Big Investment Banks Win Big in Congress

The 2005 Amendment

Section 327(a) of the Code enables a trustee to hire a professional only if that professional holds or represents no interest adverse to the estate, and if he or she is “disinterested.” (Code ' 327(a).) Section 327(a) will continue to apply here, but Congress changed the definition of “disinterested person.” Prior to the 2005 amendment, an investment banker was ineligible if it had previously been engaged for “any outstanding security of the debtor” or handled an offering within 3 years prior to the petition date. (Code '' 101(14)(b) and (c).) It also excluded the banker's attorney, and any person who was or had been a director, officer or employee of the investment banker within 2 years of the filing date. (Id.)

Effective October 2005, a debtor's prior investment banker will no longer be easily excluded. For the investment banker to be “disinterested,” it may not be: 1) a creditor, shareholder or insider of the debtor; 2) an officer, director or employee of the debtor within 2 years of the bankruptcy; or 3) hold an “interest materially adverse to the estate or any class of creditors or equity security holders, by reason of any direct or indirect relationship to, connection with, or interest in, the debtor, or for any other reason.” (Code ' 101(14)(c) (amended).)

Cases That Prompted the Amendment

Section 101(14)(b) had clearly excluded the debtor's investment bankers prior to the recent amendment. Nevertheless, the Sixth Circuit in 1993 and 1995 had to reverse two bankruptcy court orders appointing investment bankers. (See In re Eagle-Picher Indus. Inc., 999 F.2d 969 (6th Cir. 1993) and In re Federated Dep't Stores, Inc., 44 F.3d 1310 (6th Cir. 1995).) In Eagle-Picher, the bankruptcy court had approved the engagement of an investment bank as financial adviser for the debtor. But the bank had represented the debtor in connection with outstanding revenue bonds. The U.S. Trustee objected. On appeal, the Sixth Circuit found an abuse of discretion and reversed, holding that the banker should have been found “not disinterested” under the Code's plain language. In finding an abuse of discretion, the Sixth Circuit rejected the bankruptcy court's rationale that the bank would “'need less time to familiarize itself with the Debtors' business and affairs than another financial advis[e]r.'” (Eagle Picher, 999 F.2d at 970 (citations omitted).) The court reasoned that a bankruptcy court lacked discretion to permit retention of a professional who is not “disinterested,” unless the failure to be disinterested results solely from the professional's prior employment by the debtor. (Id. at 972) Moreover, the court explained, although the bankruptcy court had come up with a practical solution, it was not free to override a clear statute. Congress had to be persuaded to make a change for the sake of pragmatism. (Id. at 972 and n.5)

In Federated, another banker had been the lead underwriter in a $200 million public offering of the debtor's securities, and had acted as its investment banker in an unsuccessful leveraged buyout while continuing to hold the company's debt and preferred equity at the time of its retention application. The bank had numerous connections to the debtor spanning a period of 10 years. (Federated, 44 F.3d at 1313.) Relying upon its asserted equitable discretion, the bankruptcy court authorized the debtor to retain the banker to avoid the ” … expense and delay in getting a substitute professional up to speed and the loss of the original professional's superior expertise … [.]” (Id. at 1313-1314 (citation omitted).) The banker served as financial adviser through plan confirmation, but the U.S. Trustee objected to its subsequent fee application on the ground that the bank's retention never should have been authorized. On appeal, the district court allowed the banker to be paid despite any defects in its retention. (Id. at 1314-1315). But the Sixth Circuit reversed, rejecting the argument that in the absence of an actual conflict of interest, the bankruptcy court could exercise its discretion to authorize a retention based upon equity or judicial economy when the professional failed the statutory test for disinterestedness. (Id. at 1318-1319.)

The Act restores the bankruptcy court's discretion over the retention of investment banks. Thus, so long as an investment bank does not hold or represent an adverse interest or fall under the prohibitions of the amended ' 101(14), it may be retained.

