NEIL W. BASON, Bankruptcy Judge.
The above-captioned debtors, Sonya D. International, Inc. ("SDI") and Hazlaha, LLC ("Hazlaha"), have general bankruptcy counsel and now seek to employ additional counsel, Enterprise Counsel Group ALC ("Enterprise"), to represent them ongoing litigation known as the "Constructive Trust Litigation."
Israel objects that Enterprise has conflicts of interest.
The principal issue is whether debtors in possession ("DIPs") and their professionals can take positions that favor one set of stakeholders over other stakeholders. They can. In fact one of their essential duties is to distribute assets and it would be impossible to administer a bankruptcy estate without taking positions regarding who should receive which assets. Therefore Israel's argument fails and he cannot force the debtors to lose by default.
Israel's alternative argument is that Enterprise would have a conflict if it continues to represent not only SDI and Hazlaha but also Mimi and Donna. Admittedly the involvement of insiders is potentially troubling. The debtors might be unduly influenced to favor Mimi and Donna at the expense of other stakeholders. More generally, insider interests are pervasive in these divorce-related bankruptcy cases. The debtors might be unduly influenced to favor Sonya, or disfavor Israel, or otherwise favor or disfavor insiders at the expense of non-insiders. All of these things create potential conflicts of interest.
But potential conflicts are not automatically disqualifying. On the present record the potential conflicts are insufficient to disqualify Enterprise.
The only significant effects of accepting Israel's alternative argument would be to deprive the debtors of counsel of their choice, and increase their expenses by forcing them to hire separate counsel so as not to lose by default, instead of splitting the cost equally with Mimi and Donna. That would increase the debtors' legal bill for the Constructive Trust Litigation. Non-insiders would not benefit at all, because the Constructive Trust Litigation would still have to be litigated and the arguments would be the same. The only beneficiary would be Israel, who would gain leverage by increasing his adversaries' legal expenses.
Israel's objections are overruled. SDI and Hazlaha will be authorized to employ Enterprise by a separate order.
The divorce-related issues pervade these bankruptcy cases. Israel and Sonya, as well as other family members including Mimi and Donna, all assert claims to direct or indirect ownership of various assets (the "Disputed Assets"). The Disputed Assets include the equity ownership in SDI and Hazlaha, or assets that at one time or another have been held by those entities.
Israel argues in the Constructive Trust Litigation that, despite his and Sonya's voluntary transfer of certain Disputed Assets to Mimi, Donna and his other children, they actually only intended to transfer legal title while retaining the real ownership for the benefit of the marital community. Sonya disagrees. She asserts that she and Israel really did intend
Israel has prevailed at the trial court. But the trial court's rulings are now on appeal.
On May 1, 2011 (the "Petition Date") the debtors filed their voluntary chapter 11 bankruptcy petitions. The non-insider claims are a fraction of the assets at issue, and on the present record all of the related debtors appear to be very solvent.
In prior rulings the automatic stay has been modified to permit the divorce-related matters to be litigated (including certain determinations as to ownership, but without enforcing judgments against assets of the bankruptcy estate). In order to be able to participate in that litigation the debtors have to employ counsel.
The application to employ Enterprise has come on for hearing a number of times. Although many of those hearings were continued for procedural reasons or were consumed with other motions, all parties in interest have had ample opportunity to assert their positions.
No party in interest has cited any decision that addresses the precise issues.
Israel argues:
Israel conflates how to "divide the pie" with "shrinking the pie." The debtors and Enterprise propose to do the former, not the latter. That is perfectly acceptable for a bankruptcy trustee or DIP to do.
In these bankruptcy cases, a hypothetical example may best illustrate the "pie" that Enterprise seeks to divide. If, for example, the estate of one of the debtors currently asserts interests in three pieces of property, the pie consists of those three properties. If the state appellate court determines that two pieces of property in fact belong to Mimi and Donna, then those two pieces of the pie are divided and distributed to Mimi and Donna while the remaining property is distributed to other stakeholders. However, if the appellate court determines that Mimi and Donna do not have any interest in the two properties, then all three properties are distributed to the remaining stakeholders. Either way, the pie is the same size and is simply divided or distributed differently based on the state court judgment.
