As the holidays approach, there is nothing like sitting down in a comfortable chair in front of a warm fireplace and reading about Rule 2014 disclosure and debtor control of claim issues. While all of your other holiday activities will certainly be more cheerful than reading this month's Straight & Narrow, the issues addressed by the Delaware Bankruptcy Court in eToys and the Second Circuit in Smart World are both timely and important.

Not the Toys You Asked Santa for: In re eToys Inc.²

Those of you who follow this column know that two of our favorite topics are disclosure by professionals under Rule 2014³ and the impact that the allowance of the final fee application has on subsequent malpractice or related actions.⁴ The recent eToys decision discusses both of these issues in detail and establishes broad new disclosure requirements for officers who are hired by debtors but not retained as professionals under 11 U.S.C. §327.

Fight Club: The Background of the eToys Decision

The eToys case involved a series of actions ("sanctions motions") by a very determined pro se shareholder of eToys against committee counsel, the debtors' counsel and an officer (collectively, the "respondents") of the reorganized debtor, who were seeking (1) the removal of respondents from their roles in the cases, (2) disgorgement of the respondents' fees and sanctions for violating the disclosure requirements of Bankruptcy Rule 2014, (3) sanctions for violation of the conflict-of-interest provisions of 11 U.S.C. §327, (4) an objection to a settlement between the U.S. Trustee and committee counsel, and (5) for the bankruptcy court to refer these matters for further criminal and disciplinary investigation ("sanctions"). This litigation over these matters arose in a rather unusual context.

In March 2001, eToys and various of its affiliates (the debtors) filed chapter 11 petitions. Prior to the filing, Goldman Sachs and Co. was advanced by the debtors $3.150 million for financial services, of which $2.5 million was a refundable success fee.⁵ At the time of the bankruptcy filing, the debtors requested that two firms be retained as their primary bankruptcy counsel. One of the law firms was disqualified from being 11 U.S.C. §327(a) counsel to the debtors due to the fact that one of the debtors' vice-presidents and general counsel was to join that firm as a partner. Therefore, the remaining firm, which had originally been selected to act only as Delaware counsel, was selected as the debtors' 11 U.S.C. §327(a) counsel ("debtors' counsel").

As part of their employment application, debtors' counsel submitted an affidavit listing the parties in interest that the debtors' counsel represented within the previous three years. This affidavit failed to disclose that debtors' counsel was representing two parties in interest in the debtors' case, General Electric Capital Corp. (GECC) and two affiliates of Goldman (Goldman Affiliates) in a large but unrelated bankruptcy. Debtor's counsel did not formally update their 2014 disclosures concerning their representation of the Goldman Affiliates and GECC until after the sanctions motions were filed. The debtors' counsel's application for employment was approved without objection in April 2001. In September 2001, the debtors moved to authorize committee counsel to take over all litigation concerning Goldman and disclosed that it represented Goldman in other matters (authorization motion). The authorization motion was approved by the court in October 2001.

In March 2001 an official unsecured creditors' committee was appointed in the eToys case. The committee promptly selected its counsel, whose application for employment was approved on April 25, 2001. Approximately one month after the committee counsel was employed, the debtors hired an officer to oversee the liquidation. Sometime later, on July 23, 2001, the debtors selected the officer as their president and CEO. At no time during these proceedings did the committee counsel or the officer disclose that the officer and one of the committee counsel's senior partners were partners in an entity known as Asset Disposition Advisors LLC (ADA) or that the committee counsel had paid the officer $30,000 a month from February to May 2001 related to his services on behalf of ADA.

On Nov. 1, 2002, the court confirmed eToys' plans over shareholder objection. The plan vested the debtors' remaining assets in a reorganized debtor, which was managed by the officer as the plan administrator. Debtors' counsel was retained by the reorganized debtor as its counsel. The committee was dissolved and succeeded by a post-effective date committee (PEDC), which monitored the liquidation of the debtor on behalf of unsecured creditors. The committee counsel continued to represent the PEDC post-confirmation. The final fee applications for debtors' counsel and committee counsel for their post-petition, pre-confirmation work were approved by a final order entered Feb. 27, 2003.

