Rules Governing the Employment of Counsel in US Bankruptcy Cases

Attorneys practicing in bankruptcy court must comply with the Bankruptcy Code provisions governing ethical conduct in addition to the ethical and disciplinary rules applicable to attorneys in their local jurisdictions. The Bankruptcy Code’s ethical provisions governing the employment of attorneys to represent certain parties in the bankruptcy context are generally stricter than the ethical requirements imposed on attorneys in their local jurisdictions since, while conflicts may be generally waiveable under local rules of professional responsibility, the Bankruptcy Code contains no provisions for waiver of conflicts of interest.

Applicable Bankruptcy Ethical Provisions

In addition to the ethical rules applicable to bankruptcy attorneys practicing in their local jurisdictions, there are three sections of the United States Bankruptcy Code and one Bankruptcy Rule that impose additional ethical requirements on the representation of certain parties in the context of bankruptcy proceedings. Section 327 of the Bankruptcy Code governs the employment of “professional persons,” including attorneys, by a trustee or debtor-in-possession in a chapter 11 bankruptcy reorganization case. Section 327(a) has two basic requirements. It requires a professional person not hold or represent an interest adverse to the estate and the professional person be “disinterested.”

The requirement that professionals subject to appointment under section 327(a) be disinterested is strictly enforced in order to maintain the integrity of the bankruptcy process and to avoid the appearance of impropriety¹. The disinterestedness requirement means the attorney must not have any interest materially adverse to the creditors by reason of the attorney’s connection to the debtor². Disqualification is not precluded under section 327(a) even if there is only a potential conflict³.

Section 101(14) of the Bankruptcy Code defines the term “disinterested person.” Among other things, a disinterested person is a person who “is not a creditor, an equity security holder, or an insider” of the debtor. It is also a person who “is not and was not, within two years [of the filing of the bankruptcy case], a director, officer, or employee of the debtor.”

Section 327(c) of the Bankruptcy Code states that “a person is not disqualified for employment under this section 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.” For example, an attorney may have filed a proof of claim on behalf of an unsecured creditor in a bankruptcy case or handled some other discreet matter in connection with the chapter 11 case. Section 327(c) permits such representation unless the court finds the representation of the creditor created an
actual conflict of interest.

Section 1107(b) of the Bankruptcy Code provides that a person is not disqualified from employment under section 327 by a debtor solely because of such person’s employment by or representation of the debtor before the commencement of the chapter 11 case.

Even if an attorney cannot meet the strict requirements for general appointment under section 327(a), section 327(e) of the Bankruptcy Code permits the employment of counsel for a specified special purpose, so long as such attorney does not represent or hold any interest adverse to the debtor or to the estate with respect to the special matter on which such attorney is to be employed.

Employment Application Procedures

An application seeking Bankruptcy Court approval of the employment of professional persons, including attorneys, must be made in accordance with Bankruptcy Rule 2014. Rule 2014 requires the application state the specific facts showing, among other things, “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.” This disclosure requirement enables the court to determine if a conflict of interest exists and if the attorney otherwise satisfies the requirements of Section 327 for disinterestedness and no interest adverse to the estate.

The disclosure requirements of Rule 2014 are so important that courts have held a failure to disclose a potential conflict of interest in and of itself disqualifies the nondisclosing party, and is an independent basis for denial of compensation⁴.

Committee Representation in Bankruptcy Cases

Section 1103(a) of the Bankruptcy Code authorizes the employment of professional persons, including attorneys, to represent or perform services for committees appointed in the case. Typically, there will be appointment of an unsecured creditors’ committee and, possibly, an equity security holders’ committee in a chapter 11 case.

Section 1102 also authorizes the appointment of additional committees of creditors or of equity security holders, if necessary, to assure adequate representation of such parties in the case. Section 1103(b) provides an attorney (or accountant), employed to represent a committee appointed in a chapter 11 case, “may not, while employed by such committee, represent any other entity having an adverse interest in connection with the case.”

The same attorney application disclosure requirements outlined in Bankruptcy Rule 2014 apply for committee representation appointments. Attorneys representing a creditors’ committee are deemed to be acting in a fiduciary capacity and owe a duty of loyalty and impartiality to the committee members and to the individual creditors the committee represents. Although Section 1103(b) does not per se disqualify an attorney who represents one or more creditors of the same class from being employed by a creditors’ committee, an attorney cannot represent creditors of different classes.

Representation of Multiple Creditors in Bankruptcy Cases

Bankruptcy Rule 2019 requires disclosure of multiple representations of creditors and equity security holders in Chapter 11 reorganization cases. The applicable state law rules of professional responsibility and/or model rules of professional conduct regulate the representation of multiple creditors. There is no provision in the Bankruptcy Code prohibiting such multiple representation. Typically, a lawyer may represent more than one creditor in a bankruptcy case so long as the attorney has disclosed to the creditors the dual representation and its possible implications, and all such
creditors consent.

Compensation of Appointed Professionals

Applicable provisions of the Bankruptcy Code provide the “reasonable compensation for actual, necessary services” rendered by attorneys employed under Section 327 or 1103 of the Bankruptcy Code is treated as an administrative expense and given first priority for payment in the case. As such, compensation can only be awarded as an administrative expense if the court first approves that person’s employment as a professional under Section 327. Notwithstanding prior court appointment, if at any time during an attorney’s employment under Section 327 or 1103 the attorney is no longer disinterested or holds an interest adverse to the interest of the estate, under the authority of section 328(c) of the Bankruptcy Code, the court may deny compensation for services rendered by the attorney and for reimbursement of the attorney’s expenses.

In addition, before such professionals may be compensated, the Bankruptcy Court must issue an order approving the proposed compensation, following appropriate notice and an opportunity to be heard by all creditors and parties-in-interest in the case, in addition to the United States Trustee’s office. A “fee application” must be submitted by the appointed professional that requests approval of compensation and that must detail in strict itemized fashion the services performed, the amount of time expended to perform the work, and the hourly rates of the attorneys who performed the work, for each discrete task performed by the professional for which compensation is sought. Absent an order of the Bankruptcy Court shortening the time periods, a professional appointed in a Chapter 11 bankruptcy case may not apply to the court for approval of compensation more than once every 120 days.

Disgorgement of Attorneys Fees

Section 328(c) of the Bankruptcy Code states. “The court may deny allowance of compensation for services and reimbursement of expenses of a professional person employed under Section 327 or 1103 of this title if, at any time during such professional person’s employment under Section 327 or 1103 of this title, such professional person is not a disinterested person, or represents or holds an interest adverse to the interest of the estate with respect to the matter on which such professional person is employed.” This provision gives a bankruptcy court discretion to deny compensation when appointed counsel ceases to be disinterested, but does not require the court to deny or order the disgorgement of fees.

1 See In Re Weibel, Inc., 161 B.R. 479, aff'd 176 B.R. 209 (Bankr. N.D. Cal. 1993).
2 See Matter of Grabill Corp., 983 F.2d 773 (7th Cir. 1993).
3 See TWI Intern., Inc. v. Vanguard Oil and Service Co., 162 B.R. 672 (S.D.N.Y. 1994);
see also In Re Marvel Entertainment Group, 140 F.3d 463 (3d Cir. 1998).
4 See, e.g., In re Arlan's Department Stores, Inc., 615 F.2d 925, 933-34 (2d Cir. 1979).

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