December 5, :45pm. Panelists. Moderator Hon. Barbara Houser Chief Judge United States Bankruptcy Court Northern District of Texas Dallas, TX

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1 American Bankruptcy Institute 2008 Winter Leadership Conference Ethics Committee Session: The Good, The Bad and the Very, Very Ugly: Pitfalls of Improper or Incomplete Disclosures by Professionals December 5, :45pm Panelists Moderator Hon. Barbara Houser Chief Judge United States Bankruptcy Court Northern District of Texas Dallas, TX Ramona D. Elliott, Esq. General Counsel Executive Office of United States Trustees Washington, DC Janice Grubin, Esq. Drinker Biddle & Reath, LLP New York, NY Kelly Beaudin Stapleton, Esq. Traxi, LLC New York, NY William F. Ryan, Esq. Whiteford, Taylor, Preston, LLP Baltimore, MD Prof. Jack. F. Williams ABI Resident Scholar Managing Director, BDO Consulting Atlanta, GA ABI Ethics Committee Co-Chairs Terri Gardner, Esq. Nelson Mullins Riley & Scarborough, LLP Raleigh, NC Judith Greenstone Miller, Esq. Jaffe Raitt Heuer & Weiss, P.C. Southfield, MI ABI Ethics Committee Education Director Ted Gavin, CTP NachmanHaysBrownstein, Inc. Wilmington, DE

2 American Bankruptcy Institute 2008 Winter Leadership Conference Ethics Committee Session: The Good, The Bad and the Very, Very Ugly: Pitfalls of Improper or Incomplete Disclosures by Professionals December 5, 2008 DISCLOSURES AND CONFLICTS IN THE CONTEXT OF 363 SALES Janice Grubin, Esq. Drinker Biddle & Reath LLP At the outset, it should be noted that the facts and decisions discussed herein are components of a lawsuit that has been settled as to all defendants. No facts or liability have ever been determined and the settlement agreements, approved by Bankruptcy Court Orders, contain a denial of liability and of the facts alleged. In addition, the settlement agreement with the Debtors law firm includes a non-disparagement clause, which these materials and related presentation have studiously honored. I Introduction In two decisions issued just shy of a year apart concerning alleged misconduct and fraud in a failed auction process, Bankruptcy Judge Martin Glenn addressed important issues bearing on the integrity and transparency of bankruptcy court proceedings. First, Judge Glenn denied the motion by one of the putative defendants, the debtors counsel (the Law Firm ), to file under seal a yet-to-be-commenced adversary complaint by the chapter 11 trustee (the Trustee ) that emerged out of a Court-ordered investigation. Grubin v. Gianopoulos, 359 B.R. 543 (Bankr. S.D.N.Y. 2007) (the Sealing Decision ). Second, in Grubin v. Gianopoulos, 380 B.R

3 (Bankr. S.D.N.Y. 2008), Judge Glenn concluded that the Trustee had standing to assert six counts of the complaint against the Law Firm and two of its partners, denied the Law Firm s motion to dismiss four of the counts and granted the motion on the remaining two counts, with leave to amend one count (the Motion to Dismiss Decision and, together with the Sealing Decision, the Decisions ). The Decisions are instructive on how the public policy of keeping court records public is consistent with the disclosure obligations of bankruptcy professionals. II Underlying Facts Food Management Group, LLC ( FMG ), KMA I, Inc., KMA II, Inc., KMA III, Inc. ( KMAs ) and Bronx Donut Bakery, Inc. ( BDB and, collectively with FMG, KMAs and BDB, the Debtors ) each filed for chapter 11 relief on June 1, and June 2, Prior to the bankruptcy filings and the appointment of the Trustee, FMG had managed approximately twenty-four Dunkin Donut franchises owned and operated by the KMAs which, in turn, were serviced by a bakery operated by BDB. Also prior to the bankruptcy filings, FMG and its various affiliates who operated the Dunkin Donuts franchises (which affiliates were owned by members of the Gianopoulos family (collectively, and including any or all Gianopoulos family members, the Insiders )) settled a federal lawsuit with Dunkin Donuts. Under the October 2002 settlement agreement, the Insiders were required to transfer the Dunkin Donuts stores and bakery to newly-created companies, the KMAs and BDB, and sell the stores and bakery by July 31, 2005 to a purchaser in whom no Insiders held an interest. In January 2005, the Debtors filed a motion to conduct an auction of all of their assets. Sealing Decision, 359 B.R. at 548. The auction motion included proposed bidding procedures and an offer and registration form, which form required a 32

