# Opposition Brief — Southmark Corp. v. Coopers & Lybrand, L. L. P., 119 S. Ct. 2339 (1999) (No. 98-1643)

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## Record

- **Collection:** Supreme Court brief
- **Document type:** Opposition Brief
- **Published:** January 1, 1999

## Text

Supreme Court, U.S
2. eek w
No. 98-1645
YEON. A ee : FA: CT oR NT ah AY, nd 1299
In the doa
CLERK gh

Supreme Court of the Wviteh ett

October Term. |S98

IN THE MATTER OF: SOUTHMARK CORPORATION

SOU THMARK CORPORATION,

P Lili at }

COOPERS & LYBRAND L.L.P..

‘ _ ~ j rr y «
On Petition for Writ of Certiorari to the United S

J r
Court of Apbeats for the Fifth Circuit

BRIEF IN OPPOSITION TO PETITION
FOR A WRIT OF CERTIORARI

Judith Elkin Michael S. Feldberg
HAYNES AND BOONE, L.L.P. Counsel of Record
3100 Bank of America Plaza Frank J. LaSalle

901 Main Street SCHULTE ROTH
Dallas, Texas 75202 & ZABEL L.L.P.
(214) 651-S000 900 Third Avenue
Attorneys for Respondent New York, NY 10022
Coopers & Lybrand L.L.P. (212) 756-2000

Alton eys for Respondent
( oope rs & Lybrand eR ag

Wright/Curry & Taylor Appellate Services

COUNTER-STATEMENT OI
QUESTION PRESENTED

Whether claims alleging official raisconduct by bank
ruptey court appointed professionals constitute core bank

ruptcy proceedings

DISCLOSURE STATEMENT

Pursuant to Supreme Court Rule of Procedure 29(6),
Respondent Coopers & Lybrand L.L.P. has no parent corpo-
rations and no wholly-owned subsidiaries. Effective July 1,
1998, Coopers and Lybrand L.L.P. and Price Waterhouse
LLP combined their practices to form Pricewaterhouse Coo-

pers LLP

hl

TABLE OF CONTENTS

Counter-Statement of Question Presented

Disclosure Statement

lable of Contents .

lable of Authorities

Argument ......-.-eeeeeeereeee
| The Decision Of The Fifth Circuit Maintains
The Constitutional Limits Prescribed By
ei ny ewan es He hee oes

A. Southmark’s Claims Are In The Nature O!
A Challenge To Cooper's Disinterestedness
As A Bankruptcy Court-Appointed
Professional. .........--

B. Ensuring The Disinterestedness Of Court-
Appointed Professionals Is Essential To The
Proper Functioning Of The Bankruptcy Court
And Therefore Is Within The Core Bankruptcy

he BS, RES, Oe DE Or EF

C. Failure To Treat Southmark’s Claims As
Core Bankruptcy Proceedings Would | nder-
mine The Power Of The Bankruptcy Court lo
Restructure Debtor-Creditor Relations.
1. The Courts Of Appeals Are In Agreement
Phat Claims Of Misconduct By Court-
Appointed Officers In The Performance Of!
heir Official Duties Constitute Core Bank-
ruptcy Proceedings.
Conclusion ......-seceseeeeeee:

Appendix

?
Page

+

, ry , . , lay 4 7 *,*
Motion to Rec onsidel \ward O| f ees 10 LOO

pers & Lybrand and Brief in Support Thereof

i

In re Vebeliunas, 231 B.R. 181 (Bankr.

4b

TABLE OF AUTHORITIES
Cases

(rnold Print Works, Inc. v. Apkin, (In re Ar-
nold Print Works, Inc.), 815 F.2d 165, 169 (Ist
Ci. F96F) ws vee sdedesccwcdaes

Billing v. Ravin, Greenberg & Zackin, P.A., 22

F.3d 1242 (3d Cir. 1994) .....

Commodity Futures Trading Comm'n vy. Schor,
ry, BERS oak Gy. | ° eRe pap oe Py
In re American Solar King, 142 B.R. 772
(Bankr. W.D. Tex. 1992)

In re Balboa Improvements, Inc.. 99 B.R. 966
(B.A.P. 9th Cir, 19G9) on ici c cc eccew tases cedees
In re Diamond Mortgage Corp., 135 B.R. 78
(Bankr, N.D. Ti. T9890) 2.6 vccceee:

In re Elegant Equine, Inc., 155 B.R. 189
(Bankr. N.D. Ill. 1993) .......

In re Enviordyne, 174 B.R. 955 (Bankr. N.D
ean eedeaces

In re Vebeliunas, No. 98 B 45466, 1999 WI
152577 (Bankr. S.D.N.Y. Mar. 10, 1999)

In the Matter of Linton, 136 F. 3d 544 (7th Cir.
a aa

Northern Pipeline Co. v. Marathon Pipe Line
Co.. 458 U.S. 50 (1982)

Pierson & Galen v. Creel & Atwood, (In the
Vatter of Consolidated Bancshares, Inc.), 785
F.3d 1249 (Sth Cir. 1986) ........

Page

HO

V1

Rome v. Braunstein, 19 F.3d 54 (1st Cir. 1994)

Sanders Confectionary Products, Inc. v. Heller

Financial, Inc., 973 F. 2d 474 (6th Cir. 1992) ...

laxel v. Electronic Sports Research, (1n re
Cinematronics, Inc.), 916 F.2d 1444 (9th Cir.

SPE ac Keh oka bie ehh ieenes shawrcineet PANE rere

Torkelson v. Maggio (In re Guild and Galler)
Plus, Inc.), 72 F.3d 1171 (3d Cir. 1996) .......

Walsh v. Northwestern National Insurance Co
(In re Ferrante), 51 F. 3d 1473 (9th Cir. 1995)

Statutes

28 U.S.C. §157(b)(3)

Supreme Court Rules

Supreme Court Rule 29.6 .....

lO

ARGUMENT

r Tan ' " cy ri é
decision Ol tic UU

conflict with any decision of this ( ourt or oT an OU

Appeals. The Fifth Circuit’s holding that state-law cor

arn : -} > ‘ > > } ~ L, . ” 7 ry ' .
and tort claims asserted Dy Southmark Corporation |

mark”) against Coopers & Lybrand L.L.P. (“Coopers”

a core bankruptcy proceeding Hecause they arose out

leged misconduct in C¢ Ope»>rs performance of its duties as

are A - . hh —_ ~ -
accounting firm appointed by the bankruptcy court In 5¢

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mark $ Chapter il Dankruptcy is in accordance witn '

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grant of jurisdiction to Dankruptcy courts, <5

te { j ae *- —s, peerens ae. Sn
) (b\ i), and with this ~ourt s gecision in Oririer)

The Decision Of The Fifth Circuit Maintains |
Constitutional Limits Prescribed By Marathon.

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the state law character of a claim talismanic power in Article
II] inquiries.”). Instead, the court should inquire into the na-
ture of the proceeding——how the proceeding relates to the ba-
sic function of the bankruptcy court. See Arnold, 815 F.2d at
169. Under this analysis, the Fifth Circuit's fact-bound deci-
sion is consistent with the constitutional scope of the bank-
ruptcy power enunciated in Marathon.

A. Southmark’s Claims Are In The Nature Of
A Challenge To Cooper's Disinterestedness
\s A Bankruptcy Court-Appointed
Professional.

Southmark’s claims against Coopers for breach of
contract, fraud and deceit, breach of fiduciary duty, and negli-
gent misrepresentation arise out of Coopers’ alleged miscon-
duct as the bankruptcy court-appointed accountant for the
examiner in the Southmark bankruptcy case. Pet. at 57a-72a.
For example, in its fraud and deceit count, Southmark alleged
that

Coopers represented to Southmark that the

reason Coopers did not develop claims against

Drexel was because of lack of time, lack of

corroborative evidence, and the fact that

Drexel had filed for bankruptcy. In fact, how-

ever, Coopers never intended to investigate

claims against Drexel, its largest audit client,

and it deliberately suppressed evidence con-

cerning such claims developed by one of its

managers,

Pet. at 69a "36. Similarly, Southmark’s breach of fiduciary

duty count alleged that Coopers “subvert{ed] the

ws

investigation of claims against Drexel in the interest of

Drexel and contrary to the interest of Southmark.” Pet. at 70a
q2g.

Southmark does not contest that its claims are based
on Coopers’ alleged bias in performing its duties as the court-
appointed accounting firm, but argues that the “substantive
nature” of the claims is that they are “state-created private
rights,” based in large part on the fact that the claims arise
under state law and are to be decided through application o!
standards supplied by state law. Pet. at | 1-12. The argument
that a proceeding is non-core because it will be resolved un-
der state law has been explicitly rejected in the Bankruptcy
Code. See 28 U.S.C §157(b)\ 3).

Southmark’s claims cannot be divorced from the
bankruptcy context within which they arose. Like an exam-
‘ner or a trustee, a court-appointed professional is a creature
of the bankruptcy process. As such, it owes a duty not only
to the estate on whose behalf it was retained, but also to the
examiner/trustee, the creditors and the court, and no claim
against it can be determined without consideration of these
varied obligations. The duties of Coopers and any claims
against Coopers for its alleged breach of those duties are de

pendent upon its role in the bankruptcy process and could not

exist but for that process.

4

B. Ensuring The Disinterestedness Of Court-
Appointed Professionals Is Essential To
The Proper Functioning Of The Bank
ruptcy Court And Therefore Is Within The
Core Bankruptcy Power.

Court-appointed professionals play a prominent role
in the bankruptcy process and, as was the case here, are often
entrusted with significant responsibility in connection with
the administration of the bankruptcy estate. In recognition of
the role played by such professionals, the Bankruptcy Code
requires that professionals “do not hold or represent an inter-
est adverse to the estate, and that [they] are disinterested per-
sons.” 11 U.S.C. §327(a). The disinterestedness requirement,
in particular, is strictly enforced in order to maintain the in-
tegrity of the bankruptcy process. See Jn re Diamond Mort-
gage Corp., 135 B.R. 78, 90 (Bankr. N.D. Ill. 1990); see also
Pierson & Galen v. Creel & Atwood (In the Matter of Con-
solidated Bancshares, Inc.), 785 F.2d 1249, 1256 n.6 (Sth
Cir. 1986). To that end, bankruptcy courts are charged with
an ongoing obligation to “root out impermissible conflicts of
interest” whenever they arise. Rome v. Braunstein, 19 F.3d
54, 58 (Ist Cir. 1994) (quotation omitted); see In re Vebeliu-
nas, No. 98 B 45466, 1999 WL 152577, at *3 (Bankr.
S.D.N.Y. Mar. 10, 1999) (the disinterestedness requirement
“is so crucial to the proper functioning of the bankruptcy sys-
tem,” the court may address any alleged lack of disinterested-
ness whenever the issue arises) (a copy is attached at
Appendix 34b).

The non-core claims in Marathon and Granfinanciera
S.A. v. Nordberg, 492 U.S. 33 (1989), upon which Southmark
relies, are of an entirely different nature than the claims raised
by Southmark. In Marathon, the debtor asserted a contract

COPPA VO Z

Paice si pisses abana ah bee nie a Sane

5

claim against Marathon in relation to a pre-petition agreement
to construct a pipeline. Granfinanciera involved an action in
which the bankruptcy trustee alleged that a non-creditor had
received a fraudulent conveyance from the debtor prior to
bankruptcy. In both cases, the claims related to pre-petition
conduct that possessed neither a temporal nor structural
nexus to the bankruptcy process. In contrast, Southmark’s
claims against Coopers arose during and in the conduct of the
bankruptcy proceeding; without the bankruptcy proceeding,
Coopers would have had no relationship with Southmark and
the claims would not exist.

Southmark’s own Motion to Reconsider Award of
Fees to Coopers & Lybrand and Brief in Support Thereof (a
copy is attached at Appendix 1b) demonstrates the core na-
ture of its claims:

Shielding one of its largest clients from claims
that could have substantially enhanced creditor
recoveries was plainly inimical to the interests
of Southmark’s creditors and a violation of
Coopers & Lybrand’s fiduciary and statutory
duties... . {This type of misconduct threatens
the very integrity of, and the public trust in,
the bankruptcy process.

{58 (emphasis added). Southmark argued further that Coo-
pers’ conduct constituted fraud on the court, which South-
mark described as “fraud committed by an officer of the court
which affects the judicial machinery in such a way that the
judicial machinery cannot perform in the usual manner its
impartial task of adjudging cases that are presented for adju-
dication.” /d. at $59 (internal quotation omitted and empha-

sis added).

a

6

Claims concerning conduct that “threatens the very in-
tegrity of . .. the bankruptcy process” and that prevents the
court from “perform[ing] in the usual manner” involve the
core bankruptcy power. That proposition is no less sellf-
evident because the claims are cast in terms of tort or contract
rather than a fee objection, or because the claims are asserted
in state court rather than bankruptcy court.

i Failure To Treat Southmark’s Claims As
Core Bankruptcy Proceedings Would
Undermine The Power Of The Bankruptcy
Court To Restructure Debtor-Creditor
Relations.

Southmark argues that, to the extent its claims of offi-
cial misconduct against Coopers do implicate “public rights,”
those rights were vindicated by the bankruptcy court’s order
disgorging a portion of Coopers’ fees. Therefore, in South-
mark's view, it is free to pursue its private rights in another
forum.

Such a procedure would seriously undermine the
power of the bankruptcy court to control the conduct of court-
appointed officers. In the analogous context of a bankruptcy
court’s denial of leave to sue a trustee in state court, the Sev-
enth Circuit, through Chief Judge Posner, stated:

At stake in the present case, however, is a con-
cern... with the integrity of the bankruptcy
jurisdiction. If debtors, creditors, defendants
in adversary proceedings, and other parties to
a bankruptcy proceeding could sue the trustee
in state court for damages arising out of the
conduct of the proceeding, that court would

— Si a ae aad ne ee ete "

7

have the practical power to turn bankruptcy
losers into bankruptcy winners, and vice versa.

In the Matter of Linton, 136 F.3d 544, 546 (7th Cir. 1998).
Similarly, if debtors are permitted to raise what are essen-
tially fee objections in state court following an adverse deci-
sion by the bankruptcy court, the state court in essence gains
the power to turn a fee loser into a fee winner.

