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Court Affirms K&L Gates Failed to Make Proper Rule 2014 Disclosures of Conflicts

Monday, March 3, 2014
By Stephanie M. Acree

Feb. 28 --A bankruptcy court did not err in finding that law firm K&L Gates LLP (“KLG”), as counsel for a Chapter 11 debtor, failed to provide sufficient detail in its statement regarding connections with creditors pursuant to Rule 2014 of the Federal Rules of Bankruptcy Procedure in granting a motion to disqualify KLG as counsel for the debtor, the U.S. District Court for the Eastern District of New York held Feb. 18 (KLG Gates LLP v. Brown, 2014 BL 41819, E.D.N.Y., No. 2-13-cv-04972, 2/18/14).

However, Judge Arthur D. Spatt found that the lower court did err in implying an attorney-client relationship between KLG and certain insiders of the debtor because the insider that brought the motion to disqualify KLG had waived his right to contest any alleged conflict of interest. The court also found that the bankruptcy court erred in considering the relationship between one of the KLG attorneys and certain bankruptcy professionals involved in the case in ruling on its motion to disqualify KLG. The district court thus remanded the case to the bankruptcy court for further findings consistent with its ruling. 

Engagement Letter

In 2008, certain managers of debtor Brown Publishing Company (BPC) began exploring options to avoid a forced sale of BPC's assets, stemming from a $9 million debt owed to Windjammer Capital, and to retain control of the company. BPC's general counsel, Joel Dempsey, contacted then-KLG attorney Edward Fox for advice on this issue. Dempsey sent Fox a memo detailing a plan pursuant to which Dempsey, BPC's president and chief executive officer Roy Brown, and BPC's vice president and chief financial officer Joseph Ellingham (collectively, the “BPC insiders”) would form a new company that would acquire all of BPC's assets. In theory, the new company would be more “tax efficient,” allowing BPC to sell certain assets with lender approval and raise enough money to pay Windjammer, thus avoiding the forced sale.

Fox and the BPC insiders disagreed about the nature of the advice Fox offered regarding this issue. Brown alleged that Fox advised the BPC insiders that a quick Bankruptcy Code Section 363 sale in bankruptcy to the newly formed company would be the best way to retain control of the company. Fox claimed that he dismissed the plan outlined in the memo as a “crazy tax avoidance scheme.” Fox also claimed that he advised the BPC insiders that a sale in bankruptcy would be heavily scrutinized by the bankruptcy court.

Fox sent Dempsey an engagement letter dated Dec. 24, 2008, which provided that KLG “understood that it was being engaged to act as counsel solely for Brown Publishing Company and not for any affiliated entity (including parents and subsidiaries), shareholder, director, officer or employee of Brown Publishing Company not specifically identified herein.” 

Conflicts Waiver Letter

On June 5, 2009, Brown and Dempsey met with Fox and then-KLG attorney Eric Moser to discuss, according to Brown, how the BPC shareholders could acquire the BPC's assets in bankruptcy and thus maintain control over BPC. Fox and Moser alleged that this meeting was a typical pre-bankruptcy meeting, during which they indicated that a purchase through bankruptcy was possible, but would be subject to higher bids and would require the appointment of an independent director to oversee the sale process to avoid conflicts of interest.

In July 2009, Fox sent Dempsey a retainer agreement regarding KLG's representation of BPC in bankruptcy. On Aug. 20, 2009, Fox sent Dempsey a letter asking BPC to waive potential conflicts of interest. Among those potential conflicts, KLG was representing PNC Bank and Wilmington Trust in their capacities as indentured trustees in two separate bankruptcy cases. The waiver letter did not specify that Fox was personally involved in representing PNC and Wilmington, which he was. Brown signed the conflict waiver on behalf of BPC, thus consenting to the concurrent representations.

In June 2009, the BPC insiders began seeking financing for the asset purchase. Brown sent a memo to Gary Best of PNC, an agent of the secured lienholders, which intended to convince the secured lienholders to support the asset sale in bankruptcy. Dempsey sent the memo to Fox, who provided edits and advice regarding the memo. During a meeting with prospective financier Goldman Sachs, Brown alleged that Fox outlined the benefits of a Section 363 sale in bankruptcy, specifically that the sale would happen so quickly it would discourage other prospective bidders. The BPC insiders eventually reached an agreement with Guggenheim Partners to provide financing for the asset purchase. 

Disclosure of Potential Conflicts

Shortly before the bankruptcy filing, the BPC insiders formed Brown Media Corporation, in which they were the only equity stakeholders, to serve as the company that would purchase BPC's assets. Fox provided Dempsey with a list of tasks that would be necessary to complete negotiations regarding an asset purchase agreement. Fox also advised Dempsey, “this presumes that [Brown Media] has … retained counsel with whom we can negotiate to the extent necessary.”

Brown Media retained Richard Levy, a friend of Fox, to represent it in negotiating an asset purchase agreement with BPC. Fox also suggested that his former colleague Thomas Carlson be appointed as BPC's independent director, which BPC approved.