4 certification by each bidder that no Insiders had an involvement with the bid, nor would Insiders have any involvement in the post-acquisition business. As approved, the bidding procedures (i) required a Qualified Bidder to submit to the Law Firm an irrevocable, executed contract, a completed bidder registration form and a 10% deposit and (ii) provided for a stalking horse bid to receive a 2.5% break-up fee, if the stalking horse bid was outbid at auction. Id. at Numerous bidders submitted deposits for one, some, or all of the franchises. Among the interested parties was a businessman and close friend of one of the Law Firm s partners (the Purchaser ) and, together with his affiliates, an alleged client of the Law Firm. In addition, the year prior to the Debtors bankruptcy filings, one of Purchaser s companies had provided financing to an entity of the Insiders, Nodine Realty. Id. at 549. By letter dated March 22, 2005, the Law Firm delivered to Purchaser the October 2002 Dunkin Donuts settlement agreement and a copy of the approved bidding procedures and auction order. In the letter, the Law Firm stated that the purchase must be an arms-length transaction, that the transferee cannot be associated in any ways [sic] with the past or present management and strongly urg[ed] Purchaser to ensure that the Insiders have individual bankruptcy counsel... and insist that they do so. Motion to Dismiss Decision, 380 B.R. at On March 23, 2005, Purchaser s company, 64 East 126 th Street LLC ( 64 East ) made a $21 million bid for substantially all of the Debtors assets. 64 East tendered the required deposit of $2,100,000 and an executed contract, without a completed Offer & Bidder Registration Form. Sealing Decision at 549. At a hearing on March 24, 2005, the Law Firm sought Court approval of 64 East s bid as the stalking horse bid, with the protection of a 2.5% breakup fee. The Court approved a breakup fee for 64 East in the amount of $250,000. The Court was not told that 64 East had not provided the certification concerning the lack of involvement by the Insiders. 33

5 Subsequently, Dunkin Donuts appeared to have refused to approve the 64 East bid after conducting a background check of Purchaser. Id. at 550. The Law Firm then allegedly worked on behalf of the Purchaser to cancel the 64 East contract and get the deposit returned, including by drafting a stipulation and release that awarded to 64 East the breakup fee and returned the deposit. Id. at 552. At a hearing on March 15, 2006, the Court read into the record a letter dated March 24, 2005 from the Insiders and Nodine Realty to 64 East, which stated that [w]e have requested that you act as the purchaser of the Debtors assets. Id. at 550. The letter further stated that a $2.6 million loan from Newell Funding LLC, a Purchaser affiliate, would fund the $2.1 million deposit for the 64 East bid and if the 64 East bid was not successful, the deposit would be returned to Nodine, with all but $50,000 of any breakup fee to be given to the Insiders. Id. Finally, the letter stated that [i]t is understood that in connection with the bankruptcy proceedings referenced in the Contract, should the Court, Trustee or any creditor of the Debtor, inquire of the relationship between us and/or Newell Funding LLC and/or the LLC, or the matters surrounding this transaction and our participation, that you will make true and complete disclosure, including, the advancement of the deposit under the Contract and any other agreement that we may in the future enter into that pertains to this matter. Id. By Order dated April 4, 2006, Bankruptcy Judge Hardin authorized the Trustee to commence a Bankruptcy Rule 2004 investigation into the 64 East bid. Id. at 551. Ultimately, that investigation led to the Trustee s preparation of a ten count complaint against sixteen defendants, including Insiders and their affiliates, Purchaser and his professionals and affiliates and the Law Firm and two of its partners (the Law Firm Defendants ), alleging fraudulent concealment, conspiracy to commit fraudulent concealment, breach of fiduciary duty, conspiracy to breach 34

6 fiduciary duty, unjust enrichment, negligence and fraud on the Court. Among other things, the complaint alleged that (i) the Law Firm failed to disclose its prior representation of Nodine Realty and its connections with Purchaser as required under Bankruptcy Rule 2014(a), (ii) the Law Firm and other defendants had notice or knowledge, but failed to disclose to the Court, that the Insiders were involved in the 64 East bid, and (iii) the Trustee returned the 64 East deposit of $2.1 million on December 8, 2005 without knowing that the deposit was funded by the Insiders or of the Law Firm Defendants efforts to have the deposit returned. Id. at In October 2006, while the Trustee was attempting to resolve the unfiled complaint, the Law Firm filed the motion to seal. Id. at 551. As directed by Judge Glenn in his Sealing Decision, the Trustee filed the complaint on February 13, Thereafter, all defendants filed motions to dismiss. By Orders dated August 23 and 30, 2008, the Court approved the Trustee s settlement agreements with the thirteen Insider and Purchaser defendants, respectively, which agreements included the 64 East adversary proceeding and two of the three pending motions to dismiss. Consistent with Judge Glenn s Motion to Dismiss Decision, the Trustee filed her amended complaint on February 12, The Law Firm Defendants answered on February 25, 2008, denying any wrongdoing or liability and asserting 32 affirmative defenses. The parties then engaged in briefing on whether the action was core or noncore; the Trustee filed a motion to dismiss 21 of the 32 affirmative defenses and the Law Firm Defendants request for a jury trial; the Law Firm Defendants filed a motion to withdraw the reference. Court-approved mediation in late April led to a global settlement between the parties, which included resolution of the 64 East action and the Law Firm s fee applications seeking the final allowance of $1,215,745 in fees and expenses. After a hearing on 35

