Every firm’s conflicts department should take note of Judge Laurie Selber Silverstein’s recent ruling denying Franchise Group’s (FRG) application to retain Willkie, Farr & Gallagher as lead counsel on the grounds that Willkie was conflicted. Even though Willkie took all the steps that firms typically take in similar situations – retaining conflicts counsel and implementing an ethical wall – Judge Silverstein, who presides in the US Bankruptcy Court for the District of Delaware, ruled that this simply wasn’t enough. She found that Willkie could not represent FRG because it suffered from conflicts of interest pertaining to matters that were so integral to the formulation of FRG’s Chapter 11 plan that they could not be dealt with by the retention of conflicts counsel or the implementation of an ethical wall.

In this article, the Debtwire legal analyst team provides an overview of Judge Silverstein’s ruling and what firms should look out for when potential conflicts are present, particularly when they are hoping to win a retention for a Chapter 11 debtor that has filed, or plans to file a bankruptcy petition, in Delaware.

Willkie’s relationship with FRG and its former CEO gave rise to conflict concerns 

As recited by Judge Silverstein in her ruling, Willkie served as FRG’s primary outside counsel since it was formed in August 2018 and advised the company on “substantially all” corporate transactional matters and financing transactions. However, when former CEO Brian Kahn took the company private in 2023, creating the company’s current holdco corporate structure, Willkie chose to represent Kahn, with the law firm Troutman Pepper Locke representing FRG.

Eight months after that transaction, Willkie represented Kahn again in connection with an SEC investigation and a federal indictment in which Kahn was named as an unindicted co-conspirator related to his work as an investment advisor for Prophecy Asset Management. Claiming that Kahn’s personal troubles contributed to its business troubles, FRG separated from Kahn in 2024. Separate teams of Willkie attorneys represented Kahn and FRG  in the separation negotiations.

In November 2023, after the take-private transaction was completed, Willkie established ethical walls separating Willkie employees who were working on Kahn matters from those working on FRG matters. Notwithstanding, there was overlapping staffing. In addition, Willkie at times represented some of FRG’s current shareholders.

During 2024, Willkie provided FRG with financial and strategic advice as well as advice on a potential bankruptcy filing. As part of the preparations for the filing, in October 2024, FRG hired the law firm Patrillo, Klein & Boxer to (i) conduct an independent investigation into potential claims of the debtors’ estates, including claims against Kahn and claims arising out of the take private transaction and (ii) analyze the propriety of estate releases.

FRG and its affiliates filed their bankruptcy petitions on 23 November 2024. Post-petition, the debtors appointed Michael Wartell as independent director to the boards of directors of debtors Freedom VCM Interco Inc and Freedom VCM Inc, authorizing him to investigate claims that these holdco debtors may have against the opco debtors, among other things.

FRG’s third amended Chapter 11 plan, the most recent plan iteration filed before Judge Silverstein issued her decision, provided for either a sale of the debtors’ operating assets or an equitization transaction that would hand the new equity to the debtors’ first lien lenders. Under the plan, the estates’ claims against Kahn were to be transferred to a litigation trust, with a trustee to be chosen by the debtors and debtor-in-possession lenders. According to Judge Silverstein, Willkie drafted the various iterations of the plan, and there was “no evidence” that either the Patrillo firm or Akin Gump Strauss Hauer & Feld, hired as counsel by Wartell, had drafted any part of the plan or advised the debtors on the claims that the estates had against Kahn or in connection with the take private transaction.

When FRG filed motions to retain Willkie as its bankruptcy counsel, several parties objected, including an ad hoc group of holdco lenders (Freedom Lenders), a liquidating trust that held both equity in one of the debtors and claims against the debtors related to Kahn’s dealings with Prophecy, and the US Trustee. The objectors argued, among other things, that Willkie’s prior representations of Kahn precluded the firm from serving as bankruptcy counsel.

Willkie’s conflict linked to central elements of the Chapter 11 plan

In deciding whether Willkie could be retained as FRG’s counsel, Judge Silverstein made clear that the applicable standard was to be found in Bankruptcy Code section 327(a), which provides that a debtor may employ attorneys or other professional persons “that do not hold or represent an interest adverse to the estate, and that are disinterested persons.” Judge Silverstein further noted that where there is an “actual,” conflict of interest, as opposed to a potential conflict or the “mere appearance” of one, then such conflict is “automatically disqualifying.”

Judge Silverstein framed the issue before her as whether Willkie’s prepetition representation of Kahn and his affiliated entities, both generally and in the take-private transaction, precluded the firm’s retention under section 327(a). More specifically, she said that the issue was whether Willkie’s inability to advise the debtors on any issues related to Kahn was “so central to the case that Willkie cannot actually do its job.” Alternatively, she said that the question was whether Willkie’s representation of Kahn permitted the firm to “fairly and fully advise” the debtors in negotiating and drafting the plan of reorganization.