In November 2004, PEDC filed a motion to approve a settlement it had reached with Goldman concerning a disputed pre-petition success fee that the debtors paid to Goldman. The shareholder objected to the settlement⁶ and later filed sanction motions requesting that sanctions be imposed on the respondents. The U.S. Trustee's Office separately objected to the committee counsel's fees due to the committee counsel's failure to disclose their connection with the officer ("trustee objection"). The trustee objection was ultimately settled by committee counsel agreeing to disgorge $750,000 of fees paid to them post-petition and pre-confirmation ("trustee settlement"). This represented a reduction of approximately 50 percent of the committee counsel's fees.

eToys Prelude: Yogi Was Right—Final Orders May Not Be so Final

Two of the initial issues⁷ the court had to address in eToys was whether the claims raised by the shareholder were barred by either (1) the exculpations provided to the respondents by the plan, which released the respondents from all liability for acts or omissions occurring on or after the eToys bankruptcy was filed "except for acts constituting willful misconduct or gross negligence" ("plan releases") or (2) by the fact that the plan was confirmed and final fee orders entered more than one year prior to the sanction motions.

The bankruptcy court refused to dismiss the sanction motions based on the plan releases, concluding that if in fact the respondents knowingly failed to properly disclose "actual conflicts of interest,"⁸ such conduct was not covered by the plan releases as such actions would constitute willful misconduct.

Second, the court also rejected the argument that the sanction motions were untimely because the shareholder sought to revoke or modify earlier court orders that had been entered more than one year before the shareholder motions. (See Bankruptcy Rule of Procedure 9024 incorporating Federal Rule of Procedure 60 to bankruptcy proceedings.)

The eToys court held that while the shareholder was barred from seeking relief from the court's previous orders under Federal Rule of Civil Procedure 60(b)(1), (2) or (3),⁹ if the shareholder's allegations of nondisclosure proved true, the shareholder would be entitled to relief under Federal Rule 60(b)(6) as such failure to disclose conflicts of interest would constitute "a fraud on the court."¹⁰

Disclose: The Debtors Counsel

The eToys court then turned to the disclosure issues related to the debtors' counsel. In response to the sanction motions' allegations that the debtors' counsel failed to properly disclose its connections with the Goldman Affiliates and GECC, debtors' counsel argued that (1) it made timely and adequate disclosure of its connections with Goldman; (2) its failure to disclose its connections with GECC until after the sanction motions were filed was the result of an "inadvertent oversight;" and (3) its representation of the debtors at all times was fully consistent with §327(a), notwithstanding any inadvertent or technically deficient failures to disclose connections under 2014. The court rejected each of these contentions.

First, the court noted that debtors' counsel knew of Goldman's involvement with the debtors by May 2001, when it learned that the debtors had a potential right of recovery on at least the $2.5 million in fees, but did not take any action to disclose these connections until it filed the authorization motion four months later in late September 2001. The court also held that the timing and manner of disclosure of the connections through the authorization motion was insufficient and that a supplement declaration under Rule 2014(a) was required to properly advise the court of the Goldman connections. The court also determined that the debtors' counsel's representation of the Goldman Affiliates in the other chapter 11 case resulted in the debtors' representing a party that held an adverse interest to the debtors' estate as of May 2001, when it first learned of the conflict.¹¹

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[P]rofessionals need to look beyond representational conflicts when disclosing connections under Rule 2014.

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The court next considered debtors' counsel's failure to disclose its connections with GECC. GECC presented an unusual issue, as it was not listed by the debtor as a creditor in its schedules and matrix because at the time of the debtors' filing, GECC was not a creditor of the debtors, but became a creditor when it was assigned another creditor's position under an equipment lease.

