Retention of Restructuring Professionals

The legal requirements for retention of professionals in bankruptcy are derived from two primary sources: Section 327 of the Bankruptcy Code and Federal Rule of Bankruptcy Procedure 2014 (Rule 2014). Together, these provisions serve the global purpose of ensuring that professionals are loyal and that they provide untainted advice to the debtor. See, e.g., Rome, 19 F.3d at 58. Disinterestedness: 11 U.S.C. ' 327(a).

Section 327 of the Bankruptcy Code provides the standard for debtors to retain professionals in bankruptcy. Under that provision, debtors may only retain professionals who are disinterested, do not hold an interest adverse to the debtor's estate, and do not represent an interest adverse to the estate. See 11 U.S.C. ' 327(a); see, e.g., WorldCom, 311 B.R. at 163. The Bankruptcy Code defines a “disinterested person” in the negative:

“The term 'disinterested person' means a person that: 1) is not a creditor, an equity security holder, or an insider; 2) is not and was not, within 2 years before the date of the filing of the petition, a director, officer, or employee of the debtor; and 3) does not have an interest materially adverse to the interest of the estate or of 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.” See 11 U.S.C. ' 101(14) (the excerpts above reflect changes made to this provision in the Bankruptcy Abuse Prevention And Consumer Protection Act of 2005). However, the Bankruptcy Code provides no guidance as to what constitutes an “adverse interest.” Nevertheless, federal courts have interpreted “adverse interest” to mean: 1) an economic interest that may lessen the value of the bankruptcy estate or create an actual or a potential dispute with the estate; or 2) a predisposed bias against the estate. See, e.g., WorldCom, 311 B.R. at 163 (citing In re AroChem Corp., 176 F.3d 610, 623 (2d Cir. 1999); In re Premier Farms, L.C., 305 B.R. 717, 720 (Bankr. N.D. Iowa 2003); In re Envirodyne Indus. Inc., 150 B.R. 1008, 1016-1017 (Bankr. N.D. Ill. 1993).

Disclosure: Fed. R. Bankr. P. 2014

Rule 2014 sets forth the disclosure requirements for restructuring professionals in bankruptcy. Rule 2014 requires that a professional seeking to work on behalf of a debtor in bankruptcy must submit a verified statement disclosing “the person's connections with the debtor, creditors, any other party in interest, their respective attorneys and accountants, the United States trustee, or any person employed in the office of the United States trustee.” Fed. R. Bankr. P. 2014. Bankruptcy courts have strictly construed the language of Rule 2014 and have disallowed fees or disqualified professionals for failure to properly disclose relevant connections. See WorldCom, 311 B.R. at 164 (citing In re Leslie Fay, 175 B.R. 525, 533 (Bankr. S.D.N.Y. 1994)).

The Failed Attempt At Challenging KPMG's Retention in the WorldCom Bankruptcy

In WorldCom, the debtor retained KPMG to audit the debtor's financial statements, to provide the debtor with tax planning advice regarding, inter alia, various tax-favored inter-company transactions, and to assist the debtors with federal and state tax proceedings. 311 B.R. at 155-156. Approximately 10 months later, taxing authorities from various states moved to disqualify KPMG. Id. at 166-167. The states argued that KPMG was not disinterested because of its dual role in WorldCom's reorganization as tax adviser and auditor. Id. at 159-160. Furthermore, the states argued that KPMG held an interest adverse to WorldCom's estate because WorldCom had a potential claim against KPMG. Id. Ultimately, the bankruptcy court denied the disqualification motion and ordered immediate payment of KPMG's professional fees. In so ruling, the bankruptcy court denied the disqualification motion on substantive grounds, but also provided procedural grounds for denying the motion.

Delay Tactics

At the outset, the bankruptcy court noted that the states had been dilatory in their challenge to KPMG's disinterestedness. Id. at 165. “An unjustified delay in bringing a motion to disqualify provides a separate ground to deny the relief requested in the underlying motion.” Id. at 166-167 (citing Exco Resources, Inc. v. Milbank, Tweed, Hadley & McCloy L.L.P., et al. (In re Enron Corp., et al.), 2003 WL 223455, at *4 n.2 (S.D.N.Y. Feb. 3, 2003)). Specifically, the bankruptcy court noted that “any argument by the States that they have pursued the disqualification of KPMG to protect the public interest 'rings hollow' in light of the fact that the very conflict they allege warrants disqualification was known to them for no less than 10 months before they decided to file the [disqualification motion].” Id. Thus, the bankruptcy court found that the states' delayed response to KPMG's retention was merely a litigation tactic and that the practical implications of the states' litigation tactics would only serve to hurt WorldCom's other unsecured creditors. Id. at 168.