The answer to that last question, according to Judge Silverstein, was a firm “no.”

At the outset, the judge categorically rejected Willkie’s argument that the claims against Kahn were not “central to the bankruptcy cases.” She noted that litigation claims were one of two potential sources of recovery for creditors under the plan – the other being the sale of its operations – and that both were tied to one another by the plan of reorganization. She also noted that the Freedom Lenders had argued that the only source of recovery under the plan for holdco creditors and opco general unsecured creditors were the litigation claims. She further found that the take-private transaction in which Willkie had represented Kahn was central to the bankruptcy cases because it created the organizational and capital structure addressed by the plan. And because the debtors’ viewed Kahn as “synonymous” with FRG, his prepetition conduct was also central to the bankruptcy cases, she concluded.

Having found that the objects of Willkie’s conflicted dual representation were central to the bankruptcy cases and plan, Judge Silverstein next found that Willkie’s conflicts prevented the firm from representing the debtor on those central issues. She explained that the debtors had “misapprehen[ded]” the continuing role in the plan process of debtors’ counsel, who needed to be able to advise FRG and negotiate and draft changes with respect to “all aspects of a plan.” However, Willkie, due to its prior representations of Kahn, could not draft the portions of the plan related to the estates’ claims against him or the holdco trust that would hold those causes of action. While the drafting of such an agreement could be viewed as “ministerial,” that was not the case here, where the selection of the trustee was being contested, the judge found.

Plan amendments, conflicts counsel, and ethical walls were collectively insufficient to relieve Willkie of its conflict

As noted above, Judge Silverstein’s opinion is notable in part because she rejected outright many of the measures that law firms use to protect themselves from conflict-of-interest accusations. First, she rejected as a “non-starter” the debtors’ argument that amendments to the plan placing all claims against Kahn in a litigation trust and eliminating the release of Willkie had “nullified” any conflicts. Willkie argued that after these changes, there was at best only the potential appearance of a conflict. However, Judge Silverstein found that the record was “directly to the contrary,” as shown by the company’s determination to hire the Patrillo firm to investigate the debtors’ historical transactions, including the take-private transaction, and its relationship with Kahn. The plan amendments did nothing to change the debtors’ own “fundamental initial determination” that the claims against Kahn were significant and needed to be investigated by independent counsel. She also noted with concern that the investigation had ended without any disclosure of results and that she had no evidence of who had advised the board with respect those matters.

Second, Judge Silverstein ruled that retention of conflicts counsel failed to save Willkie’s proposed retention. First, she found that “[t]o the extent that conflicts counsel may have been a solution in these bankruptcy cases, conflicts counsel was not utilized at a point in time where it might have alleviated any concerns.” She noted that the was no evidence that Patrillo or Akin Gump had advised on, negotiated, or drafted the portions of the plan from which Willkie was conflicted.

More fundamentally, Judge Silverstein cited approvingly the Chapter 11 case of Enviva Inc, where Vinson & Elkins was disqualified because it had also represented an investment group that held 43% of debtor’s common stock and stood to retain equity under the plan. Enviva had offered to delegate the negotiations of the sections of the plan from which it was conflicted to conflicts counsel. However, the US Bankruptcy Court for the Eastern District of Virgina, where the case was filed, rejected this, finding that conflicts counsel “cannot be used as a substitute for general bankruptcy counsel’s duties to negotiate a plan of reorganization.” Judge Silverstein said that she agreed with the Enviva decision “for the general proposition that conflicts can be disqualifying when they go to central elements of a case or plan.”

Third, Judge Silverstein rejected Willkie’s argument that its prepetition institution of ethical walls to separate firm attorneys working on FRG and Kahn matters had eliminated the conflicts of interest. The debtors had argued that Willkie’s institution of those walls put them in compliance with the Model Rule of Professional Conduct 1.9, which provides that “[a] lawyer who has formerly represented a client in a matter shall not thereafter represent another person in the same or a substantially related matter in which that person’s interests are materially adverse to the interests of the former client unless the former client gives informed consent, confirmed in writing.”

Judge Silverstein disagreed, stating that the Model Rules and the Bankruptcy Code “impose independent obligations” and that the imposition of ethical remedies under those rules are “not necessarily sufficient to cure section 327 defects.” This is because bankruptcy professionals are “held to a stricter fiduciary standard,” according to Judge Silverstein.

