A Weird New World Disinterestedness for Investment Bankers under New 11 U.S.C. 101(14)

A Weird New World Disinterestedness for Investment Bankers under New 11 U.S.C. 101(14)

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Happy New Year to all Straight & Narrow readers. In celebration of the New Year, we will examine the new issues facing investment bankers who have expanded opportunities to be employed as professionals under 11 U.S.C. §327(a).1

Lack of Interest Is the Good News: Changes to the “Disinterested Person” Definition of 11 U.S.C. §101(14)

Among the numerous changes made to the Bankruptcy Code by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) was an amendment to 11 U.S.C. §101(14), which eliminated language that made investment bankers “for a security of a debtor” and the investment banker’s attorney statutorily “not disinterested.”2 Revised 11 U.S.C. §101(14) now reads:

(14) The term “disinterested per-son” means a person that—
(A) is not a creditor, an equity security-holder or an insider;
(B) is not and was not, within two years before the date of the filing of the petition, a director, officer or employee of the debtor; and
(C) does not have an interest materially adverse to the interest of the estate or of any class of creditors or equity security-hol-ders, by reason of any direct or indirect relationship to, con-nection with or interest in, the debtor or for any other reason.

This change means that a debtor-in-possession (DIP) or bankruptcy trustee could employ a debtor’s pre-petition investment banker as an estate professional if the investment bankers are otherwise disinterested and otherwise meet the requirements of §327(a).3

And Now the Bad News: How Do I Meet the Disinterestedness Standard of 11 U.S.C. §101(14) and Employment Standard of 11 U.S.C. §327(a)? The Statute Still Stands

Initially, it is important to note that investment bankers can still statutorily be a “not disinterested” person if they are (1) creditors, equity security-holders or insiders 4 of the debtors 11 U.S.C. §101(14)(A), or (2) are within two years before the filing a director, officer or employee of the debtor. 11 U.S.C. §101(14)(B).5

The case law under 11 U.S.C. §101(14)(A) is fairly clear that this provision is literally applied. Therefore any professionals, including investment bankers, should divest themselves of all equity securities 6 of the debtor and waive all claims 7 they might otherwise have against the debtor to qualify as disinterested persons. Further, investment bankers employed under 11 U.S.C. §327(a) cannot acquire claims of creditors or equity security-holders against their debtor.8 Investment bankers should also take care not to have any of their members or employees enter into any arrangements with a debtor which could make them an insider of the debtor.9 While there are cases that have allowed certain professionals to maintain either small claims against or equity interests in debtors,10 these cases are a distinctly small minority and should not be relied upon.

Similarly, courts also strictly construe §101(14)(B) and refuse to approve the employment of professionals who had partners or employees act as officers, directors or employees of the debtor in the two years prior to the bankruptcy filing under U.S.C. §327(a).11 The only exception in this area is that under certain circumstances, including the use of confidentiality barriers or “Chinese Walls,”12 some courts have refused to impute that lack of disinterestedness of a member or employee to the entire firm. Other courts have strictly imputed the lack of disinterestedness of a single member or employee to the entire firm.13 However, as discussed in more detail later in this article, the existence of such officers, directors or shareholders must be fully disclosed and any curative measures well documented if the court is to consider the possibility of not imputing a lack of disinterestedness to an entire firm.14

§101(14)(C): A Search for Meaning

The most litigation concerning a party’s disinterestedness involves §101 (14)(C), which requires parties not to have “an interest materially adverse to the interest of the estate or of any class of creditors or equity security-holders, by reason of any direct or indirect relationship to, connection with or interest in the debtor, or for any other reason” in order to be disinterested. While similar to the “not hold or represent an interest adverse to the estate” standard of 11 U.S.C. §327(a),15 it is a stricter standard than §327(a)’s requirements. As the district court in In re Glenn Electric Sales Corp.16 stated:

a nondisinterested party is one who may have an economic or practical interest that would tend to lessen the value of the bankrupt estate or that would create either an actual or potential dispute in which the estate is a rival.

There is a significant split as to the nature of an interest lender that might make a party not disinterested. The majority of courts hold that a professional may only be disqualified based on an actual or potential conflict of interest, and not on the mere appearance of conflict.17 Other courts hold that a professional may only be disqualified if there is an actual conflict of interest.18 Finally, some courts still consider the mere appearance of impropriety when analyzing conflicts of interest.19

These pronouncements, while useful, are extremely general and offer little in the way of concrete guidelines. However, there are several decisions that address certain common fact situations that can provide investment bankers with guidance in this area.

