Two years ago, I wrote an article on the proposed "new" Rule 2014, which was to take effect in December 2001 ("Disclosing Connections and Relationships Under Rule 2014," April 2001). As part of that article, I stated that a new bankruptcy bill would probably become law (which was wrong), but did note that "while almost all formally proposed amendments to the Bankruptcy Rules are ultimately enacted, all bankruptcy attorneys remember the fate of the infamous 'litigation package' of Bankruptcy Rule amendments which were withdrawn from consideration due to wide spread protest." In light of the failure of the new version of 2014 to become a Rule and of some recent important case law, revisiting Rule 2014 is once again a timely and important topic.

What Are Connections Under Rule 2014?

Under 11 U.S.C. §327(a), in order to be employed as a professional by a bankruptcy estate, the professional must not (1) "hold or represent an interest adverse to the estate" and must (2) be "disinterested."² Attorneys employed as special counsel to the estate under 11 U.S.C. §327(e) or professionals employed under 11 U.S.C. §§1103 and 1104 face less stringent requirements.³ However, all professionals whose employment must be approved by the bankruptcy court are required to make full disclosure under Rule 2014⁴ of their connections.

Currently, Rule 2014⁵ does not provide any useful limits on the disclosure of connections related to 11 U.S.C. §327 employment issues. Courts have generally applied Rule 2014 broadly and have held that professionals have little discretion in determining what is a relevant or material connection.⁶ Rule 2014 requires disclosure of all of a professional's connections with (1) the debtor, (2) any creditors, (3) other parties in interest, (4) the debtors, creditors and other parties in interest's attorneys and/or accountants, and (5) the U.S. Trustee and persons employed by the U.S. Trustee's office (collectively "2014 parties").⁷ Currently, courts have generally recognized three broad categories of "connections"—financial, business and personal⁸—that must be disclosed pursuant to Rule 2014.⁹

Financial Connections

Perhaps the most common form of connection that professionals must disclose are financial connections the professional may have with 2014 parties. One of the first decisions that discussed the need for professionals to fully disclose financial connections was In re Arlan's Dept. Stores Inc.,¹⁰ where estate counsel was denied all compensation after, among other things, failing to disclose that its $125,000 retainer was paid by taking almost all of the cash receipts from the debtor's department stores immediately before bankruptcy.¹¹

Increasingly, courts have used Rule 2014 to require debtors' professionals to disclose the sources¹² of fee payments and/or retainers¹³ paid to the professionals. The most important case concerning the degree of disclosure of financial connections needed to comply with Rule 2014 is In re Park Helena Corp.¹⁴ In Park Helena, the debtor's counsel received a $150,000 retainer from the debtor's president. While counsel disclosed the retainer, they did not disclose the actual source of the retainer until their first fee application. At that time, debtor's counsel disclosed that the retainer was paid by the debtor's president, but argued that it was part of a repayment of a loan the debtor had made to the president prior to the bankruptcy.¹⁵ The Ninth Circuit found that the debtor's counsel violated 11 U.S.C. §329 as well as Bankruptcy Rules 2014 and 2016.¹⁶ In finding a violation of Rule 2014, the Ninth Circuit held that even if the retainer was paid from the debtor's funds, and there was no conflict of interest, the "failure to describe the circumstances of the payment" was a violation of Rule 2014. The Ninth Circuit ultimately denied all requested fees.¹⁷

Two recent cases, In re Big Rivers Electric Corp.¹⁸ and In re Maximus Computers Inc.,¹⁹ demonstrate the increasing importance courts are putting on disclosure of fee and other financial arrangements. In Big Rivers, the court denied all compensation to an examiner and his law firm who worked on a highly successful chapter 11 case due to the examiner's failure to formally²⁰ and timely disclose a bonus fee enhancement from the unsecured creditors in the case. The Big Rivers court stated: "The examiner should have known that the act of soliciting the three largest unsecured creditors...was at least an apparent conflict of interest with the examiner's obligation of neutrality that should have been disclosed."²¹

In Maximus Computers, the court reversed the lower court's approval of the employment of a law firm as 11 U.S.C. §327(e) counsel for a trustee where the law firm failed to disclose it was being employed and paid by a creditor, which the law firm had previously represented against the debtor, at the same time it was being employed by the bankruptcy estate. The majority remanded the case for further consideration after suggesting the law firm could be compensated under 11 U.S.C. §503(b)(3)(B) as making a substantial contribution to the estate by its efforts.²²

Business Connections

Courts have also determined that a professional's business connections to 2014 parties (i.e., working for, representing or having a financial interest with a 2014 party) are covered by Rule 2014. Courts have held that representation of an entity that may be able to control or influence a bankruptcy estate must be disclosed.²³ Courts have also held that pre-petition work, which in and of itself was adverse to the estate, must also be disclosed.²⁴

