The Code of Professional Responsibility is a major component of what distinguishes law as a profession. The precepts set forth in the Code of Professional Responsibility are not only aspirational, but are also mandatory. In bankruptcy cases, Bankruptcy Code §327(a) mandates standards of conduct for professionals that are to be employed by a bankruptcy estate. In In re Mercury,¹ Judge Adlai S. Hardin Jr. of the U.S. Bankruptcy Court for the Southern District of New York has written an important decision concerning bankruptcy ethics that has ramifications not only for bankruptcy cases, but also for corporate reorganization cases. Judge Hardin's analysis of the interplay of the Code of Professional Responsibility and Bankruptcy Code §327(a) merits discussion and thought by the bankruptcy community.

In Mercury, Mrs. Mercury was grievously injured in a slip-and-fall accident. Thereafter, she and her husband commenced a personal injury action to recover damages. The plaintiffs' retained counsel (PI counsel) and executed a retainer agreement under which PI counsel would receive 33 percent of the personal injury award. During the course of the personal injury litigation, the plaintiffs' financial situation deteriorated, and they decided to file for chapter 7. The PI counsel received $1,200 for preparing a chapter 7 petition; however, the debtors filed pro se. Barbara Balaber-Strauss² qualified as the permanent chapter 7 trustee, and she prosecuted the personal injury claim for the benefit of the estate. Subsequently, in January 2000 a mediation was conducted, and a settlement of a $190,000 was reached with the insurance carrier. Trustee Balaber-Strauss accepted the settlement as being in the best interests of the creditors. However, the plaintiffs/debtors were dissatisfied with the settlement, and they informed the PI counsel of their desire to reject the proposed settlement and to proceed to trial.

PI counsel made an ex parte application to be relieved as bankruptcy counsel, and the application was granted. The debtors did not receive any notice of PI counsel's application to be relieved as their bankruptcy counsel. In April 2000 an application to retain PI counsel was made on behalf of the estate; however, the application failed to disclose any potential conflict of interest between the debtors and PI counsel. In May 2000, PI counsel sent the debtors a letter advising them that their interests were adverse to Trustee Balaber-Strauss and that they should retain new counsel. The debtors opposed the approval of the settlement, and they appeared at the hearing on the settlement. Judge Connelly, the bankruptcy judge initially assigned to the bankruptcy case, eventually approved the settlement. The PI counsel filed an application for compensation.

Judge Hardin denied the application in its entirety because there were numerous violations of the Code of Professional Responsibility and Bankruptcy Code §327(a).

The court noted that an attorney has a continuous professional duty to competently represent a client and with proper care. Equally significant, an attorney must seek the lawful objectives of a client, and he or she must not fail to effectuate a contract for professional services. Only a client has the authority to make substantive decisions concerning his or her case. Another important principle is that an attorney must obtain authorization from the tribunal in which a matter is pending before he or she is permitted to withdraw as counsel. A bedrock concept of professional ethics is that an attorney is precluded from representing entities with conflicting interests.

Judge Hardin then proceeded to analyze the requirements for the retention of a professional under §327(a). Judge Hardin stated:

These provisions are very clear. Under subsection (a), to be retained to represent the trustee the attorney must not "represent an interest adverse to the estate" and must be "disinterested," and under subsection (e) an attorney that has represented the debtor may represent the trustee only if "such attorney does not represent...any interest adverse to the debtor or to the estate with respect to the matter on which such attorney is to be employed." Section 101(14) defines a "disinterested person" as one that "(E) does not have an interest materially adverse to the interest of the estate...by reason of any direct or indirect relationship to, connection with, or interest in, the debtor...." As stated in In re Martin, 817 F.2d 175, 180 (1st Cir.1987), the "twin requirements of disinterestedness and lack of adversity telescope into what amounts to a single hallmark." Both §§327(a) and (e) require, at a minimum, that the attorney to be employed by the estate hold no "adverse interest." 3 Collier on Bankruptcy ¶327.04[a] at 327-60 (Lawrence P. King, et al. eds., 15th ed. rev.2001).³

The concept of adverse interest is undefined in the Bankruptcy Code. Judge Hardin adopted the following definition:

Although "adverse interest" is not defined in the Bankruptcy Code, it has been defined in the case law to mean for two or more entities (1) to possess or assert mutually exclusive claims to the same economic interest, thus creating either an actual or potential dispute between the rival claimants as to which, if any, of them the disputed right or title to the interest in question attaches under valid and applicable law, or (2) to possess a predisposition or interest under circumstances that render such a bias in favor of or against one of the entities.⁴ (citations omitted.)

