Getting off on the Right Foot: Bankruptcy Court Rejects U.S. Trustee’s Unconventional Position That Management Consultant Must be Retained Under Section 327 of the Bankruptcy Code

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In In re Nine West Holdings, Inc., the United States Bankruptcy Court for the Southern District of New York overruled the U.S. Trustee’s objection to the debtors’ application to retain Alvarez & Marsal North America, LLC (“A&M”) to provide the debtors an interim CEO and certain additional personnel pursuant to section 363(b) of the Bankruptcy Code1. The U.S. Trustee filed the only objection to the debtors’ retention application, arguing that A&M and the interim CEO were “professional persons” under section 327(a) of the Bankruptcy Code2 and must be retained pursuant to this section rather than section 363(b).

As we previously discussed here, it is not always easy to determine who constitutes a “professional” that must be retained in accordance with section 327(a). Because the Bankruptcy Code does not define the term “professional,” courts often apply a fact-driven analysis to determine which professionals fall within the scope of section 327(a). “Professionals,” as the term is used in section 327(a), must be formally retained by the debtor, subjecting the bankruptcy professional to various requirements under the Bankruptcy Code, including stringent disclosure requirements and requiring that the debtor obtain court approval before providing the bankruptcy professional with any postpetition payment for its services. An added obstacle to retention under section 327(a) is the requirement that the bankruptcy professional be “disinterested,” a term that is defined in section 101(14) of the Bankruptcy Code3. A bankruptcy professional is not disinterested if it has a claim against the debtor’s estate and, therefore, a debtor cannot hire a prepetition professional as a bankruptcy professional unless it kept current on its fees prepetition. A professional that falls outside the ambit of section 327(a), however, may be able to be retained, in certain circumstances, pursuant to (i) section 327(e) as an ordinary course professional for a “specified special purpose” or (ii) section 363(b), which permits the debtor to use estate property outside the ordinary course of business as long as the debtor’s actions are taken in good faith and in the best interests of the estate.

Background

A&M was hired by the debtors prepetition to provide vital management services to the company following an acquisition. A&M managed day-to-day operations of the business and supplemented traditional in-house functions. Initially, A&M placed Mr. Ralph Schipani as the interim Vice President of Operations and he was subsequently placed as the interim CEO of the company. During Mr. Schipani’s prepetition employment, he was appointed to several subsidiary boards, including the board of one Nine West affiliate that was also a chapter 11 debtor. Once the company filed for bankruptcy, A&M and Mr. Schipani continued their roles in managing the daily operations of the company and continued to provide the type of services they had provided to the company prepetition.

Analysis

In response to the U.S. Trustee’s objection, which argued that A&M must be retained under section 327(a) as a “professional person,” the court noted that the U.S. Trustee ignored the “mountain of precedent” contained in A&M’s reply. A&M’s reply included a list of 37 bankruptcy cases in which A&M was retained as a management consultant pursuant to section 363(b) of the Bankruptcy Code. In 36 of the cited cases where a debtor requested to employ advisors, consultants, and/or chief restructuring officers pursuant to section 363(b), the U.S. Trustee neither objected to such retentions nor argued that such retentions could only proceed under section 327(a).

The court stated that the U.S. Trustee’s position that section 363(b) cannot provide the basis for retention of management consultants lacks intellectual honesty and consistency, particularly in light of the Jay Alix Protocol (the “Protocol”) adopted by the U.S. Trustee 14 years ago. The court noted that the Protocol began as a settlement agreement executed in 2004 between the U.S. Trustee and a management consulting firm in a previous bankruptcy case. Since then, however, the Protocol has developed into a national policy adopted by the U.S. Trustee whereby the U.S. Trustee assents to the retention of management consultants by a debtor pursuant to section 363(b) as long as such firm complies with the following core requirements of the Protocol: (a) the firm sought to be retained must serve in only one capacity (i.e., as either a financial advisor, crisis manager, claims agent, or investor); (b) the firm’s retention application must be filed under section 363 of the Bankruptcy Code and the application must disclose the firm’s relationships with interested parties and make other disclosures showing the firm is otherwise disinterested; (c) the firm must file monthly staffing reports, which must be subject to court review; and (d) retention of persons furnished by the firm must be approved by and act under the direction of an independent board of directors.

The court noted that the Protocol’s “one hat” rule (which requires that the firm sought to be retained serve the debtor in only one capacity) is designed to avoid conflicts of interest between an advisor’s duty to a debtor and its own business interests where the advisory firm serves both as a financial advisor retained pursuant to section 327 and as a crisis manager with firm staff serving as officers of the debtor. Since the Protocol was published, the U.S. Trustee has not objected to section 363 retention of management consultants in hundreds of cases as long as the Protocol was followed. The court stated that the U.S. Trustee’s objection departed from its longstanding adherence to the Protocol and that the true origin of the objection was the debtors’ noncompliance with footnote three of the Protocol, which states that a financial advisor cannot seek to be retained in any capacity for an entity where any employee served as a director of the entity or an affiliate thereof within two years prior to the petition date. Although Mr. Schipani previously served as a director of one debtor entity within two years of the petition date, the court held that the purpose of the Protocol was not violated because Mr. Schipani never served on the parent boards responsible for approving the prepetition or postpetition retention or compensation of A&M. Moreover, Mr. Schipani’s board service involved “ministerial duties and approvals of transactions he had previously vetted in his role as an officer.” The court ultimately held that the circumstances surrounding the concerns that led to the development of the Protocol — avoiding undue influence by a director in the hiring of professionals — were not present in the case and that A&M complied with the core requirements of the Protocol in all material respects.

In reviewing A&M’s retention under section 363(b), the court held that such retention was necessary to preserve and maximize the value of the debtors’ business because abruptly removing A&M and Mr. Schipani from their roles would lead to an insurmountable disruption to the debtors’ operations. The court also held that A&M and Mr. Schipani were not “professional persons” under section 327(a) because their prepetition and postpetition roles were focused on running the debtors’ business rather than being solely focused on the debtors’ restructuring.

The takeaway: The tradition of reliance on section 363(b) for retention of management consultant firms is affirmed. The court made abundantly clear that the U.S. Trustee should continue walking in its predecessors’ shoes and refrain from objecting to a retention that is in the best interests of a debtor’s estate and compliant with law.

** Weil summer associate Ting Liu contributed to this post.