Determining 'Disinterestedness'

In considering employment of attorneys and other professionals in the past, the majority of Circuits have favored a strict construction approach under which a creditor, for example, would be disqualified. (See Collier ' 327.04[2][a][i] at 3-327 and nn. 18-24 citing, inter alia, (Staiano v. Pillowtex) In re Pillowtex, Inc., 304 F.3d 246 (3d Cir. 2002), In re Middleton Arms, L.P., 934 F.2d 723, 725 (6th Cir. 1991), In re Pierce, 809 F.2d 1356 (8th Cir. 1987) and In re Consolidated Bancshares, Inc., 785 F.2d 1249, 1256 n.6 (5th Cir. 1986).) The First Circuit has rejected that approach, however, in favor of examining the totality of the circumstances. (See, e.g., In re Martin; 817 F.2d 175, 180-183 (1st Cir. 1987) (remanding case for analysis of potentially disqualifying conflict caused by bankruptcy law firm's obtaining lien on debtor's property to secure repayment of legal fees.)

Nor will the mere appearance of a conflict constitute a “materially adverse” interest, at least according to the Third Circuit. (In re Marvel Entertainment Group, Inc., 140 F.3d 463, 476-477 (3d Cir. 1998) (permitting trustee's retention of his own law firm.)) Instead, the lower court should consider whether the professional has an actual or potential conflict. A professional with an actual conflict should be disqualified automatically under ' 327(a), but the court must exercise its discretion before disqualifying a person with a potential conflict of interest. (Marvel, 140 F.3d at 476, citing In re BH&P Inc., 949 F.2d 1300 (3d Cir. 1991).) In Marvel, the Third Circuit offered the following examples of when a court may permit retention of a potentially adverse professional: 1) in a large case if all other competent professionals are engaged by other parties in interest; or 2) when there is only a remote possibility that the potential conflict will become an actual one, and the reasons for retention are “particularly compelling.” (Id., citing BH&P, 949 F.2d at 1316-1317.) Even on those facts, however, retention of a professional with a potential conflict of interest is “disfavored.” (Id.)

Examples of Probable Disqualification

The investment banker, who is a creditor or shareholder (including warrants) of the debtor, will probably be disqualified. (See discussion, supra, citing Collier ' 327.04 [2][a][i] at 3-327 and nn. 18-24.) In the absence of these fatal facts, the “materially adverse interest” issue will then be relevant.

Other facts may prevent retention. An investment banker who received a preferential payment may have an actual conflict. (See, e.g., Pillowtex, 304 F.3d at 255 (held, law firm paid for antecedent debt on eve of bankruptcy was recipient of “facially plausible” preference claim; before authorizing retention, court required to hold hearing to confirm absence of adverse interest).) Alternatively, an investment banker who provided the debtor with a fairness opinion in a pre-petition merger, if sued because of that opinion, may be found to have a materially adverse interest, depending on the facts. A party in interest, for example, could challenge the merger transaction as a fraudulent transfer. Once the investment banker becomes embroiled in litigation, it presumably would assert indemnification claims against the debtor. An underwriter of the debtor's pre-bankruptcy securities may have a similar retention problem. Unless litigation is pending or overtly threatened, the investment banker might argue that it holds no materially adverse interest. If an action is commenced after the banker is engaged, however, it would probably have to resign.

Conclusion

The Act opens the door for investment bankers to participate in corporate reorganizations, but challenges bankruptcy judges to resolve these issues. Professional fees are not the only concern here. The bankruptcy court must determine whether economies gained by retaining a pre-bankruptcy investment banker are enough to overcome the risk of concealment or self-dealing. Once satisfied on those issues, the court must find that the banker's engagement will benefit the entire reorganization.

The major investment banks secured a big win with the Bankruptcy Abuse Prevention & Consumer Protection Act of 2005 (the Act). They quietly convinced Congress to remove the strongest limitation in the Bankruptcy Code (' 101(14)) on a Chapter 11 debtor's employment of an investment banker. That prohibition, in effect since the Depression, had essentially prevented the debtor's retention of a banker for any of the debtor's outstanding securities (Id.). The securities industry called the statutory ban “anti-competitive” (see, eg, Securities Industry Assn. Position Paper at http://www.sia.com (hereinafter, “SIA”)).

