Bankruptcy Rules for Disclosing Relationships: Explained
The fallout of a Texas bankruptcy judge's ethics debacle has spread to a prominent Houston law firm following revelations that it failed to disclose allegations of a romantic relationship between one of its attorneys and the judge.
Disclosures of potential conflicts of interest among attorneys and other advisers is a routine element of large, corporate Chapter 11 cases. But their importance became more pronounced when Judge David R. Jones of the US Bankruptcy Court for the Southern District of Texas announced he would resign after admitting to a long-term relationship with bankruptcy attorney Elizabeth Freeman. Freeman previously worked at Jackson Walker LLP and, before that, as a clerk to Jones himself.
The firm has since acknowledged that it knew of the allegations of the relationship since March 2021 and made sure that Freeman wouldn't work on or bill for any cases Jones was overseeing. But court filings show that it didn't disclose the allegations in many cases when the firm appeared before Jones.
Since the revelations, the Department of Justice's bankruptcy watchdog, the US Trustee, has started questioning the firm's requests for professional fees in some of the cases that both Jones and Jackson Walker were involved in, while a handful of creditors have called for sanctions. A Jackson Walker spokesman has said the firm acted responsibly and in a timely fashion once it learned of the issue.
The continued fallout from the scandal serves as a stark reminder of the disclosure and ethics rules firms must follow in bankruptcy cases.
1. What types of disclosures are expected in Chapter 11?
Conflicts of interests have long been prohibited in legal practice, but bankruptcy rules are especially strict because of the wide range of divergent interests among debtors, creditors, and others involved in complex Chapter 11 cases, said Clifford J. White, a former director of the US Trustee's office who now works for bankruptcy compliance company AIS.
Transparency generally is one of the most important aspects of bankruptcy practice. "The bedrock principles of bankruptcy are transparency, public forum, disclose, disclose, disclose.
These are principles that are drilled into our head from when we start practicing bankruptcy," said Brya Keilson, a Morris James LLP Partner and former trial attorney for the Office of the US Trustee.
Under what’s known as bankruptcy court Rule 2014, law firms and other advisers must file with the court applications for employment at the outset of a Chapter 11 case. They're expected to include, "to the best of the applicant's knowledge, all of 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," according to the rule.
The rules apply to all professionals being paid by the bankrupt company, including accountants, investment bankers, and auctioneers, said Michael L. Cook, of counsel with Schulte Roth & Zabel LLP, who concentrates on retainer and conflict issues.
Under the bankruptcy requirements, professionals should disclose the mere appearance of a connection to another party in the case, Keilson said.
"It's not just actual conflict, it's potential or apparent or perceived conflicts that permeate the bankruptcy process," Keilson said.
Lawyers and advisers have a duty to keep disclosures updated as new information comes to light. Cook noted that the First Circuit in the early 1990s made clear the expectations for professional disclosures.
"Spontaneous, timely, and complete," Cook said.
2. How does a law firm unearth potential conflicts?
Generally, the word "connections" under bankruptcy disclosure rules mean anyone with which a law firm or adviser has a business relationship.
A court "has to figure out if anyone has disguised vested interests," Nancy B. Rapoport, a bankruptcy law professor at the University of Nevada, Las Vegas, said in an email.
In a disclosure, a firm must lay out the steps it took to determine conflicts, Keilson said. That typically involves a formal internal conflict check as well as an informal conflict check through an email to all attorneys at a firm, she said.
Most law firms maintain large databases of everybody they have business connections with for every matter in which they're representing a client—not just bankruptcy matters.
Often, when a creditor or master service list comes in at the beginning of a bankruptcy case, a firm willsend it to a conflicts department or coordinator to run that list against their own database.
3. What is the judge's role in disclosures?
Judges can flag potential conflicts they're aware of themselves but generally leave that to other parties in the case. Often, the US Trustee raises objections if it catches a potential issue in a firm's employment application.
The court is typically expected to determine whether a potential conflict presented by a party in the case is disqualifying when it decides whether to approve a firm's employment application. Judges may sanction professionals who fail to make adequate disclosures.
Generally, it's understood that it's not up to the law firm to decide whether there's a conflict—it must disclose the potential issue, and the court will make the call.
Additionally, judges are required to disqualify themselves in any proceeding in which their impartiality "might reasonably be questioned" or under certain other circumstances.
Judicial Canons of Ethics require impartiality by the judge, White said. Bankruptcy Rules 5002(b) and 5004(b) prohibit a judge from approving the hiring of and compensation for a professional if the judge's connections to the person would render the employment "improper."
Judges also are required to turn in annual disclosure reports that are made public, though they're not case-specific. Those reports usually give a general overview of a judge's investments, reimbursements, gifts, and liabilities, as well as financial information for spouses if a judge is married.
4. What are the consequences for failing to disclose potential conflicts?
The consequences depend on the severity of the nondisclosure. For law firms, they can include clawing back fees already paid, rejection of future fees, and disqualification from working on a case.
"Enforcement of disclosure and conflict of interest rules is essential to the integrity of the bankruptcy system," White said.
The consequences can be even more severe.
In a 1998 case, bankruptcy partner John Gellene of what's now Milbank LLP was accused of filing a false Rule 2014 disclosure declaration by federal prosecutors. After he was convicted of "knowingly and fraudulently" making false declarations under oath in two Rule 2014 bankruptcy applications, he was sentenced to 15 months in prison.
5. Is it enough to remove an attorney from cases where they have a potential conflict with a judge?
Firms often wall off attorneys with potential conflicts from a case. If there's only a potential conflict, that solution can be sufficient for a judge overseeing a case.
But it depends on a lot of factors. Rules of professional conduct for attorneys issued by some state bars don't recognize screening of attorneys, or have complex rules for screening depending on how conflicts are imputed to all lawyers in a firm.
Some attorneys are integral to a matter, so screening isn't an option. Moreover, an actual—as opposed to potential—conflict would likely require more drastic measures to be taken than screening.
Disclosures made in bankruptcy court aren't just for individuals. Typically, the conflict of one attorney is imputed to the entire firm. There may be limited exceptions if the attorney can be completely walled off, but it will depend on the entirety of the facts and circumstances, Keilson said.
"The problem is that this practice, business bankruptcy, is filled with landmines," Cook said.
Originally posted on Bloomberg Law News (Subscription Required) Reproduced with permission. Published Nov. 1, 2023. Copyright 2023 by Bloomberg Industry Group, Inc. (800-372-1033) http://www.bloombergindustry.com
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