7 August 20, 2008, the Court granted the Trustee s settlement motion by Order entered August 21, III The Sealing Decision Pursuant to section 107(b)(2) of the Bankruptcy Code, the Law Firm moved to require that the complaint be filed under seal, arguing that the complaint contained scandalous or defamatory matter that would be damaging if made public. Id. at The Court found that the Law Firm failed to meet the requirements for sealing because the complaint did not contain scandalous or defamatory matter. In a scholarly analysis, the Court first delineated the strong public policy of open access to court records codified by section 107. The public interest in openness of court proceedings is at its zenith when issues concerning the integrity and transparency of bankruptcy court proceedings are involved, as they are in this matter. Id. at 553. The Court then discussed how section 107(b) establishes an exception to the general right of access where under compelling or extraordinary circumstances an exception is necessary. Id. at 554. Recognizing that section 107(b)(2) does not define scandalous or defamatory matter, the Court declined to adopt the test enunciated by the First Circuit in Gitto v. Worcester Telegram & Gazette Corp. (In re Gitto Global Corp.), 422 F3d 1, (1 st Cir. 2005): [t]o qualify for protection under the section 107(b)(2) exception for defamatory material, an interested party must show (1) that the material at issue would alter his reputation in the eyes of a 36

8 reasonable person, and (2) that the material is untrue or that it is potentially untrue and irrelevant or included for an improper end. Id. at In this Court s view, protection against defamatory matter only applies for statements that are untrue, and that can be clearly shown to be untrue without the need for discovery or a mini-trial. Id. The adversary complaint here followed the Trustee s Rule 2004 investigation, undertaken upon instructions from Judge Hardin after the March 24, 2005 letter from the [Insiders] to [Purchaser] came to light.the defendants in the adversary proceeding will have the opportunity to test the merits of the claims through the litigation process. Id. at 557. The Court further opined that scandalous matter requires examination of relevancy and improper purpose and that defamatory matter requires untruth. Id. at Turning to the motion, Judge Glenn concluded that the Law Firm s claim that the adversary complaint would tarnish the firm s reputation, without more evidence, was insufficient to meet the high burden of proof under section 107(b)(2) of demonstrating extraordinary circumstances and a compelling need to obtain protection. Id. at 561. Specifically, the Court reasoned that, while the complaint contained matter that may alter the Law Firm s reputation in the eyes of a reasonable person, it was neither scandalous, defamatory nor included for an improper purpose and was relevant to the causes of actions alleged. [M]ere embarrassment or harm caused to the party is insufficient to grant protection under section 107(b)(2).... [The Law Firm s] claim that the allegations will cause harm to its reputation, alone, is insufficient to overcome the public policy interest of keeping court records public. Id. at The Court also found that the Law Firm had failed to establish that the complaint s allegations were untrue. In fact, the Court noted that, while the sealing motion and reply sought to cast blame on other 25 Interestingly enough, the Court noted that, if it were to apply the Gitto test to this motion, it would conclude that nothing in the adversary complaint is potentially untrue and irrelevant or included for an improper end. Id. at fn