A Lost Map Found: Key Disinterestedness Decisions

1. Prior Employment, No Problem. 11 U.S.C. §1107(b) gives some protection for professionals as it provides that the mere fact that the professional was employed by the debtor prior to the bankruptcy does not disqualify him or her for employment under 11 U.S.C. §327(a).20 This small safe harbor provision is limited as it does not protect professionals from being held ineligible for employment by reasons of activities that occurred pre-petition during that employment.21

2. Prior Payments, Possible Problem. Pre-petition payments received from debtors are a frequent source of litigation under 11 U.S.C. §327(a). Full disclosure of pre-petition payments of pre-petition fees and retainers is absolutely required.22 Given the heavy negotiation that sur-rounds investment bankers’ compensation package, investment bankers should take care to ensure that their compensation is well defined 23 and not oppressive.24

Investment bankers must also take care to ensure that any fee payments they receive within the 90-day preference period of 11 U.S.C. §547 are both timely received and well documented. In the now infamous Pillowtex25 decision, debtors’ counsel, who had received approximately $1 million in fees during the 90-day preference period and had agreed to disgorge any payments found to be preferential and waive any claim for such fees,26 had its fees and employment challenged. The Third Circuit ruled that this arrangement did not comply with the requirements of 11 U.S.C. §327(a). The circuit held that if a professional received a preferential payment pre-petition, the preference claim would make the professional a creditor and disqualify it from being retained under 11 U.S.C. §327(a). The Pillowtex court also held that a bankruptcy court had to determine, prior to approving retention, whether the professional received a preference.27

In light of this issue, investment bankers must take care to ensure that their pre-petition payments are timely and clearly earned 28 in order to eliminate the possibility of a claim that would prevent their employment.

3. Retainers and Payment Arrangements. Why Dollars Are Different from Operating Assets. Another issue that causes problems in the disinterestedness area is the payment of retainers. Questions have frequently arisen as to both the nature and source of the retainer that have prevented parties from being retained under 11 U.S.C. §327(a).

Frequent litigation has occurred where the retainer is given to the professional in the form of property as opposed to cash. Although most courts 29 have held that retainers that are security interests in property do not per se make a professional not disinterested, these courts have imposed extremely high standards for approving such arrangements.30

The source of the retainer has also led to professionals being found to be “not disinterested.” Courts have generally held that where a professional’s retainer is paid by a third party to a professional, even when fully disclosed, that professional is not disinterested and cannot be retained under 11 U.S.C. §327(a).31 In rare cases, a court, with full disclosure, might approve a third-party retainer, but even with such disclosure, employment is not assured.32

Therefore if an investment banker intends to be retained by the debtor as a professional under 11 U.S.C. §327(a), any retainer should ideally be paid in cash from the debtor or debtors. More creative retainers run a significant risk of disqualifying the investment banker from meeting the disinterestedness standard.

Investment bankers, given the relationship-driven nature of their profession, must take special care in making their disclosures of connections.

4. Who is the Client Again? Representing the Debtors’ Principals. Further, investment bankers must take care in defining exactly who their clients are in their engagements with financially distressed companies.33 One bright-line rule would be for investment bankers never to take the ultimate equity owners of an entity or group of entities as a client unless (1) its interests are clearly and totally aligned with its subsidiaries, and (2) it will be one of the debtors in a future bankruptcy filing.34 Representing nonbankruptcy owners of debtors simultaneously with debtors in bankruptcy is strictly prohibited.35

Similarly, investment bankers must take care to review the individual interests of even a group of closely related entities in order not to run afoul of the disinterestedness requirements of the Bankruptcy Code.36 While investment bankers do not have the same range of duties as the debtors’ bankruptcy counsel have concerning related entities,37 conflicts could still arise, and investment bankers should consider taking steps in their engagement agreement to limit their duties in potential conflict situations.

5. Well-Connected Blues: Represen-tation of Creditors of the Debtor and 11 U.S.C. §327(c). Given the size of the top tier of investment bankers as well as the scope of their clients and contacts, it is inevitable that some, if not a significant number, of any given debtors’ creditors will either be a client of or otherwise doing business with 38 an investment banker. Under §327(c), a professional is not disqualified from being retained as a professional under 11 U.S.C. §327(a) “solely because of such person’s employment by or representation of a creditor” unless (1) there is an objection by another creditor or the U.S. Trustee and (2) an actual conflict of interest exists.39

In most cases, courts have routinely held where a proposed professional represents a creditor in an unrelated and non-material matter, that representation would not preclude retention under 11 U.S.C. §327(a).40 This is especially true where the creditor has given a full waiver to the profession that will allow it to represent the debtor adverse to the creditor.41 However, if the creditor has a material relation with the debtor and/or the professional has a material relation with the creditor, courts will in all likelihood find that an actual conflict of interest exists 42 and either prevent the employment of the professional or, in the case of an undisclosed relationship, order the disgorgement of fees.43

Therefore, investment bankers must, in all cases involving financially distressed entities, carefully review the entities’ creditors and other parties with whom the debtors have material relationships before accepting an engagement in order to determine whether they could qualify to be retained as a post-petition professional under 11 U.S.C. §327.