This instant case is a perfect example of this concern.
Southmark became aware of Coopers’ alleged misconduct in
1993. It subsequently moved in bankruptcy court for dis-
gorgement of Coopers’ entire $4 million fee. In March of
1995, the bankruptcy court ordered Coopers to disgorge
$220,000 of its fee, plus pay Southmark’s legal fees and costs
for its motion. The bankruptcy court also held that Coopers’
conduct did not cause Southmark to fail to file timely a proof
of claim in the Drexel Burnham Lambert, Inc. bankruptcy
case. Neither Southmark nor Coopers appealed this decision
and the judgment was immediately paid in full. It was not
until after that decision that Southmark filed its state-law
claim, alleging virtually identical facts as it had before the
bankruptcy court and, in part, seeking the same relief. The
fact that Southmark waited until 1995 to bring its state-law
action shows that the state-law action is a collateral attack on
what Southmark believed to be an unsatisfactory bankruptcy
court decision on a core proceeding: the conduct of court-
appointed professionals.

Southmark argues that permitting bankruptcy courts
to adjudicate claims such as the ones it has asserted against
Coopers interferes with the sovereignty of the state courts.
To a large extent, this contention is subsumed by the question
of whether the claims are core—if the action is a core

proceeding, by definition it is federal in nature. Moreover, a

regard for state sovereignty does not mean that states should
have the power to interfere with the bankruptcy court’s indis-
putable power to control the award of protessionals’ fees, as

would be the case here.

Il. Che Courts Of Appeals Are In Agreement That
Claims Of Misconduct By Court-Appointed Offi-
cers In The Performance Of Their Official Duties
Constitute Core Bankruptcy Proceedings.

Southmark argues that the Court should resolve the
“{[cjonfusion over what claims fall within the core of the fed-
eral bankruptcy power.” Pet. at 22. Although the Courts of
Appeals may differ somewhat on the outer constitutional lim-
its of what constitutes “core proceedings,” there is no disa-
greement that actions of the sort initiated by Southmark
against Coopers fall squarely within the constitutional con-
fines of the core of the bankruptcy power.’

In addition to the decision of the Fifth Circuit below,
three Courts of Appeals have found that actions alleging mis-
conduct of court-appointed persons in the performance of

The vast majority of bankruptcy courts faced with this question
similarly have found that claims against court-appointed individuals for
alleged misconduct in the performance of their official duties are core
proceedings. See, e.g, In re Envirodyne, 174 B.R. 955, 964 (Bankr. N.D
Il. 1994) (claims against official committee members); /n re Elegant
Equine, Inc., 155 B.R. 189, 191 (Bankr. N.D. Ill. 1993) (action against
former trustee for breach of fiduciary duty); /n re American Solar King,
142 B.R. 772, 773 (Bankr. W.D. Tex. 1992) (breach of fiduciary duty by
trustee); /n re Balboa Improvements, Inc., 99 B.R. 966, 969 (B.A.P. 9th
Cir. 1989) (claims against debtor's attorney for interference with prospec-
tive economic advantage, fraud, interference with contract, negligence,
malpractice and detriment to the estate).

9

their official duty constitute core proceedings. In Sanders
Confectionery Products, Inc. v. Heller Financial, Inc., 973
F.2d 474 (6th Cir. 1992), debtor’s parent corporation sued
one of debtor’s lenders, the lender’s attorneys and the bank-
ruptcy trustee for, inter alia, common law fraud, securities
fraud and RICO violations arising from the making and ad-
ministering of a loan to debtor. In addressing the district
court’s conclusion that the action was a core proceeding, the
lhird Circuit pronounced that, although the action against the
lender and its attorneys was non-core, the action against the
trustee was a core proceeding. /d. at 483 n.4. According to
the court, “[w]hile the specific causes of action . . . exist inde-
pendently of bankruptcy cases, an action against a bankruptcy
trustee for the trustee’s administration of the bankruptcy es-
tate could not.” Jd. Accordingly, because “{a]ll claims
against [the trustee] related to his conducted during the . . .
bankruptcy,” they were core proceedings. Id

The Ninth Circuit reached a similar conclusion in
Walsh v. Northwestern National Insurance Co. (In re Fer
rante). 51 F.3d 1473 (9th Cir. 1995). In Ferrante, a succes-
sor Chapter il trustee brought an adversary action in the
bankruptcy court against the surety of the previous trustee, al-
leging embezzlement and breach of fiduciary duty by the
prior trustee in connection with his administration of the
bankruptcy estate. The court held that the successor trustee's
action was a core proceeding because It “concern{ed] the ad-
ministration of the estate.” /d. at 1476 (quotations omitted).
The court explained: “Because this case evokes the Bank-
ruptcy Act’s imposition of duties on trustees to administer es-
tate property... , it cannot be gainsaid that it involves a core
issue.” /d.

10

Finally, the Third Circuit, in Billing v. Ravin, Green
here & Zackin, P.A, 22 ¥.3d 1242, 1249-50 (3d Cir. 1994),
held that a separate malpractice action against debtor's attor-
neys, who were retained by court order, was part and parcel
with debtor's objections to the attorneys’ fee application, and
therefore was within the bankruptcy court’s core jurisdiction.
In that case, debtor retained the law firm of Ravin, Greenberg
& Zackin, P.A. (“RG&Z”). Following approval of the reor-
ganization plan, RG&Z applied to the court for attorneys’
fees, which the debtor opposed on grounds of legal malprac-
tice. The debtor also concurrently brought suit against
RG&Z tor malpractice in the district court.

On appeal, neither party contested the district court's
finding that the malpractice suit constituted a core proceed-
ing, and therefore the issue was not addressed directly by the
court. However, in finding that RG&Z did not have a right to
a jury trial on the malpractice claims,’ the court held that, by
raising legal malpractice as a defense to RG&Z’s application
for fees, the claims were converted “into an equitable dispute
over a share of the estate.” /d at 1253. The court explained.
“[t]he close connection between the malpractice action and
the objections to fees leads us to conclude that the debtors’
allegations of malpractice are part of the process of allowance
and disallowance of claims.” /d. at 1252. Therefore, like the
decisions in Sanders Confectionery and Ferrante, this deci-
sion is entirely consistent with the decision of the Fifth Cir-

cuit below.

As noted by Southmark, this Court has explained that a determi-
nation that a party is not entitled to a jury trial on an issue before a bank-
ruptcy court is tantamount to a finding that the bankruptcy court has
jurisdiction over the claim. See Granfinanciera, 492 U.S. at 53 (quoted
in Pet. at 14.4)

1]

Southmark ignores Sanders Confectionery, Ferrante
and Billing and cites the Ninth Circuit’s decision in 7axe/ \
Electronic Sports Research (In re Cinematronics, Inc.), 916
F.2d 1444 (9th Cir. 1990), and the Third Circuit’s decision in
lTorkelson v. Maggio (In re Guild and Gallery Plus, Inc.), 72
F.3d 117i (3d Cir. 1996), to try to show a conflict between
the Courts of Appeals. This purported conflict is wholly)

illusory

In Cinematronics, the Ninth Circuit did not address
the issue of whether an action alleging misconduct against a
court-appointed person in the performance of his official du-
ties constituted a core proceeding. In that case, debtor was
sued in state court by a company unrelated to the bankruptcy
[he Chapter 11 trustee brought an action in bankruptcy court
against the third-party, alleging a violation of the automatic
stay provisions of the Bankruptcy Code (the “stay proceed-
ing”). The third-party responded in the stay proceeding by
asserting a counterclaim against the trustee, and a third-party
complaint against debtor’s president, alleging, inter alia,
breach of contract and breach of fiduciary duty. Upon motion
to determine the court’s jurisdiction, the bankruptcy court
held that the counterclaims and third-party complaint were
core proceedings. Debtor's president thereafter moved in the
district court to withdraw the reference to the bankruptcy
court so that a jury trial could be conducted on the core tis-
sues. The district court denied the motion.

On appeal, the Ninth Circuit held that the third-party
complaint against debtor’s president did not raise core issues.
However, because the court found that the trustee lacked
standing to bring an appeal, id. at 1148, it never addressed
whether the counterclaims against the trustee were core. In
fact, the issue was not even before the court because the

| 7
trustee neither challenged the bankruptcy court's finding that
the counterclaims were core proceedings, nor moved in the
district court to withdraw the reference based on his night to a
jury trial. See id

Presumably, Southmark is arguing that the court's
holding with respect to debtor’s president, in essence, 1s a
holding that the claims against the trustee likewise are not
core. However, that proposition is wholly untenable. The
Ninth Circuit’s decision rested squarely on the fact that debt-
or’s president was a non-debtor being sued in his individual
capacity. See id. at 1450 (“Here, the claims at issue are
against Pierce, a nondebtor, in his individual capacity. The
claims do not directly affect the estate or the confirmation of
the estate’s plan.”). In contrast, the trustee, as an officer of
the court charged with administering the estate, was inti-
mately tied to the bankruptcy proceeding. Moreover, the
trustee was not being sued in his individual capacity—the
conduct at issue was the trustee’s effort to enforce the auto-
matic stay provision on behalf of the estate. Finally, even if
there were ambiguity in the court’s holding, that ambiguity
has evaporated with the Ninth Circuit’s holding in Ferrante,
which indicates clearly that claims against trustees for official
misconduct are core proceedings. The decision below does
not conflict with Cinematronics.

Guild and Gallery also does not address the jurisdic-
tion of the bankruptcy court to hear and decide claims of offi-
cial misconduct by court-appointed persons. In that case, the
debtor, prior to filing for bankruptcy, took possession of sev-
eral paintings under a bailment contract. After the bank-
ruptcy petition was filed, the owner of the paintings sought
their return. One of the paintings was lost, leading to a

lawsuit against the bankruptcy trustee alleging negligence and

conversion

[he Third Circuit held that the action was not a core
proceeding based on the fact that the trustee’s alleged impro-
priety involved property that never was part of the bankruptcy
estate. 72 F.3d at 1173. As such, the alleged misconduct “a
fortiori . . . cannot fall within §157(b)(2)(A), which can only
be applied to matters concerning the administration of the
bankruptcy estate.” /d. The court in Guild and Gallery sim-
ply was not faced with the issue presented in this case and
therefore the case does not conflict with the decision below.

While Southmark argues that “[m]Jany other conflicts
flow from the uncertainty generated by Marathon,” Pet. at 23,
none of those alleged conflicts are implicated by the Fifth
Circuit’s fact-bound decision. On the issue raised in the in-
stant case. there is no controversy. Each Court of Appeal ad-
dressing, either directly or indirectly, whether claims against
court-appointed persons for alleged official misconduct con-
stitute core proceedings has, like the Fifth Circuit, answered
in the affirmative.

CONCLUSION

A bankruptcy proceeding is a unique process, and
court-appointed professionals play an integral part in that
process. In order to ensure that the process functions prop-
erly, bankruptcy courts must retain the authority to monitor
and control the professionals they appoint. In recognition of
this reality, the Fifth Circuit held that Southmark’s allega-
tions of misfeasance by Coopers in performing the official
duties with which it was charged constituted a core proceed-
ing within the meaning of the Bankruptcy Code and

Viarathon. That holding comports with the decisions of this

Court, as well as with the decisions of the other Courts of Ap-
peals, and therefore Southmark’s petition for a writ of certio-

rari should be denied.

Respectfully submitted,

Michael S. Feldberg

('‘ounsel of Record

Frank J. LaSalle

SCHULTE ROTH & ZABEL LLP
900 Third Avenue

New York. New York 10022
(212) 756-2000

Judith Elkin

HAYNES AND BOONE, L.L.P.
3100 Bank of America Plaza
901 Main Street

Dallas, Texas 75202

(214) 651-5000

Counsel for Respondent
Coopers & Lybrand L.L.P

lb

IN THE I NITED STATES BANKRUPICY ¢ OURT FOR
DISTRICT OF TEXAS
DALLAS DIVISION

in re

SOUTHMARK CORPORATION,
Debtor

Case No 389036324-SAF-1 1

MOTION TO RECONSIDER AWARD OF FEES [TO COO-
PERS & LYBRAND AND BRIEF IN SUPPORT THEREOI

Robert B. Krakow, Esq.
State Bar No. 11702000
1717 Main Street, Suite 5400
Dallas. Texas 75201-4605
lelephone: (214) 698-3 100
Facsimile: (214) 698-3400

Attorneys for Southmark

Corporation

2b

TABLE OF CONTENTS

ELA REE E Ge PAE coke hGw bss Gove oo oes |
PSE Sree éeawesSiastaa te A SRT 9
A. Jurisdictional Statement ...... RPS SN A 9)

B. Intorduction: Requirements For Employment Of

PPORCRGSOOMED TUh SIOTUNIOY oc dine sewwcviadsees sis. )
C. Coopers & Lybrand Was Not Disinterested As
Required By The Bankruptcy Code ................. 10
D. Coopers & Lybrand Held An Interest Adverse

$O EWee OWNER, TE Gc ha macseccurswonceseacsss 22
E. Coopers & Lybarnd's Failure To Disclose Man-

dates Disgorement Of Its Fees ..................000- 14

F. This Motion To Reconsider Is Timely Under
UGE SMAEE bic vingohvueareccecchbueiubes taekaterx: 16

CAFVRAMIEUEOES ho ope ncSkaebineae danse ceveienian irene 19

3b
TABLE OF AUTHORITIES
(Cases

Bros. Inc. v. W.E. Grace Mfg. Co., 320 F.2d 594

(SthCir. 19635) ...0cceee. 17
Browning v. Navarro, 826 F. 2d 335 (Sth Cir.

ROT) sc cvccuckkocbhch ps ceddnayanenuexavetiones lace bain ae
Budge v. Post, 544 F. Supp. 370 (N.D. Tex 1982) ...... 18
In re Allegheny International, Inc., 134 B.R. 814

(Bankr. W.D. Pa 1991) ...... eee cece cece eee e er eees . 9,10
In re Amdura, 121 B.R. 862 (Bankr. D. Colo.

SSP) cose coe eaccccvenneae EPP PTS Y EI ER ee yee Y
In re Arlin's Dept. Stores, Inc., 615 F. 2d 925 (2d

CS SN nc hive enna be ennhes CFLS VNERS CAE
In re Baldwin United Corp., 46 B.R. 314 (Bankr

BID Chris FGBS) vnc ccccccctcscccscsccsesedestocvodesres 18
In re Coastal Equities, Inc., 39 B.R. 304 (Bankr.

OTD Cal, FOGG) vice ave vecndscascccveeqesenesss hh, 22
In re Cody, 122 B.R. 520 (Bankr. N.D. Ohio 1990) ..... 13
In re Consolidated Bancshares, Inc., 785 F. 2d 53,
1249 (Sth Cir. 1986) ........c cece reer ereeerees a hetenct ies
In re Cropper Co., 35 B.R. 625 (Bankr. M.D. Ga.