Israel argues that a ruling in favor of Mimi or Donna would be different, because it would not simply divide the bankruptcy estate but would decrease what assets are within the bankruptcy estate. That is a distinction without a difference: the whole point of a bankruptcy case is to distribute assets to stakeholders, which inevitably decreases the assets remaining in the bankruptcy estate for other stakeholders. There is nothing wrong with that.
To cite just a few other examples of how it is proper to "divide the pie," it is perfectly acceptable and frequently necessary for a trustee or DIP and their counsel to litigate (a) against one class and in favor of another (e.g., against the holders of unperfected security interests, for the benefit of general unsecured creditors), (b) against some creditors and in favor of others in the same class (e.g., against unsecured creditors who have received preferential transfers), (c) against majorities of most classes of creditors and in favor of the debtor or its equity holders (e.g., "cramdown"), or (d) in favor of enriching the debtor at the expense of all creditors (e.g., exemptions). In fact, the Bankruptcy
A close reading of the Bankruptcy Code shows that it makes exactly these distinctions. Section 327 provides, in part:
Section 101(14) provides, in full:
The emphasized language distinguishes between (1) interests that are adverse to "the estate," which is not permissible, and (2) interests that may be adverse in some sense to a class of creditors or equity security holders but that are not "materially" adverse interests. Some examples will illustrate.
If proposed counsel were personally adverse to the estate then that would disqualify such counsel from employment. See In re Triple Star Welding, Inc., 324 B.R. 778, 795 (9th Cir. BAP 2005) ("`facially plausible' preference claim [against proposed counsel] ... must be resolved before proposed counsel can be employed (or compensated)"), distinguished, In re AFI Holding, Inc., 355 B.R. 139 (9th Cir. BAP 2006), aff'd, 530 F.3d 832 (9th Cir.2008). Other examples, from the statute itself (11 U.S.C. § 101(14)(A)), are that "a person who is a creditor, equity security holder or insider is [presumed to be] incapable of the impartial judgment required of a professional in the conduct of a case under the [Bankruptcy] Code." 3 Collier on Bankruptcy ¶ 327.04[2][a][C] pp. 327-31 to 327-32 (17th ed., Rev. 3/2011, Resnick & Summer eds.) ("Collier") (emphasis added).
As noted above, general bankruptcy counsel litigate against creditors and others all the time, so that cannot be what the statute means by a "materially" adverse interest to classes of creditors or equity holders. See generally Stoumbos v. Kilimnik, 988 F.2d 949, 964 (9th Cir.1993) (the trustee could hire special counsel to sue creditor, notwithstanding creditor's arguments that suing him would be adverse to the trustee's duties as "the fiduciary representative of all creditors").
So what would be a "materially" adverse interest to a class of creditors? If proposed counsel had represented a creditor whom the bankruptcy estate might sue, that could be materially adverse to other classes of creditors because proposed counsel's investigation and prosecution of any action might be constrained by the duty of loyalty to the former client or by the attorney-client privilege.
These are just examples. But they illustrate that Congress had something more in mind than simply taking positions contrary to creditors when it distinguished between interests adverse to the "estate" and interests "materially" adverse to creditors or equity security holders.
Israel has not established that it is impermissible for SDI and Hazlaha to employ Enterprise to advocate for the position that the debtors believe is right. Enterprise is not disqualified simply because those positions happen to be adverse to some stakeholders (principally Israel) and in favor of others (including Mimi and Donna).