Rule 2014: Still Beating the Dead Horse

One of the most important issues facing investment bankers being retained under 11 U.S.C. §327(a) is making appropriate disclosure under Bankruptcy Rule 2014.44 Rule 2014 provides:

An order approving the employment of attorneys, accountants, appraisers, auctioneers, agents or other professionals pursuant to §327, 1103 or 1114 of the Code shall be made only on application of the trustee or committee. The application shall be filed and, unless the case is a chapter 9 municipality case, a copy of the application shall be transmitted by the applicant to the U.S. Trustee. The application shall state the specific facts showing the necessity for the employment, the name of the person to be employed, the reasons for the selection, the professional services to be rendered, any proposed arrangement for compensation and, to the best of the applicant’s knowledge, all of the person’s connections with the debtor, creditors, any other party in interest, their respective attorneys and accountants, the U.S. Trustee or any person employed in the office of the U.S. Trustee. The application shall be accompanied by a verified statement of the person to be employed setting forth the person’s connection with the debtor, creditors, any other party in interest, their respective attorneys and accountants, the U.S. Trustee or any person employed in the office of the U.S. Trustee.

While courts are somewhat divided in the language they use to describe the term “connections,”45 they have all consistently held that any connection that may be in any way pertinent to a court’s determination as to retention of a professional must be fully disclosed.46

Investment bankers, given the relationship-driven nature of their profession, must take special care in making their disclosures of connections. In light of the EToys47 and Filene’s Basement48 decisions, particular care must be given to disclosing any form of business relationships with the parties covered by the dictates of Rule 2014. In light of the increasing complexity of the extent and nature of these disclosures, as well as related issues concerning the retention of investment bankers,49 investment bankers should seriously consider retaining counsel to represent their interests in being retained and having their fees paid in any significant engagement. However, please note that in a typical Catch-22 situation, investment bankers should exercise care in selecting this counsel, as their retention of counsel will itself be a connection which will have to be disclosed and reviewed in other bankruptcy proceedings.

Conclusion: The Beginning

This article represents an effort to provoke serious thought about some of the issues that will arise as a result of the changes to the disinterestedness standard made by BAPCPA. The true impact these provisions will have on bankruptcy practice will, unfortunately, not be resolved until judges, the U.S. Trustee and other parties in interest formally address these issues in litigation. Until then, I hope these unauthoritative musings have entertained and informed you.