The two most famous cases involving failure to disclose business connections are U.S. v. Gellene²⁵ and In re Leslie Fay Companies Inc.²⁶ In Gellene, a bankruptcy attorney failed to disclose his representation of a large secured creditor in a chapter 11 case in which his firm was employed as debtor's counsel and was ultimately convicted of making false oaths in a bankruptcy proceeding.²⁷ The court found the failure to disclose this connection made the 2014 disclosure false, notwithstanding Gellene's contentions that disclosure was not necessary.²⁸

In Leslie Fay, the debtor's counsel was sanctioned for failing to disclose their pre-petition representation of board members and the debtor's outside auditors, who could be sued by the debtor.²⁹ The court rejected the professional's contention that no such disclosure was necessary because counsel's investigation disclosed neither party would be liable to the debtor³⁰ and imposed significant sanctions on the professional.

A recent case highlighting the importance of full disclosure is In re Enron Corp., 2003 WL 223455 (S.D.N.Y. Feb. 3, 2003), where the district court affirmed the bankruptcy court's denial of a motion to disqualify counsel for the unsecured creditors committee in that massive case.³¹ The district court found that the committee counsel made full and complete disclosures as required by Bankruptcy Rule 2014 in their initial application and had frequently supplemented its disclosures in a "meaningful, forthright, continuous and sufficiently detailed" manner. The court found that the amount of detail demanded by the objecting party was far beyond the scope of Rule 2014.

Personal Connections

The final important category of connections, which courts are increasingly requiring to be disclosed, are personal connections.³² Although the full range of personal connections between professionals and 2014 parties, which must be disclosed, has not been fully developed,³³ three recent cases illustrate the types of connections that need to be disclosed.

In In re El San Juan Hotel Corp.,³⁴ counsel for a successor chapter 7 trustee was denied all fees due to his failure to disclose (1) his retention in a separate bankruptcy case by the previous trustee of the estate, who was ultimately convicted of embezzlement from the bankruptcy estate, and (2) his close friendship with the attorney who served as counsel to the previous trustee in litigation with the current trustee.³⁵

In In re Bonneveille Pacific Corp.,³⁶ counsel for the unsecured creditors' committee resigned from the case when it was discovered that an "of counsel" attorney with the committee and counsel were married to an insider to one of the debtor's subsidiaries.³⁷ This connection had not been previously discovered or disclosed.

Finally, in the Merry-Go-Round³⁸ case, the accountant for a chapter 11 debtor was forced to settle a lawsuit against it for $185 million. One of the reasons for the settlement was an allegation that the accounting firm had concealed, from the debtor and the court, various relationships, including personal relationships, that members of the accounting firm had with the debtor's counsel, which allegedly led to the debtor's bankruptcy not disclosing the accountants alleged malpractice in the debtor's case.³⁹

Is There Such a Thing as a de Minimis Connection?

While cases such as In re Park-Helena Corp.⁴⁰ and In re Crivello⁴¹ contain sweeping dicta that all connections, no matter how de minimis, must be fully disclosed, the holdings of these cases and other decisions addressing Rule 2014 clearly indicate that the "missing" disclosures were, in most cases, material⁴² to a determination of whether a professional could be employed. This was recognized by the bankruptcy court in In re Rusty Jones,⁴³ where the noted ownership of a hot dog stand 20 years ago by a professional and an owner of the debtor would be so de minimis that they need not be disclosed.⁴⁴ The Rusty Jones court noted that connections that are either related to the bankruptcy proceedings or could "reasonably have an effect on the attorney's judgment in the case" are the types of connections that must be disclosed.⁴⁵ Unfortunately, neither Rusty Jones nor any other decisions clearly define what connections could "reasonably effect" an attorney's judgment or more importantly should be brought to a court's attention.

How to Approach Rule 2014 Disclosures, or Frodo Baggins Had It Easy Approaching Mount Doom

As can be seen from the foregoing discussion, Rule 2014 imposes a significant burden on attorneys seeking to be employed by either the bankruptcy estate or a committee without giving much guidance on how or what must be disclosed. However, there are some steps that professionals can take to make this process less treacherous.

In order to comply with Rule 2014, professionals should take a four-step approach to making the required Rule 2014 disclosures both in their employment application and throughout the case. First, professionals should describe, in detail, what steps they have taken in investigating their firm connections, relationships and interests for purposes of the Rule 2014 disclosure. This should include a statement that the firm is eligible for employment under the appropriate provision of the Code. These steps in a particularly large case may include a direct inquiry to a professional firm describing the debtor and the 2014 parties and asking if anyone has "connections" with the 2014 parties. A detailed discussion of the nature of the inquiry will greatly reduce the possibility that a court will later determine that a professional "did not look very hard" for possible conflicts, as well as give the court, U.S. trustee's office and other interested parties an opportunity to immediately explore other relevant areas, rather than wait until late in the case, to second-guess a professional's choices in investigating his firm's connections, relationships and interests.