Disinterested and Adverse Interest

The bankruptcy court ultimately rested its decision on the substantive insufficiencies of the states' motion for disqualification and concluded that all three of the states' allegations lacked merit. First, the bankruptcy court found that KPMG did not hold an interest adverse to WorldCom's estate. Id. The states based their allegations on the fact that KPMG had given WorldCom tax planning advice with respect to various inter-company royalty charges. Id. Moreover, the states alleged that KPMG may be liable to WorldCom's estate if the royalty deductions were deemed invalid. Id. at 169.

The bankruptcy court rejected this argument because speculation and conjecture are insufficient bases for an adverse interest. The court observed that KPMG may not have been liable even if the states were correct that the royalty deductions were invalid and that KPMG was liable for the underpayments. Id. Indeed, the court noted that WorldCom had discretion whether to pursue the claims against KPMG. Id. Furthermore, WorldCom and KPMG never stood down from their position that WorldCom's royalty deductions were valid. Id. As such, the bankruptcy court concluded that WorldCom's “potential” claim against KPMG was simply too remote to be considered an adverse interest.

Second, the bankruptcy court also disagreed with the states' allegations that KPMG's dual-role as tax advisor and auditor destroyed its disinterestedness. Id. The court noted that the Securities Exchange Act of 1934, as amended under the Sarbanes-Oxley Act of 2002 (SOX), permits accounting firms to take a dual-role, albeit subject to certain exceptions. Id. at 169-170. The states provided no evidence to show that KPMG's tax services were prohibited activities under the Securities Exchange Act. See Id. (citing 15 U.S.C. ' 78(j)-1(g)). Accordingly, the court concluded that KPMG was in fact disinterested. Id.

Third, the bankruptcy court rejected the states' contention that the appearance of impropriety warranted KPMG's disqualification. Id. In so holding, the court reemphasized its analysis under the disinterested and adverse interest standards. Id. The bankruptcy court also mentioned that various structural safeguards were in place to insure that the corporation's decisions were truly in the best interests of WorldCom's estate. Id.

Lessons Learned from WorldCom

The bankruptcy court's decision in WorldCom provides some much-needed guidance for restructuring professionals. First, restructuring professionals can rest assured that disclosures in the beginning of the case will not come back to haunt them just before confirmation or at a later time. Unreasonable delay in objecting to a particular professional's retention will not be countenanced. Id. at 167; Enron, 2003 WL 223455, at *4 n.2. As such, disclosure is restructuring professionals' best tool for avoiding disqualification from a case, and/or disgorgement of fees. While it seems somewhat obvious, it is worth providing a simple reminder that professionals must make full disclosures of connections not conflicts in accordance with Federal Rule of Bankruptcy Procedure 2014. In addition, all professionals should continue to update the bankruptcy court when the professional's involvement with another matter or client could possibly interfere with the professional's disinterestedness.

Second, parties do not have to resort to speculation or conjecture to protect themselves from disgorgement or disqualification. The rise of the global economy has led to an increasing probability that a restructuring professional may have a potential interest that is adverse to the debtor's estate. As such, a broad policy of disqualifying individuals based on a remote or speculative adverse interest could place severe restraints on restructuring professionals. WorldCom clarifies this standard for restructuring professionals and provides necessary limits on the range of possibilities that must be considered for purposes of disclosure: 'simply because there is a speculative possibility that in the future, some event may render [a professional] and the [d]ebtor adverse' is not grounds for per se disqualification. Id. at 168-169.

Richard Wynne ([email protected]) is a restructuring partner in the Los Angeles office of Kirkland & Ellis LLP. Chad Husnick ([email protected]) is a restructuring associate in the firm's Chicago office.

Restructuring professionals must be acutely aware of potential conflicts of interest. Indeed, federal courts on occasion have disqualified a professional or ordered the disgorgement of the professional's fees in situations where that professional failed to properly disclose a conflict of interest. The importance of conflicts of interest is especially evident in today's global economy, in which restructuring matters routinely involve many of the same parties.

