Judge Isgur Refuses to Apply Vicarious Disqualification

Judge Marvin Isgur of the Southern District of Texas has rejected application of a per se vicarious disqualification rule in a case involving Bracewell Giuliani. No. 07-32417, In re Cygnus Oil and Gas Corporation, (Bankr. S.D. Tex. 5/29/07). In the Cygnus case, a Bracewell partner owed 100,000 shares of the debtor and has served as a director for four months during the year prior to bankruptcy. Under the language of 11 U.S.C. §101(14), the individual partner was clearly not a disinterested person entitled to be employed. If the interested status of the partner was imputed to the firm, then the firm itself would not be disinterested and could not be employed.

Judge Isgur noted that the Delaware Bankruptcy Court had applied the per se rule of vicarious disqualification. In re Essential Therapeutics, Inc., 295 B.R. 203 (Bankr. D. Del. 2003). That court found that in the “current climate of distrust of officers and directors” the corporate leadership could be subjected to interrogation for their role making it “impossible” for a firm employing such an officer or director to adequately represent the debtor’s interests.

Going out on a limb, Judge Isgur pointed out that the Ninth Circuit BAP had rejected a per se approach to vicarious disqualification. In re S.S. Retail Stores Corp., 211 B.R. 699 (9th Cir. BAP 1997). Moving on to more solid ground, the court found that the statutory language did not support the pre se rule. Judge Isgur stated:

“Rules of statutory interpretation direct the Court to ‘presume that a legislature says in a statute what it means and means in a statute what it says there.’ (citation omitted). On examination of §101(14), this Court, in accordance with the majority of circuits addressing this issue, finds that no per se rule of disqualification exists under the Bankruptcy Code. ‘Person’ is defined in §101(41) as including an ‘individual, partnership, and corporation.’ (citation omitted). The Code is unambiguous. Section 101(14) by its plain language applies to any ‘person.’ ‘Person’ specifically refers to Bracewell. McBride is the equity holder and was the Cygnus director—not Bracewell. Had Congress intended to impute a single member’s disqualification to her entire firm, it would have done so. (citation omitted). Accordingly, the Court find that based on a plain reading of the statute, Bracewell is not disqualified . . . “

Memorandum Opinion at 5.

However, the Court did not stop at this conclusion. It went on to note that under §101(14)(C), a firm could be disqualified if it possessed “an interest materially adverse to the estate . . . by reason of a direct or indirect relationship to . . . the debtor.” The firm clearly had an indirect relationship to the debtor because of the interest of its partner. However, Bracewell established that (i) its partner no longer maintained a role with the debtor, (ii) that he owned 0.3% of the debtor’s stock, (iii) that he agreed not to vote his shares, (iv) that shareholders were unlikely to receive anything from the debtor’s estate and (v) and that the former director had been “walled off” from the reorganization team. The Court found that no evidence had been presented that the firm would have a materially adverse interest based on the fact that one of its many partners had served as a director for a brief period of time.

Judge Isgur should get credit for reading the statute the way Congress wrote it. Section 101(14)(A) and (B) absolutely exclude certain specified “persons” from the definition of “disinterested person,” while Section 101(14)(C) applies to both direct and indirect relationships. Thus, the per se rule applies to direct relationships, while the “materially adverse” standard applies to indirect relationships as well. Indirect relationships require a factual inquiry, while direct relationships invoke per se disqualification. This standard is sensitive enough to identify actual conflicts (for example, if a firm employing Jeffrey Skilling had applied to represent Enron), while weeding out technical ones (as in the Cygnus Oil case).

Bracewell also gets credit for making the proper disclosures. Unlike the John Gellene case (discussed in this blog last year), Bracewell was prompt to point out its “connections” with the debtor as required by Fed.R.Bankr.P. 2014. As a result, the court was able to examine the evidence and render a decision on the front end of the case. The Cygnus case certainly provides a powerful case for the benefits of making full disclosure up front.

While Cygnus Oil certainly upholds the canon of strict statutory construction, its benefits are more likely to flow to mega-firms than small ones. In a firm where one litigation partner out of many hundreds of overall partners had been a director of the debtor, it is easy to avoid finding a materially adverse interest. However, where one out of three lawyers in a firm had been intimately involved with the debtor, disqualification would be more difficult to avoid.

As a post-script, it is worth noting that the employment rules exclude firms which fail the disinterested test, but do not require the employment of the most qualified firms. The quality of the firm employed is governed by both the open market and the court’s ability to approve the fees requested. If a firm is disinterested but mediocre, it could be hoped that an efficient market place would not employ that firm or that the court would reduce the fees awarded to that firm causing the inefficient firm to withdraw from the marketplace.