawyer has been directly involved in a specific transaction, subsequent representation of other clients with materially adverse interests in that transaction is clearly prohibited. On the other hand, a lawyer who recurrently handled a type of problem for a former client is not precluded from later representing another client in a factually distinct problem of that type even though the subsequent representation involves a position adverse to the prior client... The underlying question is whether the lawyer was so involved in the matter that the subsequent representation can be justly regarded as a changing of sides in the matter in question.

Stanfield argued that the debtors' pre-petition debt structure was the "matter" for which it and the FLC hired the law firm. The law firm, on the other hand, argued that Stanfield hired the law firm to analyze "a discrete refinancing transaction...that was mooted by the debtor's bankruptcy filing."⁷

The court, however, agreed with Stanfield and concluded that "[w]hile Stanfield's immediate objective in hiring [the law firm] was to implement the proposed receivables facility, its ultimate objective was to protect its second-lien position."⁸ The court explained that the law firm, in outlining the steps necessary for the debtor to implement the proposed DIP credit facility, discussed many of the concepts that were also relevant to the debtors' present DIP financing. In addition, during its representation of Stanfield, the law firm explained to Stanfield how it could protect its position vis-á-vis the other lenders. As the court found, the law firm "described this work as 'a matrix containing...analysis of the various intercreditor issues arising in respect of the first- and second-lien loan positions for Meridian.'"⁹ The law firm was now providing the FLC with advice concerning the same intercreditor issues, this time advising the FLC how the first-lien creditors would protect themselves from the second-lien creditors, which, importantly, included Stanfield.

The court concluded that such representation of Stanfield and later the FLC regarding their rights under the credit documents amounted to "changing sides in the matter in question."¹⁰ As a result, "the FLC and Stanfield representations concerned the 'same matter' under Model Rule 1.9(a)."¹¹

The Law Firm's Arguments

The law firm argued unsuccessfully that the matters were not "substantially related" under Model Rule 1.9 because the sole purpose of Model Rule 1.9 is to protect client confidences, and since it did not obtain any confidential information from Stanfield, Model Rule 1.9 had not been violated."¹² The law firm cited the court to Integrated Health Services of Cliff Manor Inc. v. THCI Co.¹³ and Satellite Financial Planning Corp. v. First Nat'l. Bank of Wilmington.¹⁴

In THCI Co., Arent Fox advised Integration Health Services (IHS) regarding certain regulatory obligations associated with a transfer of its stock under a stock purchase agreement. Arent Fox's representation of IHS terminated when the stock was transferred.

THCI was the current owner of the properties on which the plaintiffs operated nursing home facilities. The plaintiffs filed a state court declaratory judgment action against THCI seeking various rulings on the validity/invalidity of the leases as well as certain other lease terms. Thereafter, the plaintiffs sought to disqualify Arent Fox under, among other Rules, Model Rule 1.9(a) from representing THCI because of its earlier representation of IHS.

The court looked solely at the "substantially related" prong of Model Rule 1.9(a). The court, quoting Satellite Financial Planning, stated the test for the "substantially related" prong:

In order to determine whether Arent Fox has violated Rule 1.9(a), the court must make a "painstaking analysis of the facts" and answer the following three questions:

1. What is the nature and scope of the prior representation at issue;
2. What is the nature of the present lawsuit against the former client; and
3. In the course of the prior representation, might the client have disclosed to his attorney confidences which could be relevant to the present action and in particular, could any such confidences be detrimental to the former client in the current litigation?

The court, in answering the first and second questions, found that Arent Fox represented IHS solely on regulatory matters and not on any matters involving the leases at issue.¹⁵ In discussing the third question, the court explained that it "should not look to what information the attorney or [firm] actually acquired from the former client but whether the attorney 'might have acquired information relating to the subject matter of his subsequent representation.'"¹⁶

The court continued to look at the parties' relationship and explained that the information supplied to Arent Fox by IHS related solely to the regulatory issues. Although the plaintiffs argued that even though Arent Fox was hired for regulatory work, it would not have been unusual for it to receive information relating to the structure and financing of certain other entities. But the court explained that for it "to find that relevant confidential information 'might' have been communicated in this...case, it would be forced to hypothesize a conceivable but unlikely situation."¹⁷

The bankruptcy court in MASCO disagreed with the law firm's analysis of the "substantially related" prong under Rule 1.9(a), finding that THCI Co. and Satellite Financial Planning did not fully state the Rule 1.9(a) test. Once again looking at the comments to Rule 1.9(a), the court recognized that "[m]atters are 'substantially related' for purposes of [Rule 1.9(a)] if they involve the same transaction or legal dispute or if there is a substantial risk that confidential factual information as would normally have been obtained in the prior representation would materially advance the client's position in the subsequent matter."¹⁸ Thus, as the court concluded, although the risk of obtaining client confidences in a previous representation would satisfy the "substantially related" prong of Model Rule 1.9(a), it is not a necessary predicate.¹⁹ The law firm's representation of Stanfield and the FLC "with respect to the same loan documents raises duty-of-loyalty concerns that are alone sufficient to support a violation of Model Rule 1.9."²⁰