Israel objects that not only will Enterprise represent SDI and Hazlaha, it will also simultaneously represent Mimi and Donna. As noted above, it is true that the involvement of insiders is potentially troubling because the debtors might be unduly influenced to favor Mimi and Donna, or Sonya, or disfavor Israel, all at the expense of other stakeholders. That creates potential conflicts of interest. But in the circumstances of this case that is insufficient to disqualify Enterprise for two reasons.
Mimi and Donna seek distributions of assets in which the estates may have an interest. The estates, who are represented by general bankruptcy counsel (different from Enterprise), agree that the right result is to distribute those assets to Mimi and Donna rather than Israel (or others). Therefore the estates agree with Mimi and Donna and there is no conflict.
If an actual conflict develops, or if there is a sufficiently troubling potential conflict of interest, then it may be necessary for those various parties to retain separate counsel. But no such actual or potential conflict has been established at present. See generally In re Marvel Entm't Group, Inc., 140 F.3d 463, 476 (3d Cir.1998) ((1) section 327 imposes a per se disqualification of any professional who has an actual conflict of interest; (2) the court may, within its discretion, disqualify a professional who has a potential conflict of interest; and (3) the court may not disqualify a professional solely on the basis of an appearance of conflict).
General bankruptcy counsel would have to investigate whether to agree with Mimi and Donna (as SDI and Hazlaha have decided to do) or disagree with them (as Israel wants the debtors to do). General
Israel argues that Enterprise cannot be employed as "special counsel" under subsection (e) of Section 327 because that subsection is only applicable to counsel who "has represented the debtor" prepetition, and SDI and Hazlaha do not claim that Enterprise represented them prepetition. 11 U.S.C. § 327(e) (emphasis added). The alternative is for Enterprise to be employed under Section 327(a), in which event it must be a "disinterested person." Compare 11 U.S.C. § 327(a) (incorporating by reference the "disinterested person" requirement of § 101(14)) with § 327(e) (no such incorporation).
Israel may be correct. There is certainly substantial authority that Section 327(e) does not apply in the present circumstances. See 3 Collier ¶ 327.04[9][b] pp. 327-51 to 327-52 (the "majority" approach "imposes an express requirement of prior representation of the debtor"). But cf. In re Covenant Fin. Group of Am., Inc., 243 B.R. 450, 455 & n. 8 (Bankr. N.D.Ala.1999) (asserting that "[m]ost courts" reach the opposite conclusion, and citing cases).
But Enterprise still can be employed for a limited purpose. The Bankruptcy Appellate Panel of the Ninth Circuit (the "BAP") has held that special counsel can be employed even when such counsel has not represented the debtor prepetition. See In re Fondiller, 15 B.R. 890, 892 (9th Cir. BAP 1981) (emphasis added), appeal dism., 707 F.2d 441 (9th Cir.1983).
Fondiller has been interpreted as authorizing employment under subsection (e) of Section 327. See, e.g., Covenant, 243 B.R. at 455 n. 8. But the precise holding appears to be that special counsel can be employed under subsection (a) of Section 327 because any "omission" in Section 327(e) does not limit the general authority in Section 327(a). See Fondiller, 15 B.R. at 891-92 (interpreting § 327(a) by comparison with § 327(c) and (e)).
In any event, Fondiller held that when counsel is only employed to perform limited services, then an interest "adverse to the estate" means "an adverse interest relating to the services which are to be performed by that attorney." Fondiller, 15 B.R. at 892.
The difference between retaining general counsel and special counsel is not academic. In Fondiller, the BAP affirmed the employment of a law firm as special counsel to investigate and recover allegedly concealed or fraudulent conveyed assets. That law firm had represented the largest creditor of the bankruptcy estate prepetition and sought to represent the bankruptcy estate without "sever[ing]" its relationship with that creditor — i.e., special counsel for the debtor in that case would continue to represent the creditor seeking the largest distribution out of the "pie." Id. In interpreting the statute the BAP stated:
As in Fondiller, the proposed employment of Enterprise is limited to a narrow field (the Constructive Trust Litigation) for a specific purpose (prosecuting that matter to final judgment or disposition). Enterprise is not simultaneously in the position of being adverse to the same parties it will be representing, because SDI and Hazlaha seek the same outcome as Mimi and Donna. The simultaneous representation of all four of those parties does not disqualify Enterprise.
