Bay Street Lawyers Beware: U.S. Court Finds Conflict of Interest Representing Debtor and One of Its Major Shareholders in Bankruptcy Proceedings

This decision serves as a caution to law firms to carefully consider conflicts of interest where they represent the interests of both debtor entities and shareholders, whether private equity sponsors or otherwise.

The Court noted that in restructuring proceedings, Debtor’s counsel must be able to fairly and fully give advice in negotiating and drafting a restructuring plan of reorganization.^[2] Here, the Court found that there was a conflict of interest which affected the Firm’s ability to advise the Debtor based, in part, on the substantial amount of legal work the Firm did for the Client.^[3] The Court also decided that the retention of conflicts counsel can be useful for a discrete portion of a case, such as the prosecution of preference or fraudulent transfer claims, but it cannot be used as a substitute for general bankruptcy counsel’s duties to independently negotiate a plan of reorganization.^[4]

In the Canadian context, in some cases, an ethical wall (which would prohibit lawyers from accessing non-public materials and discussing the case with colleagues who represent the adverse party) could be employed to manage legal conflicts of interest and allow a law firm to represent multiple, potentially adverse parties in an insolvency matter. However, the Court noted that an ethical wall was impossible to erect in this case as attorneys at the Firm were identified as working on both the Client and the Debtor’s behalf.^[5] Further, as the Court found a conflict based on the substantial amount of legal work the Firm did for the Client, it is not clear whether an ethical wall, established at the Firm between entirely different teams of lawyers, would have properly managed the identified conflict.

The Court refused to provide any threshold under which a law firm would be considered “disinterested” (which the Court noted is a statutory requirement to represent the Debtor).^[6] Here, the Court found that the Firm could not be disinterested and could not represent the Debtor in the insolvency proceedings as: (a) the Client owned 43% of the Debtor’s equity; (b) the Client had the right to appoint (and had appointed) two of the Debtor’s 13 directors; (c) the Client was a multimillion-dollar-a-year client of the Firm; and (d) no ethical walls were, or could have been, constructed in this case.^[7]

Unlike in certain U.S. bankruptcy proceedings, Canadian law firms are not required to seek court approval before being retained by a Debtor entity. In Canada, there is an obligation under applicable law society (or the equivalent) rules and other professional obligations to consider potential conflicts before agreeing to take on a mandate, and to refrain from acting in situations of conflict, which can later be challenged. Firms that represent both large shareholders, including institutional private equity clients, and a debtor company should carefully consider the relationships they have with each client and consider whether those relationships may have an impact on the firm’s ability to impartially negotiate a restructuring plan for both of their clients simultaneously.

While the opinion does not have direct precedential value in Canada, it should serve as a warning to Canadian law firms to carefully consider whether there is a conflict between the interests of their corporate client and the equity holders of that corporate client who are also clients of the firm. In part, this analysis should likely consider the percentage ownership of the shareholder client of the corporate client and the extent to which either such client might impact the firm’s revenue in considering whether there is a substantial risk that a firm’s representation of one of these clients would materially and adversely affect its representation of the other.^[8] Further consideration should also be given as to whether an ethical wall could protect the interests of both clients and permit the Canadian law firm to act on insolvency cases for both corporate clients and their shareholder clients.

If you require legal counsel regarding insolvency proceedings, including in situations where counsel is conflicted or to consider whether a conflict exists, please contact the authors or a member of our Financial Services Group.

[1] In re Enviva Inc, et al, Case No. 24-10453-BFK.