How Many Connections are Too Many?  Bankruptcy Court Finds Multiple Attenuated Connections Not Enough to Warrant Disqualification of Debtors’ Professional

How Many Connections are Too Many?  Bankruptcy Court Finds Multiple Attenuated Connections Not Enough to Warrant Disqualification of Debtors’ Professional

Introduction 

            In a recent decision of the United States Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”) in the chapter 11 cases of Scandinavian Airlines (“SAS”),1 the Bankruptcy Court overruled an objection submitted by the Office of the United States Trustee arguing that SAS’s proposed co-investment banker, SEB, could not be retained due to (i) certain indirect connections and prior business relationships SEB has with SAS and (ii) potential claims SEB may hold against SAS’s estates.  Ultimately, the Bankruptcy Court held that none of the connections give rise to an interest materially adverse to SAS’s interests and that none of the alleged claims render SEB a creditor.  Accordingly, the Bankruptcy Court approved SEB’s retention.2

            The decision is a strong reminder that the disinterestedness standard in section 101(14) of title 11 of the United States Code (the “Bankruptcy Code”) focuses on whether there is a present material adverse interest and that “[i]nterests are not considered to be ‘materially adverse’ just because it is possible to imagine a set of remote and unlikely circumstances that might create issues.”3  To disqualify an estate professional from being retained, an objecting party must establish that the professional holds an interest adverse to the debtor that is actual rather than speculative and is material enough to give rise to a bias against the debtor or an economic interest that jeopardizes the professional’s loyalty.  

Background  

            SAS sought to retain SEB as its co-investment banker under section 327(a) of the Bankruptcy Code, which enables a debtor to employ “professional persons” to assist with carrying out its duties under the Bankruptcy Code if, among other things, the professionals are “disinterested persons.”  Section 101(14) of the Bankruptcy Code defines “disinterested person,” in relevant part, as a person that (i) “is not a creditor, an equity security holder, or an insider” of the debtor and (ii) “does not have an interest materially adverse to the interest of the [debtor’s] estate or of any class of creditors or equity security holders, by reason of any direct or indirect relationship to, connection with, or interest in, the debtor, or for any other reason.”  

            Prior to the chapter 11 cases, SEB provided SAS with both investment and commercial banking services.  Since 2000, SEB worked with SAS on the majority of its prior capital raises and advised SAS on six debt capital market transactions, three M&A transactions, and a previous out-of-court restructuring.  In addition, SEB was a lender under a prepetition NOK 1.5 billion (approximately $147,102,750) term loan facility with SAS (the “Term Loan”), served as one of SAS’s primary cash management banks holding over $400 million of its deposits, and provided credit card services to SAS through one of its subsidiaries resulting in a prepetition balance owed to the subsidiary.

Objection

            In its objection, the U.S. Trustee argued there were multiple bases to find that SEB was not disinterested.

             a. Material Adverse Interest

              First, the U.S. Trustee argued SEB holds an interest materially adverse to SAS because (i) the chairman of SEB’s board of directors (the “Chairman”) is also a director on the boards of several non-profit foundations (the “Foundations”) that collectively own, through an investment company (the “Investment Company”), approximately 3.4% of the stock of SAS’s parent company, SAS AB, (ii) the Chairman is also the chairman of the board of the Investment Company, (iii) a cousin of the Chairman sits on both the board of directors of the Investment Company and SAS AB’s nominating committee, and (iv) a senior advisor to the Foundations is also a member of SAS AB’s board of directors.  The U.S. Trustee alleged these connections, taken together, give rise to a material adverse interest because they could influence SEB to seek favorable treatment for SAS AB’s existing equity holders, including the Investment Company, in the chapter 11 cases.

            Second, the U.S. Trustee contended that SEB was the recipient of preferential payments in connection with the Term Loan.  Prior to SAS’s chapter 11 filing, SEB sold its principal position in the Term Loan to the guarantor thereunder.  The U.S. Trustee alleged this prepetition transfer allowed SEB to “improve” its position in the chapter 11 cases.4

            Third, the U.S. Trustee raised concerns with certain commercial banking services SEB provides to SAS.  As of the chapter 11 filing date, SAS had approximately $485 million deposited in bank accounts, many of which are maintained with SEB.  The U.S. Trustee alleged SEB’s investment banking services to SAS could be tainted if SEB were required to advise SAS as to whether its bank deposits should be moved to an alternate bank or whether certain changes should be made to its cash management system.  The U.S. Trustee also argued that SEB is a potential source of exit financing for SAS and that such financing would become unavailable if SEB were engaged.

            Fourth, the U.S. Trustee argued the sheer number of connections described above disqualified SEB from being retained as SAS’s investment banker. 

              b. Creditor

              The U.S. Trustee also argued that SEB should be disqualified because it is a creditor of SAS.  The U.S. Trustee alleged SEB’s creditor status arises out of (i) prepetition investment banking services, (ii) prepetition payments of cash management fees that could be unwound as preferences, (iii) prepetition credit card services, (iv) prepetition foreign exchange trades, and (v) prepetition guarantees issued by SEB and related indemnity agreements that require SAS to reimburse SEB for any payments SEB makes under the guarantees.