Moreover, the ethical walls implemented by Willkie also failed for two reasons. First, they were imposed too late, only after the take-private transaction was completed. To Judge Silverstein, this meant that any knowledge that Willkie acquired from representing Kahn in that transaction already was imputed to the law firm at large. Second, even if Willkie had timely imposed the ethical walls prepetition, “[c]ompliance with state bar rules do not equate to disinterestedness” under section 327(a). In fact, Judge Silverstein made clear that a waiver of a conflict was “simply not relevant to a section 327(a) analysis.” Thus, the fact that Kahn did not oppose the retention was “irrelevant.”

In her ruling, Judge Silverstein acknowledged as “legitimate” the debtors’ concerns that denying the retention application and the resultant loss of counsel knowledgeable about the case and the debtors’ operations could set the case back and cause the debtors to miss court-ordered milestones and potentially even default under the restructuring support agreement. However, none of those concerns outweighed the actual conflict because, she explained, allowing such concerns to override an actual conflict would render a bankruptcy court “rarely, if ever,” able to deny a retention application.

Lessons learned – the big picture

When considering what Willkie could have done differently to save its prospective bankruptcy retention, the answer, unfortunately, is “not much.” Judge Silverstein found that there was simply no way to rectify the fact that Willkie (i) suffered from actual conflicts of interest that were “central” to the representation of FRG in its bankruptcy cases, and (ii) did not and could not employ, effectively, the typical measures that firms take to eliminate conflicts.

Going forward, at least in Delaware, a firm would be wise to ask whether its prior representations create an actual conflict of interest on issues that are central to a bankruptcy case or plan – such as creditor recoveries. If so, attempts to “neutralize” those conflicts through plan amendments, the hiring of conflicts counsel, and even compliance with the Model Rules of Professional Conduct through the imposition of ethical walls likely would not suffice under the reasoning of Judge Silverstein’s decision.

Moreover, even obtaining a waiver of the conflict would be ineffective in Judge Silverstein’s courtroom because such consent would be “irrelevant” to the section 327(a) adverse interest and disinterestedness analysis. This makes sense in a Chapter 11 scenario. As Judge Silverstein explained that it is “challenging” to apply the conflict rules in a multiparty, as opposed to two-party, dispute. In a dispute in a bankruptcy case, even if Kahn did not object, he would not be the only party affected because in Chapter 11 cases in general, third-party creditors are at risk of harm arising from conflicts, and therefore a waiver by one party would not remove the potential for general harm to all creditors.

Thus, given the centrality of Willkie’s prepetition representations of Kahn to the issues addressed by the plan of reorganization – and given Judge Silverstein’s ruling that typical remedial measures would be ineffective in eliminating those conflicts – it doesn’t appear that there was much that Willkie could have done to save its representation by the time that it sought its retention. Indeed, it appears that the best way for Willkie to have preserved its ability to represent FRG in a future bankruptcy case would have been for it to decline the representation of Kahn in the take-private transaction or any other matters that would implicate issues central to FRG’s bankruptcy cases, including the formulation of a Chapter 11 plan.

Notwithstanding, Judge Silverstein’s opinion does leave open one door for counsel in Willkie’s situation. Although the issue wasn’t before her, Judge Silverstein said that Willkie’s historical knowledge of the debtors’ operations had “positioned it well” to act as corporate counsel under Bankruptcy Code section 327(e). That statute permits a debtor to employ counsel “for a special purpose, other than to represent the trustee in conducting the case,” provided it doesn’t hold an adverse interest with respect to the matter on which it is employed. Such counsel’s work, however, could not be duplicative of work performed by a debtor’s lead bankruptcy counsel.

Ultimately, while Judge Silverstein’s opinion is not binding on other courts in other jurisdictions, or even on other judges within the Delaware Bankruptcy Court, it still serves as a warning to counsel to think carefully before engaging in dual representations for a company that may possibly end up in Chapter 11. For law firms seeking to preserve a relationship with a company in anticipation of a potential bankruptcy filing, it appears that the more prudent course of action may be to forego more immediate and potentially disqualifying dual representations.

FRG is now working with the law firm of Kirkland & Ellis in its Chapter 11 cases although has not yet filed a retention application.

Paul Gunther is a former practicing restructuring and litigation attorney. Prior to joining Debtwire as a Legal Analyst, Paul practiced in the New York offices of Dentons US LLP, Salans LLP and Mayer Brown LLP. He has represented various constituencies in high-profile restructurings.

Any opinion, analysis or information provided in this article is not intended, nor should be construed, as legal advice, including, but not limited to, investment advice as defined by the Investment Company Act of 1940. Debtwire does not provide any legal advice and subscribers should consult with their own legal counsel for matters requiring legal advice.