BPC filed for Chapter 11 protection on April 30, 2010. Four days later, the debtor moved to sell its assets under Section 363 of the Bankruptcy Code on expedited notice. The debtor also filed an application to retain KLG as counsel. As required by Rule 2014 of the Federal Rules of Bankruptcy Procedure, Fox filed an affidavit on behalf of KLG which listed 483 of BPC's creditors which were being, or had been, represented by KLG in unrelated matters. PNC and Wilmington were among the creditors listed. The court approved KLG's retention and Fox and Moser served as lead counsel for the debtor. 

Financing Withdrawn, Disqualification Granted

The asset sale took place on July 19, 2010, with Brown Media as the winning bidder for most of BPC's assets. However, Guggenheim withdrew its financing and PNC became the successful bidder as the next-highest bidder. A reorganization plan was confirmed on June 16, 2011, which established a liquidating trust to succeed to the assets of the debtor's estate. The plan also provided that the trust could retain KLG.

Before the plan was confirmed, Brown, Dempsey, and Carlson met at KLG's offices. At this meeting, Brown learned that he would likely be sued on behalf of the trust. Brown, who was represented by his own counsel at this time, did not object to the confirmation of the plan. However, on March 15, 2012, Brown moved to disqualify KLG from representing the trust in litigation against Brown. Brown alleged that prior to the bankruptcy filing, KLG had really been acting on behalf of the interests of the BPC insiders rather than on behalf of the interests of BPC. Brown later amended the motion to allege that KLG failed to fully disclose information regarding potential conflicts of interest as required by Rule 2014.

On April 29, 2013, the bankruptcy court granted the motion to disqualify KLG based on an implied, undisclosed attorney-client relationship between KLG and the BPC insiders and based on KLG's failure to make proper Rule 2014 disclosures. The bankruptcy court later required KLG to disgorge $100,000 of the fees it collected from BPC to the trust. KLG appealed to the district court. 

Delay Results in Waiver

The court said that it need not consider whether the bankruptcy court erred in implying an attorney-client relationship existed between KLG and the BPC insiders because “Brown's delay in bringing the disqualification motion amounted to a waiver of his right to contest this alleged conflict of interest.” The court said the factors to consider in determining if such a waiver has occurred include the length of the delay, when the movant learned of the conflict, whether or not the movant was represented by counsel and when, whether or not the motion was delayed for tactical reasons, and whether granting disqualification would result in prejudice to the nonmoving party.

In this case, the court said that: “(1) Brown delayed almost three years until bringing the [d]isqualification [m]otion in 2012, though he knew of the alleged conflict between KLG and the [BPC insiders] as early as 2008 or 2009; (2) Brown relied on advice from other law firms during this delay; (3) Brown concedes that he delayed for tactical purposes; and (4) disqualification prejudiced the [l]iquidating [t]rust because the [p]lan had been effective for nearly nine months before Brown filed the [d]isqualification [m]otion.” Finding that all these factors weighed against Brown, the court found that Brown had waived his right to contest KLG's conflict of interest. 

Importance of Thorough Disclosures

However, the court found no error in the bankruptcy court's finding that KLG had failed to make proper disclosures under Rule 2014. Section 327(a) of the Bankruptcy Code states that attorneys representing the debtor must not “hold or represent an interest adverse to the estate.” In furtherance of this section, Rule 2014 requires that an attorney's application to represent a debtor “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.”

The court said that “[c]ourts have emphasized the importance of making thorough disclosures of any connections as required by Rule 2014” and that the obligation to make such disclosures is a “continuing one.” The court said that though the term “connections” in Rule 2014 is not clearly defined, “the broad reach of Rule 2014 suggests that the word encompasses individual attorneys, as well as their law firms.” The court said that in this case, KLG had failed to abide by Rule 2014 by not disclosing Fox's personal representation of PNC and Wilmington. The court said that BPC's waiver of conflicts did not rectify this error, and noted that the conflict waiver letter did not specify Fox's personal involvement.

KLG argued that it could find no prior case law where a firm was disqualified when it identified all potential conflicts, but did not disclose the individual attorneys that staffed those matters. Therefore, KLG argued that disqualifying it raised due process because KLG had no prior notice that such disclosures were necessary. The court disagreed based on its broad interpretation of “connections” in Rule 2014. 

Due Process Concerns

Finally, the court noted that the bankruptcy court “expressed [] concern” about the lack of disclosure regarding Fox's relationships with Levy and Carlson. The district court said that it was unclear how much weight, if any, the bankruptcy court gave to this issue in disqualifying KLG.

The district court found that “to the extent the [b]ankruptcy [c]ourt based its determinations on KLG's failure to disclose this information, the [c]ourt finds that the determination was made in error as such disclosures are beyond the scope of Rule 2014.” The court said that such prior relationships between bankruptcy professionals are typical and that sanctioning KLG for such non-disclosures would raise due process concerns. Therefore, the court declined to uphold KLG's disqualification and remanded the case to the bankruptcy court to determine if disqualification remained appropriate in light of the district court's findings.

Anthony C. Acampora of Silverman, Acampora LLP, Jericho, N.Y., represented the appellant.

Daniel L. Abrams of Law Office of Daniel L. Abrams PLLC, New York, and Kenneth A. Reynolds of McBreen & Kopko, Jericho, N.Y., represented the appellee.

To contact the reporter on this story: Stephanie M. Acree in Washington at sacree@bna.com

To contact the editor responsible for this story: Jay Horowitz at jhorowitz@bna.com

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