This is the second of a series of posts on the use of other people’s money to potentially fund claims against a debtor, and when that will give rise to standing for that party in the bankruptcy case. Today’s post looks at the Second Circuit’s decision in Savage & Associates v. K&L Gates and Alex Mandl (In re Teligent, Inc.). Teligent involves the standing of a law firm – ostensibly, the party with “brass in pocket” – to challenge a settlement agreement reached by the debtor and one of its former employees whereby the former employee was required to sue the law firm for malpractice and remit 50% of the net value of any malpractice recovery to the debtor’s estate.
When Teligent hired its CEO, Alex Mandl, in 1996, it lent Mandl $15 million. If he resigned without “good reason,” Mandl would have to repay the loan immediately. If terminated other than for “cause,” however, Teligent would forgive the loan. Later, Mandl hired K&L Gates LLP to represent him in his departure from Teligent and to draft his severance agreement. The settlement agreement specified that Teligent had terminated Mandl other than for cause, thus triggering automatic forgiveness of the outstanding loan balance of $12 million. Shortly thereafter, in 2001, Teligent commenced a chapter 11 case in the bankruptcy court for the Southern District of New York. It confirmed a plan of reorganization the following year and emerged from bankruptcy.
The debtor’s plan provided for the appointment of Savage & Associates as the “unsecured claims estate representative” to prosecute estate avoidance actions and claims objections. Savage & Associates initiated an adversary proceeding against Mandl to recover the balance of the loan that had been forgiven as part of the severance agreement. K&L Gates again represented Mandl in the adversary proceeding. After a one-day bench trial, the bankruptcy court ruled that Mandl had resigned before Teligent terminated his employment, and, therefore, was liable for the balance of the loan. After entry of judgment, Mandl discharged K&L Gates, hired new counsel, and filed a motion for relief from judgment. Around the same time, Savage & Associates filed a fraudulent transfer action against Mandl, his wife, and an affiliate of Mandl in the Eastern District of Virginia.
After a mediation, Mandl and Savage & Associates agreed to a settlement of both the fraudulent transfer suit in Virginia and the adversary proceeding in New York. Under the proposed settlement, the Virginia action would be dismissed, and Mandl would pay $6 million to Teligent’s estate, sue K&L Gates for malpractice, and remit half of any proceeds in the malpractice action to Teligent’s estate. K&L Gates was invited to participate in the mediation because Mandl claimed that it had committed legal malpractice in preparing his severance agreement and representing him in the adversary proceeding. K&L Gates, though, declined to participate in the mediation. The bankruptcy court subsequently approved the settlement (and, consequently, the assignment of proceeds from any future malpractice action). As contemplated by the settlement, Mandl later sued K&L Gates for malpractice in the District of Columbia.
K&L Gates asserted as a defense in the malpractice action that Mandl’s claims were barred by the unlawful proceeds assignment under the settlement. It then moved in the bankruptcy court to lift the protective order limiting disclosure of the mediation proceedings so that it could use documents from the mediation in the malpractice action. Savage & Associates filed a cross-motion seeking to enjoin K&L Gates from using the validity of the settlement agreement as a defense in the malpractice action on the basis that K&L Gates was estopped from doing so because it had the opportunity to contest the 9019 motion in the bankruptcy court to approve the settlement and had failed to do so.
The bankruptcy court denied both motions, and specifically found that K&L Gates was not estopped from challenging the validity of the settlement agreement as a malpractice defense because it was not a party in interest with standing to challenge the settlement in the bankruptcy case as it had no financial stake in the outcome of the bankruptcy case. It also had no stake in the outcome of the 9019 motion, according to the bankruptcy court, because the settlement did not require K&L Gates to pay any money to Teligent’s estate or to Mandl; at most, the settlement affected K&L Gates by requiring Mandl to sue it for legal malpractice. K&L Gates’ interest was as a party defendant, with no pecuniary interest in the court order authorizing suit against it. That is, any financial exposure to K&L Gates was contingent upon the plaintiff (Mandl) prevailing in the malpractice litigation. Even if served with the 9019 motion, the bankruptcy court found that K&L Gates lacked standing as a party in interest to challenge the court’s approval of the settlement.
The district court and the Second Circuit affirmed. The panel agreed that K&L Gates could not have appeared before the bankruptcy court to challenge the settlement agreement because it lacked both constitutional standing to object to the bankruptcy court’s order, and it was not a party in interest under 11 U.S.C. § 1109(b). Recognizing that the term “party in interest” is broadly interpreted, the appeals court explained that a party in interest must have a direct financial stake in the outcome of the case, although in some limited circumstances courts have recognized that a party with a legal interest may appear. Judge Pooler wrote, “There is no question in this case that K&L Gates had too remote an interest in the settlement agreement to have been considered a party in interest for purposes of being heard before the bankruptcy court on the agreement’s approval.” The Second Circuit panel agreed with the bankruptcy court that K&L Gates was “merely a potential debtor of Teligent’s debtor (i.e., Mandl)” and thus “had no financial stake in the outcome of the bankruptcy case.” Further, the settlement agreement did not require K&L Gates to pay anything to Teligent or Mandl, so K&L Gates had no stake in the outcome of the 9019 motion. As it lacked standing to challenge the settlement agreement when it was before the bankruptcy court, K&L Gates was not estopped from asserting a defense in the malpractice action related to the validity of the settlement agreement.
In GIT, the Third Circuit found the postpetition increase in silica claims asserted against the debtors in that case and the coverage obligations and administrative costs attendant to such claims gave rise to injuries that were not too speculative to deny standing to the insurers to object to the debtors’ plan, even if the insurers’ ultimate liability on the silica claims was contingent. In Teligent, K&L Gates’ increased financial exposure from a lawsuit that could, if successful, result in assets that would fund recoveries for creditors of the estate did not constitute a direct financial stake in the bankruptcy case to give K&L Gates party in interest standing to challenge the bankruptcy court’s approval of the settlement assigning half of any potential proceeds to the estate. Both interests are contingent in nature – any silica claims deemed valid were still subject to the insurers’ coverage defenses, and Mandl’s recovery against K&L Gates was subject to any malpractice defense, including to the assignment of proceeds. Clearly, however the GIT insurers had a more direct interest in the outcome of the bankruptcy case than K&L Gates did. It might be said that the pockets the Debtors could be reaching into were really Mandl’s – and he, in turn, was reaching into K&L Gates’ pockets. Moreover, the insurers in GIT affirmatively sought to participate in the chapter 11 case and were denied the opportunity, whereas the parties in Teligent were attempting to use the failure of K&L Gates to participate in Teligent’s chapter 11 case to bind K&L Gates to a result. As such, it does not appear that the Third Circuit and Second Circuit are in direct conflict over the issue of standing, and it is quite possible that the Third Circuit would have come to the same conclusion in Teligent.