The court did not find fault with debtors' counsel's position that it would have been impossible to disclose its connections with GECC in its initial disclosures. However, the court did find that the debtors' counsel failed to supplement its Rule 2014 disclosures when it learned, through litigation, of GECC claims against the estate. The court specifically held that even if the debtors' counsel's failure to conduct additional conflicts searches and supplemental disclosures after they were retained was due to an inadvertent oversight, it was still a violation of their duty to disclose.¹²

The last defense raised by debtors' counsel was that no sanctions were warranted for its failures to make full disclosures under Rule 2014, as the estate was not harmed by these actions. The eToys court rejected this argument, finding that (1) there was harm arising from the duplication of effort between debtors' counsel and the committee concerning the Goldman issues, and (2) no harm is required for a court to sanction a party where there is an undisclosed conflict of interest.¹³

The court then turned to the remedies for debtors' counsel's disclosure failures. While the court noted that it could order the disgorgement of all fees¹⁴ earned after the debtors ceased being disinterested (approximately May 2001), the court instead exercised its discretion and merely ordered the disgorgement of all fees related to debtors' counsel work on matters related to Goldman and GECC. The court held that debtors' counsel's violations were not so serious as to require more severe sanctions.

And Disclose: The Committee Counsel

Although the court did not think much of the shareholders' pleadings concerning its objection to the actions of committee's counsel,¹⁵ the court and the U.S. Trustee were clearly disturbed by the committee counsel's failure to disclose (1) the business relationship between a partner of committee counsel and officer in ADA,¹⁶ and (2) its other professional relationships with the officer.¹⁷

The court rejected all of committee counsel's defenses to its admitted nondisclosure of its connections with the officer except for its argument that there was no basis for its disqualification as counsel because under 11 U.S.C. §1103(b), which governs the retention of attorneys by a committee, attorneys for a committee do not have to be disinterested. Committee counsel argued that its connections with the officer merely raised an appearance of a conflict that did not require their disqualification under the Third Circuit's decision in In re Marvel Entertainment Group Inc., 140 F. 3d 463, 476 (3rd Cir. 1998) (holding that disqualification for an appearance of a conflict was discretionary, while disqualification for an actual conflict of interest was mandatory).

The court never addressed committee counsel's Marvel defense, as the issue of committee counsel's fees arose in the context of the shareholders' objection to the settlement between the committee counsel and the Office of the U.S. Trustee of the Trustee's objection. The eToys court found that the $750,000 disgorgement provided for by the trustee settlement was appropriate under Rule 9019 and provided "a reasonable penalty for the transgression committed...[and] also serves as a 'lighthouse' to others warning them to avoid the rocks of nondisclosure."¹⁸

And Disclose Some More: The Officer

Finally, the court overruled the shareholders' objections to the officers' fees based on his alleged breaches of loyalty, conflicts of interest, improper disclosures and other misdeeds that the shareholders claimed the officer committed. The court found no evidence of any conflicts of interest by officer. The eToys court distinguished this case from In re Coram Healthcare Corp.,¹⁹ where the court found that the CEO violated his duty of loyalty to the debtor by working for one of its creditors.

The court also found that the officer did not breach his duty of loyalty to the debtors. The court stated that while the officer's relationship with ADA and the committee counsel raised a question as to his loyalty, there was no evidence that the officer took any actions that would compromise his duty of loyalty.

Finally, the court held that while the officer did not disclose any of his connections with committee counsel, the Code does not require officers hired by debtors to either be employed under 11 U.S.C. §3327(a) or make disclosures under Rule 2014.²⁰ Therefore, the court did not find that the officer could or should be sanctioned for his alleged failure to disclose.²¹

However, the court did hold that in the future officers of chapter 11 debtors will have to make Rule 2014-like disclosures of their connections with parties in interest and professionals in those cases, or they will be subject to possible disgorgement of compensation.

You Can Stop Disclosing Now: Importance of eToys

eToys presents yet another chilling case of what happens when disclosures under Rule 2014 are not properly made. eToys highlights three major points related to Rule 2014 disclosures.

First, professionals must continue to make conflict checks throughout bankruptcy cases and promptly update their Rule 2014 disclosures. Both the debtors' counsel and committee counsel in this case ran into problems with connections that arose after they properly completed their initial disclosures in connection with their employment. Professionals should designate a party at their firms to be responsible for such disclosures and who will monitor entries of appearances and other critical pleadings so that new parties can be searched and updated disclosures can be filed.

Second, professionals need to look beyond representational conflicts when disclosing connections under Rule 2014. In eToys, the committee counsel's problems arose primarily from an undisclosed business relationship between one of its partners and the officer. Bankruptcy professionals should consider adding business, community and professional relationships to their conflict databases. While obtaining such information will be difficult, the cost of not making such disclosures could be extremely costly.