The foregoing analysis is reinforced by the analogous provisions of Section 327(c). That section provides that a professional in a chapter 11 case "is not disqualified for employment under this section solely because of such person's employment by or representation of a creditor, unless there is objection by another creditor or the United States trustee, in which case the court shall disapprove such employment if there is an actual conflict of interest." 11 U.S.C. § 327(c) (emphasis added).
The foregoing analysis is further reinforced by practical considerations. If the Court were to accept Israel's principal argument then the debtors could not hire any attorneys to litigate in the divorce-related proceedings because any such attorneys would be deemed to have a disqualifying conflict of interest (even if they worked at no cost to the estate).
In addition, if SDI and Hazlaha were determined by the state courts to be indispensible parties, then Mimi's and Donna's rights might be undermined as well. In other words, as noted at the start of this Memorandum Decision, if Israel's view of the statute is correct then some or all of the parties adverse to him would be forced to lose by default.
To illustrate, suppose that Enterprise litigates the pending appeals to a final judgment in favor of its clients (Mimi and others) and against other parties (Israel and others). In that scenario, that is the legally proper result by definition (because it is a final judgment) and Israel and Sonya's creditors never had any legitimate claim to be paid out of the disputed assets, so they have not been deprived of anything that they should have. It would be antithetical to the principles of the Bankruptcy Code if, in such a situation, the debtors, Mimi and others were forced to lose their meritorious claims by default.
Conversely, if a final judgment is against the position advocated by Enterprise for its clients, then Israel, Sonya and Sonya's creditors will receive a larger share of the pie and Mimi and others will receive less. That, too, will be acceptable.
The point is that the Bankruptcy Code should be interpreted to permit parties to litigate the merits, not lose by default. That supports the foregoing interpretation of the statute.
For all of these reasons, SDI and Hazlaha may employ Enterprise as special counsel under Section 327(a) to undertake the litigation described in the application. Israel's objections are overruled.
A separate question is who should bear the financial burden of that litigation. It is one thing for the debtors to have a legitimate interest in determining how to divide the pie. It is another thing for them to bear the cost of litigating on behalf of other parties such as Mimi and Donna, if the latter have the funds, the standing, and the motivation to protect their own interests.
The application papers propose that each of the four represented parties (SDI, Hazlaha, Mimi and Donna) bear 25% of the fees and costs of Enterprise. See Statement of Disinterestedness (dkt. 176) at Sec. 3. But it appears that the bankruptcy estate might be able, at substantially less cost, to join in whatever Mimi and Donna argue.
All of that said, there is no evidence in the record regarding the relative abilities of Mimi and Donna to pay for the litigation, or how much the litigation might cost. Nor has any party in interest objected on this precise ground.
In these circumstances the current proposed allocation of fees and costs is approved, but the Court may determine at a later date to cap the dollar amount that the bankruptcy estates can spend on this litigation, at least if those fees and costs become substantial relative to the benefits to the bankruptcy estates in figuring out how to divide the pie. As always, the debtors and Enterprise should exercise their judgment in deciding how much to spend on any given issue.
For the foregoing reasons, and for all of the reasons stated on the record at the hearings on these matters, SDI and Hazlaha will be authorized by separate order to employ Enterprise. Enterprise or counsel for SDI and Hazlaha should submit a proposed order authorizing that employment "for the reasons stated in, and subject to
Sonya initially joined in the application by the other debtors to employ Enterprise, but she has withdrawn that application and has stated that "she will now be represented by Dennis E. Braun, Esq. in connection with the state court litigation." Statement of Disinterestedness (SDI dkt. 160) at para. 3. No employment application has been filed yet for that representation.
