When seeking retention as a professional for a debtor-in-possession (DIP), it is black-letter law that the proposed professional must be disinterested. See 11 U.S.C. §§101(14), 327(a). The timing and method of determining disinterestedness is not as clear-cut. Indeed, it is common for courts to approve the employment of a professional on an interim basis or final basis with a caveat that the court may later rule on disinterestedness, particularly when the alleged interest is more potential than actual at the outset.

Recently, however, the Third Circuit has addressed the need to determine disinterestedness in the earliest stages of a case. See In re Pillowtex Inc., 304 F.3d 246 (3d Cir. 2002). While the alleged conflict found in Pillowtex—preferential transfers to a professional—is not new, the Third Circuit's holding as to the timing of determining disinterestedness is a further complication to the early stages of a bankruptcy case.

In re Pillowtex

In Pillowtex, the U.S. Trustee objected to the employment of proposed counsel for the DIP based on counsel's alleged receipt of preferential transfers. After the district court approved counsel's employment, with the caveat that if the court later determined that counsel had received a preferential transfer, counsel would "promptly return the same to [the bankruptcy] estate...and waive any unsecured claim it has by virtue thereof," the U.S. Trustee appealed to the Third Circuit.

Meanwhile, the underlying bankruptcy proceeding moved forward, and the debtor confirmed a reorganization plan, which would appear to have mooted the appeal. Further, no party asserted a preference action against counsel, nor did any other party object to counsel's employment. The Third Circuit, however, disagreed that confirmation mooted the appeal. In re Pillowtex, 304 F.3d at 250; citing Citicorp Venture Capital Ltd. v. Committee of Unsecured Creditors, 160 F.3d 982, 986 (3d Cir. 1998).

In considering the issues on appeal, the Third Circuit first examined the three levels of conflict it had previously found: (1) an actual conflict of interest, which requires disqualification; (2) a potential conflict of interest, for which the district court has discretion to disqualify; and (3) the appearance of a conflict, for which the district court may not disqualify without other basis. See In re Pillowtex, 304 F.3d at 251; citing In re Marvel Entertainment Group Inc., 140 F.3d 463, 476 (3d Cir. 1998). The Third Circuit then reiterated its holding in First Jersey Securities that "[a] preferential transfer to [debtor's counsel] would constitute an actual conflict of interest between counsel and the debtor, and would require the firm's disqualification." In re First Jersey Securities Inc., 180 F.3d 504, 509 (3d Cir. 1999). In First Jersey Securities, however, the court held that the record demonstrated that counsel had received a preferential transfer, thereby creating an actual conflict of interest, whereas no such evidence existed on the record in Pillowtex.

Without such evidence, the Third Circuit could not rule on whether an actual conflict existed. Indeed, the Third Circuit stressed that a record of such evidence is important, despite counsel's assertions that such a hearing would be expensive and unnecessary, because a preferential transfer can be, but is not always, an actual conflict requiring disqualification. In re Pillowtex, 304 F.3d at 250-52; citing Jackson, Thomas H., "Avoiding Powers in Bankruptcy," 36 Stan. L. Rev. 725, 757 (1984).¹ Thus, since counsel failed to proffer any evidence as to the nature of the pre-petition fees received on or within 90 days prior to the petition date, the Third Circuit could not determine what fees were preferential transfers and what fees were for bankruptcy preparation. In re Pillowtex, 304 F.3d at 253. Consequently, since the record did not reflect such evidence, the Third Circuit reversed and remanded the matter to the district court for a hearing on whether the fees paid within 90 days of the petition date were preferential transfers and whether an actual conflict existed.

Avoiding the Avoidance Conflict

Pillowtex's ruling does not change the conflicts analysis, only the timing of the analysis. Indeed, Pillowtex mandates that a bankruptcy or district court resolve any disinterestedness issues during the preliminary stages of a bankruptcy case. Although prior to Pillowtex early resolution was achieved by the reservation of such objections and/or waivers of claims resulting from avoidance actions, Pillowtex clearly states that the mere promise to waive a claim resulting from the avoidance of a preferential transfer is not sufficient. Id. at 253.

While it may be sufficient to waive past due fees and expenses prior to employment, that waiver is quite different from the waiver suggested by counsel in Pillowtex. Id. A professional that has not waived pre-petition, antecedent fees, and has actually received payments on account of such antecedent fees, may have liability to the bankruptcy estate and may become a creditor. That situation is quite different from a situation where a proposed estate professional has waived pre-petition, antecedent fees prior to employment, and has not received payment for antecedent fees.