RE es is ke ckbe be cere becnsenure tees Py oer rae
In re Diamond Lumber, Inc., 88 B.R. 773 (N.D.

Fae SORRY ks cov cowagss vie cheese Cadeestseerenees eR

In re Diamond Mort. Corp. of Illinois, 135 B.R. 78
(Bankr. N.D. Ill. 1990) ........ 0 eee eee cece eee ees 13, 15

In re EWC. Inc., 138 B.R. 276 (Bankr. W.D. Okl.
es ETA MEER OE POT ELE TE ayia? |.

4b

In re Food Town, Inc., 208 F. Supp. 139 (D. Md.

SEE a 256i vn Fk is ges ee OAR ed ae awe 18
In re H.B. Michelson, 141 B.R. 715 (Bankr. E.D.

CMR, ROPERS bcs Fic ae Sia os CPSs Ke ead a Le a 17
In re Kendavis Industries Intern., Inc., 91 B.R. 742

i UME 20 Ray DOK: ROD ci kak Geeks ban sedeegs besa on 13
In re Kuykendahl Place Associates, Ltd., 112 B.R.

B57 CRONE, Bild. BOK Te lank ire cs ukies cankbeatacks 13
In re Marine Outlet, Inc., 135 B.R. 154 (Bankr.

MLD; FUG O99T) so aes ieee re as 15
In re Micro-Time Managment Systems, Inc., 102 14,45,
BR. O02 (aot ED): Nich foe 6 a icin 16
In re Philadelphia Athletic Club, 20 B.R. 328

CREP PR See ass ck ese a eae hens 1]

In re Roberts, 46 B.R. 815 (Bankr. D. Utah 1985)
aff'd in relevant part and rev'd in part, 75 B.R.402 ‘13, 14,

HNO Ty 72 Seep reaper ar an aebsrienry n an RN aperg Van 15
In re Sky Valley, Inc., 135 B.R. 925 (Bankr. N.D.

AMM Se niece tateae suk s tee aay rials eit eevee kees ews 15
In re Southmark Corporation, 113 B.R. 280

(Haske, ND: Te, FI a sek eee a ie. 3
In re Thompson, 54 B.R. 311 (Bankr. N.D. Ohio

SRE 5 ecco cea os ee ee 15
In re Tinley Plaza Associates, L.P., 142 B.R. 272

(Hane, TEL UR. 2992S ok bo i ene ee eee ieee 15
In re Woods v. City Nat. Bank & Trust Co., 312

JD. 20Kj OF Tes Re WRT T AOD ike oe rie een rnes 13,14
Lucas v. City of Juneau, 20 F.R.D. 407 (D. Alaska

SPST) ik bach eis Ieper cal 17

en)

Batis:

Roger J. Au & Son, Inc. v. Aetna Ins. Co., 64 B.R.

GOO (0e2), CHD TSO 255 FG AREA I Te 13
United States v. McDonald, 86 F.R.D. 204 (N.D.

Beh POY co eo hig dhe ck ed a Rs a gk 17

Statutes

EB ORS ly BL | Sarr Tah eennes Meer coe rter Pe, 10
SAT te EN Kin cud chase cence can peascadoe pe anaes 10
PTA Oe BLAG Gos kc sk dna bask ba hs 09s Chonan ts ERGs 10
TRB S Ge S59 CMe spay meer Deane reer eee 10, 14
PE Ree SE ine ha Nein sendeks Canwest Se aenes 30,55
PR AO Sack se sk ve kakentce vans css reatawalynoees 9
PUTS TUE 2088 sinc gsc 'vnp as nen ebesdeenees 10, 14, 15
Bankruptcy Rule 9024 onic vec ccc eeteks cweewane 1, 16
PITY FE FOS acc i cdicncs cased cnesacsinenes Eo
Ee ae, | OP Ae Serene prey tee 1, 16,17, 18

Other Authorities

2 Collier on Bankruptcy § 327.03 at 327-19, 20
CES, TIS ois es i wees a REE 10, 11

6b

SOUTHMARK CORPORATION (“Southmark” or
the “Debtor’), hereby submits its Motion to Reconsider
Award of Fees to Coopers & Lybrand pursuant to Bankruptcy
Rule 9024, incorporating Fed. R Civ. P. 60(b), and in support
thereof shows the Court as follows:

STATEMENT OF FACTS

1. Southmark was organized in 1970 as a
Maryland real estate investment trust. later known as South-
mark Properties. In 1981, Gene E. Phillips and William S.
Friedman acquired control of Southmark Properties and ap-
pointed themselves chairman and vice-chairman, respec-
tively. Southmark Properties’ headquarters was moved to
Dallas, Texas, and on May 1, 1982, Southmark Properties
was convened to a Georgia corporation and its name was
changed to Southmark Corporation.

2. The principal business of Southmark was
sponsoring private and publicly syndicated real estate partner-
ships. Through private and public borrowings, Southmark ac-
quired other real estate companies, as well as a savings and
loan association and insurance companies.

3. In April, 1989, fouowing two years of in-
creasing financial distress, Southmark announced a $1 billion
write-down of its asset values. This write-down wiped out
Southmark’s shareholders’ equity, reducing equity from $604
million to negative $428 million. On July 14, 1989, South-
mark filed a Chapter 11 bankruptcy proceeding in Atlanta.
The case was subsequently transferred to Dallas. Under the
plan of reorganization adopted by the Bankruptcy Court,
holders of Southmark’s more than one billion dollars in pub-
lic debt received approximately five cents on each dollar of

sss. Nt" SSS,

inniitiionidevendniniscinuaanaiiaalll

RESIS 5 RS

7b

their investment in cash, as well as securities in reorganized
Southmark which could be worth as much as another 13 cents
on the dollar.

4. From 1982 until shortly before South-
mark’s bankruptcy in 1989, Drexel Burnham Lambert
(“Drexel”) served as underwriter, broker and financial advi-
sor to Southmark and several of its subsidiaries. Much of
Southmark’s dealings with Drexel were directly with the
High Yield Department, run by Michael Milken. Through the
High Yield Department Drexel was able to foster and sustain
the illusion of a liquid market for issues of high yield corpo-
rate debt and preferred stock, which eventually and more ac-
curatcly came to be known as “junk bonds.” Underwriting

junk bond issues and manipulating the junk bond markets

earned Drexel exorbitant profits through underwriting fees,
markups and trading profits.

5. Issuers of Drexel-underwritten bonds. such
as Southmark, were forced through a variety of means to in-
vest a portion of the issue proceeds in junk bonds underwrit-
ten by Drexel for other clients. Drexel clients who refused to
invest in junk bonds found Drexel unwilling to underwrite
further debt or preferred stock issues, which were frequently
necessary just to retire maturing debt or redeem earlier pre-
ferred stock issues.: Drexel clients who did not continue to
purchase Drexel-underwritten bonds for their own portfolios
also found Drexel unwilling to sell bonds the companies al-
ready owned.

6. Through the efforts of Drexel, Southmark
raised well over a billion dollars through high-interest public
debt issues, which quickly imposed a huge interest expense
and principal repayment obligations on Southmark. The debt

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incurred by Southmark was well in excess of the legitimate
operational needs of the company. Southmark was induced by
Drexel to invest the excess funds, over $400 million, in high-
yield bonds of other Drexel clients. Southmark ultimately lost
substantially in excess of $150 million on these junk bonds in
1988 and 1989. The crushing burden of debt service on junk
bond issues, combined with devastating losses in its junk
bond portfolio, contributed directly and substantially to
Southmark’s demise.

7. On July 28, 1989, shortly after it filed for
bankruptcy, Scuthmark moved the Bankruptcy Court for the
appointment of an Examiner, stating, “the Debtor believes
that it is in the best interests of the estate and this Chapter | |
case to have a disinterested, independent individual review
and investigate the pre-Chapter 11 activities of the debtor as
they relate to third party transactions and relationships, and
potential causes of action against such third parties on behalf
of Southmark and the estate.” Motion, § 6. Southmark sought
“an unbiased, independent assessment as to whether legal ac-
tion by Southmark against various third parties, including any
of its former officers and directors, is appropriate and should
be pursued.” Id. 4 9.

8. On September 8, 1989, the Bankruptcy
Court issued an order approving the appointment of Neal Bat-
son, a partner in the firm of Alston & Bird, as Examiner. The
order charged the Examiner with the “investigation and re-
view of any allegations of fraud, dishonesty, incompetence,
misconduct, mismanagement or irregularity in the manage-
ment of the pre-Chapter 11 affairs of the Debtor, and ...
making recommendations as to causes of action discovered in
such investigation and review.” The Court specifically
authorized the Examiner to retain attorneys and accountants

sews ae
ose

Suan Saeaae

9b

to assist the Examiner in his investigation and review, with
“the fees and expenses of such professionals to be paid from
the estate upon proper application” On September 14, 1989,
the Court approved the appointment of Alston & Bird as at-
torneys to assist the Examiner.

9. On September 26, 1989, the Examiner ap-
plied to the Court for an order authorizing the employment of
Coopers & Lybrand as accountants to the Examiner, to inves-
tigate allegations of fraud, dishonesty, incompetence, miscon-
duct, mismanagement or irregularity in the management of
the pre-Chapter 11 affairs of the Debtor. The application is
attached hereto as Exhibit A.

10. Attached to the application of the Exam-
iner was an affidavit from David A. Carpenter, the engage-
ment partner from Coopers & Lybrand. In paragraph 3 of that
affidavit. Carpenter listed all “known connections” between
Coopers & Lybrand and other parties in interest. Mr. Carpen-
ter noted that “Coopers & Lybrand provides accounting and
consulting services for Drexel in matters unrelated to this
case.” Mr. Carpenter did not indicate that Coopers & Ly-
brand’s relations with Drexel would in any way impede or in-
terfere with its duties as accountants to the Examiner

11. The appointment of Coopers & Lybrand
was subsequently approved by the Court, pursuant to section
10S5(a) of the Bankruptcy Code, effective September 26,
1989. This Court noted that, “[w]hile the court could direct
that the appointed examiner use the services of the commit-
tee’s court-appointed accountant, that might defeat the objec-
tive of a disinterested examiner not associated with or serving
creditors or equity security holders,” In re Southmark Corpo-
ration, 113 BR. 280, 282 (Bankr N.D. Tex. 1990).

10b

12. Most of the investigative work between
September 26, 1989 and July 9, 1990, the date of the Examin-
er’s final report, was performed by Coopers & Lybrand. In-
deed, Coopers & Lybrand itself wrote substantial portions of
the various interim and final reports filed by the Examiner.

13. On or about October 1, 1989, there was an
initial meeting of the Coopers & Lybrand engagement team,
which consisted of David Carpenter, Knute Kurtz (a new
partner working under Carpenter), and a number of managers,
including Selene Yu, David Kennedy, Steve Schocket and
William Galbally. At that meeting, Carpenter assigned vari-
ous members of the team to work on and investigate specific
issues concerning the Southmark bankruptcy. Mr. Galbally
was assigned to investigate issues including but not limited to
possible avoidance claims that Southmark might have against
Drexel arising, inter alia, out of Drexel’s relationship as un-
derwriter of bonds sold by Southmark and as broker of “high
yield” bonds (i.e., payments by Southmark during the ninety
days preceding the filing for bankruptcy that might be recov-
erable by Southmark).

14. Between October 2, 1989 and approxi-
mately December 4, 1989, Mr. Galbally worked on various
litigation issues including possible claims against Drexel. As
his work progressed, Mr. Galbally came to believe that
Southmark’s claims against Drexel were potentially the most
significant and valuable of all the claims Southmark might
pursue. In particular, Mr. Gaibally believed that Southmark
had substantial claims against Drexel in connection with
Drexel’s activities as underwriter of bonds issued by South-
mark and as broker for bonds purchased by Southmark. Prior
to December 4, 1989, Mr. Galbally told Mr. Kurtz among

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others, about the potential significance of the claims against
Drexel.

15. On or about the night of December 4,
1989, Mr. Carpenter and Mr. Kurtz visited Mr. Galbally at
the apartment in Dallas that Mr. Galbally shared with David
Kennedy. According to Mr. Galbally, Mr. Carpenter asked
Mr. Galbally what he (Galbally) had on Drexel. Mr. Galbally
told Mr. Carpenter that Southmark’s claims against Drexel
were the most important in the engagement, that there ap-
peared to be substantial misconduct by Drexel, and that
Drexel had very deep pockets. According to Mr. Galbally,
Mr. Carpenter became extremely angry and screamed repeat-
edly at Mr. Galbally. Mr. Carpenter told Mr. Galbally not to
pursue the Drexel issues any further. Mr. Carpenter shouted
at Mr. Galbally, among other things: “Don’t [mess] with
Drexel. Drexel is our largest audit client.” When Mr. Galbally
insisted that the Drexel issues had to be investigated, Mr.
Carpenter told Mr. Galbally that he (Galbally) was being
taken off the issues related to Drexel. Mr. Galbally was sub-
sequently Sent to Atlanta to work on Southmark preference
actions under the supervision of David Kennedy, even though
Mr. Kennedy was Mr. Galbally’s junior at Coopers & Ly-
brand. See Affidavit of William Galbally, attached hereto as
Exhibit B.

16. On or about January 3, 1990, the potential
claims against Drexel were reassigned to Jeffrey Kessler. De-
spite billing time to the Drexel matter, Mr. Kessler never de-
veloped a basis for claims against Drexel as identified by Mr.
Galbally. On information and belief, Mr. Kessler, among oth-
ers, knew why Mr. Galbally had been reassigned, and this
knowledge effectively chilled any further Coopers & Lybrand
investigation of the Drexel claims identified by Mr. Galbally.

12b
17. On February 13, 1990, Drexel’s parent,
[he Drexel Burnham Lambert Group, Inc. (“Drexel Group”),
filed a petition for relief under chapter | | of the Bankruptcy
Code. The court in the Drexel Group bankruptcy set October
|, 1990 as the bar date for the assertion of pre-petition claims
against Drexel Group,

18. On March 1, 1990. John C. Weitnauer of
Alston & Bird, wrote to R. Paul Wickes, Thompson &
Knight, to explain that Southmark might wish to pursue cer-
tain claims against Drexel in connection with the Examiner's
review of potential preferential transfers, of which Drexel
may have received $985,000 or more. Mr. Weitnauer’s letter
did not however, mention any potential claims Southmark
might have against Drexel arising out of Drexel’s activities
identified by Mr. Galbally, including those as underwriter of
bonds issued by Southmark and as broker for bonds pur-
chased by Southmark.

