Professional Troubles: Payment of Retainers by Third Parties May Be Permitted, But Nondisclosure Is Costly

Contributed by Will Hueske
In the case of In re Am. Int’l Refinery, Inc., the United States Court of Appeals for the Fifth Circuit considered an issue of first impression in whether a retainer payment to a debtor’s counsel – which would usually be made by the debtor – may be made by a third party creditor on behalf of the debtor without creating a disqualifying adverse interest under the Bankruptcy Code.  The court held that, while such payments certainly may arouse suspicion of favoritism towards, or undue influence of, the third party, the totality of the circumstances must be considered, and in the instant case, no disqualifying adverse interest was demonstrated.  Despite its ultimate finding that no disqualifying interest existed, however, the court reaffirmed the imperative in the Bankruptcy Rules that a professional must disclose any potential interest that may be adverse or disqualifying adverse interest and upheld a sanction of 20% of the debtors’ counsel’s fees for failure to do so.
In the underlying bankruptcy case of In re American International Refinery, the liquidating trustee brought an adversary proceeding seeking disgorgement of fees awarded to the debtor’s counsel, Adams & Reese LLP (A&R), during the bankruptcy, claiming that because a creditor, GCA Strategic Investment Fund Ltd., had provided the firm with its retainer through an arrangement with the debtor, the firm had shown “favoritism” to the creditor.  The trustee claimed that this “favoritism” or “loyalty” to the GCA was evidenced by the following actions of counsel:

(1) negotiation of a pre-petition “lock-up” agreement between the debtor and GCA;

(2) consideration of various plan strategies favorable to GCA;

(3) recommendation to the debtors not to litigate GCA’s secured claims; and

(4) drafting of a stay relief motion on behalf of GCA as part of negotiations with the debtor.

Under section 327(a) of the Bankruptcy Code, a professional may only be employed by a debtor in possession or trustee if the professional does not hold a disqualifying “adverse interest” to the debtor.  Additionally, regardless of whether the professional actually holds such a disqualifying interest, the professional is also required under Bankruptcy Rule 2014(a) to fully disclose any interest that may potentially be disqualifying or adverse.  Specifically, Bankruptcy Rule 2014(a) requires any professional applying for employment by a debtor in possession to set forth “to the best of the applicant’s knowledge” all known connections of the applicant with the “debtor, creditors, or 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.”  Failure to disclose such connections pursuant to Rule 2014(a) constitutes grounds to revoke an employment order and deny compensation, and the willfulness of the nondisclosure may be considered in determining the level of sanction.
In this case, the evidence demonstrated that A&R failed to disclose the source of its retention payment in its original retention application and in three subsequent fee applications. The bankruptcy judge held that, while the circumstances were indeed suspicious, no disqualifying adverse interest existed. Nonetheless, the judge ruled that A&R would be sanctioned for failing to disclose the source of the retainer payment and the full relationship it held with GCA.  In considering the amount of sanction to level against A&R, the bankruptcy court noted A&R’s explanation that the applications were prepared by “an associate with little to no bankruptcy experience” and that senior attorneys had simply neglected to review the associate’s work prior to filing.  Thus, the court found that such nondisclosure was negligent rather than willful, justifying a sanction of 20%, or $135,000, instead of a full disgorgement of fees.
Fifth Circuit Decision
On appeal, the Fifth Circuit agreed with the bankruptcy court’s holding that, while the circumstances were indeed “suspicious” and “strange,” they failed to demonstrate the “egregious” level of favoritism or loyalty to a non-debtor party that is required for a finding of a disqualifying adverse interest.  The Fifth Circuit considered two potential rules for adoption: a per se rule where payment of counsel’s retainer by a third party always creates a disqualifying adverse interest, barring retention of the professional, or a “totality of the circumstances” rule where the details of the payment arrangement and the relationship between the professional and third party must be considered.  The court applied a “totality of the circumstances” test, rather than a strict per se test used in some bankruptcy courts, explaining that the existence of a conflict should be determined “with an eye to the specific facts of each case.”  With respect to the suspicious facts of this case, the court held that many of the actions taken by A&R towards GCA, such as deciding not to litigate GCA’s secured claims and discussing liquidation plans favorable to the claims of GCA, were not the result of “loyalty” or “favoritism,” but rather ordinary actions that a debtor’s counsel may take when dealing with a major creditor.
The court then looked at the requirements of Bankruptcy Rule 2014(a) in deciding whether to uphold the bankruptcy court’s 20% sanction against A&R.  It called attention to the fact that the standard set forth in Rule 2014(a) is broader than the standard for an adverse interest under section 327 of the Bankruptcy Code, in that, pursuant to Rule 2014(a), any connection is to be disclosed, regardless of whether it may be adverse.  The court held that A&R missed many opportunities to make a full disclosure of the relationship between it and GCA, but because the evidence showed the omission was negligent instead of willful, the 20% sanction was appropriate.
This case establishes the Fifth Circuit rule that a professional may be retained on behalf of a debtor through payment of a retainer via a third party without such payment constituting a disqualifying adverse interest per se, provided that the totality of the circumstances demonstrate no favoritism or loyalty by the professional to the third party in the bankruptcy case.  It also serves as a warning that, regardless of how the professional believes a court may view its interests in the bankruptcy case, full disclosure of every connection to a party in interest is always required under Rule 2014(a), and even unintentional omission may still result in painful sanctions.