It is not always easy for professionals to determine whether they are disqualified from providing services to a debtor in bankruptcy. For example, it is well settled that disclosures are not limited to actual conflicts, but also include potential conflicts. See, e.g., Halbert v. Yousif and Tanners, Inc. , 225 B.R. 336, 345-346 (Bankr. E.D. Mich. 1998) (“the concept of disinterestedness in ' 327(a) unquestionably covers not only actual, but also potential, conflicts of interest, and includes the avoidance of an appearance of a conflict of interest”) ( citing Rome v. Braunstein , 19 F.3d 54, 57-58 (1st Cir. 1994)). However, are professionals really required to resort to speculation and conjecture in order to unearth every potential conflict of interest? Should professionals be concerned that parties will make strategic challenges to their employment in a particular proceeding? The bankruptcy court's decision in the WorldCom bankruptcy addressing a motion to disqualify WorldCom's accountant provides some important clarification regarding professional retention in bankruptcy. See In re WorldCom, Inc., 311 B.R. 151 (Bankr. S.D. 2004).

Basic Standard for Professional Retention in Bankruptcy

The legal requirements for retention of professionals in bankruptcy are derived from two primary sources: Section 327 of the Bankruptcy Code and Federal Rule of Bankruptcy Procedure 2014 (Rule 2014). Together, these provisions serve the global purpose of ensuring that professionals are loyal and that they provide untainted advice to the debtor. See, e.g., Rome, 19 F.3d at 58. Disinterestedness: 11 U.S.C. ' 327(a).

Section 327 of the Bankruptcy Code provides the standard for debtors to retain professionals in bankruptcy. Under that provision, debtors may only retain professionals who are disinterested, do not hold an interest adverse to the debtor's estate, and do not represent an interest adverse to the estate. See 11 U.S.C. ' 327(a); see, e.g., WorldCom, 311 B.R. at 163. The Bankruptcy Code defines a “disinterested person” in the negative:

“The term 'disinterested person' means a person that: 1) is not a creditor, an equity security holder, or an insider; 2) is not and was not, within 2 years before the date of the filing of the petition, a director, officer, or employee of the debtor; and 3) does not have an interest materially adverse to the interest of the estate or of 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.” See 11 U.S.C. ' 101(14) (the excerpts above reflect changes made to this provision in the Bankruptcy Abuse Prevention And Consumer Protection Act of 2005). However, the Bankruptcy Code provides no guidance as to what constitutes an “adverse interest.” Nevertheless, federal courts have interpreted “adverse interest” to mean: 1) an economic interest that may lessen the value of the bankruptcy estate or create an actual or a potential dispute with the estate; or 2) a predisposed bias against the estate. See, e.g., WorldCom, 311 B.R. at 163 (citing In re AroChem Corp., 176 F.3d 610, 623 (2d Cir. 1999); In re Premier Farms, L.C., 305 B.R. 717, 720 (Bankr. N.D. Iowa 2003); In re Envirodyne Indus. Inc., 150 B.R. 1008, 1016-1017 (Bankr. N.D. Ill. 1993).

Disclosure: Fed. R. Bankr. P. 2014

Rule 2014 sets forth the disclosure requirements for restructuring professionals in bankruptcy. Rule 2014 requires that a professional seeking to work on behalf of a debtor in bankruptcy must submit a verified statement disclosing “the person's connections with the debtor, creditors, any other party in interest, their respective attorneys and accountants, the United States trustee, or any person employed in the office of the United States trustee.” Fed. R. Bankr. P. 2014. Bankruptcy courts have strictly construed the language of Rule 2014 and have disallowed fees or disqualified professionals for failure to properly disclose relevant connections. See WorldCom, 311 B.R. at 164 (citing In re Leslie Fay, 175 B.R. 525, 533 (Bankr. S.D.N.Y. 1994)).

The Failed Attempt At Challenging KPMG's Retention in the WorldCom Bankruptcy

In WorldCom, the debtor retained KPMG to audit the debtor's financial statements, to provide the debtor with tax planning advice regarding, inter alia, various tax-favored inter-company transactions, and to assist the debtors with federal and state tax proceedings. 311 B.R. at 155-156. Approximately 10 months later, taxing authorities from various states moved to disqualify KPMG. Id. at 166-167. The states argued that KPMG was not disinterested because of its dual role in WorldCom's reorganization as tax adviser and auditor. Id. at 159-160. Furthermore, the states argued that KPMG held an interest adverse to WorldCom's estate because WorldCom had a potential claim against KPMG. Id. Ultimately, the bankruptcy court denied the disqualification motion and ordered immediate payment of KPMG's professional fees. In so ruling, the bankruptcy court denied the disqualification motion on substantive grounds, but also provided procedural grounds for denying the motion.

