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  The Law Firm also noted that Netflix was no longer a client because the Law Firm had withdrawn from the patent litigation pending in the District of Delaware.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)).

Second Circuit Holds Violation of Bankruptcy Discharge Injunction May Nullify Mandatory Arbitration Requirement Under Federal Arbitration Act

by John P. Schneider

In In re Anderson v. Credit One Bank, N.A., 884 F.3d 382 (2d Cir. 2018), the Second Circuit held that it is within a bankruptcy court’s discretion to deny arbitration of disputes involving a violation of the bankruptcy discharge injunction.  In doing so, it found that despite the strong congressional preference for arbitration generally, the importance of the Bankruptcy Code’s fresh start, and the bankruptcy court’s powers to enforce the discharge injunction, prevailed.

Orrin Anderson (the “Debtor”) was the holder of a consumer credit card account with Credit One Bank, N.A. (“Credit One”).   In March 2012, Credit One “charged off” the Debtor’s delinquent debt, sold it to a third-party purchaser, and reported these changes to each of the nation’s leading credit reporting agencies.  The Debtor subsequently filed a voluntary Chapter 7 bankruptcy petition and was granted a discharge in May 2014.

The Debtor’s claim arose after Credit One refused his request to remove the charge-off from his credit report.  The Debtor contended that Credit One’s refusal violated the discharge injunction by attempting to coerce him into paying a discharged debt, knowing that debtors would be more inclined to pay charged-off (rather than “discharged”) debt to clear their credit report.

In December 2014, the bankruptcy court permitted the Debtor to reopen the bankruptcy case to file a class action seeking damages against Credit One for violating Bankruptcy Code section 524’s discharge injunction.  In response, Credit One moved to stay the proceedings and to initiate arbitration of the dispute in accordance with an arbitration clause contained in the Debtor’s cardholder agreement.  The bankruptcy court denied Credit One’s motion and held that because the Debtor’s claim was a core bankruptcy proceeding which “went to the heart of the fresh start guaranteed to debtors” under the Bankruptcy Code, it was not subject to arbitration.[1]

As was its right under the Federal Arbitration Act (the “FAA”), Credit One filed an interlocutory appeal of the bankruptcy court’s denial of its motion to compel arbitration in June 2015.  The District Court for the Southern District of New York affirmed the bankruptcy court’s decision in June 2016.  Credit One then  appealed to the Second Circuit.

Reviewing the bankruptcy court’s decision under an abuse of discretion standard, the Second Circuit initially stated that although the FAA establishes a federal policy favoring arbitration, “[t]his preference . . . is not absolute[]” and its mandates may be overridden by a contrary congressional command.  Therefore, given the presence of the Bankruptcy Code’s discharge provisions, the ultimate issue was whether Congress intended those provisions to preclude enforcement of arbitration agreements under the FAA.

Keenly aware that the discharge is the foundation upon which the Bankruptcy Code is built and of Congressional intent to afford the “honest but unfortunate debtors an opportunity to reorder their financial affairs and get a fresh start,” the Second Circuit recognized that this would only be possible if discharge injunctions were fully heeded by creditors.  Violations of the discharge order “damage the foundation on which the debtor’s fresh start is built.”[2]  Not surprisingly, the court determined that requiring arbitration to enforce the bankruptcy court’s discharge injunction would seriously jeopardize the effectiveness of the discharge, because: (i) the discharge injunction is integral to the bankruptcy court’s ability to provide debtors with the fresh start at the very foundation of the Bankruptcy Code; (ii) the Debtor’s claim against Credit One related to an ongoing bankruptcy matter requiring bankruptcy court supervision; and (iii) the equitable powers of the bankruptcy court to enforce its own injunctions are central to the structure of the Bankruptcy Code.[3]

Moreover, because the power to enforce a bankruptcy discharge injunction complements the duty to obey the injunction, only the bankruptcy court would have the power to enforce the injunction under section 524 of the Bankruptcy Code.  Arbitration of the claim, the Second Circuit found, would present an inherent conflict with the Bankruptcy Code.

Because the Second Circuit determined that there was an inherent conflict between arbitration of the Debtor’s claim against Credit One and the Bankruptcy Code, the court concluded that the bankruptcy court “properly considered the conflicting policies in accordance with the law” and acted within its discretion to deny Credit One’s motion to compel arbitration.[4]

 

[1] Id. at 385.

[2] Id.

[3] Id. at 389-90 (internal citation omitted).

[4] Id. at 392 (internal citation omitted).