Law Firm Did Not Obtain Informed, Written Consent

Model Rule 1.9(a) provides a built-in exception to the general rule that an attorney cannot represent a former client in a same or substantially related matter. This exception provides that if the former client gives his informed, written consent, there is no violation of Model Rule 1.9(a). Informed consent is defined by Model Rule 1.0(e) as "the agreement by a person to a proposed course of conduct after the lawyer has communicated adequate information and explanation about the material risks of and reasonably available alternatives to the proposed course of conduct." Comment 7 to Model Rule 1.0 explains this definition:

Obtaining informed consent will usually require an affirmative response by the client or other person. In general, a lawyer may not assume consent from a client's or other person's silence. Consent may be inferred, however, from the conduct of a client or other person who has reasonably adequate information about the matter.²¹

Moreover, "confirmed in writing" is defined as:

informed consent that is given in writing by the person or a writing that a lawyer promptly transmits to the person confirming an oral informed consent... If it is not feasible to obtain or transmit the writing at the time the person gives informed consent, then the lawyer must obtain or transmit it within a reasonable time thereafter.²²

The law firm in MASCO argued, again unsuccessfully, that among other things, Stanfield impliedly consented to the law firm's representation of the FLC.²³ First, the law firm asserted that Stanfield consented by failing to bring the conflict to the law firm's attention in a reasonable time. The court quickly shot down this argument, explaining that the law firm was already representing the FLC when Stanfield received notice of the representation; thus, the law firm had already violated Model Rule 1.9(a).

Second, the law firm argued that the Final DIP Order confirmed Stanfield's consent because the order authorized the payment of the law firm's attorneys' fees for representing the FLC.²⁴ The court explained that the Final DIP Order did not qualify as a "confirmatory writing" under Rule 1.9(a) because "it was neither 'given by' Stanfield nor 'transmitted by' the law firm.²⁵

Conclusion

The bankruptcy court in MASCO makes it abundantly clear that a conflict of interest can arise even if no confidential information could have been gained by the law firm's prior representation. Thus, bankruptcy professionals, as well as all professionals subject to the ethics rules, are subject to disqualification if they switch sides and represent a new client in a matter that is the same as or substantially similar to the matter in which it represented its former client. Moreover, the bankruptcy court in MASCO strictly interpreted what constitutes informed, written consent for purposes of waiving a conflict with a former client. Thus, if a conflict of interest exists under Model Rule 1.9(a), counsel should obtain written permission from its former client before taking on the representation, unless counsel accepts the risk of disqualification.

 

---

Footnotes

1 See In re Meridian Automotive Sys.-Composite Ops. Inc., 340 B.R. 740, 750 (Bankr. D. Del. 2006) (quoting Century Indem. Co. v. Congoleum Corp. (In re Congoleum Corp.), 426 F.3d 675, 686 (3rd Cir. 2005).

2 340 B.R. 740.

3 Id. at 743.

4 Id. at 745. The fund manager testified that he was referring to the second lienholders when he said "we really just decided to move on." The court found the fund manager's testimony not credible. Id.

5 Under Model Rule 1.7(b), a lawyer may represent a client, notwithstanding the existence of a concurrent conflict of interest, if: 1. the lawyer reasonably believes that the lawyer will be able to provide competent and diligent representation to each affected client; 2. the representation is not prohibited by law; 3. the representation does not involve the assertion of a claim by one client against another client represented by the lawyer in the same litigation or other proceeding before a tribunal; and 4. each affected client gives informed consent, confirmed in writing.

6 In re Meridian Automotive Sys.-Composite Ops. Inc., 340 B.R. at 745.

7 Id. at 746.

8 Id.

9 Id.

10 Id.

11 Id.

12 In re Meridian Automotive Sys.-Composite Ops. Inc., 340 B.R. at 746.

13 327 B.R. 200, 206-07 (D. Del. 2005).

14 652 F. Supp. 1281 (D. Del. 1987).

15 THCI Co., 327 B.R. at 208-10.

16 Id. at 208-09 (quoting Richardson v. Hamilton Int'l. Corp., 469 F.2d 1382, 1385 (3rd Cir. 1972)) (emphasis in original).

17 Id. at 209 (citing Satellite Fin. Planning, 652 F.Supp. at 1284).

18 In re Meridian Automotive Sys.-Composite Ops. Inc., 340 B.R. at 747 (quoting Model R. Prof'l. Conduct 1.9, cmt. 3) (emphasis added by court).

19 Id.

20 Id. The court explained, however, that even if confidentiality concerns were a necessary factor for whether a matter is "substantially related," the law firm obtained confidential information because the analyses that it did for Stanfield "could materially advance the FLC's position by giving it a head start in assessing the intercreditor issues...and revealing precisely what Stanfield perceived to be the strengths and weaknesses of its own position." Id.

21 Emphasis added.

22 Model Rule 1.0(b) (emphasis added).

23 In re Meridian Automotive Sys.-Composite Ops. Inc., 340 B.R. at 747.

24 The order required "that the debtors pay, as adequate protection for the FLC members, (1) up to $250,000 of [the law firm's] reasonable fees and expenses incurred prior to the Final DIP Order and (2) 'the reasonable fees and expenses of...one law firm (if any) as counsel' for the FLC with respect to 'intercreditor issues.'"

25 Id.