Allegations that Judge David R Jones of the US Bankruptcy Court for the Southern District of Texas had an undisclosed romantic relationship with Elizabeth Freeman while she was an attorney at Jackson Walker, where she frequently appeared before Jones as counsel to debtors and other parties, is beginning to have consequences beyond Judge Jones’ resignation from the bench. For one, as the Debtwire legal analyst team discussed earlier this month, Judge Jones’ failure to recuse himself could serve as a basis for parties to move to vacate prior rulings in Chapter 11 cases that he oversaw where Jackson Walker was involved. However, Judge Jones arguably wasn’t the only one that failed to comply with a disclosure obligation. In this article, Debtwire’s legal analyst team takes a look at the risk that Jackson Walker could be compelled to disgorge fees it was paid in cases overseen by Judge Jones while Freeman was employed by the firm.
Disclose or disgorge: retention rules and ramifications
As Debtwire reported, the US Trustee requested, and was granted, a postponement of a hearing on Jackson Walker’s final fee application in the Chapter 11 cases of GWG Holdings, where Jones was appointed to mediate in a dispute involving the debtors, which were represented by Jackson Walker as co-counsel. The US Trustee requested the postponement to allow additional time to investigate the propriety of the fees billed by Jackson Walker and Freeman herself, who continues to act as the wind down trustee appointed as part of the company’s confirmed plan. The propriety of awarding the requested fees is an issue because professionals retained by a debtor must disclose various relationships that could affect their involvement in the case. Failure to do so can result in disallowance of fees requested and even disgorgement of fees already paid.
Although Freeman left Jackson Walker in December 2022, Jackson Walker has reportedly acknowledged that it learned about Freeman’s relationship with Jones in 2021. We are not aware that Jackson Walker has ever formally disclosed the relationship between Jones and Freeman in any of the cases assigned to Judge Jones in which Jackson Walker has been retained. The table below lists all such cases in Debtwire’s Restructuring Database where Jackson Walker was retained between 2017 and 2022 and identifies the fees generated by the firm, separating out those billed by Freeman.
Attorneys representing Chapter 11 debtors or any other attorneys entitled to compensation from a debtor’s estate must comply with additional obligations imposed by the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure (Bankruptcy Rules) that do not apply to other professionals. For example, section 327 of the Bankruptcy Code provides that in order for attorneys and other professionals to be retained, two main requirements must be met: (i) the professional must not hold or represent an interest adverse to the estate and be disinterested; and (ii) the employment must be approved by the bankruptcy court overseeing the Chapter 11 case.
Two key concepts are at play here, including (i) what type of an interest is adverse to the estate and (ii) what it means to be “disinterested.” An adverse interest is generally defined to mean “any economic interest that would tend to lessen the value of the bankruptcy estate or that would create either an actual or potential dispute in which the estate is a rival claimant.”[1] Under section 101(14) of the Bankruptcy Code, a professional is disinterested if it:
- is not a creditor, an equity security holder, or an insider;
- is not and was not, within two years before the date of the filing of the petition, a director, officer, or employee of the debtor; and
- 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.
Like retention, attorneys’ compensation also requires bankruptcy court approval. Section 328 of the Bankruptcy Code provides that although professionals may be retained “on any reasonable terms and conditions of employment . . . “[n]otwithstanding such terms and conditions, the court may allow compensation different from the compensation provided under such terms and conditions after the conclusion of such employment if such terms and conditions prove to have been improvident in light of developments not capable of being anticipated at the time of the fixing of such terms and conditions.” (emphasis added). Under section 328(c), a bankruptcy court is authorized to deny allowance of a professional’s fees and expenses if, at any time during such professional’s employment, the professional is not disinterested, or represents or holds an interest that is adverse to the interest of the estate with respect to the matter on which the professional is employed.