Third, at least in Delaware Rule 2014, disclosures are no longer just for debtor and committee professionals. Key officers of the debtor will now have to make disclosures of their connections with debtors, creditors, other parties in interest, the U.S. Trustee's Office and their professionals. Attorneys may have an opportunity for new clients to ensure compliance with the officer disclosure requirements.

Mine, Mine, Mine: In re Smart World Technologies LLC

²²

How many times have you arrived at a sold-out show, airport or baseball game ready to enjoy yourself and you start looking for your tickets, only to realize you have forgotten them? These predicaments mirror the problem faced by the proponents of a settlement in Smart World, which explores the limits of fiduciary duties and derivative standing in the context of Rule 9014 settlement motions.

Source Code: Smart World's Background

The facts of Smart World, taken primarily from the Second Circuit's decision,²³ are reasonably straightforward. Prior to bankruptcy, Smart World entered into an agreement with a large Internet provider (buyer) to sell its Internet subscriber base through an 11 U.S.C. §363 sale. Smart World filed for bankruptcy on June 29, 2000, and its §363 sale was approved on July 19, 2000.

As soon as the sale was approved, a dispute arose between Smart World and the buyer as to the calculation of the amounts owed by the buyer under the sale.²⁴ After a hearing was scheduled as to the buyer's good faith under the §363 sale in September 2000, the buyer filed a declaratory judgment action (AP) seeking to establish that it had properly performed under the sale. Smart World counterclaimed in the AP, asserting numerous claims against the buyer. Smart World also hired with court approval special litigation counsel on a contingency basis to litigate its claims.

After limited²⁵ discovery, the bankruptcy court stayed all discovery and proceedings in the AP while one of Smart World's largest creditors and the buyer, with the knowledge of the unsecured creditors' committee, negotiated a settlement of the debtors' claim. Neither the creditor nor the committee sought formally to obtain control of the debtors' underlying claim prior to the filing of the Rule 9019 motion nearly three years after the AP was filed and after all meaningful discovery was stayed.

In May 2003, the creditor, committee and buyer filed a motion under Bankruptcy Rule 9019 ("settlement motion") to approve a settlement of the debtors' claims against the buyer ("settlement").²⁶ The bankruptcy court approved the settlement motion over the objections of Smart World, finding the settlement reasonable and that, under 11 U.S.C. §105 and the Second Circuit's derivative standing case law, the creditor had standing to bring the settlement motion.²⁷ The settlement provided that the buyer would pay $5.5 million to the debtors' estate, $500,000 of which would go to a creditor to satisfy a specific claim. Under the terms of the settlement, the creditor could assert a secured claim as to the remaining $5 million. Among the reasons the bankruptcy court approved the settlement was that the bankruptcy estate would be administratively insolvent but for the settlement payments.

On appeal the district court affirmed, finding both that the settlement was within the range of reasonableness under which courts can approve Rule 9019 motions.²⁸ Although the district court found that the issue of whether a creditor—as opposed to a trustee or debtor-in-possession—has standing to bring a Rule 9019 motion was one of first impression,²⁹ it ruled that under 11 U.S.C. §105 and the Second Circuit's derivative standing case law, the creditor had standing to file the settlement motion. Smart World then appealed to the Second Circuit.

Litigating Lawsuits Is Different from Settling Lawsuits, Even in Bankruptcy Courts

Unlike the lower courts, which clearly believed that Smart World was not following its fiduciary duties by failing to accept the settlement offered by the buyer, the Second Circuit initially focused on what it saw as evidentiary problems with the underlying Rule 9019 analysis. The Second Circuit ultimately found that the failure of the bankruptcy court to permit "any meaningful discovery" prevented the bankruptcy court from properly analyzing the appropriateness of the settlement.³⁰