Intimately connected to Bankruptcy Code §327(a) is Federal Rule of Bankruptcy Procedure 2014(a), which requires an attorney to disclose all the facts that are pertinent to his or her retention, including those facts that relate to a potential conflict of interest. The failure to disclose a fact that is germane to a bankruptcy court's determination may result in an attorney's being subsequently disqualified in a disallowance of the applicant's fees. The consequences for a violation of either Bankruptcy Code §327(a) or Federal Rule of Bankruptcy Procedure 2014(a) are significant. In addition, Bankruptcy Code §328(c) authorizes a bankruptcy court to deny compensation if the professional was not disinterested or held or represented an interest adverse to the estate. Judge Hardin wrote:

The case law confirms what the statute expressly provides—that a professional retained to represent the estate under §327 may be denied compensation and reimbursement of expenses if he was not disinterested or was burdened by a conflict of interest. "When a law firm is found not to be disinterested, disallowance of fees is appropriate."⁵

The court found that PI counsel had violated his ethical obligations to the debtors. The PI counsel never withdrew as personal injury counsel to the debtors; therefore, it continued to have a duty to effectuate its professional obligations to the debtors. Judge Hardin stated:

As attorneys of record for the Mercurys in the personal injury action, F & H owed to the Mercurys all of the ethical, contractual and legal obligations of competence under Canon 6, zealous advocacy and fidelity under Canon 7 and undivided loyalty under Canon 5 quoted in point I, above. Without reiterating and juxtaposing the authorities and the acts and omissions of F & H set forth above, it is perfectly plain that F & H violated their retainer agreement and all of the ethical and legal rules discussed in point I.⁶

Equally significant was the conflict of interest that PI counsel had because of the dual representation of both the debtors and the chapter 7 trustee. Judge Hardin stated:

In this case there was an actual, luminous conflict between the chapter 7 trustee and the Mercurys with respect to the settlement of their personal injury action. The potential for that conflict was evident from the moment that the Mercurys expressed their disinclination to participate in a mediation. The conflict became patent during and after the mediation, not only because the Mercurys made clear their rejection of settlement and their desire to go to trial, but because the proposed settlement was palpably contrary to the debtors' interests, although it was recommended to the trustee by F & H.⁷

The court noted that the conflict of interest was real, and the PI counsel was under a fundamental duty to protect the interests of the debtors. Judge Hardin remarked:

At the Jan. 29, 2002, evidentiary hearing, Mr. Fellows and F & H's counsel appeared to suggest that there was no conflict of interest because after the bankruptcy filing F & H somehow became answerable to the trustee and required to serve the best interests of the estate, rather than the interests of the debtors (see, e.g., the Fellows testimony quoted in footnote 4), or perhaps because F & H's allegiance as counsel in the personal injury action was to the claim, so that when the claim became part of the debtors' estates, F & H's ethical and legal duties as counsel also were transferred to the estate. Such arguments, if such were indeed their arguments, are baseless. The attorney-client relationship exists between the attorney and his client, and counsel's ethical, contractual and legal obligations are owed to the client, not the client's claim and certainly not to a debtor-client's chapter 7 trustee, whose interests are fundamentally adverse to those of the debtor.⁸

The consequence of counsel's apostasy was disastrous for the Mercurys. Had F & H zealously urged the chapter 7 trustee to permit the Mercurys to go to trial, as they were ethically required to do under the authorities in point I(A)(1), above, it is quite likely that the trustee would have had no alternative but to accede to the position of the debtors and their trial counsel. If, nevertheless, the chapter 7 trustee moved to settle the personal injury action, F & H were contractually and ethically bound to represent the Mercurys in opposition. In addition, F & H had the ethical duty to advise the Mercurys of their right to trump the chapter 7 trustee's attempt to settle by the simple expedient of a motion to convert to chapter 11.⁹

PI counsel had a real conflict of interest because the debtors were adamantly opposed to the proposed settlement. PI counsel refused to disclose the conflict of interest in its retention affidavit, and the retention affidavit was materially false. If PI counsel had disclosed that the debtors were opposed to the settlement, then PI counsel would not have been retained as special counsel to the chapter 7 trustee. Under these circumstances, the appropriate remedy was the denial of all compensation.

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Footnotes

¹ 280 B.R. 35 (Bankr. S.D.N.Y. 2002). Return to article

² Ms. Balaber-Strauss is a senior and respected chapter 7 trustee in the Southern District of New York. Ms. Balaber-Strauss is a member of the Board of Directors of the National Association of Bankruptcy Trustees. Return to article

³ In re Mercury, 280 B.R. 35, 53 (Bankr. S.D.N.Y. 2002). Return to article

⁴ Id. at 54. Return to article

⁵ Id. at 57. Return to article

⁶ Id. at 60. Return to article

⁷ Id. Return to article

⁸ Id. at 61. Return to article

⁹ Id. at 62. Return to article

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