9 defendants.[t]he time and place to test the claims and defenses must await future proceedings. Id. Regarding relevancy, for instance, the Court found that the allegations dealing with Purchaser s March 2005 interest in purchasing the Debtors assets and utilizing the Law Firm s services after the Debtors bankruptcy filings fairly raise questions about the [Law Firm s] current and prior relationship with [Purchaser], arguably giving rise to divided loyalties; they also raise questions whether the [Law Firm] properly supplemented its Rule 2014 disclosures to disclose conflicts or potential conflicts or connections with the debtor, creditors, or any other party in interest that arise after counsel s initial application. Id. at The Court applied a similar analysis to the proposed complaint s paragraphs concerning the Law Firm s alleged failure to disclose its prior representation of Nodine Realty and its past and present connections with the Insiders and Purchaser. Id. at 564. In further support of its decision not to seal the complaint, the Court found that the vast majority of the facts on which the Trustee bases the allegations in the adversary compliant are already part of the public record, or were obtained as a result of the voluntary turnover of files, or as a result of the Fed. R. Bankr. P investigation ordered by Judge Hardin. The Court lacks the authority to seal information derived from public documents. Id. at 565. The Court closed its opinion by noting that [t]he adversary complaint contains serious allegations of misconduct by lawyers representing the Debtors and other parties in interest in this chapter 11 case, as well as by the Debtors principals and by other third parties. In addition to the [Law Firm] and several of its partners, the defendants include [Purchaser s] attorneys, who also allegedly had notice or knowledge of the Insiders involvement with [Purchaser] in While noting a professional s continuing duty of disclosure under Rule 2014(a), the Court was careful to acknowledge that it was not deciding whether the Law Firm made timely and adequate disclosure of its connections with Purchaser as this issue was not presented by the sealing motion. 38

10 East s bid, failed to disclose the facts, and indeed may have assisted in documenting the allegedly improper agreement between the [Insiders] and [Purchaser]. None of these lawyers or for that matter any of the other defendants has had an opportunity to respond to the allegations contained in this adversary complaint. At this point the allegations remain unproven. But the public interest in this adversary proceeding cannot be questioned, as the allegations relate to the integrity and transparency of the bankruptcy court proceedings. Whether the adversary complaint has properly stated claims, and whether the claims have any merit, must await future developments. Id. IV Decision on the Motion To Dismiss In granting in part and denying in part the motion to dismiss by the Law Firm Defendants, the Court, in a 59-page opinion, first addressed standing issues and then assessed the legal sufficiency of each of the six counts as pled. Pursuant to sections 541 and 544 of the Bankruptcy Code, the Law Firm Defendants argued that the Trustee lacked standing to commence the complaint because the 64 East bid deposit was never property of the estate and, hence, not recoverable. Motion to Dismiss Decision, 380 B.R. at 692. The Court s response was that the complaint s post-petition causes of action arising from alleged misconduct by the Law Firm Defendants had nothing to do with the bid deposit; rather, the bid deposit only came into play as an element of damages based on the Trustee s position that, because of the defendants wrongful conduct, the $2.1 million bid deposit had been forfeited. Id. [The Law Firm Defendants] appear to conflate the issue of standing with the issue of damages.[t]he determination whether the Trustee can recover this amount as damages will have to await further developments in the litigation. Id. at

11 Next, the Law Firm Defendants questioned the Trustee s standing under the in pari delicto doctrine and Wagoner rule because the only victim of any alleged conduct was Dunkin Donuts, and not the Debtors or the estate. The Court rejected the doctrine s or rule s application as a defense or a bar to standing on the Trustee s claims since the agency principles that girded both principles did not mandate the imputation of the Insiders post-petition conduct -- relating to a sale outside the ordinary course of business to the Trustee. A chapter 11 trustee as the representative of the estate is in no sense a wrongdoer (imputed or otherwise) when fraud is committed by the debtor s principals in connection with a Bankruptcy Code section 363 sale of estate assets that requires court approval. Id. at 694. The Court found further support for its non-imputation ruling in the adverse interest exception to the in pari delicto doctrine, and dispensed with the exception s sole actor rule by finding that, in the context of a 363 sale requiring court approval, it could never apply. On the allegations in the complaint, the Court was an innocent decision maker that was deceived by the withholding of facts surrounding the allegedly collusive auction bid. Id. at 697. The Court acknowledged that the Wagoner rule was the law of the Circuit in barring claims by a trustee based on a debtor s prepetition misconduct. The Court found, however, that the complaint sufficiently alleged that the Wagoner Rule was inapplicable to the facts presented even if the Rule still generally barred litigation by a chapter 11 trustee over a debtor s principal s postpetition conduct. Id. at 700. Citing to the complaint, the Court stated that [t]he [Insiders] were not in total control of the approval of the bid, and were the Court made aware of the Insiders involvement in the 64 East stalking-horse bid, the Court would not have approved the bid, as it was made in violation of the Bidding Procedures. Id. 40

