BANKRUPTCY COURT TAKES LIBERAL VIEW OF SECTION 327(C)’S “ACTUAL CONFLICT” PROVISION

by John P. Schneider

In re Relativity Media, LLC, 2018 Bankr. LEXIS 2037 (Bankr. S.D.N.Y. 2018) presents a very informative discussion of the ethical pitfalls which may arise when a law firm concurrently represents adverse parties. Prior to its bankruptcy filing, certain disputes arose between Relativity Media, LLC (the “Debtor”) and Netflix, Inc. (“Netflix”) relating to a distribution contract between the parties.  When the Debtor filed its Chapter 11 bankruptcy petition, it sought to retain Winston & Strawn, LLP (the “Law Firm”) as counsel.  In its retention application, the Law Firm disclosed that at the time of the petition, it represented Netflix in certain patent litigation in the United States District Court for the District of Delaware, and that this representation preceded the Debtor’s engagement of the Law Firm for the bankruptcy case.

Shortly thereafter, Netflix filed a complaint seeking to have the Bankruptcy Court declare that the Debtor had breached the parties’ distribution contract prior to commencement of the bankruptcy case.  In response, the Law Firm filed an answer on behalf of the Debtor, contending there was no default, and that the Debtor intended to assume, assign, and sell the Netflix contract to a third-party purchaser.

Two objections to the Debtor’s retention of the Law Firm were filed.  Netflix argued that the Law Firm’s representation of the Debtor in disputes with Netflix would violate the professional obligations owed to it by the Law Firm.  Netflix opposed the Law Firm’s retention, but only to the extent of the Debtor’s dispute with Netflix.  It urged that the Court require the Debtors to retain special counsel for matters involving Netflix.  The Office of the United States Trustee filed a much more general objection, arguing that the simultaneous representation of both the Debtor and Netflix created an actual conflict of interest which barred the Law Firm’s employment by the Debtor under section 327 of the Bankruptcy Code (the “Code”) entirely.

In response, the Law Firm argued that Netflix previously had agreed to waive conflicts to permit the Law Firm’s representation of other clients in unrelated matters which may be adverse to Netflix.  The Law Firm also noted that Netflix was no longer a client because the Law Firm had withdrawn from the patent litigation pending in the District of Delaware.  Netflix countered that it had never agreed to the advance waiver of conflicts and that even if it had, such an agreement would be unenforceable under relevant state law.  Netflix also cited the so-called “hot potato” rule in contending that the Law Firm’s subsequent withdrawal as counsel in the patent litigation did not cure the violations of its duty of loyalty to Netflix.  As the Court noted, the theory of the “hot potato” rule “is that a law firm owes a duty of loyalty to its client, and dropping the client so the law firm can be adverse to the client is just as much a breach of that duty of loyalty as if the law firm were to be adverse to a current client.”[1]

In its review of the Law Firm’s retention application, the Bankruptcy Court began with the relevant Code provisions.  Section 327(a) states that a debtor may employ attorneys who “do not hold or represent any interest adverse to the estate.”  Section 327(c) makes clear that in a Chapter 11 case, a law firm is not disqualified “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.”[2]

The Court discussed that there are two schools of thought about the meaning of “actual conflict” under section 327(c).  The first employs an objective test that “excludes any interest or relationship, however slight, that would even faintly color the independence and impartial attitude required by the Code and Bankruptcy Rules.”[3]  But this test could “effectively negate the clear language of section 327(c),” which provides that the representation of a creditor is not inherently disabling, unless there is an actual conflict of interest.   A second school of thought, which the Court found more palatable, provides that no “actual conflict” exists under section 327(c) unless there is “an active competition between two interests, in which one interest can only be served at the expense of the other.”[4]

Whether the Law Firm’s representation of Netflix in the patent suit was continuing or not, the Court concluded that the Law Firm was not disqualified altogether because the duties associated with the representation of the Debtor in the bankruptcy case generally would not be adverse to Netflix and would not cloud its ability to remain independent and loyal to the Debtor.  So, the Court turned to the question of whether the Law Firm could represent the Debtor in matters adverse to Netflix, given its purported withdrawal from the patent suit.

The Court stated that Netflix had raised the Law Firm’s conflict from the very beginning of bankruptcy case.  And even if the Law Firm finalized its withdrawal from the patent suit, the “hot potato” rule prevented the firm from now asserting it had cured the breaches of its duty of loyalty to Netflix.  Moreover, upon review of certain engagement letters and emails between Netflix and the Law Firm, the Court determined that any advance waivers contained therein were only applicable in particular matters which had since ended, and were not a general waiver for any matter in which the Law Firm may be hired by Netflix in the future.  The fact that separate waivers were obtained in specific representations of Netflix only reinforced this notion.

Although the Court did not rule finally on whether the Law Firm would be disqualified from becoming adverse to Netflix, it stated that such an outcome was likely, but permitted the parties to further brief the issue.  As stated previously however, the Court did resolve the disputed retention application under section 327(c) by allowing the Law Firm to serve as Debtor’s general bankruptcy counsel so long as the Debtor engaged another firm to handle matters involving Netflix.

Hence, attorneys should be mindful to identify early the likely need for special counsel in these circumstances and confer with the prospective client about this issue as soon as possible.

[1] 2018 Bankr. LEXIS 2037, at *5 (internal citation omitted).

[2] Emphasis added.

[3] Id. at *6 (citing In re Granite Partners, 213 B.R. 22, 33 (Bankr. S.D.N.Y. 1998)).

[4] Id. at *7 (citing In re Empire State Conglomerates, Inc., 546 B.R. 306, 315 (Bankr. S.D.N.Y. 2016)).