To Retain (Under Section 327(a) or 363(b) of the Bankruptcy Code) or Not to Retain? Retention of Liquidation Consultants in Bankruptcy Cases

In a recent opinion – In re Heritage Home Group LLC, et al., Case No. 18-11736 (KG), 2018 WL 4684802 (Bankr. D. Del. Sept. 27, 2018) – the Delaware Bankruptcy Court addressed the longstanding issue of which professional persons must be retained under section 327(a) of the Bankruptcy Code. While section 327(a) requires that a debtor seek court approval to retain certain professionals, the Bankruptcy Code provides little guidance as to who may qualify as “professional persons.” In practice, section 327(a) imposes a number of requirements, including the submission of a retention application that includes a sworn affidavit from the professional disclosing, among other things, any connections to a party-in-interest or potential conflicts-of-interest, and attesting to the professional’s disinterestedness. Because of this cumbersome process and the disinterestedness requirements that it necessitates, many companies employed by the debtor during the bankruptcy case may prefer to avoid retention under section 327(a) if they may be retained through other means. Notably, in Heritage Home Group, Judge Kevin Gross held that a liquidation consultant hired by the debtors was not a professional subject to section 327(a). Only days after Judge Gross’s ruling, Judge Brendan L. Shannon of the Delaware Bankruptcy Court issued a similar opinion in which he looked to Heritage Home Group for guidance. See In re Brookstone Holdings Corp., 592 B.R. 27 (Bankr. D. Del. 2018).

Retaining Professionals Under the Bankruptcy Code

Chapter 11 cases typically involve various professionals – attorneys, accountants, appraisers, auctioneers, and others – assisting a debtor in possession in carrying out its duties under the Bankruptcy Code. To retain these professionals, a debtor is often required to comply with section 327(a) of the Bankruptcy Code. Section 327(a) provides, in relevant part, that a debtor in possession

with the court’s approval, may employ one or more attorneys, accountants, appraisers, auctioneers, or other professional persons, that do not hold or represent an interest adverse to the estate, and that are disinterested persons, to represent or assist the trustee in carrying out the trustee’s duties under this title.

In practice, section 327(a) requires, among other things, that a debtor submit a retention application seeking court approval of a professional. The application will include a sworn declaration from the professional disclosing the proposed scope of services, fee structure, and connections or potential conflicts-of-interest the professional holds or may hold with other creditors or significant parties-in-interest in the case. The application will state that the debtor and the professional individually reviewed the professional’s disclosures and believe they do not represent an adverse interest to the estate. The professional also agrees not to represent any such creditor or party-in-interest against the debtor while a professional retained under section 327(a).

Attorneys, accountants, appraisers, and auctioneers are expressly listed in, and must be retained under, section 327(a). However, what constitutes a “professional person” subject to section 327(a) is sometimes debatable because it is not a defined term in the Bankruptcy Code. If a professional is not a “professional person” under section 327(a), a debtor may seek to retain such professional under section 363(b), which does not include an express disinterested requirement.

Under section 363(b) of the Bankruptcy Code, the trustee “may use, sell, or lease, other than in the ordinary course of business, property of the estate” after notice and a hearing. Courts considering whether to approve a debtor’s use of estate property outside the ordinary course of business generally defer to the debtor’s business judgment. As a result, retention under section 363(b) is less onerous, and it is therefore not surprising that certain professionals may prefer to be retained under section 363(b), rather than under section 327(a). While professionals such as financial advisors and investment bankers are generally retained under section 327(a), most bankruptcy courts have permitted retention under section 363(b) for certain professionals, such as chief restructuring officers and temporary employees. However, drawing a clear line between 327(a) retentions and 363(b) retentions for other professionals, such as consultants, can be more difficult than one might expect.

The Heritage Home Group Decision

As mentioned above, in a recent opinion – In re Heritage Home Group LLC, et al., Case No. 18-11736 (KG), 2018 WL 4684802 (Bankr. D. Del. Sept. 27, 2018) – the Delaware Bankruptcy Court provided some clarity as to which professional persons must be retained under section 327(a) of the Bankruptcy Code. Judge Gross held that a consultant hired by the debtors to assist with the liquidation of certain of the debtors’ assets was not a professional subject to section 327(a).

