PRIVATE EQUITY, CONFLICTS, AND CHAPTER 11: THE THREE TYPES OF ATTORNEY CONFLICTS THAT UNDERMINE CORPORATE RESTRUCTURING. (COMMENT)

• Date: 01 March 2024
• Author: Schneider, Crawford G.
• Published date: 01 March 2024

INTRODUCTION 1126
                I. PRIVATE EQUITY'S CENTRAL ROLE IN INSOLVENCY 1130
                 A. The Relevance of Attorney Conflicts
                 Has Increased with the Power
                 of Private Equity 1132
                II. CONSTRAINTS AND DUTIES OF RESTRUCTURING ATTORNEYS 1135
                III. THE THREE TYPES OF ATTORNEY CONFLICTS 1137
                 A. Type One and Type Two Conflicts 1138
                 B. Type Three Conflict 1149
                IV. SOLUTIONS 1152
                 A. Disclosure and Consent to Conflict 1153
                 B. Public Shaming, Judicial Notice 1154
                 C. Bankruptcy Code of Ethics 1154
                CONCLUSION 1154
                

INTRODUCTION

MyTheresa was particularly valuable to its parent company Neiman Marcus ("Neiman"). (1) As an online retailer, it was immune from the decline of brick-and-mortar luxury retail that plagued Neiman itself. (2) As a result, Neiman, which had been purchased in October 2013 by the private-equity firm Ares Management ("Ares"), was in dire financial straits. (3) Indeed, Ares could see the writing on the wall--Neiman was headed for insolvency. (4) So, concerned with salvaging its historic investment, Ares turned to its go-to law firm, Kirkland and Ellis ("Kirkland"), for help. Kirkland identified MyTheresa as a potential source of value and, understandably, Ares wanted it. More specifically, Ares wanted to maintain control of MyTheresa regardless of the fate of Neiman. Kirkland, eager to please an important client, devised a clever corporate structure and executed a deal that moved MyTheresa, Neiman's most valuable asset, from the retailer to an Ares-controlled subsidiary. (5) Importantly, that subsidiary "had no obligation to service or repay any of Neiman's $5 billion in debt." (6)

Shortly thereafter, in May of 2020, Neiman Marcus filed for Chapter 11 bankruptcy. (7) At their side to usher Neiman through the process was none other than Kirkland, (8) serving as attorney to the estate, or more specifically, to Neiman itself as the debtor in possession ("DIP"). (9) Upon filing its petition for Chapter 11 bankruptcy, the Neiman estate was created as a legal entity. (10) All of Neiman's assets became part of that estate which would, upon confirmation of a plan of reorganization, either be transferred to the surviving corporation or liquidated. (11) But, before a plan is proposed or liquidation is considered, the DIP and its counsel, Kirkland, have a duty to marshal assets and maximize the value of the estate. (12) The Bankruptcy Code ("Code") provides several mechanisms to fulfil that duty, including rejecting executory contracts, (13) repossessing assets, (14) avoiding unperfected security interests, (15) voiding preferential transfers to favored creditors, (16) and unwinding both actual and constructive fraudulent transfers. (17)

Upon filing, creditors of the estate scrutinize pre-petition transfers of assets to determine if any could be considered "constructively fraudulent." (18) Any transfer can be unwound as constructively fraudulent if it took place on or within two years before the date of filing and if the debtor (i) received less than reasonably equivalent value in exchange, and (ii) was insolvent at the time of the transfer or was made insolvent as a result of the transfer. (19) In the Neiman case, unsurprisingly, creditors zeroed in on the MyTheresa transaction. (20) In their estimation, that transaction stripped significant value from Neiman just a few years before filing for bankruptcy and could be vulnerable to a fraudulent transfer claim. (21) The investigation and if necessary, litigation, of that claim fell to the DIP and its counsel.

For Kirkland, finding itself in the driver seat of a major corporate restructuring was nothing new. In the world of corporate restructuring, Kirkland is king. (22) So, in theory, creditors to the estate were in good hands, having retained the top of the top--the best attorneys that money can buy. But there was one problem. Kirkland was suffering from a serious conflict of interest--one that called into question their willingness to vigorously pursue redress for the potentially fraudulent transfer of MyTheresa.

Indeed, Kirkland's conflict of interest was comically obvious. Kirkland had a legal and ethical obligation to try to unwind the MyTheresa transaction--the very transaction that Kirkland itself devised and facilitated. (23) Not only did Kirkland have a responsibility to question the legality of a transaction it had consummated, but it also had a responsibility to work to strip a long-time and lucrative client, Ares, of a prized asset.

