Advising a Financially Distressed Business, 0321 SCBJ, SC Lawyer, March 2021, #51

• Author: Michael M. Beal.
• Position: Vol. 32 Issue 5 Pg. 51

Advising a Financially Distressed Business

Vol. 32 Issue 5 Pg. 51

South Carolina BAR Journal

March, 2021

Michael M. Beal.

According to National Geographic, an approaching tsunami is often preceded by a noticeable fall in water levels.^[1] In 2020, there were fewer business bankruptcy flings and out-of-court workouts in South Carolina than normal despite a global pandemic, government mandated shutdowns and recession, so, perhaps the economic experts are correct—a wave of business failures and restructurings is about to come crashing down upon us. This article highlights some of the issues and considerations practitioners should consider when advising business clients facing financial distress.

ENGAGEMENT ISSUE

I. conflicts

As with all clients, at or before the initial client meeting, you must determine whether you have a conflict of interest. Although you might be able to represent a client in an out-of-court workout with a single creditor, you might have a conflict which would preclude you from representing the same client in a Chapter 11 bankruptcy case if the out-of-court effort fails. Conflicts in a bankruptcy context can be much more nuanced and numerous than conflicts in civil litigation. In a Chapter 11, you will be representing the client in a proceeding against all of its creditors. If you have a conflict with any one of your client’s creditors, you can be disqualified from representing the client in a Chapter 11 case.

Proposed counsel for a debtor-in-possession must file a verified statement which discloses “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.”² Full disclosure is paramount and the Bankruptcy Code (11 U.S.C. § 101 et seq.) requires an applicant to “disclose all connections regardless of whether they are sufficient to rise to the level of a disqualifying interest . . . .”³ The verified statement is closely scrutinized by the United States trustee and the court to determine whether counsel is “disinterested”.⁴

If the verified statement discloses a potential conflict and an objection is fled, the court must determine whether an actual conflict exists.⁵ Furthermore, the obligation to make conflict disclosures continues throughout the bankruptcy case.⁶ Failure to make adequate disclosures can result in counsel disqualification⁷ and forfeiture or disgorgement of legal fees.⁸

II. Client identification

You should immediately review the entity’s organizational documents (by-laws, operating agreement, shareholder agreements, etc.) to make certain that the persons who engaged you are authorized to do so and that the client will be able to obtain the corporate authorization necessary to dissolve or file bankruptcy. You should also determine whether the entity has observed all corporate formalities or acted in a manner which could lead to veil piercing litigation.

Your client might have numerous affiliates. In your engagement letter you should clearly identify who you represent, and will be well-served to specify who you do not represent. Counsel representing multiple parties (e.g., a company and its owners) must disclose those relationships and could be disqualified from representing one or more of the parties if the Court finds an actual conflict of interest.⁹

III. Fees and adequate retainer

Get an adequate retainer, make certain that your client pays your fees on a timely basis, and ensure that your retainer always exceeds the amount your client owes you. If you are owed money on the date the bankruptcy case is fled (i.e., the petition date), expect to have to waive any claim for unpaid legal services to avoid being disqualified because you, as a creditor, hold an interest adverse to the debtor’s estate.

If your client gets behind on pre-petition invoices, payments you receive within 90 days of the petition date could be considered preferential transfers,¹⁰ which can disqualify you from representing your client in bankruptcy. Furthermore, receipt of these payments increases the likelihood that you might be sued for recovery of the payments.

Ideally, the retainer should come from the client. The source of all payments, payment terms, identity of any guarantor, etc. should be disclosed under Rule 2014. Payments from a third-party can also create conflict issues practitioners should consider.

INITIAL ADVICE

I. Fiduciary duties

After you are retained, you should advise your client’s management¹¹ about their fiduciary duties as directors and officers of an insolvent business. Upon insolvency, fiduciary duties owed by directors and officers shift from shareholders to creditors,¹² and decisions must be made in the best interests of creditors, not equity. Directors and officers can be liable for violating fiduciary duties. Chapter 7 trustees focus on events that occur in the period between insolvency and the petition date and often sue officers and directors for breaches of fiduciary duties.

II. Attorney/client privilege

We all know communications between attorneys and clients are privileged. However, if the client is a corporate entity and ends up in a Chapter 7 bankruptcy case, the privilege will belong to the Chapter 7 trustee, who can waive the privilege.¹³ Courts have also allowed Chapter 11 trustees,¹⁴ creditors’ committees,¹⁵ and examiners¹⁶ in Chapter 11 cases to obtain privileged information based on the same theory. Be very careful about advice you give distressed business clients. If the company lands in bankruptcy court, your formerly privileged advice could become Exhibit A in a lawsuit against you and the directors and officers.

III. Assess immediate threats

If a foreclosure, claim and delivery, or other creditor action is pending, or if a critical contract or lease is in danger of being terminated, assess that risk immediately as it will likely dictate the time constraints and options available.

Property sold at a final foreclosure sale cannot be recovered absent...