Second, professionals must disclose any connection, interest or relationship that they may have with the debtor or any other party that could have some possible impact on a court's determination of whether the professional should be employed. If there is any doubt, disclose.⁴⁶ At worst, you will not be employed. However, in those circumstances when disclosure was clearly required, if the non-disclosure is discovered, all or a significant portion of your fees will be disallowed. At best, the issue will be fully and finally resolved before expending a great deal of time and expense in the case.⁴⁷

Third, professionals are advised to describe any particular interest, connection or relationship in some detail. Boilerplate statements that "you represent various creditors of the debtor in other non-related matters" is in some respects worse than no disclosure as the court and other parties' view of what is trivial, or unimportant representations, may vary greatly from the view of the disclosing professionals. The detail given in a disclosure under 2014 must at least be sufficient to put the court and other parties on notice as to what ethical issues may be involved in a particular connection or relationship.⁴⁸ In the recent Enron decision, the district court agreed with this line of reasoning and held there was a limit to the amount of detail required about connections, stating:

The bankruptcy court found that Exco would require Milbank to disclose information beyond the requirements of Rule 2014, such as every possible consequence resulting from Milbank's connections, as well as a prediction as to the outcome of any possible litigation that may relate to its connections. This court agrees with the bankruptcy court that such disclosures are beyond the scope of Rule 2014 and that Milbank's disclosures complied with Rule 2014.

2003 WL 223455 at *6.

Finally, a professional must update, as needed, his 2014 disclosures as the facts of the case and the professional's business change. As noted in the Enron decision, "meaningful, forthright, continuous and sufficiently detailed" supplements to Rule 2014 disclosures will be well received by, if not required by, a bankruptcy court.

Conclusion

The failure of proposed Rule 2014 to become an official Bankruptcy Rule is clearly a blow to bankruptcy practitioners who are looking for some guidance as to the outer limits of what connections need to be disclosed in an application for employment under the Bankruptcy Code. However, short of either binding case law, a new national Bankruptcy Rule or local rules addressing what disclosure is necessary under Rule 2014, law firms will be faced, like the vertically challenged hero of The Lord of the Rings Trilogy, with a long, hard and uncertain journey to an uncertain goal. However, unlike our Hobbit friend, we currently do not have clear instructions as to how to reach that goal.

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Footnotes

¹ Board-certified in business bankruptcy by the American Board of Certification. Return to article

² See 11 U.S.C. §101(14) (definitions of disinterested person). Return to article

³ See 11 U.S.C. §§327(e), 1103 and 1104. Return to article

⁴ While Rule 2014 implicitly contemplates that disclosures will be supplemented if needed during the case (see In re Granite Partners LP, 219 B.R. 22 (Bankr. S.D.N.Y. 1998)), Rule 2016(b) has an express duty to supplement disclosures concerning compensation. See Hansen, Jones & Leta PC v. Segal, 220 B.R. 434 (D. Utah 1998). Return to article

⁵ Rule 2014. Employment of Professional Persons

(a) Application for an order of employment: 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 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. Return to article

⁶ See, generally, In re Crivello, 134 F.3d 831 (7th Cir. 1998); In re Park-Helena Corp., 63 F.3d 877 (9th Cir. 1995); Rome v. Braunstein, 19 F.3d 54 (1st Cir. 1994). Return to article

⁷ For an excellent discussion of the scope of disclosure required of professionals seeking approval of their employment by a bankruptcy court, see Rapaport, Nancy B., "Avoiding Judicial Wrath: The Ten Commandments for Bankruptcy Practitioners," 5 J. Bankr. L. & P. 615 (1996) [hereinafter "10 Commandments"]. Return to article

⁸ These categories are solely the creation of the author, and there is a great deal of overlap between each group. Further, there are some connections that fall outside these categories. See Pearson v. First NH Mortgage Corp., 200 F.3d 30, 37 (1st Cir. 1999) (professional failed to disclose that it has a possible conflict of interest under state code of professional conduct). Return to article

⁹ See "10 Commandments" at 619-622. Return to article

¹⁰ 615 F.2d 925. (2d Cir. 1979). Return to article

¹¹ Id. at 935. See, also, In re Burke, 147 B.R. 787 (Bankr. N.D. Okla. 1992) (debtor's attorney took all of debtor's funds for retainer, which allowed debtor's cattle herd to starve). Return to article