19. On April 17, 1990, Neal Batson sent a let-
ter to R. Paul Wickes, Thompson & Knight (with copies to
David Carpenter and Knute Kurtz) advising Thompson &
Knight to pursue a “potential voidable preference paid to
Drexel Burnham Lambert Incorporated ... within the ninety-
day period prior to Southmark’s Chapter 11 filing on July 14,
1989.” In this letter, the Examiner specifically states that he
and his experts “have not attempted to invesrigate” any “se-
curities claims which Southmark may have as the purchaser
of bonds underwritten or sold by Drexel.” The Examiner also
stated that “[i]n light of the plan requirement that the Exam-
iner file his final report by the conclusion of the hearings on
confirmation and the recent bankruptcy of the parent, we are
not inclined to devote additional resources to a further inves-
tigation of any potential Southmark claims against Drexel.” A

ee

true and correct copy of the April 17, 1990 letter is attached
hereto as Exhibit C.

20. On May 1, 1990, the Examiner filed his
Fourth Interim Report (the “Report’). Despite the disclaimer
in the Examiner’s April 17 letter stating that he and his ex-
perts had not investigated claims which Southmark may have
as the purchaser of bonds underwritten or sold by Drexel, this
Report purported to deal with precisely those claims. The Re-
port, which was written by Coopers & Lybrand. notes that
“Southmark’s access to the high-yield bond market was
largely due to the efforts of Drexel” and that Souchmark lost
large amounts of money by buying on margin from Drexel a
large portfolio of high-yield bonds. The Report then states
that Drexel’s role in these activities “was investigated more
extensively [than other aspects of the Drexel relationship] be-
cause of the general, oft-repeated, potential charge that
Drexel clients had to support the high-yield bond network.”

21. The Report notes that “[pJublic ailegations
involving Drexel and the support of the high-yield bond net-
work revolve round allegations of Drexel’s underwriting of
high-yield bond issuances for companies with the understand-
ing that the company would use part of the proceeds to pur-
chase the high-yield bonds of other Drexel clients, thus
helping to create what effectively would be a false market for
these high-yield instruments.” The Report, however, states at
page 41 that proving these allegations was “made difficult by
the facts.” The Report states that any “ultimate proof” of
Drexel’s wrongdoing “must await examination of the in-
volved parties.” The Report goes on to note that “[s]uch ex-
aminations have not, and will not be a priority for the
Examiner as any claims against Drexel Burnham Lambert
and/or Michael Milken could be of limited value due to the

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[Drexel bankruptcy] and [Milken’s indictment on criminal
charge].” The Report then states that the Examiner had spe-
cifically referenced these issues to Southmark’s legal counsel.
In fact, no such reference was ever made. True and correct
copies of excerpted portions of the Fourth Interim Report are
attached hereto as Exhibit D.

22. William Galbally read the portions of the
Report dealing with Drexel before it was sent to the Exam-
iner for his approval. According to Mr. Galbally, he told Mr.
Kessler that the Report on Drexel was completely inadequate
and that Coopers & Lybrand had an obligation either to in-
vestigate the Drexel issues fully and fairly or else to explain
to the Examiner that, because of Drexel’s status as a major
audit client of Coopers & Lybrand. the firm had decided not
to investigate Drexel. Mr. Galbally further told Mr. Kessler
that the sort of self-serving disclaimer put in the Report, shift-
ing the responsibility for investigation to counsel for South-
mark, was improper. According to Mr. Galbally, Mr. Kessler
responded that Mr. Carpenter wanted the Drexel issues han-
dled this way and that he (Mr. Kessler) was not going to
delve into the substance of those issues in the Report.

23. On July 9, 1990, the Examiner filed his Fi-
nal Report. In the Final Report, which was also written by
Coopers & Lybrand, Coopers & Lybrand provides yet another
excuse for its failure fully to investigate potential claims
against Drexel. Appendix I to the Final Report states that
“[tlime has not permitted a complete investigation into the
awareness of... Drexel Burnham about the true financial con-
dition of Southmark or the soundness of its business methods
and operations. The Examiner has requested Southmark’s
counsel, Thompson & Knight to undertake the necessary

15b

investigation into/and pursuit of any claims against Drexel
Burnham While these outside professionals must have been
aware of the specific actions they took, the Examiner has not
evaluated their levels of knowledge and whether they fully
appreciated how their actions may have produced and main-
tained the Southmark mirage.” The Final Report acknowl-
edges, however, that “*the Southmark mirage could not have
been projected without the assistance, inadvertent or inten-
tional, of these outside professionals.” The Final Report then
state that since Drexel filed for bankruptcy during the pen-
dency of Southmark’s bankruptcy, “the Examiner left to
counsel for Southmark the necessary investigation into and
pursuit of any claims against Drexel Burnham The Examiner
does not know whether Southmark’s counsel has taken any
action in this regard.” In fact, there was never any specific
reference of claims against Drexel to Southmark’s counsel,
and Coopers & Lybrand never provided outside counsel for
Southmark with any investigative material with respect to po-
tential claims against Drexel. True and correct copies of ex-
cerpted portions of the Final Report are attached hereto as
Exhibit E.

24. At no time during the course of Coopers &
Lybrand’s engagement on the Southmark bankruptcy did
Coopers & Lybrand inform the Examiner, counsel for South-
mark, or Southmark itself that Coopers & Lybrand was hold-
ing back from a full investigation of potential claims that
Southmark might have against Drexel in order to protect
Coopers & Lybrands lucrative audit engagement with Drexel.

25. At no time during the course of Coopers &
Lybrand’s engagement on the Southmark bankruptcy did
Coopers & Lybrand inform the Examiner, counsel for South-
mark, or Southmark itself that the Coopers & Lybrand

l6b

employee originally charged with investigating the Drexel
claims believed, contrary to the Reports prepared for the Ex-
aminer, that Southmark had substantial claims against Drexel
arising out of Drexel’s activities as underwriter of bonds is-
sued by Southmark and as broker for bonds purchased by
Southmark.

26. Coopers & Lybrand failed to investigate
claims against Drexel that one of its managers considered to
be perhaps the most significant claims held by Southmark.
According to that manager, who is still today a Coopers &
Lybrand emplovee, the investigation was blocked due to a
conflict of interest never disclosed to Southmark to the Ex-
aminer or to this Court. Indeed, upon information and belief,
Mr. Carpenter went out of his way to convince the Examiner
and his counsel that the Drexel audit relationship would not
impair the thoroughness of the investigation of Drexel claims.

27. Beyond the failure to investigate (or to dis-
close why it could not investigate) Drexel claims, Coopers &
Lybrand drafted the Examiner’s Fourth Interim Report to sug-
gest that it had dome some investigation of such claims and
that such claims would be difficult to prove.

28. Southmark emerged’ from bankruptcy in
August 1990. One of the first major decisions for reorganized
Southmark was whether to engage outside professionals to in-
vestigate further claims against Drexel in order to be in a po-
sition to file a claim in the Drexel Group bankruptcy on or
before the October 1, 1990 bar date imposed in that case. Due
to a combination of factors including Southmark’s limited li-
quidity at the time and the express and implicit lack of enthu-
siasm for such claims in the Examiner’s report, Southmark

17b

did not pursue a further investigation at that time and did not
file a claim in the Drexel Group bankruptcy.

29. In early 1991, its coffers somewhat in-
creased, Southmark engaged an outside law firm to investi-
gate the Drexel claims for purposes of the possible filing of a
claim against a fund set up by Mr. Milken to compensate de-
frauded Drexel investors. That investigation revealed the ex-
istence of claims virtually identical to the claims Mr. Galbally
wanted to further investigate.

30. Southmark proceeded to file a claim
against the Milken settlement fund for more than $600
million. Although negotiations are still ongoing, Southmark
believes that the magnitude of its claim entitles it to a signifi-
cant part of the $250 million in the Milken settlement fund.
Had Southmark filed a claim in the Drexel Group bankruptcy
- which it surely would have done had Mr. Galbally’s theories
been further investigated and disclosed - Southmark likely
would have recovered many millions of dollars on that claim

as well.

31. On or about March 5, 1991, this Court is-
sued its Memorandum Opinion and Order on Final Applica-
tions for Compensation for Professional Persons and
approved Coopers & Lybrand fees and expenses in this case
in the approximate amount of $3.7 million.

29

32. In the early part of 1993, Southmark
learned from a former Coopers & Lybrand employee that Mr.
Galbally wanted to speak with Southmark about what had
happened. Notwithstanding the obvious peril to his own ca-
reer, Mr. Galbally told Southmark about the events that give
rise to this motion. Since that disclosure, Southmark has had

18b

a number of discussions with Coopers & Lybrand in an at-
tempt to resolve this matter. Those discussions have not led
to a resolution, and Southmark therefore brings this motion
for determination by the Court of whether Coopers & Ly-
brand should be required to disgorge some or all of the fees
previously awarded by the Court.

ARGUMENT
A. Jurisdictional Statement

33. This Court has jurisdiction over this Mo-
tion pursuant to 28 U.S.C. § 1334 and the plan of reorganiza-
tion confirmed by this Court.

B. Introduction: Requirements For Employment

Of Professionals In Bankruptcy

34. Professionals in the bankruptcy process
owe a fiduciary duty, not only to the parties they represent,
but also to the court. /n re Allegheny International Inc., 134
BR. 814, 820 (Bankr. W.D. Pa. 1991). “The professionals
must be capable of proving that all actions taken are ethical
and accomplished in good faith." Jd.

35. In order to ensure that bankruptcy profes-
sionals live up to their fiduciary duty of good faith, the Bank-
ruptcy Code sets forth certain employment and disclosure
requirements. Section 327(a) of the Bankruptcy Code sets
forth a two part test for the appointment of a professional per-
son: (1) the professional may not hold or represent an interest
adverse to the estate and (2) the professional must be a disin-
terested person. 11 U.S.C. § 327(a).

19b

36. Additionally, Bankruptcy Rule 2014 sets
forth the disclosure requirements for employment pursuant to
Bankruptcy Code sections 327, 1103 or 1114. An application
for the employment of a professional person requires disclo-
sure “at any time during such person’s employment” of,
among other things, “all the professional’s connections with
the debtor, Creditor, any other party in interest, their respec-
tive attorneys and accountants.” The statutory basis for denial
of compensation is found in Bankruptcy Code section 328(c)
which states that if, during the employment of a professional
under sections 327 or 1103, a court determines that the pro-
fessional is no longer disinterested or holds or represents an
adverse interest the court may deny compensation for services
and reimbursement of expenses. 11 U.S.C. § 328(c).

es Coopers & Lybrand Was Not Disinterested
As Required By The Bankruptcy Code

37. Section 101(14) of the Bankruptcy Code
defines a disinterested person as one who:

(A) is not a creditor, an equity secu-
rity holder, or an insider,. . .

(E) does not have an interest mate-
rially adverse to the interest of the estate
or of any class of creditors or equity se-
curity holders, by reason of any direct or
indirect relationship to, connecton with,
or interest in, the debtor or an invest-
ment banker . . . . or for any other
reason

11 U.S.C. § 101(14)

20b

38. In quoting Collier, the Fifth Circuit stated
that the requirement of disinterestedness:

Appears broad enough to include anyone
who in the slightest decree might have
some interest or relationship that would
color the independent and impartial atti-
tude required by the Code. ... Indirect
or remote association or affiliations, as
well as direct, may engender conflicting
loyalties.

In re Consolidated Bancshares, Inc., 785 F.2d 1249, 1256
(Sth Cir. 1986) quoting 2 Collier on Bankruptcy § 327.03 at
327-19, 20(15th ed. 1985) (emphasis added).

39. The Fifth Circuit went on to say that Con-
gress has determined that, due to the unique nature of the
bankruptcy process, the employment of professionals in a
bankruptcy case must be subject to strict standards. /d fn. 6,
citing /n re Cropper Co., 35 B.R. 625, 629 (Bankr. M.D. Ga.
1983). Finally, on the subject of disinterestedness, the Fifth
Circuit quotes language from /n re Philadelphia Athletic
Club, Inc., which states as foilows:

Professionals engaged in the conduct of
a bankruptcy case should be free of the
slightest_personal interest which might
be reflected in their decisions concern-
ing matters of the debtor’s estate or
which might impair the high degree of
impartiality and detached judgment

|
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Te ie OE EN Get EN Sma REMUS TET St aR ACT TaN SearE TELE Ene aren MAE TE iS Ce aU RS RCE Cac

A EE RETNS

21b

expected of them during the course of
administration.

Consolidated Bancshares, 785 F.2d at 1256, n.6. quoting /n
re Philadelphia Athletic Club, 20 B.R. 328, 334 (E.D. Pa.
1982) (emphasis added).

40. It is clear that applying the language of
Consolidated Bancshares Coopers & Lybrand could not have
been held to be disinterested if it had fully disclosed the na-
ture of its relationships with Drexel. Coopers & Lybrand was
not free of personal interest and its relationship with Drexel
did in fact color the independent and impartial attitude re-
quired by the Bankruptcy Code.

41. Coopers & Lybrand will surely point to the
fact that it did disclose the existence of the Drexel audit rela-
tionship. The nature of that disclosure, however, did not indi-
cate that the Drexel relationship would impede or impair the
investigation of claims against Drexel. And once Coopers &
Lybrand had made the determination that it would not inves-
tigate these claims valued in the hundreds of millions of dol-
lars, surely it had a duty to disclose this conflict to the
Examiner, Southmark and the Court, particularly in light of
the extensive role Coopers & Lybrand played in the investi-
gation of third party claims,

42. Rather than disclose the conflict, Mr. Car-
penter told the Examiner that there was no conflict. To add
insult to injury, Coopers & Lybrand then expressly (by noting
how difficult it would be to prove such claims) and implicitly
(by running up millions of dollars in fees investigating far

22b

less significant claims) downplayed the significance of such
claims in conscious disregard to its duties in this case.

43. A similar issue was raised in In re Amdura
where the court stated that the past representation of a former
client does not create a conflict, unless the professional be-
lieves, that for any reason, it would not be able to “diligently
and zealously” represent the debtor on the issue involving the
former client. /n re Amdura, 121 B.R. 862, 870 (Bankr. D.
Colo. 1990). The court stated that if the former client is “not
the band that feeds,” and if the firm is not otherwise inhib-
ited, the professional is not prohibited from acting as counsel.
On the other hand, where the professional had openly de-
clared an inability or unwillingness to “joust” with an ongo-
ing client, the issues surrounding that client were pervasive,
and the ongoing client was a multi-million-dollar-a-year cli-
ent of the professional, the court stated that it found it diffi-
cult if not impossible, to find the professional disinterested.
Id.