The SEC had warned Congress 2 years ago, when the SIA had proposed a legislative change, that a “one-size-fits-all” approach may be insufficient in light of a 1938 study of corporate reorganization practices. (See letter dated May 22, 2003 from SEC Chairman William H. Donaldson to Hon. P. Leahy and Hon. P. Sarbanes). The SEC's study showed that potential or actual conflicts had often existed among underwriters, investment bankers and their attorneys due to … the extent of the financial interest of the underwriter in the enterprise, the underwriter's relationship to the management under whose auspices the company failed, participation in the acts of mismanagement for which legal liability might be imposed or which might make new management desirable or necessary, and fraudulent or negligent activities in connection with the sale of the securities. (Collier on Bankruptcy, ' 327.04[2][a][iii][D] at 3-327 and n. 44 (15th rev. ed. 2005) citing SEC, Report on the Study and Investigation of the Work Activities, Personnel and Functions of Protective and Reorganization Committees, pt. II at 172.)

Assuming that the investment bank is not a creditor, shareholder or insider, the only issue now under the Act will be whether the bank holds a “materially adverse interest to the debtor or its estate, or to creditors or equity security holders … [.]” (Code ' 101(14) (amended).) The investment bank will still have to show its “disinterested” status at the outset, however. And even if a potential conflict is overcome early on, the nature of the bank's involvement may be reassessed later.

The 2005 Amendment

Section 327(a) of the Code enables a trustee to hire a professional only if that professional holds or represents no interest adverse to the estate, and if he or she is “disinterested.” (Code ' 327(a).) Section 327(a) will continue to apply here, but Congress changed the definition of “disinterested person.” Prior to the 2005 amendment, an investment banker was ineligible if it had previously been engaged for “any outstanding security of the debtor” or handled an offering within 3 years prior to the petition date. (Code '' 101(14)(b) and (c).) It also excluded the banker's attorney, and any person who was or had been a director, officer or employee of the investment banker within 2 years of the filing date. (Id.)

Effective October 2005, a debtor's prior investment banker will no longer be easily excluded. For the investment banker to be “disinterested,” it may not be: 1) a creditor, shareholder or insider of the debtor; 2) an officer, director or employee of the debtor within 2 years of the bankruptcy; or 3) hold an “interest materially adverse to the estate or any class of creditors or equity security holders, by reason of any direct or indirect relationship to, connection with, or interest in, the debtor, or for any other reason.” (Code ' 101(14)(c) (amended).)

Cases That Prompted the Amendment

Section 101(14)(b) had clearly excluded the debtor's investment bankers prior to the recent amendment. Nevertheless, the Sixth Circuit in 1993 and 1995 had to reverse two bankruptcy court orders appointing investment bankers. (See In re Eagle-Picher Indus. Inc., 999 F.2d 969 (6th Cir. 1993) and In re Federated Dep't Stores, Inc., 44 F.3d 1310 (6th Cir. 1995).) In Eagle-Picher, the bankruptcy court had approved the engagement of an investment bank as financial adviser for the debtor. But the bank had represented the debtor in connection with outstanding revenue bonds. The U.S. Trustee objected. On appeal, the Sixth Circuit found an abuse of discretion and reversed, holding that the banker should have been found “not disinterested” under the Code's plain language. In finding an abuse of discretion, the Sixth Circuit rejected the bankruptcy court's rationale that the bank would “'need less time to familiarize itself with the Debtors' business and affairs than another financial advis[e]r.'” (Eagle Picher, 999 F.2d at 970 (citations omitted).) The court reasoned that a bankruptcy court lacked discretion to permit retention of a professional who is not “disinterested,” unless the failure to be disinterested results solely from the professional's prior employment by the debtor. (Id. at 972) Moreover, the court explained, although the bankruptcy court had come up with a practical solution, it was not free to override a clear statute. Congress had to be persuaded to make a change for the sake of pragmatism. (Id. at 972 and n.5)

In Federated, another banker had been the lead underwriter in a $200 million public offering of the debtor's securities, and had acted as its investment banker in an unsuccessful leveraged buyout while continuing to hold the company's debt and preferred equity at the time of its retention application. The bank had numerous connections to the debtor spanning a period of 10 years. (Federated, 44 F.3d at 1313.) Relying upon its asserted equitable discretion, the bankruptcy court authorized the debtor to retain the banker to avoid the ” … expense and delay in getting a substitute professional up to speed and the loss of the original professional's superior expertise … [.]” (Id. at 1313-1314 (citation omitted).) The banker served as financial adviser through plan confirmation, but the U.S. Trustee objected to its subsequent fee application on the ground that the bank's retention never should have been authorized. On appeal, the district court allowed the banker to be paid despite any defects in its retention. (Id. at 1314-1315). But the Sixth Circuit reversed, rejecting the argument that in the absence of an actual conflict of interest, the bankruptcy court could exercise its discretion to authorize a retention based upon equity or judicial economy when the professional failed the statutory test for disinterestedness. (Id. at 1318-1319.)