However, the Second Circuit did not reverse the lower court's decisions on the grounds of an inadequate evidentiary record, but rather on the grounds that the parties to the settlement motion lacked standing to bring a Rule 9019 motion to approve the settlement of a debtors' claim. The Second Circuit first noted that under Rule 9019's plain language, only trustees and debtors-in-possession (DIPs) (by virtue of 11 U.S.C. §1107) can bring motions to settle claims of the debtor under Rule 9019.³¹ The Second Circuit determined that, for numerous reasons, limiting standing to file a motion to settle the debtors' claims to DIPs and trustees³² was appropriate under the provisions of the Code that govern chapter 11 cases. However, the Second Circuit did not foreclose the possibility that in an appropriate case, a court could grant derivative standing to another party³³ to file a Rule 9019 settlement motion on behalf of a debtor, but rather held that under the facts of this case the granting of derivative standing was not appropriate in this case.³⁴

The Second Circuit also distinguished its derivative standing line of cases by ruling that a debtor's failure to assert a claim was a far greater problem than the possibility that a debtor would fail to properly settle a case it was pursuing. Therefore, the Second Circuit held that its derivative standing line of cases did not apply in the Rule 9019 settlement motion context.³⁵ The Second Circuit also found that it would be bad policy to freely give parties other than the DIP or trustee derivative standing to settle the debtors' claims, as the possibility of such standing would create a "perverse dynamic" of encouraging parties against whom the debtors have claims not to settle with the debtor in hopes a derivative party would offer a better deal.³⁶

Finally, the Second Circuit also rejected the other grounds under which the buyer, creditor and committee asserted they had standing to assert the settlement motion. The circuit held that neither 11 U.S.C. §1109(b), the Rules Enabling Act of 28 U.S.C. §2075 or 11 U.S.C. §105 gave standing to the creditor, committee or buyer to prosecute the settlement motion or otherwise take over the debtors' claim.

And to all a Good Night

The Smart World case does not mean that nondebtors cannot either take over the litigation of debtor claims or settle those claims in appropriate circumstances. Rather, Smart World requires nondebtor parties to first properly gain control of the debtors' claim by either (1) having a trustee or examiner appointed who will have authority to settle the claim, (2) reaching an agreement (with court approval) with the debtor to be assigned or otherwise given authority to pursue and settle the claim, or (3) obtaining court authorization to pursue a claim on behalf of the debtor after appropriate litigation before the court. Therefore, enjoy the holidays, and like Santa Claus, don't put your sleigh before the reindeer.

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Footnotes

¹ Board Certified in Business Bankruptcy Law by the American Board of Certification. Return to article

² ____ B.R. ____ 2005 WL 2456255 (Bankr. D. Del. Oct. 4, 2005). See related column on p. 34. Return to article

³ See Bowles, "Fighting Nazgul, Trolls and Orcs Is Easy; Disclosing under Rule 2014 Is Hard," 22 ABI Journal 24 (April 2003); Bowles, "Disclosing Connections and Relationship under Rule 2014," 20 ABI Journal 28 (April 2001). Return to article

⁴ Bowles, "When and Where: Limits on Malpractice Claims Against Debtors' Counsel," 19 ABI Journal 8 (Oct. 2000). Return to article

⁵ $2.5 million of Goldman's fees was to be refunded if certain financial goals were not met. None of the financial goals were met. Return to article

⁶ The shareholder was originally joined in his objection by a corporation whose objections were summarily dismissed because the corporation's pleadings were filed without counsel. Under the doctrine of Rowland v. California Men's Colony, 506 U.S. 194, 202 (1993), corporations may not appear in federal court without counsel. Return to article

⁷ The bankruptcy court overruled the vast majority of relief requested by the shareholder on various technical and procedural grounds. The court also refused to dismiss the shareholder's pleadings as being filed in bad faith, finding that even if the pleadings were filed in bad faith, the issue of inadequate disclosure they raised was so important that the court was "compelled to address the merits of the motions." 2005 WL 2456255 at *5. Return to article

⁸ Id. Return to article

⁹ Modifications under Federal Rule of Procedure 60(b)(1) (mistake, inadvertence, surprise or excusable neglect) 60(b)(2) (newly discovered evidence) or 60(b)(3) (fraud, misrepresentation or misconduct) must be requested by motion within one year of the entry of the challenged pleading. Return to article

¹⁰ 2005 WL 2456255 at *6, citing Pearson v. First NH Mort. Corp., 200 F.3d 30 (1st Cir. 1999); In re Southmark Corp., 181 B.R. 291, 295 (Bankr. N.D. Tex. 1994). Return to article