1 11 U.S.C. §327(a) provides: Except as otherwise provided in this section, the trustee, with the court’s approval, may employ one or more attorneys accountants, appraisers, auctioneers or other professional persons, that do not hold or represent an interest adverse to the estate, and that are disinterested persons, to represent or assist the trustee in carrying out the trustee’s duties under this title. 2 In re Eagle-Picher Industries Inc., 999 F.2d 969 (6th Cir. 1993) (investment banker disqualified from case despite factual finding by bankruptcy court that investment banker was a “disinterested person”); In re Federated Department Stores Inc., 44 F.3d 1310 (6th Cir. 1995); In re Capital Metals Co. Inc., 228 B.R. 724 (9th Cir. CAP) (financial advisor’s principal who served pre-petition as debtor’s CFO was statutorily not a “disinterested person”). 3 Investment bankers cannot be employed “for a specified special purpose” under 11 U.S.C. §327(e), as that provision only applies to attorneys. 4 See 11 U.S.C. §101(31). 5 See In re Capitol Metals Co. Inc., 228 B.R. 724 (9th Cir. BAP). 6 See In re Daig Corp., 799 F.2d 1251 (8th Cir. 1986); In re Intech Capital Corp., 87 B.R. 232 (Bankr. D. Conn. 1988). 7 U.S. Trustee v. Price Waterhouse, 19 F.3d 138 (3rd Cir. 1994); In re CIC Inv. Corp., 175 B.R. 52 (9th Cir. BAP). However, if debt is owed by a related nondebtor entity, a professional might not be statutorily not disinterested. See In re Bendlers Inc., 106 B.R. 480 (Bankr. N.D. Ohio 1989). 8 See Gray v. English, 30 F.3d 1319, 1321, 1324 (10th Cir. 1994). 9 11 U.S.C. §101(31) The categories of insiders set forth in 11 U.S.C. §101(31) is an illustrative rather than exclusive list, and determinations of who is an insider will be made on a case-by-case basis. Matter of Krehl, 86 F.3d 737 (7th Cir. 1996). 10 See In re O’Connor, 52 B.R. 892 (Bankr. D. Okla. 1985) (ownership by member of debtor’s law firm of 1,000 shares out of approximately 13,000,000 shares of debtor’s stock did not disqualify law firm under 11 U.S.C. §327(a)); In re Jaimalito’s Cantina Associates Ltd. Partnership, 114 B.R. 1 (Bankr. D. Col. 1990). 11 In re United Color Press Inc., 129 BR 143 (Bankr. S.D. Ohio 1991) (managerial consultant who served on debtor’s board pre-petition solely to ensure adequate number of directors existed was not disinterested); In re GHR Energy Corp., 60 BR 52 (Bankr. S.D. Tex. 1985). See, also, Bowles, Getting Paid: Retention and Compensation in Bankruptcy Cases—A Guide for Non Attorney Professionals (ABI, 2005) for a discussion of the possibility of retention under 11 U.S.C. §363. 12 See In re Chicago South Shore and South Bend R.R., 101 BR 10 (Bankr. N.D. Ill. 1989); see, also, In re Capen Wholesale Inc., 184 B.R. 547 (N.D. Ill. 1995). 13 See In re Michigan Interstate Ry. Co. Inc., 32 B.R. 327 (Bankr. E.D. Mich. 1983) (where law firm disqualified in part for failing to disclose that “special partner” of firm was former director, president and general counsel of debtor). 14 See In re Essential Therapeutics Inc., 295 B.R. 203 (Bankr. D. Del. 2003); In re Rusty Jones Inc., 134 B.R. 321 (Bankr. N.D. Ill. 1991). 15 “[T]he twin requirements of disinterestedness [of 11 U.S.C. §101(14)] and lack of adversity telescope into what amounts to a single hallmark.” In re Martin, 817 F.2d 175, 180 (1st Cir. 1987). 16 99 B.R. 596, aff’g., 89 BR 410 (Bankr. D. N.J. 1988). 17 In re Marvel Entertainment Group Inc., 140 F.3d 463, 476 (3d Cir. 1988). 18 See General Electric Co. v. Industra Products Inc., 683 F. Supp. 1254 (N.D. Ind. 1988). 19 See In re Granite Partners L.P., 219 B.R. 22 (Bankr. S.D.N.Y. 1988) (applying the appearance of impropriety standard with respect to the requirements of Bankruptcy Code §327(a)). 20 In re Pillowtex, 304 F.3d 246, 251 (3rd. Cir. 2002). 21 See In re Federated Department Stores Inc., 44 F.3d 1310, 1318 (6th Cir. 1995) (noting that the 11 U.S.C. §1107(b) exception is extremely narrow). See, also, In re Prince, 40 F.3d 356, 360 (11th Cir. 1994) (attorney disqualified from representation for assisting debtor in transferring $600,000 in property to debtor’s wife). 22 See In re Vann, 136 B.R. 863, (D. Colo. 1992), aff’d., 986 F.2d 1431 (10th Cir. 1993) (full direct and comprehensive disclosure about fees is required). 23 See In re Farmland Industries Inc., 397 F.3d 647 (8th Cir. 2005); In re eToys, 331 B.R. 176 (Bankr. D. Del. 2005) 24 See In re Prudhomme, 152 B.R. 91 (Bankr. W.D. La. 1993) (debtors’ counsel). 25 In re Pillowtex, 304 F.3d 246 (3rd Cir. 2002). 26 This procedure has been used in other courts to eliminate the conflict problem. See In re Enron Corp., 2003 U.S. Dist. Lexis 1442 (S.D.N.Y. 2003). 27 In re Pillowtex, 304 F.3d at 255. 