Decision

            After holding argument, the Bankruptcy Court found that SEB does not hold an interest materially adverse to SAS or any claim that renders it a creditor of SAS’s estates, and approved SEB’s retention application. 

              a. SEB Does Not Possess a Material Adverse Interest  

            First, the Bankruptcy Court found the connections between the Chairman, the Foundations, and SAS do not give rise to a material adverse interest because the Foundations’ indirect stock holdings in SAS AB are just a tiny fraction (less than 1%) of the Foundations’ total assets.  Moreover, the Chairman agreed to be walled off from any SEB board decision involving SAS and to recuse himself from voting on any issues pertaining to SAS in his capacity as a director of the Investment Company and another related company.  The Bankruptcy Court also required an ethical wall that prevents the Chairman from communicating with SEB’s investment banking team regarding the SAS engagement and any non-public information regarding SAS.  The Bankruptcy Court called the use of ethical walls “routine” to cleanse professionals of potential issues that may otherwise disqualify the professionals from being retained.5  Considering these circumstances, the Bankruptcy Court stated that “[i]t was only through strained speculation that a potential issue [could] even be posited” with respect to the Chairman.6

            Second, as to the Term Loan position sold by SEB to the guarantor, the Bankruptcy Court found that SEB did not improve its position because the loan was already guaranteed by the purchaser and no property of SAS was transferred to SEB on account of the Term Loan.  The Bankruptcy Court found there was nothing “suspicious” about the transaction and that it did not raise any conflict of interest.7  Furthermore, the Bankruptcy Court found there is nothing wrong with a professional selling a claim prepetition to avoid being a creditor and noted that courts have approved similar techniques in other cases.  See, e.g., In re 7677 E. Berry Ave. Assocs., L.P., 419 B.R. 833 (Bankr. D. Colo. 2009).

            Third, the Bankruptcy Court rejected the U.S. Trustee’s arguments relating to SEB’s commercial banking services.  The Bankruptcy Court remarked that it is not aware of any “theory under which the speculative loss of a potential future borrowing opportunity ([SAS’s] ability to approach SEB to participate in exit financing) ought to be considered as a presently disabling factor in SEB’s retention.”8  The Bankruptcy Court also opined that SEB’s role as an investment banker does not include providing advice as to the location or management of SAS’s bank accounts.  Accordingly, the Bankruptcy Court found that the U.S. Trustee’s concern of future conflicts related to the commercial banking services is speculative and does not give rise to a material adverse interest that requires denial of SEB’s retention.

            Fourth, the Bankruptcy Court rejected the argument that the sheer number of connections between SEB and SAS warrants disqualification of SEB.  Although multiple connections could give rise to a materially adverse interest, the Bankruptcy Court noted that it is still necessary to point to “specific issues that actually exist.”9  Therefore, in the absence of a materially adverse interest, the Bankruptcy Court refused to deny SEB’s application based on “speculation that some unknown issue might arise out of SEB’s past work.”10

              b. SEB Is Not a Creditor of SAS’s Estates

            The Bankruptcy Court also concluded SEB is not disinterested as a result of any alleged claims held by SEB against SAS.

            First, with respect to the prepetition investment banking services provided by SEB, the Bankruptcy Court noted that section 1107(b) of the Bankruptcy Code expressly provides that a professional’s prepetition work for a debtor does not disqualify the professional from being retained on a postpetition basis.  The Bankruptcy Court also found there is no evidence the payments for SEB’s prepetition services were improper in any way or subject to recovery as preferential transfers. 

            Second, with respect to the prepetition cash management fees, the Bankruptcy Court found that SEB likely has a right of offset, rendering the claims for the fees fully secured and, therefore, not subject to a preference attack.  See 11 U.S.C. §§ 506, 553.  In addition, the U.S. Trustee stipulated to the accuracy of a declaration that the fees were paid in the ordinary course of business.  Thus, the Bankruptcy Court found no reason to believe the prepetition payment of the cash management fees resulted in any voidable preference.

            Third, with respect to the small prepetition claim (less than $15,000) related to the credit card program, a subsidiary of SEB provided the credit card services and thereby holds the claim against SAS.  The Bankruptcy Court ruled this subsidiary’s claim does not create a material adverse interest to disqualify SEB. 

            Fourth, with respect to the prepetition foreign exchange trades, the Bankruptcy Court concluded that because those transactions closed in accordance with their terms and no issues were identified that would give rise to a potential claim, the trades do not warrant disqualification of SEB.

            Finally, with respect to the SEB-issued guarantees, the Bankruptcy Court noted that, notwithstanding SAS being current on the guaranteed obligations, SEB holds contingent claims against SAS that would render it a creditor.  However, after the Bankruptcy Court indicated an initial concern with these contingent claims, SEB agreed to waive any and all prepetition claims it has or may have for indemnification, reimbursement, or other similar amounts with respect to the guarantees, which resolved that portion of the U.S. Trustee’s objection.

Key Takeaways

            The Bankruptcy Code recognizes a debtor’s right to choose its own professionals.  Sometimes that right must give way to competing interests, for example, when a professional has an adverse interest that would prevent it from loyally discharging services to the debtor.  However, adverse interests must be material and legitimate, not speculative or hypothetical, to be disqualifying.  Bankruptcy courts will closely scrutinize allegations that a debtor’s choice of professional is not disinterested instead of relying on theoretical assertions of conflicts and other issues.  Notwithstanding the Bankruptcy Court’s decision, debtors and their professionals should continue to review any potential connections and interests carefully to ensure there are no disqualifying conflicts and provide any appropriate disclosures.

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Amer Mustafa

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