In Heritage Home Group, the debtors sought to retain SB360 Capital Partners, LLC (the “Consultant”) pursuant to a store closing and asset disposition agreement (the “Disposition Agreement”). The Disposition Agreement provided that the Consultant’s services would include, among other things, recommending appropriate discounting, providing qualified supervision to oversee the sale, establishing and monitoring accounting functions for the sale, and recommending loss prevention strategies. In exchange, the debtors agreed to pay the Consultant commissions from the sale of assets and a separate commission for the sale of furniture, fixtures, and equipment. The court noted that under the Disposition Agreement, (1) the debtors would maintain control over personnel, merchandise, and furniture, fixtures, and equipment; (2) the debtors were responsible alone for sales taxes; and (3) the Consultant had no discretion over business decisions and was limited to making recommendations to the debtors. Following the debtors’ motion to retain the Consultant pursuant to sections 105(a) and 363(b), the U.S. Trustee filed an objection, arguing that the Consultant should be retained under section 327(a). Among the U.S. Trustee’s arguments were that the Consultant was a “professional like an auctioneer.” The court rejected this notion, relying on the Black’s Law Dictionary definition of “auctioneer” and noting that the Consultant could not be considered an auctioneer when there was no auction. Instead, the court clarified that the Consultant was an advisor.

The court then looked to relevant caselaw to determine if the Consultant fell within the “other professional” sphere under section 327(a), noting a narrow split of authority. The U.S. Trustee relied primarily on two cases, In re Borders Group, Inc., 453 B.R. 477, 485 (Bankr. S.D.N.Y. 2011) and In re First Merchants Acceptance Corp., 1997 WL 873551 (D. Del. Dec. 15, 1997), in support of 327(a) retention. Addressing Borders Group, the court acknowledged that the Borders Group bankruptcy court “favored” retention pursuant to section 327(a) for “brokers, auctioneers and liquidators to conduct de minimis asset sales,” but noted that the court did not state its reasoning. The court then looked to First Merchants, in which the Delaware District Court addressed the two traditional “qualitative” and “quantitative” analyses applied by courts with respect to professionals and noted that the two tests “need not be mutually exclusive.” In lieu of applying either test, the First Merchants court attempted to wed the two tests by setting out a number of factors to be considered in determining the necessity of 327(a) retention for professionals. In summarizing the factors and creating a modified test, Judge Gross concluded that “[w]hat is clear in First Merchants is that a ‘professional’ is limited to those occupations which control, purchase or sell assets that are important to reorganization, is negotiating the terms of a plan of reorganization, has discretion to exercise his or her own personal judgment, and whether he or she contributes ‘some degree of special knowledge or skill.’” The court determined that although the Consultant did have specialized knowledge, it was not at the center of the reorganization, and the Disposition Agreement nullified its degree of control.

Before concluding, the court looked to two recent cases for guidance and further simplified the First Merchants test by focusing on the professional’s degree of “intimacy.” In In re Nine West Holdings, Inc., 2018 WL 3238695 (Bankr. S.D.N.Y. July 2, 2018), the bankruptcy court held that the debtors were authorized to use section 363(b) to hire a management consultant, who had overseen the debtors’ daily operations for over four years prior to the petition date, to provide the debtors with an interim CEO and certain additional personnel. The court cited Comm. Of Asbestos-Related Litigants v. Johns-Manville Corp., 60 B.R. 612, 619 (Bankr. S.D.N.Y. 1986) for the proposition that a professional under section 327(a) plays an intimate or central role in the reorganization process. Relying on this principle, Judge Gross determined that the Consultant was not a 327(a) professional because it was not intimately involved in the reorganization. Finally, the court looked to In re hhgregg, Inc., Case No. 17-01302-RLM-1 (Bankr. S.D. Ind. May 8, 2017), in which a consultant was not subject to section 327(a) because the consultant (1) carried out the debtor’s judgment, (2) did not play a central role in the reorganization, (3) did not have broad discretion, and (4) had no control over sales prices. Comparing the terms of the Disposition Agreement, the court held that the Consultant’s responsibilities were “clearly advisory and [did] not constitute an intimate role in the Debtors’ plans.”

The Impact of Heritage Home Group

Heritage Home Group provides some clarity, at least in Delaware, as to the status of liquidation consultants as 363(a) professionals (or non-professionals for that matter). Additionally, the court’s analysis of those intimately involved in the reorganization process may lend guidance to other professionals as well. As Judge Shannon recognized in a subsequent case following shortly thereafter, with very few exceptions, liquidation consultants have traditionally been retained by service contracts pursuant to sections 365(a) and 363(b) of the Bankruptcy Code. In re Brookstone Holdings Corp., 592 B.R. 27 (Bankr. D. Del. 2018). Following Judge Gross’s ruling, Judge Shannon similarly looked to the First Merchants factors for guidance and agreed only days later that an industry peer did not qualify as a professional for purposes of section 327(a). Although it remains a recent decision, Heritage Homes is already beginning to gain traction.