In re Source Enterprises, Inc., 2008 WL 850229 (Bkrtcy. S.D.N.Y. 2008)

Brief Summary
A New York bankruptcy judge denied a law firm any compensation for its work because the firm had failed to disclose that it was a creditor and had breached ethical and professional obligations.

Complete Summary
In September 2006 Source Enterprises (“Enterprises”) entered chapter 11 bankruptcy and retained law firm Windels Marx Lane & Mittendorf, LLP (“Windels”) as bankruptcy counsel. Earlier in 2006, when it had become clear that Enterprises was struggling, a preferred shareholder, Black Enterprise/Greenwich Street (“BEGS”), acting under Windels’ counsel, took control of Enterprises’ board and assumed financial responsibility for its operations. Windels’ relationship with BEGS also led to Windels’ retention as Enterprises’ bankruptcy counsel. Windels and BEGS had agreed to a flexible billing arrangement, and prior to bankruptcy, BEGS and some of Enterprises’ affiliates owed Windels money.

In Windels’ retention application filed with the bankruptcy court, Windels did not disclose its current relationship with BEGS, the close connection between BEGS and Enterprises or Windels’ status as a creditor to Enterprises.

In October 2006 a Committee of Unsecured Creditors (the “Committee”) moved the court to establish compensation for professional services. Windels did not discuss this motion with Enterprises and did not object to this motion. After the motion was granted, Windels relied on the court’s order to seek unpaid fees. When BEGS refused to pay, Windels withdrew. Windels then sought payment through the court through a fee application.

The court denied Windels any compensation because Windels had failed to disclose multiple conflicts of interest in violation of the bankruptcy code and had breached its ethical and professional obligations. The court interpreted 11 U.S.C. §§ 327(a) & 328(c) to allow the court to deny compensation when “the court subsequently learns that during the counsel’s employment he was not disinterested or held or represented an interest adverse to the estate . . . .” Id.

The court stated that the most egregious conflict was Windels’ simultaneous status as a creditor and bankruptcy counsel. Windels argued that it was not a creditor because it had waived Enterprises’ debt. The court discounted this argument because, although Windels did tell the Trustee that the debt had been written off, this was not reflected in Windels’ books, and Windels had not communicated this to Enterprises or BEGS. In fact, the court found evidence of Windels’ attempts to collect the debt even after withdrawing as counsel.

Windels was also a creditor of at least one of Enterprises’ close affiliates, Source Entertainment. Because Enterprises’ affiliates were also likely to file bankruptcy petitions, the court asserted that Windels should have disclosed this creditor status as well.

The court also noted that Windels had argued that the Debtor’s Original Plan — which did not provide recovery for unsecured creditors — was improperly influenced by BEGS. The court threw this argument back at Windels, noting that if Windels believed its client was being improperly influenced, Windels had a duty to at least inform the client before filing the plan. Windels similarly had a duty to discuss the Committee’s compensation motion with Enterprises, especially given that Windels, in the court’s view, represented Enterprises’ interests at the hearing on the motion.

Significance of Opinion
On the facts as assumed, the full denial or disgorgement of fees should come as no surprise, particularly in a bankruptcy setting.

This alert has been prepared by Hinshaw & Culbertson LLP to provide information on recent legal developments of interest to our readers. It is not intended to provide legal advice for a specific situation or to create an attorney-client relationship.

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Impaired and Poorly Behaving Partners: Managing the Risks

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