NY Judge Takes Forgiving View of "Actual Conflict"

July 10, 2018

Bankruptcy Judge Michael E. Wiles of New York allowed a debtor’s counsel to avoid an “actual conflict” by resigning the simultaneous representation of a creditor. Although he invoked the so-called hot potato rule to bar debtor’s counsel from becoming adverse to its soon-to-be former client, the judge approved the firm’s retention as general bankruptcy counsel for the chapter 11 debtor in possession.

According to Prof. Nancy Rapoport, the July 6 opinion was “Solomonic, given that [the debtor’s counsel] was already deeply involved in the case.” Prof. Rapoport is the Garman Turner Gordon Professor of Law at the Univ. of Nevada at Las Vegas William S. Boyd School of Law, where she is an expert on legal ethics.

The firm in question had represented Netflix Inc. in several matters over the years. Relativity Media LLC selected the firm to be its bankruptcy counsel. At the time of the filing of the chapter 11 petition, the firm was representing Netflix in a patent litigation in federal district court.

Disputes regarding a contract between Netflix and the debtor predated the chapter 11 filing. In bankruptcy court, Netflix initiated an adversary proceeding to declare that the debtor was in default and determine the amount of damages.

The firm answered the complaint on behalf of the debtor, contended there was no default, and asserted counterclaims. The litigation was not merely a claim dispute, because the debtor intended to assume, assign and sell the Netflix contract to a third-party buyer.

The U.S. Trustee opposed the firm’s retention, contending that the firm was disqualified under Section 327(c) as the result of an “actual conflict” resulting from the concurrent representations of Netflix and the debtor. According to Judge Wiles, Netflix only sought to preclude the firm from representing the debtor in matters involving Netflix.

After bankruptcy, the firm evidently moved to withdraw as counsel for Netflix in the patent litigation. Judge Wiles was unsure whether the withdrawal had become effective.

Addressing the firm’s disqualification, Judge Wiles said in his bench opinion that the case turned on the interpretation of Section 327(c), which he characterized as meaning that “representing a creditor is not inherently disabling, unless there is an actual conflict of interest.”

Judge Wiles said there are two schools of thought about the meaning of “actual conflict.” Some courts, he said, employ an objective test that “‘excludes any interest or relationship, however slight, that would even faintly color the independence and impartial attitude,’” quoting In re Granite Partners, 219 B.R. 22, 33 (Bankr. S.D.N.Y. 1998).

Another decision, also from New York, found no “actual conflict” absent “‘an active competition between two interests, in which one interest can only be served at the expense of the other,’” citing In re Empire State Conglomerates Inc., 546 B.R. 306, 315 (Bankr. S.D.N.Y. 2016).

Judge Wiles took the less stringent approach, that the “faint color” test “would automatically disqualify counsel who has a concurrent representation” and “would effectively negate the clear language of Section 327(c).”

Given the firm’s impending withdrawal as counsel for Netflix in the patent suit, Judge Wiles concluded that the firm was not disqualified altogether because discharging the general duties thrust on a debtor’s counsel would not be adverse to Netflix or impinge on the firm’s independence and loyalty.

Finding the firm not disqualified from serving as debtor’s counsel, Judge Wiles turned to the question of whether the firm could represent the debtor in matters adverse to Netflix, given that the withdrawal as Netflix’s counsel in the patent suit was imminent.

The so-called hot potato rule came into play, which Judge Wiles described as meaning that “counsel who face conflicts based on concurrent representations are not permitted to solve the problem by just dropping one of the two clients.” Dropping a “client so that the law firm can be adverse to the client is just as much a breach of that duty of loyalty as if the firm were to become adverse to a current client,” he said.

Strictly speaking, Judge Wiles did not rule on whether the firm would be disqualified from becoming adverse to Netflix, although he did say that disqualification from being adverse to Netflix was “likely.”

Judge Wiles resolved the disputed retention application by allowing the firm to serve as debtor’s bankruptcy counsel as long as the debtor engaged another firm to handle matters involving Netflix.

In the process, Judge Wiles ruled that prospective conflict waivers in the firm’s engagement agreements with Netflix did not apply to the case at hand. In that respect, Prof. Rapoport said she agreed “wholeheartedly that these blanket advance waivers, even with sophisticated clients, don’t get rid of the issues that Netflix raised.”

Judge Wiles did say that the firm was “a bit reckless” in forging ahead “with full awareness of the risks.” The judge also said it was “absurd” for the firm to contend that the potential conflict was unforeseeable when the disputes with Netflix “were apparent long ago and prior to the bankruptcy filing.”

Prof. Rapoport said she understood the “U.S. Trustee’s point that the debtor’s counsel knew about Netflix way ahead of time (or should have), which is why the U.S. Trustee tried to disqualify [the firm] completely.” In her message to ABI, she said the result was “a close call, but the ‘already in too deep’ argument wins a lot of the time.”

Prof. Rapoport added that she was “was charmed by [Judge Wiles’] writing style. Sardonic, clear, pithy.”

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