Complying with Section 327(a) of the Bankruptcy Code: What Counsel for a Debtor-in-Possession Need to Know

December 19, 2013 - An attorney appointed to be counsel for a debtor in possession must first attest in a sworn affidavit that he or she does not represent any materially adverse interests to the estate or is not an interested party according to Section 327(a) of the Bankruptcy Code.  Even performing all duties zealously and properly, however, does not immunize the attorney from sanction if the court later finds out that the attorney represents an adverse interest to the estate.  The attorney can not only be disqualified and replaced, but also may be barred from receiving compensation for the legal work already performed. These potential dire outcomes could have a real impact on how forthright attorneys may be in their sworn affidavits to be appointed counsel for the debtor.  If counsel were allowed to receive attorneys’ fees even if they intentionally omitted a materially adverse interest, this could create a perverse incentive for lawyers to leave out information knowing that they will get paid nonetheless.  Bankruptcy courts, however, also recognize that any potential sanction must toe the line between deterring intentional concealment and punishing accidental or negligent omissions.

The Bankruptcy Court for the Eastern District of North Carolina confronted this issue in In re: Kimberly Nifong Mitchell, Case No.11-08880-8-ATS (Bankr. E.D. No. Car. 2013) [Doc. No. 294].  There, the court held that the attorney for the debtor in possession was not entitled to fees for services rendered.  The bankruptcy court had granted the debtor’s application to employ the petitioner law firm on January 9, 2012.  Later that day, the debtor’s financial schedules were amended to show that, shortly before her bankruptcy petition, the debtor conveyed real property worth $640,000 to an LLC.  At the time of that transaction, the law firm had represented Mr. Hamilton, a 50% owner of the LLC.  Mr. Hamilton and the debtor had enjoyed close personal and business relationships with one another.

On the bankruptcy administrator’s motion, the court disqualified the law firm from representing the debtor in possession because Mr. Hamilton was clearly an interested party.  The law firm represented Mr. Hamilton, and Mr. Hamilton benefited from the conveyances of real property.  In its defense, the law firm had filed an amended affidavit disclosing its representation of Mr. Hamilton and reiterating that it did not have a conflict of interest.  Additionally, the firm claimed to have prepared an affidavit during the initial application process disclosing the connections between Mr. Hamilton and the debtor, but did not file this affidavit due to administrative error.

A year later, when the law firm filed an application to recover administrative expenses, the court looked to the Sixth and Seventh Circuits for guidance on interpreting Section 328(c) of the Code, which states that a court “may” deny allowance of compensation for professional services where the professional is interested or represents an interested party.  The firm argued that this section gives the court discretion to allow the expenses despite the firm’s administrative error.  The bankruptcy administrator argued that, because the initial approval was invalid due to the conflict, the court had no discretion to award administrative expenses.  The Sixth Circuit had interpreted Section 328(c) not to confer discretion to a bankruptcy court where the initial approval of employment was invalid, while the Seventh Circuit reached the opposite conclusion.  Realizing its interpretation might lead to an unintended incentive for attorneys to conceal potential conflicts, the Seventh Circuit counseled that a bankruptcy court should consider whether the omission was intentional and use its discretion in those instances to deny allowance.

In Kimberly, the bankruptcy court adopted the Seventh Circuit’s interpretation, but ruled that the law firm in this case was still not entitled to its requested fees.  The court found that an experienced law firm should have known that representing both parties was an actual conflict of interest, and the law firm at minimum should have brought it to the court’s attention.  The firm knew about Mr. Hamilton’s 50% interest in the LLC, and the real property conveyance made disclosure essential.  The court would not accept the firm’s excuse of administrative error because the firm had several opportunities to disclose the conflict and did not do so.  As a result, the court concluded, the firm assumed the risk that it would be disqualified and would not be compensated for the legal work it performed pursuant to a misleading and incomplete affidavit.

This decision and its analysis of persuasive out-of-circuit precedent provide helpful guidance for attorneys and bankrupt entities on how to handle the appointment of legal counsel.  The case suggests that attorneys will be held responsible for the information they knew or should have known at the time of application and left out of their affidavits.  Courts following this precedent would likely not give a sophisticated attorney or powerful law firm the benefit of the doubt when explaining why material information regarding a potential conflict of interest was not provided in the affidavit.  This could result in a reputational hit in disqualification and, worse, denial of all attorney fees earned—regardless of the quality and propriety of the work—during the bankruptcy proceeding.