44. Drexel was indeed “the hand that feeds”
Coopers & Lybrand and Coopers & Lybrand failed to openly
declare to this Court its unwillingness to “joust” with Drexel.
Coopers & Lybrand clearly displayed its inability to “dili-
gently and zealously” represent Southmark on issues involv-
ing Drexel. In fact, the relationship between Coopers &
Lybrand and Drexel perfectly mirrors the relationship in /n re
Amdura that the court found impossible to label disinterested.
Coopers & Lybrand declared, albeit not openly, an unwilling-
ness to “joust” with Drexel, the Drexel issues were pervasive
and Drexel was a multi-million dollar client. Had this been
disclosed to the Court, Coopers & Lybrand could not possibly
have been deemed disinterested. Indeed, had the conflict been

disclosed to the Examiner, he almost certainly would not
have sought to retain Coopers & Lybrand in the first instance.

D. Coopers & Lybrand Held An Interest
Adverse To The Southmark Estate

45. Although the term “adverse interest” is not
defined in the Bankruptcy Code itself, the following judicial
definition has developed:

(a) to possess or assert any eco-
nomic interest that would tend to lessen
the value of the bankruptcy estate or that
would create either an actual or potential
dispute in which the estate is

a rival claimant; or

(b) to possess a predisposition un-
der circumstances that render such a bias
against the estate.

In re Diamond Mortg. Corp. of Illinois, 135 BR 78 94 (Bankr
N.D. Ill. 1990): In re Kuykendahl Place Associates, Ltd., \\2
B.R. 847, 850 (Bankr. S.D. Tex. 1989); In re Roberts, 46
B.R. 815, 827 (Bankr. D. Utah 1985) aff'd in relevant part
and rev'd in part, 75 B.R. 402 (D. Utah 1987); Roger J. Au &
Son, Inc. v. Aetna Ins. Co., 64 B.R. 600, 604 (N.D. Ohio
1986).

46. Under the judicial definition of adverse in-
terest, Coopers & Lybrand clearly should have been disquali-
fied fromm employment by the examiner. Coopers & Lybrand
had a predisposition which rendered a bias against the estate
in favor of its multi-million dollar client. Not only did it have

24b

a predisposition it actually did “render such bias against the
estate” in failing to vigorously pursue the Drexel claims.

47. The Supreme Court has held, in the con-
text of a bankruptcy proceeding, that: “[w]here an actual con-
flict of interest exists, no more need be shown in this type of
case to support a denial of compensation.” /n re Woods v
City Nat. Bank & Trust Co., 312 U.S. 262, 268, 61 S.Ct. 493,
497 (1940). See also Consolidated Bancshares, 785 F.2d at
1256; In re EWC, Inc., 138 B.R. 276, 280 (Bankr W.D. OkI.
1992); In re Diamond Mortg. Corp. of Illinois, 135 B.R. at
92; In re Coay, 122 B.R. 520, 526 (Bankr. N.D. Ohio 1990):
In re Micro-Time Management Systems, Inc., 102 B.R. 602.
606 (Bankr. E.D. Mich. 1989); In re Kendavis Inc., 91 B.R.
742, 752 (Bankr. N.D. Tex. 1988). In other words. no show-
ing of fraud or unfairness need be shown, in fact, nothing
more than the conflict itself is required to be shown. Woods,
61 S.Ct. at 497.

48. The Supreme Court gives the following
reason for not requiring any showing beyond the actual
conflict:

The incidence of a particular conflict of
interest can seldom be measured with
any degree of certainty. The bankruptcy
court need not speculate as to whether
the result of the conflict was to delay ac-
tion where speed was essential, to close
the record of past transactions where
publicity and investigation were needed,
to compromise claims by inattention
where vigilant assertion was necessary
or otherwise to dilute the undivided

aa a a aici

25b

loyalty owed to those whom the claim-
ant purported to represent.

Id.

49. As with the discussion of disinterestedness
above, based upon Mr. Gallbally’s sworn statements, there
can be no genuine dispute as to whether Coopers & Lybrand
had an actual conflict here. Plainly, it did. Accordingly, under
either prong of section 327(a), Coopers & Lybrand was not
qualified to work on behalf of Southmark and the Examiner.

E. Coopers & Lybrand’s Failure To
Disclose Mandates Disgorgement Of Its Fees

50. Pursuant to Bankruptcy Rule 2014 and its
predecessor, the professional who seeks to represent the
debtor must fully disclose at the time of the application for
employment all connections with the debtor, creditors and
other parties in interest. See /n re Arlin’s Dept Stores, Inc.,
615 F.2d 925, 931 (2d Cir. 1979); In re Roberts, 73 B.R. at
411: In re Coastal Equities Inc., 39 B.R. 304, 308 (Bankr.
S.D. Cal. 1984); Jn re Diamond Lumber, Inc., 88 B.R. 7753,
776 (N.D. Tex. 1988). All facts that may be relevant to a de-
termination of whether a professional is disinterested or holds
or represents an interest adverse to the debtor estate must be
disclosed to the court. See, e.g., Jn re Arlin, 615 F.2d at
931-933: In re Diamond Lumber, 88 B.R. at 777, In re Rob-
erts. 75 B.R. at 411; In re Coastal Equities, Inc..39 B.R. at
308. The duty to disclose is broad because the court, rather
than the professional, must decide whether the facts consti-
tute an impermissable conflict of interest. See /n re Roberts,
75 B.R. at 410-411; In re Coastal Equities, Inc., 39 B.R. at

ee heee |

308: In re Diamond Lumber, 88 B.R. at 777

26b

51. The duty to disclose is not only predicated
on the statutory requirements of Rule 2014, but also the obli-
gation to disclose in the capacity as an officer of the court and
fiduciaries. /n re Coastal Equities, 39 B.R. at 308.

52. Professionals, when making disclosure, are
on notice that if the disclosure is inadequate, if the facts are
incorrect or if the changing facts and circumstances reveal an
actual conflict, and the professional is later proved to be in-
terested, the court is empowered to deny or reduce fees. /n re
Sky Valley, Inc., 135 B.R. 925, 935 (Bankr. N.D. Ga. 1992).
See also In re EWC, Inc., 138 B.R. at 282 (“[p]rofessionals
employed for the estate are under a continuing duty to dis-
close their connections.”): Jn re Diamond Mortg. Corp., 133
B.R. at 90. Furthermore, if the duty to properly disclose is ne-
glected, however innocently, the professional performs the
duties to the estate at its peril. Jn re Coastal Equities, 39 B.R.
at 308.

53. Many courts have held that failure to com-
ply with the disclosure requirement is an independent basis
for denial of all fees under 11 U.S.C. Section 328, The court
in Jn re EWC, Inc., stated as follows:

Therefore, if, a person has at any time
during employment by the estate, any
connections with the debtor, creditors,
any other party in interest, their attor-
neys and accountants, . . .. pursuant to
Fed. R.Bankr.Pro. 20 14(a), and fails to
disclose those ‘connections’ to the best
of his or her knowledge, it is necessary
and appropriate that employment of that

j
4
‘3
4
4
4

hit ate

27b

person must be set aside to carry out the
provisions of the Bankruptcy Code. Any
request for compensation must be de-
nied, and any compensation received
must be disgorged.

138 B.R. 276, 280-281 (Bankr. W.D. Okl. 1992). See also
Consolidated Banchsares, 755 F.2d at 1256 n. 7; In re Rob-
erts, 75 B.R. at 412; Jn re Coastal Equities, 39 B.R. at 308;
In re Thompson, 54 B.R. 311, 316 (Bankr. N.D. Ohio 1983);
In re Marine Outlet, Inc., 135 B.R. 154, 156 (Bankr. M.D.
Fla. 1991) (“failure to comply with the mandate of Bank-
ruptcy Rule 20 14(a) merits a total forfieture of all fees”); /n
re Tinley Plaza Associates. L.P., 142 B.R. 272, 278 (Bankr.
N.D. Ill. 1992) (“if an attorney does not disclose a conflict
arising after employment has been allowed, the court must. .
. disgorge any compensation granted during the period the
conflict existed”); Jn re Micro-Time, 102 B.R. at 608 (all
compensation was denied the trustee and accountant because,
had they fully disclosed they would not have been appointed
and thus they have nothing on which to base their claim for
compensation, despite substantial contribution). Contra /n re
Roberts, 75 B.R. at 412 (“where equities outweigh the need
for attorney discipline for failure to disclose potential con-
flicts, the law does not require the denia! of fees and costs”).
The court in /n re Micro-Time, in referring to the complete
denial of fees, stated:

The argument that possible harm .

could be counter-balanced by greater
benefit [to the estate] does not cover the
policy considerations which look to the
harm to representation, the loss of confi-
dence, etc. Moreover, [i]t is almost

28b

impossible for a court to determine what
benefit has accrued to the estate as op-
posed to what detriment might have
accrued...absent a conflict of interest....

In re Micro-Time, \02 B.R. at 608.

54. Although Coopers & Lybrand disclosed
the existence of its relationship with Drexel, it failed to dis-
close the significance of that relationship and the potential
impact on its duties as the accountant to the Court appointed
examiner. While this Court endeavored to employ a disinter-
ested examiner to diligently review the potential claims of the
estate, Coopers & Lybrand failed to disclose its predisposi-
tion to protect its relationship with Drexel and thus tainted
the disinterestedness of the Examiner. As noted in /n re
Micro-Time, in hindsight it is impossible for this Court to de-
termine what benefit might have accrued to the estate absent
this conflict of interest and what detriment did in fact accrue.

¥. This Motion To Reconsider Is Timely
Under Rule 60(B)

55. Rule 60(b) of the Federal Rules of Civil
Procedure, through the operation of Bankruptcy Rule 9024,
governs both the rounds and the time limitations for a motion
to reconsider a bankruptcy court order.

56. Rule 60(b) provides that:

[o]n motion and upon such terms as are
just, the court may relieve a party or a
party’s legal representative from a final

Maths Stes Stain earl

29b

judgment, order, or proceeding for the
following reasons: (1) mistake, inadver-
tence, surprise, or excusable neglect; (2)
newly discovered evidence which by
due diligence could not have been dis-
covered in time to move for a new trial
under Rule 59(b); (3) fraud (whether
heretofore denominated intrinsic or ex-
trinsic), misrepresentation, or other mis-
conduct of an adverse party; (4) the
judgment is void; (5) the judgment has
been satisfied, released, or discharged,
or a prior judgment upon which it is
based has been reversed or otherwise
vacated, or it is no longer equitable that
the judgment should have prospective
application; or (6) any other reason
justifying relief from the operation of
the judgment. The motion shall be made
within a reasonable time, and for rea-
sons (1), (2), and (3) not more than one
year after the judgment, order, or
proceeding was entered or taken. A
motion under this subdivision (b) does
not affect the finality of a judgment or
suspend its operation. This rule does not
limit the power of a court to set aside a
judgment for fraud upon the court...

Fed. R. Civ. P. 60(b) (emphasis added). As is evident from
the language of the Rule itself, Rule 60(b)’s one year time
limitation for bringing a motion to reconsider does not apply
to (a) Rule 60(b)(6) (“any other rcason justifying relief from
the operation of a judgment”) or (b) fraud upon the court.'

30b

57. Rule 60(b)(6): The purpose of Rule
60(b)(6), which provides relief from a judgment for “any
other reason justifying relief”, is to prevent extreme hardship
or injustice. See United States v. McDonald, 86 F.R.D. 204,
208 (N.D. Ill. 1980). Once hardship or injustice is found,
“Rule 60(b)(6) is to be liberally applied to ‘accomplish jus-
tice.”” Id. In the Fifth Circuit, Rule 60(b)(6) applies where
“something more” than mistake, fraud or newly discovered
evidence is shown. See, e.g., Bros. Inc. v. W.E. Grace Mfg.
Co., 320 F.2d 594, 608-09 (Sth Cir. 1963) (Rule 60(b)(6) in-
voked upon showing of “something more” than mere plea to
reopen based upon newly discovered evidence or fraud).

58. Here, Coopers & Lybrand committed fraud
by failing to disclose that its substantial relationship with
Drexel would preclude its vigorous investigation of claims
against Drexel. However, Coopers & Lybrand’s activities (as
developed more fully herein) go far beyond mere fraud. Here,
the “something more” arises from the context of Coopers &
Lybrand’s misconduct, i.e. Coopers & Lybrand's fiduciary
Status with respect to the Court, its affirmative duty to
: Both of these exceptions to Rule 60(b)’s one year time limitation
appear, based upon the language of the Rule, to apply only to judgments
as opposed to orders: however, case law interpreting Rule 60(b) does not
support such a rigid interpretation. See Lucas v. City of Juneau, 20 F.R.D.
407, 410 (D. Alaska 1957) (Rule 60(b)(6) applies to order as well as judg-
ment); /n re H.B. Michelson, 141 B.R. 715, 725-26 (Bankr. E.D. Cal.
1992) (fraud on the court is basis for revoking order confirming reorgani-
zation plan). Moreover, even if the Rule 60(b)(6) and the fraud upon the
court exceptions apply only to judgments, these exceptions still apply un-
der the presented facts since Bankruptcy Rule 9002 defines “judgment”,
as it is used in the Federal Rules of Civil Procedure including Rule 60(b),
to include “any order appealable to an appellate court. “ Because the order
of this Court approving Coopers & Lybrand’s fee is an appealable order,
it is also a “judgment” pursuant to Bankruptcy Rule 9002.

31b

disclose any potential conflicts of interest to the Court, the
requirement of disinterestedness and, most important, the
public interest in seeing that the creditors of Southmark are
treated fairly and equitably. Shielding one of its largest clients
from claims that could have substantially enhanced creditor
recoveries was plainly inimical to the interests of South-
mark’s creditors and a violation of Coopers & Lybrand’s fi-
duciary and statutory duties. Moreover, this type of
misconduct threatens the very integrity of, and the public trust
in, the bankruptcy process. Consequently, the Court must re-
consider its order award of fees to Coopers & Lybrand pursu-
ant to Rule 60(b)(6).