¹¹ In connection with this analysis, the court rejected the debtors' counsel's passing argument (based on In re Enron Corp., 2002 WL 32034346 at Pg. 5 (Bankr. S.D.N.Y. 2002), aff'd., 2003 WL 223455 (S.D.N.Y. 2003)), that it was not required to disclose every minor or insignificant connection. Debtors' counsel argued that they were not required to disclose "every conceivable interpretation of its counsel's debtors' counsel's connections" under Rule 2014. The eToys court noted that given the facts of this case, disclosures related to connections with Goldman were clearly needed as there was a clear potential for a conflict of interest. Return to article

¹² 2005 WL 2456255 at 12-13. Return to article

¹³ Id., citing In re Leslie Fay Cos., 175 BR 525, 531 (Bankr. S.D.N.Y. 1994). Return to article

¹⁴ See In re Crivello, 134 F. 3d 831 (7th Cir. 1998); In re Downs, 103 F.3d 472 (6th Cir. 1996). Return to article

¹⁵ "Although his pleadings are replete with hyperbole and assertions that were revealed to be false when tested at trial...." 2005 WL 2456255 at *13. Return to article

¹⁶ See Id. at *14. Return to article

¹⁷ In 2001, the officer was hired by committee counsel as a consultant in two other large chapter 11 cases. Further, committee counsel recommended the officer for his position with the debtors. Id. Return to article

¹⁸ Id. at 7. Perhaps a better analogy would have been the execution of Admiral John Byng, who was executed on March 14, 1757, for failing to relieve the British base at Minorca. Traditionally, it has been said, Byng was executed not primarily for his incompetence, but to encourage other Admirals to do their utmost. Return to article

¹⁹ 271 B.R. 228 (Bankr. D. Del. 2001) (the court noted that the creditor who paid the debtor's CEO a $1 million consulting fee received favorable treatment from the debtor, and the CEO apparently performed little work for the fee). Return to article

²⁰ 2005 WL 2456255 at *19-21. Return to article

²¹ Id. at *21. Return to article

²² 423 F.3d 166 (2nd Cir. 2005). Return to article

²³ Reading the district court's opinion and the Second Circuit's opinions leads one to question whether they were addressing the same case. Return to article

²⁴ The sale provided that the buyer would pay Smart World certain amounts for "qualified subscribers" in stock and cash with the stock component of the purchase price increasing as the total purchase price increased. By the time of the Second Circuit's decision, the value of the buyer's stock had greatly increased, and there was a dispute as to whether Smart World was entitled to that increase in stock price. Return to article

²⁵ The Second Circuit described the discovery as the buyer having "dumped tens of thousands of documents on Smart World's counsel just days before the hearing [on good faith]." 423 F.3d at 168. Return to article

²⁶ It also settled certain claims between the creditor and the buyer. Return to article

²⁷ See In re STW Enters., 779 F.2d 901 (2d Cir. 1985) (giving committees the right under certain circumstances to file suit on behalf of the debtors). Return to article

²⁸ See In re Best Product Co. Inc., 68 F.3d 26, 33 (2d Cir. 1995); In re Teletronics Services Inc., 762 F.2d 185 (2d Cir. 1985). Return to article

²⁹ Rule 9019(a), Fed. R. Bankr. P., provides that on motion by the trustee and after notice and a hearing, the court may approve a compromise or settlement. Notice shall be given to creditors, the U.S. Trustee, the debtor and indenture trustees as provided in Rule 2002 and to any other entity as the court may direct. Return to article

³⁰ 423 F.3d at 179. Return to article

³¹ Id. at 174. Return to article

³² An interesting question not addressed in Smart World is if there is a strict standing limitation on using Rule 9019, how can parties compromise on claims or other disputes in a bankruptcy case that do not involve claims of a debtor (for example, an objection to a secured proof of claim made by a creditor or committee)? Return to article

³³ Id. at 179-180. However, under Smart World, any party being given such derivative standing would have to have interests that were closely aligned with the estate. Return to article

³⁴ Id. at 180. Return to article

³⁵ Id. at 177. Return to article

³⁶ Id. Return to article