¹² See In re Park Helena Corp., 63 F.3d 877 (9th Cir. 1995); In re Smitty's Truck Stop Inc., 210 B.R. 844 (B.A.P. 10th Cir. 1997). Return to article

¹³ See In re Downs, 103 F.3d 472, 478 (6th Cir. 1996). Return to article

¹⁴ 63 F.3d 877. Return to article

¹⁵ Id. at 881. Return to article

¹⁶ Id. at 882. Return to article

¹⁷ Id. Return to article

¹⁸ 284 B.R. 580 (W.D. Ky. 2002). Return to article

¹⁹ 278 B.R. 189 (9th Cir. BAP 2002). Return to article

²⁰ In the case, the examiner argued that during a private meeting with the bankruptcy judge (which had been authorized by the order appointing the trustee to permit the trustee to disclose in camera the results of aspects of his investigation of the debtor), he disclosed his actions related to seeking a bonus payment from the unsecured creditors. The district court found that this alleged disclosure was inadequate and a violation of the terms of his appointment order. 284 B.R. at 599-600. Return to article

²¹ 284 B.R. at 599. Return to article

²² The BAP's decision to reverse the order on employment shows the seriousness with which courts are reviewing these matters in that the court noted in its opinion that by accepting the trustee's allegations as true, "this appeal smacks of a 'strategic' effort by the defendants to divert attention from the merits of the allegations they stole about $7 million by looting a corporation." 279 B.R. at 189. Return to article

²³ In re Crivello, 134 F.3d 831 (7th Cir. 1998); In re EWC Inc., 138 B.R. 276 (Bankr. W.D. Okla. 1992). Return to article

²⁴ In re Southern Kitchens Inc., 216 B.R. 819 (Bankr. D. Minn. 1998); In re Amdura Corp., 139 B.R. 963 (Bankr. D. Colo. 1992). Return to article

²⁵ 182 F.3d 578 (7th Cir. 1999). Return to article

²⁶ 175 B.R. 525 (Bankr. S.D.N.Y. 1994). Return to article

²⁷ 182 F.3d at 585. Return to article

²⁸ Id. at 591-93. Return to article

²⁹ 175 B.R. at 553. Return to article

³⁰ Id. Return to article

³¹ The bankruptcy court's unpublished decision was fully and expertly discussed by Michael Richman, a contributing editor of Straight & Narrow, in his article "Mega Case Conflict Issues: Enron Committee Counsel," which appeared in the September 2002 issue of the ABI Journal and will not be addressed here. Return to article

³² See In re Neuman, 138 B.R. 683-685 (S.D.N.Y. 1992) (noting that special counsel employed under 11 U.S.C. §327(e) properly disclosed that the individual debtor was a cousin of a partner in the law firm). Return to article

³³ See, generally, In re Bennett Funding Group Inc., 226 B.R. 331 (Bankr. N.D.N.Y. 1998) (requiring disclosure of details of clients of accounting firms for which the trustee provided regulatory and legislative advice); In re Cody, 122 B.R. 520 (Bankr. N.D. Ohio 1990) (failure to disclose that the attorney shared office space with creditors' attorney). Return to article

³⁴ 239 B.R. 635 (1st Cir. B.A.P. 1999). Return to article

³⁵ Id. at 639. Return to article

³⁶ 196 B.R. 868 (Bankr. D. Utah 1996). Return to article

³⁷ Id. at 879. Return to article

³⁸ See, generally, In re Merry-Go-Round Enterprises Inc., 222 B.R. 254 (D. Md. 1998). Return to article

³⁹ See "Ernst Pact Spells Caution in Bankruptcy," New York L.J. (May 6, 1999); "$185 Million Suit by Former Client Could Probe Bounds of Bankruptcy Law and Legal Ethics," Legal Times (March 20, 2000). Return to article

⁴⁰ 63 F.3d 877 (9th Cir. 1995). Return to article

⁴¹ 134 F.3d 831 (7th Cir. 1998). Return to article

⁴² See, generally, "10 Commandments" at 619-622. Return to article

⁴³ 134 B.R. 321 (Bankr. N.D. Ill. 1991). Return to article

⁴⁴ Id. at 346. Return to article

⁴⁵ Id. Return to article

⁴⁶ "10 Commandments" at 619-622. Return to article

⁴⁷ Keeping with my running movie theme, just think how much better off the Lord of the Rings: The Fellowship of the Ring would have been if Gandalf had disclosed what he knew about the Mines of Morida before they entered into them. Return to article

⁴⁸ In re Crivello, 134 F.3d at 831; In re Park Helena Corp., 63 F.3d at 877. Return to article