59. Fraud upon the Court: Like a motion
brought pursuant to Rule 60(b)(6), a motion to reconsider
based on fraud upon the court is not subject to the one year
time limitation of Rule 60(b). Fed. R. Civ. P. 60(b). “Fraud
upon the court” is fraud committed by an officer of the court
which affects the judicial machinery in such away “that the
judicial machinery cannot perform in the usual manner its im-
partial task of adjudging cases that are presented for adjudica-
tion.” Browning v. Navarro, 826 F.2d 335, 344-45 n. 12 (Sth
Cir. 1987); Budge v. Post, 544 F. Supp. 370, 377 (N.D. Tex.
1982). The Examiner is an officer and fiduciary of this Court.
See In re Baldwin United Corp., 46 B.R. 314, 318-17 (Bankr.
S.D. Ohio 1985) (examiner, as non-adversarial officer o the
court, operates as a civil grand jury “to ascertain legitimate
areas of recovery” for the estate). By concealing the extent of
its relationship with Drexel and by failing to develop claims
against Drexel. Coopers & Lybrand tainted the Examiner’s
Interim Reports, and committed a fraud upon this Court.
Moreover, Coopers & Lybrand, as court-appointed account-
ants, were quasi-officers and fiduciaries of this Court. See /n
re Food Town, Inc., 208 F. Supp. 139, 148-49 & n.6 (D. Md.

32b

1962). By concealing the effect of its relationship with Drexel .
on the work it was charged to perform and by failing to inves-
tigate and/or covering up Southmark’s claims against Drexel,
Coopers & Lybrand perpetrated a fraud upon both the Court-
appointed Examiner and this Court.

60. Consequently, this Motion is not time
barred by the one year limitations period set out in Rule
60(b).

CONCLUSION

61. Coopers & Lybrand’s failure to disclose its
disinterestedness and adverse interest resulted in the very type
of injury to the estate that the strict requirements of the Bank-
ruptcy Code seek to avoid. Coopers & Lybrand failed to vig-
orously pursue certain actions against Drexel creditors.
Complete disgorgement here is necessary and appropriate (a)
in light of the harm caused Southmark by the Coopers & Ly-
brand misconduct and (b) to serve as a warning to other pro-
fessionals that the requirements under the Bankruptcy Code
are to be taken seriously and that misleading partial disclo-
sures of conflicts of interest will not be tolerated. Accord-
ingly, Southmark respectfully requests that the Court
reconsider the previous award of over $3.7 million in frees
and expenses to Coopers & Lybrand and order Coopers &
Lybrand to fully disgorge all such fees and expenses to
Southmark.

DATED: January 4, 1994.
Respectfully Submitted,

GIBSON, DUNN & CRUTCHER
By:

Robert B. Krakow, Esq.

State Bar No. 11702000

1717 Main Street, Suite 5400
Dallas, Texas 75201-4605
Telephone: (214) 698-3100
Facsimile: (214) 698-3400
Attorneys for Southmark
Corporation

34b

‘Any footnotes trail end of document)

UNITED STATES BANKRUPTCY COURT FOR THE
SOUTHERN DISTRICT OF NEW YORK

IN RE: VYTAUTAS VEBELIUNAS, Debtor
Chapter 7, Case No. 98 B 45466 (TLB)

March 10, 1999, Decided

COUNSEL: Edgar H. Booth, Esq., Donald L. Kuba, Esq.,
Warren R. Graham, Esq., WARSHAW BURSTEIN COHEN,
SCHLESINGER & KUH, L.L.P., New York, New. York, for
Chapter 7 Trustee.

ROY BABITT, ESQ., Chapter 7 Trustee, New York, New
York.

VYTAUTAS VEBELIUNAS, Debtor, Pro se, Richmond
Hill, New York.

Alan E. Gamza, Esq.,. MOSES & SINGER, L.L.P., New
York, New York, for Citibank, N.A.

TRACY HOPE DAVIS, ESQ., Office of the United States
Trustee, New York, New York.

JUDGES: HONORABLE TINA L. BROZMAN, CHIEF
UNITED STATES BANKRUPTCY JUDGE.

OPINION BY: TINA L. BROZMAN

OPINION: OPINION DISQUALIFYING COUNSEL TO
CHAPTER 7 TRUSTEE

HONORABLE TINA L. BROZMAN

WN Dm tay

SPE SEL PRIEST PS IORI AA RI HS

ve)
WA
oe

CHIEF UNITED STATES BANKRUPTCY JUDGE:

Concerns and fears of partisan bias in the House of Represen-
tatives and in the voting by Senators rocked the impeachment
process of President William Jefferson Clinton. As it turned
out, once the Senators viewed the evidence and gave it the
weight they deemed appropriate, they did not vote along uni-
fied party lines but acquitted the President. I mention this
only to illustrate what a destructive force bias can be if it is
allowed to go unchecked and how important in the judicial
and quasi-judicial arenas it is first to amass reliable evidence
and only then to formulate an opinion.' In fact. the point in
time when an opinion is formed is essential to the distinction
between bias on the one hand and reasoned judgment on the
other. Today, I address that very issue as it relates to the dis-
interestedness of counsel to the chapter 7 trustee on account
of his clear expression of prejudice against the debtor before
any § 341 or other examination of him by the trustee.

A. Procedural History

Vytautas Vebeliunas, the debtor pro se in this converted
chapter 7 case, moved to disqualify Roy Babitt, the chapter 7
trustee assigned to his case, by reason of an alleged conflict
of interest arising out of a prior representation of the debtor's
affiliate by the firm where Mr. Babitt is of counsel but which
does not represent him in this matter. In a decision issued

36b

from the bench, | held that there was absolutely no basis in
law or fact warranting the trustee's disqualification for a con-
flict of interest or for any other reason, however, I instructed
the trustee to engage substitute counsel because it had be-
come apparent from the pleadings that his counsel, specifi-
cally Warren Graham of Warshaw Burstein Schlesinger &
Kuh ("Warshaw Burstein"), was not disinterested as required
by § 327(a) of title 11 of the United States Code (the "Bank-
ruptcy Code"). Warshaw Burstein expressed shock at my rul-
ing, not only because the firm clearly did not appreciate it,’
but because it claims it was not put on notice that | was going
to raise and address what was in the papers but what the
debtor did not address during his oral argument. Being a firm
believer in due process and not wishing to deprive anyone of
his or her right to be heard, I allowed Warshaw Burstein to
respond in writing and then orally at a subsequent hearing.” |
did this despite the fact that I regarded the issue of counsel's
disinterestedness to be sufficiently glaring from the papers
submitted that adequate and sufficient notice of its existence
was provided. However, that is only my opinion and reason-
able minds do differ.

B. Background

1. The Lattingtown Question

Vebeliunas may or may not own a piece of property located
in Lattingtown, New York, which was last valued at $ 4.5
million. When he filed his chapter 11 petition, Vebeliunas did
not schedule the property, taking the position instead that it is
owned by a trust in which he has a 20% interest. Several

37b

banks with liens against the property totaling less than $ 2
million moved to dismiss the chapter 11 case, asserting that
Vebeliunas did indeed own the property but that they could
pursue foreclosure in state court. Instead, because Vebeliunas
may have significant unsecured debt which, if the Latting-
town property is his, possibly could be satisfied in whole by
his equity in that property, I converted the case to a chapter 7
liquidation, noting that the trustee was to examine into the
ownership question. Roy Babitt was appointed chapter 7 trus-
tee, with Warshaw Burstein being retained as his counsel.

2. The Telephone Call With Monica Setikas

Prior to the debtor's scheduled § 341 examination,’ Vebeliu-
nas' assistant, Ms. Monica Setikas, telephoned Graham re-
questing information about the upcoming meeting. Her
reason for calling, she claimed, was that Vebeliunas had not
received timely notice of it and that the notice he finally did
receive contained inaccurate information. In response to her
request, Graham allegedly told Ms. Setikas that he did not be-
lieve "anything the debtor said in this case," that he was get-
ting a court reporter and that Vebeliunas had better be at the
meeting. This conversation was first brought to the court's at-
tention in Vebeliunas' papers moving for the trustee's dis-
qualification. See Vebeliunas Moving Affidavit, P15. In his
papers opposing the debtor's motion, Graham recounts the
same exchange as follows:

The Debtor's suggestion in paragraph 15 of the
Vebeliunas Affidavit that "Mr. Babitt, without
ever speaking to [him], has instructed his

38b

attorneys not to believe [him]," is also without
any factual basis. The Debtor's motion papers
then go on to detail a conversation between
Monica Setikas, an associate of tne Debtor,
and Warren R. Graham, a member of the War-
shaw Burstein firm, and the author of these pa-
pers, quoting Mr. Graham as stating that he
"did not believe anything Mr. Vebeliunas said
in this case." While that quote is substantially
accurate, the skepticism contained therein is
entirely predicated on the record and the gross
inconsistency of the Debtor's position concern-
ing ownership of the property, with among
other things, his previous sworn statements."”

See Trustee's Opposition, P19 (emphasis added). However, at
the hearing, Graham testified that he did not remember the
conversation with any specificity; with respect to his com-
ment expressing his disbelief of Vebeliunas, Graham said he-
thought that he made that remark in connection with Vebeliu-
nas claims of deficient notice. In their papers moving for re-
consideration, neither the firm nor Graham makes any
statement reflecting this position. In fact and significantly, the
firm's and Graham's affidavits in opposition to disqualifica-
tion continue to recount Graham's remark to Monica Setikas
as one expressing disbelief of anything the debtor had to say
in the case generally. See Warshaw Burstein Affidavit in Op-
position to Disqualification, P12; Graham Affidavit Annexed
to Warshaw Burstein Affidavit in Opposition to Disqualifica-
tion, P7. In paragraph 7 of Graham's affidavit, he goes
through a detailed list of reasons, only one of which was the
repeated claim of deficient notice, why "in frustration and ex-
asperation, [he] spontaneously remarked that [Graham] did
not believe anything [Vebeliunas] said." Graham Affidavit

Pere Sond

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ieee alice eet BS ba © Soe tie

39b

Annexed to Warshaw Burstein Affidavit in Opposition to
Disqualification, P7. If Graham had wished to clarify the con-
text in which he remarked on the debtor's credibility, he had
several opportunities to do so before the de novo hearing. But
he did not. Had Graham not changed his story when he testi-
fied, it would have been unnecessary to make a credibility de-
termination. But I believe I have no other choice now other
than to render such a determination. | find Graham's testi-
mony at the hearing to have been evasive and not credible.

In the most recent brief submitted by Warshaw Burstein in
opposition to its disqualification, Warshaw Burstein attempts
to justify Graham's conclusions about the debtor by stating:

it is respectfully urged upon this court that
when a debtor swears to directly contrary facts
on numerous occasions and transfers the same
piece of property numerous times outside the
chain of title, it is not essential for the Trustee,
or his counsel, to "get his side of the story"
prior to concluding that he has no credibility.

See Warshaw Burstein Affidavit in Opposition to Disqualifi-
cation, P27. Graham also suggested that his frustration and
exasperation with the debtor® "together with the Debtor's
status as a convicted felon [which] gave [Graham] ample jus-
tification to doubt [Vebeliunas'] credibility, and did not im-
pose upon [Graham] an additional duty 'to get his side of the
story." See Graham Affidavit annexed to Warshaw Burstein
Affidavit in Opposition to Disqualification, P8. Notwith-
standing Graham's statements, Vebeliunas has contended in
court papers that the other parties in interest misapprehend

40b

the facts relating to the chain of title of the property and Ve-
beliunas further says that he has an explanation to support his
own view of the documents to which Graham has referred.

II.

Counsel's compliance with the disinterestedness requirement
under § 327(a) not only applies at the time of retention but
also throughout the case, see In re Granite Partners, L.P., 219
B.R. 22, 32 (Bankr. S.D.N.Y. 1998); Rome v. Braunstein, 19
F.3d 54, 62 (1st Cir. 1994), and is so crucial to the proper
functioning of the bankruptcy system that a court may raise it
and dispose of it whenever its sanctity is questioned. See In re
Martin, 817 F.2d 175, 180 (1st Cir. 1987) (discussing the
bankruptcy court's fundamental responsibility to monitor the
integrity of the proceedings before it); In re Plaza Hotel Cor-
poration, 111 B.R. 882, 891 (Bankr. E.D. Cal. 1990) (the
court has a continuing supervisory role during the case which
includes the ability to revisit issues such as disinterestedness
whenever appropriate); Booth v. Continental Insurance Com-
pany, 167 Misc. 2d 429, 634 N.Y.S.2d 650, 653-654 (Sup.
Ct. West. Co. 1995) (citing Wagenheim v. Pomerantz,
N.Y.L.J. 7/7/70, p.13, col.7 at p. 14, col.1 (Sup. Ct. West.
Co.) (citing cases) ("the judiciary will not close its eyes when
the suggestion of impropriety appears on the record and the
issue may be raised sua sponte"); In re Kelton Motors, Inc..
109 B.R. 641, 650 (Bankr. D.Vt. 1989); see generally Flush-
ing Savings Bank v. FSB Properties, Inc., 105 A.D.2d 829.
482 N.Y.S.2d 29, 31 (App. Div. 1984). If there was any infir-
mity in my issuing my prior ruling without advising the firm
that | was considering its removal, that infirmity has been
cured by the leave I subsequently granted Warshaw Burstein
to appear and be heard on this issue. See Kelton Motors, 109
B.R. at 650.

nn

ge kane ae ae eee nD

41b

The crux of Warshaw Burstein's argument is that neither the
trustee nor trustee's counsel need be disinterested vis-a-vis
the debtor and that counsel had no duty to question the debtor
before concluding that he is completely untrustworthy. Fur-
ther, Warshaw Burstein argues, Graham was entitled to disbe-
lieve the debtor pre-examination without compromising
counsel's disinterestedness should I find that that standard ap-
plies to the firm.

IT.

I feel compelled to first put to bed any doubt as to Graham's
bias and how I reached the conclusion that he possessed one.
The pertinent facts are simple. Prior to any examination of
the debtor by the trustee or his counsel in connection with the
chapter 7 case, Graham made an unequivocal statement to the
effect that he believed Vebeliunas to be a liar. In his affida-
vits, Graham manifested a further belief that the debtor did
not deserve the opportunity to explain himself because he is a
convicted felon. See Graham Affidavit annexed to Warshaw
Burstein Affidavit in Opposition to Disqualification, P8.
WEBSTER'S THIRD NEW INTERNATIONAL DICTION.
ARY defines prejudice as "a preconceived judgment or opin-
ion" and "an opinion or leaning adverse to anything without
just grounds or before sufficient knowledge." WEBSTER'S
THIRD NEW INTERNATIONAL DICTIONARY ( Merriam-
Webster, Springfield Mass. 1981). The same source defines
bias as "such prepossession with some object or point of view
that the mind does not respond impartially to anything related
to this object or point of view."’ Id. While Vebeliunas may
turn out to be guilty, as alleged, of supplying misinformation
to the parties in interest, Graham simply cannot have

42b

concluded that Vebeliunas is lying absent a bias or prejudice
on Graham's part because there has not been an examination
of Vebeliunas, and, therefore, the totality of evidence needed
for Graham to have formed a reasoned judgment is not yet
available. Quite obviously Graham is biased against the
debtor, for when Ms. Setikas merely requested information
for Vebeliunas, Graham responded by attacking the debtor's
credibility, thereby demonstrating a complete lack of imparti-
ality with respect to anything having to do with him.