12 The Court upheld the sufficiency of Count II, Fraudulent Concealment. The Court found that the complaint alleged sufficient facts to withstand the motion to dismiss under the requirements of pleading fraud pursuant to Rule 9(b) and New York substantive law. Id. at 701. The Court dismissed with prejudice Count III, Conspiracy to Commit Fraudulent Concealment, and dismissed with leave to amend Count VI, Conspiracy to Commit Breach of Fiduciary Duty. On the former count, the Court found that the complaint fail[ed] to plead, with the particularity required by Rule 9(b), facts supporting a strong inference that the [Law Firm] defendants acted with actual intent to participate in the alleged conspiracy and to injure the plaintiff and that it was redundant of Count II, Fraudulent Concealment. Id. at 704. On the latter count, the Court expressed skepticism about whether it could be amended to comply with the particularity required for the intent element but permitted leave to amend. To the extent the Trustee pleads a separate cause of action for conspiracy against the [Law Firm] Defendants, based upon the Insiders breach of fiduciary duty, a valid conspiracy claim can be stated against the [Law Firm] Defendants. Id. at 705. In denying the motion to dismiss as to Count IV, Breach of Fiduciary Duty, the Court disagreed with the Law Firm Defendants position that they owed no fiduciary duty to the Debtors or the estate and, to the extent such a duty existed, that damages were limited to disgorgement of $800,000 in fees they received. After reviewing applicable New York law and the Restatement (Third) of the Law Governing Lawyers, the Court quickly disposed of the Law Firm Defendants contention that they did not owe a fiduciary duty to their clients, the Debtors. Id. at 706. The Court then discussed the conflicting law regarding debtor s counsel s fiduciary duty to the estate and acknowledged and embraced the majority view which recognized such a 41

13 duty. The Court noted that the scope of the Law Firm Defendants fiduciary duties to the estate, a nonclient, is certainly narrower than a lawyer s duties to his client. Id. at 708. While the Court agreed with the Law Firm Defendants that they had no obligation to ensure their clients compliance with agreements, they cannot simply close his or her eyes to matters having an adverse legal and practical consequence for the estate and creditors. Id. at 708 (quoting In re St. Stephen s 350 East 116 th St., 313 B.R. 161, 171 (Bankr. S.D.N.Y. 2004)). The Court further stated that actual knowledge by the [Law Firm] Defendants is not required to impose liability on this theory [of a heightened duty of care]. The [Law Firm] Defendants cannot escape liability if they closed their eyes to what someone with their superior intelligence would find obvious. But, importantly for the [Law Firm] Defendants, knows neither assumes nor requires a duty of inquiry. Id. at 710. Noting that the Law Firm Defendants had characterized their failure to disclose the absence of the required certification from 64 East as an administrative oversight, the Court stated that [t]his may have been a case of ignoring what was plainly apparent. Id. at 711. Having found that a fiduciary duty from the Law Firm to the Debtors and the estate existed, the Court analyzed the elements required under New York law to allege a breach: (i) existence of a fiduciary duty, (ii) the breach of the fiduciary duty, and (iii) damages resulting from the breach. The Court reviewed the bankruptcy requirements that counsel must qualify as a party free of conflicts of interest throughout the case in compliance with section 327(a) of the Bankruptcy Code and Bankruptcy Rule 2014(a). Id. at 711. Regarding damages, the Court found that there was no basis now to hold that damages are limited to [the fees the firm received as counsel] Bankruptcy law also gives a court wide discretion in fixing a remedy for breach of fiduciary duties by a bankruptcy professional The available remedies range from 42

14 sanctions or the refusal, reduction, or disgorgement of attorney fees.even in the absence of actual harm to the estate. Id. at 713. The Court upheld Counts IX and X, for Negligence and Fraud on the Court, respectively. Regarding the claim for professional negligence, the Court found that it had previously rejected the in pari delecto doctrine, the only ground relied on by the Law Firm Defendants to support the dismissal of Count IX. Id After recounting the required elements for Fraud on the Court, the Court found that many of the same allegations supporting the breach of fiduciary duty claim support the fraud on the court claim. If the Trustee successfully establishes that the [Law Firm] Defendants had knowledge of and failed to disclose material facts concerning the auction of estate assets, the Trustee may recover for fraud on the court. It is not clear that the Trustee would be entitled to any remedy not otherwise available on one of the other claims but that is not a basis to dismiss the claim on the Rule 12(b)(6) motion. Id. at 715. V Conclusion While the Decisions were issued prior to discovery and trial and the lawsuit is now settled as to all defendants by final orders with no determination of the facts alleged or liability, the Decisions, as well as the alleged facts underlying the chain of events in these cases, implicate important issues of transparency and integrity in the bankruptcy process through the lenses of public access and disclosure. 43