The Bankruptcy Rules complement the Bankruptcy Code sections governing professional retention and compensation. Particularly, Bankruptcy Rule 2014 provides that all applications of a debtor to employ professionals must be filed on the docket and a copy must be delivered to the US Trustee, which serves as a watchdog to ensure that the Bankruptcy Code and Rules are complied with, particularly as they apply to professional retention and compensation. Rule 2014 obligates professionals to make certain disclosures to enable the bankruptcy court judge to make a finding that the professionals do not hold adverse interests and are disinterested, and thereby satisfy the standards set forth in Bankruptcy Code section 327. Specifically, Rule 2014 requires that a retention application must disclose “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.” Under Rule 2014, retention applications must be “accompanied by a verified statement of the person to be employed setting forth 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.”
In the eToys case, Judge Mary Walrath of the US Bankruptcy Court for the District of Delaware applied a broad reading of the disclosure requirements, stating that Bankruptcy Rule 2014 requires that the attorney seeking employment disclose all connections with parties in interest in the case, rather than only those that appear to implicate “disinterestedness” or “adverse interest” concerns under section 327(a). Moreover, the duty to disclose is ongoing. Promptly after learning any additional material information relating to its employment, an attorney is obligated to file and serve a supplemental affidavit setting forth the additional information.
In terms of the disclosure requirements of Rule 2014, Judge Walrath explained in the eToys case that “[d]isclosure goes to the heart of the integrity of the bankruptcy system . . . [and] [t]herefore, the duty to disclose under Bankruptcy Rule 2014 is considered sacrosanct because the complete and candid disclosure by an attorney seeking employment is indispensable to the court's discharge of its duty to assure the attorney's eligibility for employment under section 327(a) and to make an informed decision on whether the engagement is in the best interest of the estate.”[2]
Noncompliance with the disclosure requirements generally merits denial of compensation plus disgorgement of compensation already received. Moreover, a party seeking disallowance or disgorgement of fees need not prove, or even allege, that any harm ensued as a result of the non-disclosure. Harm to the estate is not necessary to a decision to order disgorgement of fees where there is a conflict of interest. In fact, courts have held that compensation should be disallowed for services rendered by a professional who holds conflicting interests even if no fraud or unfairness resulted from the conflict.
It is also important to note that a bankruptcy court can order the disgorgement of fees even in cases where a Chapter 11 plan has been confirmed and gone effective. Although the post-confirmation jurisdiction of a bankruptcy court is extremely limited, bankruptcy courts retain jurisdiction after confirmation to enforce Chapter 11 plans. It is also worth noting that although most Chapter 11 plans provide releases to a debtor’s professionals, the releases typically exclude acts constituting willful misconduct or gross negligence. In the case of eToys, Judge Walrath held that if a professional has an actual conflict of interest which they knowingly failed to disclose at the time of their retention and throughout the case, such failure to disclose would constitute willful misconduct and therefore not benefit from the plan’s releases. In that case, Judge Walrath explained that a failure to disclose conflicts of interest that would have barred a professional’s retention constitutes “a fraud on the Court.”
Plausible arguments on both sides call for settlement
While it seems logical that Jackson Walker should have disclosed Freeman’s relationship with Judge Jones as soon as it became aware, the rules discussed above do not, on their face, explicitly obligate a law firm to disclose an attorney’s relationship with a judge. The disclosure requirements focus on disclosing an interest, or representation of a party with an interest, that could be materially adverse to a debtor’s estate. One would be hard pressed to argue that Freeman’s relationship with Jones, particularly where Jackson Walker was retained as debtor’s counsel, was adverse to the debtor. On the other hand, a party could make an argument that the relationship was adverse to a class of creditors or equity security holders.
In any event, this is not a typical case of undivided loyalty to a debtor due to a professional representing an interested third party. Nor was it a “fraud on the court” as no relationship was withheld from Judge Jones. Additionally, Bankruptcy Rule 2014 requires professionals to disclose relationships with the debtor, creditors and other parties in interest, and Judge Jones does not neatly fall within any of these categories. Rule 2014 even goes on to require disclosure of relationships with the US Trustee and anyone employed at the office of the US Trustee – but it does not mention the court or any court employees.