Warshaw Burstein and Graham contend that the comments to
Ms. Setikas about the debtor were perhaps "impolitic" but not
serious enough to raise a question as to counsel's disinterest-
edness. An impolitic remark is an unwise remark. See id.
During his conversation with Ms. Setikas, had Graham
quipped "Vebeliunas probably threw out the notice I sent
him," that would have been an unwise and inappropriate re-
mark, but not one indicating bias or prejudice. However, tell-
ing a debtor's representative that you don't believe a word the
debtor says before you have spoken with the debtor is signifi-
cantly more troubling. It indicates a predisposition not to
trust, listen to, believe in or have confidence in that person.

| recognize that, factually at least, this case is unique, unlike
any other reported decision. Whereas most of the decisions
regarding the propriety of the retention of counsel involve a
conflict of interest, this case admittedly does not address an
actual, potential or apparent conflict; the debate that sur-
rounds disqualifying conflicts of interest is not implicated
here. Jurisprudential precedent on this topic therefore may
only serve to guide me as | make inroads into what amounts
to be pristine territory. See Board of Education of the City of
New York v. Nyquist, 590 F.2d 1241, 1246 (2d Cir. 1979)
(quoting Fund of Funds, Ltd. v. Arthur Andersen & Co., 567
F.2d 225, 227 (2d Cir. 1977)).

43b

IV.

The Bankruptcy Code sets forth a two-pronged test for the re-
tention of estate professionals. See 11 U.S.C. § 327(a); 11
U.S.C. § 101(14). In order for the trustee to retain profession-
als to represent or assist him or her in carrying out the duties
spelled out under § 704 of the Bankruptcy Code, those pro-
fessionals must meet both requirements. See Martin, 817 F.2d
at 180; Granite, 219 B.R. at 32; In re Envirodyne Industries,
Inc., 150 B.R. 1008, 1016 (Bankr. N.D.IIl. 1993). First, §
327(a) authorizes the trustee, with the court's approval, to em-
ploy "one or more attorneys ... that do not hold or represent
an interest adverse to the estate;" and second, "that are disin-
terested persons.” 11 U.S.C. § 327(a). The "adverse interest"
element in § 327(a) is undefined by the Bankruptcy Code but
has been judicially fashioned to mean either (1) the posses-
sion or assertion of any economic interest that would tend to
lessen the value of the bankruptcy estate or create an actual or
potential dispute with the estate as a rival claimant, or (2) a
predisposition of bias against the estate. Kravit, Gass & We-
ber, S.C. v. Michel (In re Crivello), 134 F.3d 831, 835-36
(7th Cir.1998); Smith v. Marshall (In re Hot Tin Roof), 205
B.R. 1000, 1003 (B.A.P. Ist Cir. 1997); Granite, 219 B.R. at
33; Envirodyne, 150 B.R. at 1016-17; In re Roberts, 46 B.R.
815, 827 (Bankr. D. Utah 1985) aff'd in part, modified in part
and rev'd in irrelevant part, 75 B.R. 402 (D. Utah 1987). We
are unconcerned here with § 327(a)'s first prong, no adverse
interest, but are more concerned with disinterestedness, the
second prong, because the bias exhibited is against the
debtor, rather than the estate.

44b

Unlike the "adverse interest" prong of the test, disinterested-
ness is delineated in the Bankruptcy Code. So far as relevant
here, § 101(14)(E) of the Bankruptcy Code, more commonly
known as the catch-all clause, see Granite, 219 B.R. at 32; 3
L. King, COLLIER ON BANKRUPTCY, P327.04[4}[e] at
327-43 (15th ed. rev. 1996), defines a disinterested person as
one that “does not have an interest materially adverse to the
interest of the estate or of any class of creditors or equity se-
curity holders, by reason of any direct or indirect relationship
to, connection with, or interest in, the debtor or an investment
banker specified in subparagraph (B) or (C) of this paragraph,
or for any othe’ reason.” 1] U.S.C. § 101(14)(E) (emphasis
added); see In re Marvel Entertainment Group, Inc., 140 F.3d
463, 476 (3d Cir. 1998) ("One is a ‘disinterested person’ only
if he [or she] has no interest that is materially adverse to a
party in interest in the bankruptcy."). It is well-recognized
that the meaning of the phrase "interest materially adverse” in
the definition of a disinterested person overlaps with that of
"interest adverse" in the first prong of § 327(a) and together,
they form one hallmark with which to evaluate whether pro-
fessionals seeking court-approved retention (or to remain re-
tained by the estate) meet the absence of adversity
requirements embodied in the Bankruptcy Code. See Martin,
817 F.2d at 180: Hot Tin Roof, 205 B.R. at 1003; Granite,
219 BR. at 33: In re Leslie Fay Cos., 175 B.R. 525, 532
(Bankr. S.D.N.Y.1994); Envirodyne, 150 B.R. at 1017.

Warshaw Burstein does not deny that it must be disinterested
but takes issue with whether it must be so vis-a-vis the
debtor, since the latter is not named in the statute. See 1]
U.S.C. § 101(14)(E). Only if I determine that the debtor is
owed such a duty need I address the second question, which

45b

is whether Graham's bias constitutes a lack of disinterested-
ness under the second prong of § 327(a).

A. Must Warshaw Burstein Be Disinterested As To The
Debtor?

1. The Debtor As A Potential Equity Security Holder

Counsel's obligation to be disinterested runs to the parties in
interest. See Marvel, 140 F.3d at 476. In the typical case, the
debtor has no standing to be heard on many matters not in-
volving the discharge of debt because the outcome is irrele-
vant to the debtor when the estate will not generate a surplus.
However, cases discussing a chapter 7 debtor's right to be
heard when he or she retains an equity interest in the estate
hold that the debtor has standing to lodge an objection to a
claim against the estate or to participate in litigation sur-
rounding the asset that stands to produce the surplus. See 4 L.
King, COLLIER ON BANKRUPTCY, P502.02[2][c] at
502-14 (15th ed. rev. 1996) (debtor is a party in interest and
has standing to object to a claim where there could be a sur-
plus after all claims are paid); In re Manshul Construction
Corp., 223 B.R. 428, 430 (Bankr. S.D.N.Y. 1998); In re
McCorhill Publishing, Inc., 89 B.R. 393, 396 (Bankr.
S.D.N.Y. 1988) (in a liquidation under chapter 7, a debtor has
standing to object to claims where disallowance of the claims
would produce a surplus); In re Sobiech, 125 B.R. 110, 113
(Bankr. $.D.N.Y. 1991); In re Silverman, 10 B.R. 734, 735
(Bankr. S.D.N.Y. 1981), affd 37 B.R. 200 (S.D.N.Y. 1982).
In In re Gulph Woods Corporation, 116 B.R. 423 (Bankr.
E.D. Pa. 1990), the receiver for the plaintiff in an adversary

46b

proceeding commenced against the debtor sought to prevent
the debtor from participating in litigation regarding the sale
of property of the estate. The receiver argued that the only in-
terest the debtor could have would be a residuary one under §
726(a)(6), which is not an independent interest and therefore
unable to confer standing on the debtor to assert a claim
against the receiver. The court held that standing in bank-
ruptcy cases is unlike standing in other cases and that "a
debtor may participate in litigation if that litigation will gen-
erate or protect a surplus in the estate." Id. at 428. In inter-
preting Silverman, a case from this district which ultimately
denied the debtor's request for standing to object to a claim
against the estate because the court determined that no sur-
plus would be generated from the claim's disallowance, the
Gulph Woods court explained that "the [Silverman] court's
language clearly implied that, if the debtor could have shown
that there may have been a surplus for his estate, he would
have had standing, independent of trustee [sic], to object to
the claim in question." Id. at 428-29 (emphasis added).

Pursuant to § 726(a)(6), if all of Vebeliunas’ obligations are
satisfied, he will be entitled to any surplus proceeds generated
by the liquidation of the Lattingtown property.’ Thus, this
debtor should be considered a party in interest, see COL-
LIER, P502.02[2][c] at 502-14; McCorhill, 89 B.R. at 395
(debtor is a party in interest where he or she will retain a pe-
cuniary interest in the equity of the estate if all the creditors
can be paid in full); In re Hutchinson, 5 F.3d 750, 756 (4th
Cir. 1993) (party in interest is generally understood to include
all persons whose pecuniary interests are affected by the
bankruptcy proceedings); In re James Wilson Assoc., 965
F.2d 160, 169 (7th Cir. 1992) (everyone with a claim to the
res has a right to be heard before the res is disposed of since
that disposition will extinguish all such claims), the legal
consequence of which is that Graham ought be disinterested

Oe ee ae eee

47b

vis-a-vis Vebeliunas because he is, for all intents and pur-
poses, the potential class of equity security holders under | |
U.S.C. § 101(14)(E). There is no method of protecting Ve-
beliunas later while a non-disinterested professional is pres-
ently in charge of the investigation, should Vebeliunas prove
to be the class of equity holders. The only protection can be
given now. But the broader point, despite the statute's refer-
ence to equity security holders rather than debtors,’ is that the
trustee's professionals cannot be allowed under any circum-
stances to lack disinterestedness through bias against a debtor
given the responsibilities of the trustee in regard to a natural
debtor, specifically, to examine into and object to inappropri-
ate proofs of claim (which can inure to a debtor's benefit if
the claim is not dischargeable or if there may be a surplus); to
investigate into the debtor's financial affairs; if advisable, to
oppose the debtor's discharge; and, if there be a surplus, to
deliver it to the debtor. See 11 U.S.C. §§ 704(4), (5) and (6)
and 726(a)(6).

2. "Or For Any Other Reason"

Separate and apart from whether or not Vebeliunas can be
considered tantamount to an equity security holder under §
101(14)(E), there is a strong argument to be made that the "or
for any other reason" language at the end of that subsection is
intended, as noted by Collier, '° to permit "the court to find a
particular person lacking in disinterestedness for reasons
other than the non-exclusive statutory guidelines." Roberts,
46 B.R. at 828 n.26 (citing In re Philadelphia Athletic Club,
Inc., 20 B.R. 328, 333 (E.D. Pa. 1982) (quoting | COLLIER
BANKRUPTCY MANUAL § 101.13 (1981))). The oft-
quoted language '' that "professionals engaged in the conduct

48b

of a bankruptcy case should be free of the slightest personal
interest which might be reflected in their decisions concern-
ing matters of the debtor's estate or which might impair the
high degree of impartiality and detached judgment expected
of them during the course of administration," '’ lifted from
the COLLIER BANKRUPTCY MANUAL excerpt quoted in
Philadelphia Athletic Club and Roberts is the manual's con-
clusion of the function and effect of the "or for any other rea-
son" clause as it affects the meaning of disinterestedness.
COLLIER BANKRUPTCY MANUAL § 101.13. Under this
view, the definition of disinterestedness pursuant 11 U.S.C. §
101(14) is not exclusive and is an attempt, albeit not a very
clear one from the drafting perspective, to allow a court to re-
ject an attorney if it "deems a particular person's associations
to be prejudicial to disinterestedness ... even though those as-
sociations do not come within the purview of section
101(13)." Id. Although the Second Circuit has not passed on
this issue, other Circuits have implicitly endorsed this view
by quoting Roberts (and hence the COLLIER BANK-
RUPTCY MANUAL) when defining disinterestedness. See
Crivello, 134 F.3d at 835 (citing In re BH&P, Inc, 949 F.2d
1300, 1308 (3d Cir. 1991) (citing In re BH & P, Inc. 119 B.R.
35, 42 (D.N.J. 1990) (citing In re Glenn Electric Sales Corp.,
99 B.R. 596, 601 (D.N.J. 1988) (quoting Roberts, 46 B.R. at
828 n.26)))) (the catch-all clause is sufficiently broad to in-
clude any professional with an "interest or relationship that
would even faintly color the independence and impartial atti-
tude required by the Bankruptcy Code); Winship v. Cook (In
re Cook), 223 B.R. 782, 789 (B.A.P. 10th Cir. 1998) (quoting
BH&P, 949 F.2d at 1309 (quoting Roberts, 46 B.R. at 828
n.26))(same). Under this broad view, Graham is required to
be disinterested with respect to the debtor regardless of
whether or not Vebeliunas is a potential equity security
holder.

49b

B. Standards of Disinterestedness

Courts examine the goals and purposes of the disinterested-
ness requirement in order to understand the full contours of
that concept. To be disinterested is "to prevent even the ap-
pearance of a conflict irrespective of the integrity of the per-
son or firm under consideration." In re Codesco, 18 B.R. 997,
999 (Bankr. S.D.N.Y. 1982) (quoted in Martin, 817 F.2d at
181; Hot Tin Roof, 205 B.R. at 1003; In re Kendavis Indus-
tries International, Inc., 91 B.R. 742, 754 (Bankr. N.D. Tex.
1988)). Further, a disinterested person "should be divested of
any scintilla of personal interest which might be reflected in
his decision concerning estate matters." Codesco, 18 B.R. at
999 (quoted in Martin, 817 F.2d at 181; Hot Tin Roof, 205
B.R. at 1003; Kendavis, 91 B.R. at 754). The most modest in-
terest or relationship will undo a person's disinterestedness if
it "would even faintly color the independence and impartial
attitude required by the Code and Bankruptcy Rules.” Rob-
erts, 46 B.R. at 828 n. 26 (quoting Philadelphia Athletic
Club, 20 B.R. at 334 (quoting COLLIER BANKRUPTCY
MANUAL, § 101.13)); Granite, 219 B.R. at 33; COLLIER,
P327.04[3][a] at 327-30 (citing and cited in Envirodyne, 150
B.R. at 1017) ("Professional persons employed by the trustee
should be free of any conflicting interest which might in the
view of the trustee or the bankruptcy court affect the perform-
ance of their services or which might impair the high degree
of impartiality and detached judgment expected of them dur-
ing the administration of a case."). From this we see that what
is behind prohibiting the existence of a conflict of interest or
relationship is the desire to ensure the independence and im-
partiality of the professional to be retained.