28 See, generally, In re eToys Inc., 331 B.R. 176 (Bankr. D. Del. 2005) (issue arose as to pre-petition investment bankers’ right to certain pre-petition payments). 29 In re Martin, 817 F.2d 175 (1st Cir. 1987) (no per se disqualification). But see In re Escalera, 171 B.R. 107 (Bankr. E.D. Wash. 1994) (per se disqualification). 30 In re Martin, 817 F.2d at 182-183 (setting forth list of requirements to retain security interest retainer and be disinterested). 31 In re Park-Helena Corp., 63 F.3d 877 (9th Cir. 1995) (debtors’ counsel disqualified for accepting retainer from debtors’ president and failing to disclose source of retainer). 32 See In re BBQ Resources Inc., 237 B.R. 639 (Bankr. E.D. Ky. 1999). 33 In re Occidental Financial Group Inc., 40 F.3d 1059, 1062-63 (9th Cir. 1994) (retainer agreement identified owners as client). However, even if owners are not technically listed as clients, professionals can have their fees rejected and employment revoked if they in fact act for the owners of a debtor. See In re Kendavis Industries Intern Inc., 91 B.R. 742 (Bankr. N.D. Tex. 1988) (totality of circumstances indicated the debtor’s counsel represented interests of equity owners). 34 See Matter of Wiredyne, 3 F.3d 1125, 1128 (7th Cir. 1993) (noting that attorney not required to disgorge fees for pre-petition representation of owners and debtors where interests aligned). In re Wheatfield Business Park LLC, 286 B.R. 412 (Bankr. C.D. Cal. 2002) (“reputable presumption of lack of disinterest when representing related parties”); In re Global Marine Inc., 108 B.R. 998 (S.D. Tex. 1987) (no per se disqualification for representation of multiple debtors). 35 See In re Occidental Financial Group Inc., 40 F.3d at 1059 (law firm disqualified and ordered to disgorge all fees where it represented the debtor’s nonbankrupt owners and their various subsidiaries. Law firm also failed to disclose conflict). 36 See In re Interwest Business Equipment Inc., 23 F.3d 311, 316-18 (10th Cir. 1994), and In re BH&P Inc., 949 F.2d 1300 (3rd Cir. 1991), where professionals were disqualified due to conflicts between the various bankruptcy estates. 37 It is important to note that investment bankers, being primarily concerned with obtaining the highest and best dollars for the debtors for their assets from a business standpoint, generally do not have the same conflict-of-interest problems as debtor’s counsel or a turnaround management firm would have in a similar situation. 38 See In re eToys Inc., 331 B.R. at 195-97 (discussing business partnership between debtor’s CEO and committee counsel). 39 See In re Marvel Entertainment Group Inc., 140 F.3d at 463 (there must be either a potential or actual conflict of interest from the creditor representation for professional to be disqualified as debtor’s professional). 40 See, generally, In re Marvel Entertainment Group Inc., 140 F.3d 463 (3rd Cir. 1998); In re Klregl Bros. Universal Stagelighting Co. Inc., 189 B.R. 874 (Bankr. E.D.N.Y. 1995). 41 See In re Marvel Entertainment Group Inc., 140 F.3d at 482 (unconditional waiver by creditor of debtor demonstrated disinterestedness of law firm). But see In re Joe Corp., 298 B.R. 703 (Bankr. D. Mont. 2003) (incomplete and improperly disclosed waiver did not make professional disinterested). 42 See In re Granite Partners L.P., 219 B.R. 22 (Bankr. S.D.N.Y. 1998); In re Lee Way Holding Co., 100 B.R. 950 (Bankr. S.D. Ohio 1989). 43 In re Lee Way Holding Co., 100 B.R. at 950 (chapter 11 debtor’s counsel disqualified and ordered to disgorge fees when it failed to disclose conflicts). 44 For a recent article discussing Rule 2014 disclosures in more detail, see Bowles, “The Revenge of the Dot Coms: In re eToys Inc. and In re Smart World Technologies,” LLC 24 ABI LJ 16 (December/January 2006). 45 Compare In re BH&P Inc., 119 B.R. 35, 44 (D. N.J. 1990), aff’d., 949 F.2d 1300 (3rd Cir. 1991). (“[Rule 2014] may not be so generous as to require the party to raise with the court every imaginable conflict which may occur in bankruptcy”) with In re Park-Helena, 63 F.3d 877, 881 (9th Cir. 1995) (“the duty of professionals is to disclose all connections with the debtor, debtor-in-possession, insiders, creditors and parties in interest... They cannot pick and choose which connections are irrelevant or trivial... No matter how old the connection, no matter how trivial it appears, the professional seeking employment must disclose it”). 46 In re Park-Helena, 63 F. 3d at 882. 47 In re eToys Inc., 331 B.R. at 176. 48 In re Filene’s Basement Inc., 239 B.R. 845 (Bankr. D. Mass. 1999). 49 See In re Commercial Financial Services Inc., 427 F.3d 804 (10th Cir. 2005) (discussing a $1 million reduction in a financial advisors’ fees).
Journal Date: 
Wednesday, February 1, 2006