Most cases involving allegations that a debtor’s professional has failed to comply with Rule 2014’s disclosure requirements concern a failure to disclose that the professional recently represented (or is currently representing) a third party that either could be a creditor in the case, a party against whom the debtor holds a claim or cause of action, or some other party in interest. For example, in the Chapter 11 case of eToys, Judge Walrath ordered that Morris Nichols, Arsht & Tunnell (MNAT), counsel to the debtor, must disgorge all fees received in the case for work it had done on matters involving Goldman Sachs & Co because MNAT failed to disclose that, at that time, MNAT was representing General Electric Capital Corporation (GECC) and two affiliates of Goldman Sachs in the bankruptcy case filed by Finova Capital Corporation on the same day that the eToys filed its case. GECC was a creditor of eToys and eToys had claims against Goldman Sachs (including litigation that was currently being prosecuted by the post effective date UCC). A more recent example is when Mar-Bow, a vehicle formed by Jay Alix, founder of AlixPartners, accused McKinsey Recovery & Transformation Services of failing to disclose all of its – and its affiliates’ – connections with the debtors and other parties-in-interest in 13 cases.
We have not uncovered any precedent involving a law firm’s failure to disclose a relationship with a judge overseeing a bankruptcy case in which the firm has been retained. This likely is because the onus typically falls to the judge to disclose relationships that could lead to the appearance of impropriety or to recuse himself. Nonetheless, one case law sheds some light on the situation. In the case of Southmark Corp, Coopers & Lybrand was retained by the debtor’s examiner to do accounting investigatory work.[3] At the time of the retention, Coopers failed to disclose that it had performed accounting and auditing work for Drexel Burnham Lambert for which it earned approximately USD 18.5m. Also, when it came time to investigate Southmark's securities claims against Drexel, Coopers pulled its staff, did not pursue the investigation and did not disclose this activity to the court. Coopers did not file a supplemental disclosure either informing the court that it would not investigate potential Southmark securities claims against Drexel.
Once the debtor learned of the situation, the debtor sought relief from the final order approving Coopers’ compensation under Rule 60(b), which the Debtwire legal analyst team discussed earlier in connection with Judge Jones’ resignation. The debtor argued that it was entitled to relief from the order under Rule 60(b) due to Coopers’ non-disclosure. The court ruled that pulling staff was not an appropriate remedy, and that Coopers' “failure to fully disclose connections and activities with and regarding Drexel prevented the court from fully performing its function under the Bankruptcy Code and thereby frustrated the purposes of the Code to assure that the professional person employed by the examiner tenders undivided loyalty and provides untainted advice and assistance.”[4]
Bankruptcy courts typically assess compensation disgorgement issues under the particular facts of each case, taking into consideration a variety of factors, including the value of services provided by the professional, any harm to the estate, time and labor employed, and egregiousness of the professional person's non-disclosure. In the Southmark case, the judge ordered Coopers to disgorge compensation paid in connection with work regarding Drexel, which amounted to approximately USD 55,000. In addition, the court stated that if Coopers had informed the court that it had effectively terminated the investigation of securities claims against Drexel, the development of those claims would have proceeded on a different basis. Consequently, the court trebled the disgorgement amount for an additional sanction of USD 165,000.
The case is relevant for a number of reasons. If Jackson Walker was obligated to disclose Freeman’s relationship with Judge Jones, the fact that Freeman left Jackson Walker arguably would not absolve Jackson Walker of its disclosure obligation if Freeman was employed at Jackson Walker at the outset of the retention. Moreover, this case highlights the fact that even if disgorgement is appropriate, full disgorgement is not automatically the remedy. The extent of disgorgement would need to be addressed on a case-by-case basis, with the court attempting to measure any harm resulting from nondisclosure and the benefits provided by Jackson Walker.
Given that there is no bright line answer to (i) whether disclosure should have been made under a strict reading of the Bankruptcy Code and Rules, and (ii) if disclosure was required, what amount of fees appropriately should be disgorged, we would not be surprised if Jackson Walker and the US Trustee ultimately agree to a partial fee reduction in certain of the impacted cases, including GWG Holdings.
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[1] In re eToys, 331 B.R. 176 (Bankr. D. Del. 2005).
[2] See id.
[3] See In re Southmark Corp, 181 B.R. 291 (Bankr. N.D. Tex. 1995).
[4] In re Southmark Corp, 181 B.R. at