Creditors, cognizant of this conflict, objected to Kirkland's appointment as counsel to the estate, requesting the judge deny Kirkland's appointment, or at a minimum, prohibit the firm from participating in the investigation of the MyTheresa transaction. (24) The creditors' efforts were futile. The Bankruptcy judge, seemingly unfazed by the blatant conflict, approved Kirkland's retention. (25)

Kirkland's conflict of interest in the Neiman case represents one of the more egregious examples of attorney conflicts of interest in bankruptcy. But that conflict and others like it are becoming increasingly likely due to the emergence of private equity as a dominant force in the American economy and, in particular, distressed investing. (26) Furthermore, as private equity has grown in stature, its legal needs have exploded, (27) and the country's largest and most prestigious law firms eagerly filled the void. Consequently, law firms and private equity formed a symbiotic relationship. Each entity has grown in wealth and reputation with the assistance of the other. And yet, bankruptcy judges often refrain from scrutinizing that relationship. (28) This Comment hypothesizes that judges refrain in part because they lack a cohesive understanding of the conflicts and their associated risks. The pages that follow constitute a modest attempt to bridge that gap. By highlighting the problem, categorizing the conflicts and risks, and pointing to key case law, this Comment serves as a jumping-off point for practitioners, judges, and scholars keen on restoring the ethical foundation of corporate restructuring.

Specifically, I define and examine three types of conflicts that have resulted from the dominance of private equity in Chapter 11. Type One conflicts occur where counsel to the estate is bound by the Code to attempt to unwind a transaction that they (or their firm) facilitated. Type Two conflicts exist where the firm, serving as counsel to the DIP, has a prior and significant relationship with a private equity investor of the company operating within Chapter 11. Finally, Type Three conflicts arise when a firm serves as counsel to a company and its private equity parent in the zone of insolvency.

For each of these types of conflicts I will do three things: First, I will provide a normative description of how the conflict arises and why the rise of private equity makes the conflict common and pervasive. Second, I will apply the relevant bankruptcy provisions and rules of professional conduct to the conflict situation. And third, I will examine relevant case law to provide judges with precedent to address the specific conflict of interest. Then, to conclude, I will provide three solutions for addressing attorney conflicts in Chapter 11.

I. PRIVATE EQUITY'S CENTRAL ROLE IN INSOLVENCY

The dramatic rise of private equity has reshaped the American economy.^ Over a seven-year period between 2000 and 2017, the number of companies controlled by private equity sponsors increased nearly fivefold. (30) What's more, assets under management are set to reach 9.11 trillion by 2025, more than double the amount in 2020. (31) The repercussions of private equity's explosive growth on law and economics has not gone unnoticed. To be sure, the impact of coordinated, sophisticated funds of private money on the American financial system is as broad as the scholarship that examines it. (32) That said, the private equity industry's dominance is felt most acutely in distressed investing and bankruptcy. (33)

The relationship between private equity-owned companies and financial distress is, in large part, a function of industry practice and strategy. One specific mechanism, the leveraged buyout (LBO), is of particular importance. (34) LBOs are commonly utilized by private equity funds and lead to increased use of Chapter 11 for private equity--backed portfolio companies. (35) In short, an LBO is a mechanism whereby a private equity firm finances an acquisition by securing new debt against the target's assets and making regular payments on the debt with the target's future cash flows. (36) This corporate finance maneuver leaves the target company with a debt-heavy capital structure that could, in some cases, reach into the ninety percent debt-to-equity ratio. (37) As a result, from the outset, private equity--owned companies, purchased via LBOs, operate under significant financial strain. (38)

The use of LBOs is even more popular during times of low interest rates, which has characterized most of the last decade. (39) In fact, LBO volume reached nearly $1 trillion in dollar value in 2021, more than double the prior peak in the 2007-08 financial crisis. (40) Viewed as a piece of the larger LBO market, private equity sponsor--backed leveraged loan issuances accounted for over sixty percent of the entire leveraged loan market every year since 2020. (41) These leveraged loans are more likely to default because they make up a disproportionate amount of the riskiest tiers of high-yield debt. (42) Unsurprisingly, in the second quarter of 2020, more than half of the companies that defaulted in the second quarter were owned by private equity firms. (43)

This phenomenon and the increase of private equity's power in bankruptcy is itself a paradigm shift in the field. (44) The traditional understanding of bankruptcy is that creditors' interests drove the proverbial bus. (45) Those in the field will recall the phrase "Creditor-in-Possession," which was first introduced by practitioner...