50b

Any determination regarding Graham's disinterestedness
would not be complete without a!so taking into account the
fiduciary duties he has as counsel to the chapter 7 trustee. A
trustee in bankruptcy, see King v. United States, 379 US.
329, 337, 13 L. Ed. 2d 315, 85 S. Ct. 427 (1964); In re Lehal
Realty Associates, 101 F.3d 272, 276 (2d Cir. 1996) (a bank-
ruptcy trustee is an officer of the court that appoints him or
her); Marvel, 140 F.3d at 474, as well as his or her counsel,
are officers of the court. nl13 See Securities and Investor Pro-
tection Corporation vy. Charisma Securities Corporation, 506
F.2d 1191, 1193-1194 (2d Cir. 1974); Grant v. George Schu-
mann Battery and Tire Company, 908 F.2d 874, 884 (11th
Cir. 1990); Continental Illinois National Bank & Trust v.
Charles N. Wooten, Ltd. (In re Evangeline Refining Com-
pany), 890 F.2d 1312, 1323 (Sth Cir. 1989). "Where persons
perform duties in the administration of the bankruptcy estate,
they act ‘as officers of the court’ and not private persons.”
Evangeline Refining, 890 F.2d at 1323. "As such, trustees
and attorneys for trustees are held to high fiduciary standards
of conduct.” Id.; Marvel, 140 F.3d at 474; Philadelphia Ath-
letic Club, 20 B.R. at 333 ("the attorney for the trustee had to
exercise the same degree of disinterestedness as the trustee
himself"); Codesco, 18 B.R. at 999 ("trustee's selection of
counsel, however, must be consistent with high standards re-
quired of the officers of the federal courts"). These fiduciary
duties are owed not only to the entire creditor body but to the
debtor as well. See Germain v. The Connecticut National
Bank, 988 F.2d 1323, 1330 n.8 (2d Cir. 1993). So the trus-
tee's disinterested counsel must treat with the debtor in accor-
dance with the high standards of conduct expected from
fiduciaries in bankruptcy.

Moreover, as an attorney admitted to practice in the State of
New York, Graham is subject to the American Bar Associa-
tion's Code of Professional Responsibility, specifically

Sib

Canons 5 and 9, which require that a lawyer exercise inde-
pendent judgment on behalf of his client and that "a lawyer
should avoid even the appearance of impropriety." MODEL
CODE OF PROFESSIONAL RESPONSIBILITY, Canons 5
and 9 (1997). Without a dcubt, this case differs from the ar-
chetypical conflicts case which gives rise to consideration of
the Canons. Canon 5 applies by analogy, a situation which is
not so unfamiliar in the bankruptcy context because the Can-
ons of Professional Responsibility are not an exact fit in cases
involving potentially hundreds of parties and shifting alli-
ances. See Gerald K. Smith, "Standards for the Employment
of Professionals in Bankruptcy Cases: A Response to Profes-
sor Zywicki's 'Case for Retaining the Disinterestedness Re-
quirement for Debtor in Possession's Professionals," 18
MISS. C. L. REV. 327, 357-58 (Spring 1998). If we consider
Warshaw Burstein's client to be the trustee and the estate,
Canon 5 calls for the firm and, by extension, Graham to exer-
cise independent judgment when making decisions on their
behalf, a directive which sounds strikingly familiar to the
goals of disinterestedness just discussed. See Martin, 817
F.2d at 181; Hot Tin. Roof, 205 B.R. at 1003; Kendavis, 91
B.R. at 754; Codesco, 18 B.R. at 999 (a disinterested person
must be devoid of "any scintilla of personal interest which
might be reflected in his decision concerning estate matters");
COLLIER, P327.04[3][a] at 327-30.

Most courts acknowledge that to be disinterested also re-
quires an attorney to heed the admonition contained in Canon
9. See Martin, 817 F.2d at 180-81 ("Section 327 is intended
... to address the appearance of impropriety as much as its
substance, to remove the temptation and opportunity to do
less than duty demands."); Hot Tin Roof, 205 B.R. at 1003;
Granite, 219 B.R. at 34 (despite the fact that the Model Rules
of Professional Conduct have dropped the appearance of im-
propriety standard, § 327(a) nevertheless retains it) n14;

52b

Glenn Electric, 99 B.R. at 601 ("the bankruptcy rules in and
of themselves incorporate considerations which are the
equivalent of Canon 9's ‘appearance of impropriety’ stan-
dard"); Codesco, 18 B.R. at 999; but see Marvel, 140 F.3d at
477 ("We do not believe that BH&P’s discussion of §
101(14)(E)'s disinterest requirement, as applied to the dis-
qualification of a trustee, mandates a conclusion that apparent
conflicts alone allow a finding of disinterestedness."'’).

C. Cv unsel Is Not Disinterested

Just because there is no conflict of interest does not mean that
the disinterestedness standard has not been violated and that
there has not been a breach of the Canons of the Code of Pro-
fessional Responsibility. Where there is a conflict, the fear is
that counsel's attention and loyalty are divided by the dual
representation or that counsel is swayed by an economic or
personal interest so that one party is favored over another.
See generally Leslie Fay, 175 B.R. 525 (counsel investigating
financial irregularities of debtor in possession failed to dis-
close relationships with directors who were targets of investi-
gation, thereby calling into question validity of investigation
as a result of which counsel was sanctioned and removed
from all new matters in case). The bottom line concern is that
counsel's independent judgment should not be compromised
in any way. If the goal is disinterestedness, whether an attor-
ney holds a bias or instead suffers from the likelihood of
tainted judgment as a result of a conflict of interest, the
wrong is the same, for his or her ability to maintain independ-
ence of judgment will be negatively affected.

a ee ee

Ad nati ai ail Ry

a a alam er

Tench Sie AED ah! tm

53b

Another reason why this case is different from the more typi-
cal one is, for lack of a better term, the direction of the bias.
While the ratio decidendi of most cases dealing with conflicts
of interest centers on the actuality or eventuality that counsel
will favor or is favoring cne party over another, there is a flip
side to this coin. Where one party is actively or purposely fa-
vored, another party becomes disfavored. Thus, whether
counsel is disfavoring one party over another is equally sig-
nificant to a court's reasoning in determining whether or not
counsel is disinterested. The reason the latter construct is
probably less often discussed is because the natural course of
events assumes the former: that counsel develops a bent in fa-
vor of one party which disturbs the balance of impartiality
and causes another party necessarily to become slighted, al-
beit unintentionally. In other words, counsel may not have
started off with any bias against this second party.

Graham's attitude is impossible to reconcile with counsel's fi-
duciary duties to the debtor as well as his duty to avoid even
the appearance of impropriety and to exercise independent
judgment. Graham is not disinterested as to Vebeliunas as
Graham is required to be, either because Vebeliunas is poten-
tially akin to the class of equity security holders under §
101(14)(E) or because Graham fails the disinterest test pursu-
ant to a more expansive reading of the subsection's last
clause. His bias impairs "the high degree of impartiality and
detached judgment expected from [counsel to the trustee]"
during a case. COLLIER, P327.04[3][a] at 327-30; see supra
n.11. Without a doubt Graham has leapfrogged right over the
mere appearance of impropriety to land four-square on im-
propriety itself. This is not a situation where ethical concerns
are raised by circumstantial evidence. There is direct evi-
dence of actual bias and prejudice against the debtor. War-
shaw Burstein was retained to assist the trustee in performing
his duties, such as spearheading the investigation of the

54b

financial affairs of the debtor and advising the trustee to op-
pose the debtor's discharge, if advisable. See 11 U.S.C. § 704.
Graham has a fiduciary duty on behalf of the trustee, the es-
tate and the debtor to carry out these tasks impartially. This is
why he must be disinterested. In explaining why counsel for a
chapter 11 trustee needed to be disinterested, the court in
Philadelphia Athletic Club explained:

This, of course, ... (was) quite sensible, for it would be
anomalous indeed to require a trustee to be aloof from all
connection with the debtor or its management, yet permit the
trustee's attorney, who would necessarily be active in further-
ing the trustee's duties of investigation, management, prose-
cution, development of plans and the like, to have a close
relationship with the debtor, its management or associates.

Philadelphia Athletic Club, 20 B.R. at 333 (citing 6 L. King,
COLLIER ON BANKRUPTCY, P7.06 at 1203 (14th ed.
1978)). Obviously, in that case, the court was concerned that
the trustee's counsel's bias would cause him to favor the
debtor over the rest of the creditor body. The converse con-
cern is present in this case, but the same reasoning governs.
Given Graham's prejudice, it would be naive on my part to
expect Graham to be able now to conduct an impartial, un-
tainted and independent investigation of the debtor, particu-
larly since, in Graham's newest papers and aware of my
concerns, he nevertheless asserts that he has no duty to be im-
partial regarding the debtor and has enough information
without ever talking to the debtor to disbelieve him. See Gra-
ham Affidavit annexed to Warshaw Burstein Affidavit in Op-
position to Disqualification, P8.

D. Disinterestedness Aside, Counsel Should Be Removed

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At least one court has found: that disinterestedness need not
be the exclusive test when evaluating the propriety of an at-
lorney’s retention. nl6 In In re Kurtzman, 220 B.R. 538
(S.D.N.Y. 1998), the district court affirmed the bankruptcy
court's refusal to approve the retention of the chapter 7 trus-
tee's chosen counsel. The bankruptcy court had denied the re-
tention because it believed the Jaw firm to be irresponsible
with its billing practices and determined that it would not be
in the best interest of the estate for the trustee to retain this
particular firm. The district court affirmed, reasoning:

Indeed, section 327(a) vests the authority for
“approval” within the sound discretion of the
Court. That authority would be eviscerated
were the Court required to approve counsel
who met the technical test for disinterest but
was ill-suited for other reasons such as, for ex-
ample, inexperience.

Id. at 542. Recognizing that the Third Circuit's decision in
Marvel limited disqualification of an attorney on the basis of
conflicts of interest to situations involving actual or potential
conflicts, the district court remarked:

Marvel, however, did not bar considerations other than con-
flict of interest in a court's determination of whether to ap-
point an attorney as trustee's counsel under § 327(a). Thus.
while disinterestedness and the absence of conflicts may be
central to the inquiry, they are by no means exclusive.

56b

Id. Applying that rationale to this case, | believe Graham is
ill-suited to serve as the trustee's counsel because of his ex-
pressed prejudice against the debtor. Cf. Plaza Hotel, 111
B.R. at 891.92 (where debtor's counsel exhibited clear gender
bias against the chapter 11 trustee and the United States Trus-
tee and an unwillingness to work with them for that same rea-
son, debtor's counsel was disqualified for his unwillingness to
assist the debtor in performing its duty to cooperate with
them). In addition, if, indeed, the likely litigation surrounding
the Lattingtown property results in a judgment that it is prop-
erty of Vebeliunas’ estate, then there is a possibility that Ve-
beliunas will receive a distribution in his case. With this in
mind, Graham's bias takes on new proportions. His fiduciary
obligations to Vebeliunas not only with respect to the latter's
bankruptcy discharge but also with respect to his potential eq-
uity in the Lattingtown property may be compromised by
Graham's partiality and impaired judgment.

Without question, | am vested with the authority to disqualify
counsel where there is evidence of lack of disinterestedness
or an ethical violation justifying such a sanction. See Cheng
v. GAF Corp., 631 F.2d 1052, 1055 (2d Cir. 1980) (disquali-
fication is within the court's discretion); W.T. Grant Co. v.
Haines, 531 F.2d 671, 678 (2d Cir. 1976); Martin, 817 F.2d at
182 ("it is for the court to decide whether the attorney's pro-
posed interest carries with it a sufficient threat of material ad-
versity to warrant prophylactic action (say, disqualification or
disgorgement or invalidation of a lien)."); Leslie Fay, 175
B.R. at 538 (court has wide discretion in its selection of the
appropriate remedy). The Second Circuit, however, generally

57b

disfavors disqualification because it can have an immediate
adverse effect on the client by separating him or her from his
or her counsel of choice. n17 See Nyquist, 590 F.2d at 1246:
In re Wingspread Corp., 152 B.R. 861. 863 (Bankr. S.D.N-Y,
1993), On the other hand, an exception to that general rule
has been created where the attorney's conduct tends to taint
the underlying trial, see Nyquist, 590 F.2d at 1246: Wing-
spread, 152 B.R. at 863, with any doubts to be resolved in fa-
vor of disqualification, See Hull v. Celanese Corp., 513 F.2d
568, 571 (2d Cir, 1975); Wingspread, 152 B.R. at 863.

In this regard, "disqualification has been ordered only in es-
sentially two kinds of cases: (1) where an attorney's conflict
of interests in violation of Canons § and 9 of the Code of Pro-
fessional Responsibility undermines the Court's confidence in
the vigor of counsel's representation, or. more commonly, (2)
when the attorney is at least potentially in a situation to use
privileged information concerning the other side through
prior representation... " Nyquist, 590 F.2d at 1246 (citing
Fund of Funds, 567 F.2d at 232-33: Cinema 5, Ltd. v. Cin-
erama, Inc., 528 F.2d 1384 (2d Cir.1976): Emle Industries,
Inc. v. Patentex, Inc., 478 F.2d 562. 565 (2d Cir. 1973)). It
goes without saying that the inquiry is case-specific. See
Nyquist, 590 F.2d at 1246; Martin, 817 F.2d at 182 (the bank-
ruptcy judge is on the front line and in the best position to
view the situation and make the delicate judgment calls
which a disqualification decision entails).

However, while separating a client from his or her chosen
counsel will undoubtedly cause disruption, "where the choice
of counsel must be approved by the court as appropriate, such
that the integrity of the judicial process is implicated, the cost
and delay of replacing counsel with a conflict of interest may
be outweighed." Leslie Fay, 175 B.R. at 538 (citing Bohack
Corp. v. Gulf & Western Industries, Inc. (In re Bohack
Corp.), 607 F.2d 258, 263-64 (2d Cir. 1979)). This is

S8b

especially true in the bankruptcy context because "the disin-
terestedness requirement must be strictly enforced." Hot Tin
Roof, 205 B.R. at 1003; Consolidated Bancshares, 785 F.2d
at 1256 n.6 ("standards for the employment of professional
persons are strict, for Congress has determined that strict
standards are necessary in light of the unique nature of the
bankruptcy process"); Plaza Hotel, 111 BR. at 890; Philadel-
phia Athletic Club, 20 B.R, at 333 (tests of disinterestedness
to be rigidly applied); Codesco, 18 B.R. at 1000 (citing
Woods v. City National Bank & Trust Co,, 312 U.S. 262,
269, 85 L. Ed. 820, 61 S. Ct. 493 (1940) (citing Meinhard vy,
Salmon, 249 N.Y, 458, 464, 164 N.E. 545 (1928) (Cardozo,
J.))) (only strict adherence to these equitable principles can
keep the standard of conduct for fiduciarie

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40386018_1588%3A3. Public record. Not legal advice.