As a professional employed by the DIP, that someone with such potential liability would have an interest in discouraging the investigation and pursuit of avoidance actions, particularly if the potential distribution to unsecured creditors is minimal, if expected at all. And in the Third Circuit, only the DIP or a chapter 11 trustee can bring avoidance actions. See Official Committee of Unsecured Creditors of Cybergenics Corp. vs. Chinery, 304 F.3d 316 (3d Cir. 2002). Due to the Cybergenics holding, the protection previously provided by committee investigation of avoidance actions appears to be gone.²

Thus, "when there has been a facially plausible claim of a substantial preference, the district court and/or the bankruptcy court cannot avoid the clear mandate of the statute by the mere expedient of approving retention conditional on a later determination of the preference issue." Pillowtex, 304 F.3d at 255. Pillowtex, therefore, mandates an early resolution to potential conflicts.

Moreover, early resolution is important to the professional to prevent the potential for great economic loss. After all, if an appellate court finds that a professional must be disqualified because of an actual conflict of interest, then that professional may be subject to the total disgorgement of all fees and expenses incurred during the bankruptcy, as well as the subsequent disgorgement of the preferential transfer, regardless of the success of the case.

Thus, professionals would be wise to resolve potential conflicts early in a bankruptcy case. To resolve allegations of actual conflict due to preferential transfers, a professional must proffer evidence that the alleged preferential transfers were payment for pre-bankruptcy services, or that subsequent new value was otherwise provided. Such evidence may be introduced at the hearing on the employment application as opposed to a full-blown adversary proceeding. Indeed, the Third Circuit did not hold that an adversary proceeding and trial were necessary, and implied that a hearing was needed to determine whether the U.S. Trustee could establish a prima facie case that preferential transfers were made.

If, however, the transfers were on account of an antecedent debt and meet the elements of §547, with none of the defenses therein, the professional must face the inevitable: He or she is the recipient of preferential transfers. But it is better to determine and address the conflict before thousands or millions of dollars in fees are incurred.

Upon a finding that a preferential transfer was made, the district court must determine whether such transfer created an actual conflict for the proposed professional. Indeed, such conflict might be avoided by the retention of special conflicts counsel to investigate and pursue preferential transfers against estate professionals. See In re Air South Airlines Inc., No. 97-07229-W, 1998 WL 34020727, *5 (Bankr. D. S.C. Jan. 16, 1998). With the employment of special conflicts counsel, the professional is no longer in actual conflict as that professional is not employed or authorized to investigate and/or advise a DIP on such issues. In fact, many courts have analyzed §327(c) and held that there is no conflict of interest where counsel represents or is a creditor of the debtor, but is employed for certain purposes in the case for which no conflict exists. In re Hoffman Associates Inc., No. 90-02419-W, 1996 WL 33340782, *3 (Bankr. D. S.C. Sept. 10, 1996); citing In re RPC Corp., 114 B.R. 116 (M.D.N.C. 1990); In re Fondiller, 15 B.R. 890, 892 (9th Cir. B.A.P. 1981); Matter of Lorandos, 58 B.R. 519 (Bankr. S.D. Ohio 1986). While special conflicts counsel would be employed by the DIP, the conflict is removed from the conflicted professional, and an effective investigation of potential avoidance actions against other estate professionals may occur.

Proposed professionals could also avoid conflicts by introducing evidence of special circumstances in the particular case. For example, if the debtor had filed a "pre-pack" bankruptcy that provided for payment in full of all creditors, there would be no need to avoid any preferential transfers. Presumably, other such circumstances could also exist.

Alternatively, the conflict can be avoided by having such a hearing and complying with the findings. If the court finds a preference that creates an actual conflict, counsel has the opportunity to withdraw or remit the preference and waive their claim, thereby avoiding the conflict. As painful as this result would be, professionals are not excepted from the provisions of §547.

Conclusion

The conflict discussed in Pillowtex is not a new issue. Requiring resolution of the conflicts issue in the earliest stages of a bankruptcy case, however, is not the common practice in many courts. For quite some time, professionals have delayed such issues with promises to waive and/or reservations of the right to pursue such actions.

Certainly, many such determinations will be resolved favorably and create some unnecessary delay and additional expense. However, the delay and expense need not be large, as the issues are certainly capable of resolution in a summary proceeding. Absolute proof through an adversary proceeding is not the intended result. Instead, courts need to determine whether a prima facie case exists that preferential transfers were made to which the proposed professional cannot rebut or demonstrate a defense.

Granted, this will prevent many proposed professionals from serving as estate professionals. However, for a professional with the potential for disgorgement and the always-present ethical issues, is waiting really worth the risk?

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Footnotes

¹ In stating that a preferential transfer to a proposed professional could be an actual conflict, the Third Circuit appears to be backing away from its affirmative holding in First Jersey Securities that this "would be an actual conflict." Return to article

² Currently, there is a split in Second and Third Circuit authority as to the standing of a creditor and/or committee to bring avoidance actions. See Official Committee of Unsecured Creditors of Cybergenics Corp. vs. Chinery, 304 F.3d 316 (3d Cir. 2002); Banque Nationale de Paris vs. Murad (In re Housecraft Industries USA Inc.), No. 01-7998, 2002 WL 31388883, -- F.3d -- (2d Cir. Oct. 24, 2002). Return to article