The Act restores the bankruptcy court's discretion over the retention of investment banks. Thus, so long as an investment bank does not hold or represent an adverse interest or fall under the prohibitions of the amended ' 101(14), it may be retained.

Determining 'Disinterestedness'

In considering employment of attorneys and other professionals in the past, the majority of Circuits have favored a strict construction approach under which a creditor, for example, would be disqualified. (See Collier ' 327.04[2][a][i] at 3-327 and nn. 18-24 citing, inter alia, (Staiano v. Pillowtex) In re Pillowtex, Inc., 304 F.3d 246 (3d Cir. 2002), In re Middleton Arms, L.P., 934 F.2d 723, 725 (6th Cir. 1991), In re Pierce, 809 F.2d 1356 (8th Cir. 1987) and In re Consolidated Bancshares, Inc., 785 F.2d 1249, 1256 n.6 (5th Cir. 1986).) The First Circuit has rejected that approach, however, in favor of examining the totality of the circumstances. (See, e.g., In re Martin; 817 F.2d 175, 180-183 (1st Cir. 1987) (remanding case for analysis of potentially disqualifying conflict caused by bankruptcy law firm's obtaining lien on debtor's property to secure repayment of legal fees.)

Nor will the mere appearance of a conflict constitute a “materially adverse” interest, at least according to the Third Circuit. (In re Marvel Entertainment Group, Inc., 140 F.3d 463, 476-477 (3d Cir. 1998) (permitting trustee's retention of his own law firm.)) Instead, the lower court should consider whether the professional has an actual or potential conflict. A professional with an actual conflict should be disqualified automatically under ' 327(a), but the court must exercise its discretion before disqualifying a person with a potential conflict of interest. (Marvel, 140 F.3d at 476, citing In re BH&P Inc., 949 F.2d 1300 (3d Cir. 1991).) In Marvel, the Third Circuit offered the following examples of when a court may permit retention of a potentially adverse professional: 1) in a large case if all other competent professionals are engaged by other parties in interest; or 2) when there is only a remote possibility that the potential conflict will become an actual one, and the reasons for retention are “particularly compelling.” (Id., citing BH&P, 949 F.2d at 1316-1317.) Even on those facts, however, retention of a professional with a potential conflict of interest is “disfavored.” (Id.)

Examples of Probable Disqualification

The investment banker, who is a creditor or shareholder (including warrants) of the debtor, will probably be disqualified. (See discussion, supra, citing Collier ' 327.04 [2][a][i] at 3-327 and nn. 18-24.) In the absence of these fatal facts, the “materially adverse interest” issue will then be relevant.

Other facts may prevent retention. An investment banker who received a preferential payment may have an actual conflict. (See, e.g., Pillowtex, 304 F.3d at 255 (held, law firm paid for antecedent debt on eve of bankruptcy was recipient of “facially plausible” preference claim; before authorizing retention, court required to hold hearing to confirm absence of adverse interest).) Alternatively, an investment banker who provided the debtor with a fairness opinion in a pre-petition merger, if sued because of that opinion, may be found to have a materially adverse interest, depending on the facts. A party in interest, for example, could challenge the merger transaction as a fraudulent transfer. Once the investment banker becomes embroiled in litigation, it presumably would assert indemnification claims against the debtor. An underwriter of the debtor's pre-bankruptcy securities may have a similar retention problem. Unless litigation is pending or overtly threatened, the investment banker might argue that it holds no materially adverse interest. If an action is commenced after the banker is engaged, however, it would probably have to resign.

Conclusion

The Act opens the door for investment bankers to participate in corporate reorganizations, but challenges bankruptcy judges to resolve these issues. Professional fees are not the only concern here. The bankruptcy court must determine whether economies gained by retaining a pre-bankruptcy investment banker are enough to overcome the risk of concealment or self-dealing. Once satisfied on those issues, the court must find that the banker's engagement will benefit the entire reorganization.