Delay Tactics

At the outset, the bankruptcy court noted that the states had been dilatory in their challenge to KPMG's disinterestedness. Id. at 165. “An unjustified delay in bringing a motion to disqualify provides a separate ground to deny the relief requested in the underlying motion.” Id. at 166-167 (citing Exco Resources, Inc. v. Milbank, Tweed, Hadley & McCloy L.L.P., et al. (In re Enron Corp., et al.), 2003 WL 223455, at *4 n.2 (S.D.N.Y. Feb. 3, 2003)). Specifically, the bankruptcy court noted that “any argument by the States that they have pursued the disqualification of KPMG to protect the public interest 'rings hollow' in light of the fact that the very conflict they allege warrants disqualification was known to them for no less than 10 months before they decided to file the [disqualification motion].” Id. Thus, the bankruptcy court found that the states' delayed response to KPMG's retention was merely a litigation tactic and that the practical implications of the states' litigation tactics would only serve to hurt WorldCom's other unsecured creditors. Id. at 168.

Disinterested and Adverse Interest

The bankruptcy court ultimately rested its decision on the substantive insufficiencies of the states' motion for disqualification and concluded that all three of the states' allegations lacked merit. First, the bankruptcy court found that KPMG did not hold an interest adverse to WorldCom's estate. Id. The states based their allegations on the fact that KPMG had given WorldCom tax planning advice with respect to various inter-company royalty charges. Id. Moreover, the states alleged that KPMG may be liable to WorldCom's estate if the royalty deductions were deemed invalid. Id. at 169.

The bankruptcy court rejected this argument because speculation and conjecture are insufficient bases for an adverse interest. The court observed that KPMG may not have been liable even if the states were correct that the royalty deductions were invalid and that KPMG was liable for the underpayments. Id. Indeed, the court noted that WorldCom had discretion whether to pursue the claims against KPMG. Id. Furthermore, WorldCom and KPMG never stood down from their position that WorldCom's royalty deductions were valid. Id. As such, the bankruptcy court concluded that WorldCom's “potential” claim against KPMG was simply too remote to be considered an adverse interest.

Second, the bankruptcy court also disagreed with the states' allegations that KPMG's dual-role as tax advisor and auditor destroyed its disinterestedness. Id. The court noted that the Securities Exchange Act of 1934, as amended under the Sarbanes-Oxley Act of 2002 (SOX), permits accounting firms to take a dual-role, albeit subject to certain exceptions. Id. at 169-170. The states provided no evidence to show that KPMG's tax services were prohibited activities under the Securities Exchange Act. See Id. (citing 15 U.S.C. ' 78(j)-1(g)). Accordingly, the court concluded that KPMG was in fact disinterested. Id.

Third, the bankruptcy court rejected the states' contention that the appearance of impropriety warranted KPMG's disqualification. Id. In so holding, the court reemphasized its analysis under the disinterested and adverse interest standards. Id. The bankruptcy court also mentioned that various structural safeguards were in place to insure that the corporation's decisions were truly in the best interests of WorldCom's estate. Id.

Lessons Learned from WorldCom

The bankruptcy court's decision in WorldCom provides some much-needed guidance for restructuring professionals. First, restructuring professionals can rest assured that disclosures in the beginning of the case will not come back to haunt them just before confirmation or at a later time. Unreasonable delay in objecting to a particular professional's retention will not be countenanced. Id. at 167; Enron, 2003 WL 223455, at *4 n.2. As such, disclosure is restructuring professionals' best tool for avoiding disqualification from a case, and/or disgorgement of fees. While it seems somewhat obvious, it is worth providing a simple reminder that professionals must make full disclosures of connections not conflicts in accordance with Federal Rule of Bankruptcy Procedure 2014. In addition, all professionals should continue to update the bankruptcy court when the professional's involvement with another matter or client could possibly interfere with the professional's disinterestedness.

Second, parties do not have to resort to speculation or conjecture to protect themselves from disgorgement or disqualification. The rise of the global economy has led to an increasing probability that a restructuring professional may have a potential interest that is adverse to the debtor's estate. As such, a broad policy of disqualifying individuals based on a remote or speculative adverse interest could place severe restraints on restructuring professionals. WorldCom clarifies this standard for restructuring professionals and provides necessary limits on the range of possibilities that must be considered for purposes of disclosure: 'simply because there is a speculative possibility that in the future, some event may render [a professional] and the [d]ebtor adverse' is not grounds for per se disqualification. Id. at 168-169.

Richard Wynne ([email protected]) is a restructuring partner in the Los Angeles office of Kirkland & Ellis LLP. Chad Husnick ([email protected]) is a restructuring associate in the firm's Chicago office.