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Sorry Counsel, You Signed It: Ethics, Rule 9011, and Inadequate Filings

I. Standards for Imposing Sanctions.

Bankruptcy Rule 9011 requires an attorney for a represented party to sign every paper filed in a bankruptcy case "except a list, schedule, or statement, or amendments thereto." Bankruptcy Rule 9011(a). The exception has led some courts to question whether the rule applies to a debtor's counsel when misrepresentations are made in the debtor's schedules and statement of affairs. But subpart (b) of Rule 9011, as amended in 1997, provides for sanctions not only with respect to documents signed by an attorney, but also documents he "presents" by "filing" or "later advocating." Bankruptcy Rule 9011(b). Courts have relied on this language to hold counsel accountable for inaccuracies and misstatements in schedules.

The pending Bankruptcy Reform Act and its predecessors over the past few years have included a "sense of Congress" that Rule 9011 should be amended to require all documents, including schedules, to be submitted only after the debtor or debtor's attorney has made a reasonable inquiry to verify the information. That proposed legislation implies that Rule 9011 does not currently empower the court to sanction the debtor's counsel for misleading schedules. To the extent Rule 9011 is inapplicable, however, some courts have employed their "catch all" powers under Bankruptcy Code § 105 and inherent authority of the court to sanction misconduct, including with respect to bankruptcy schedules.

The standards for imposition of sanctions are different under Bankruptcy Rule 9011 and under Code § 105. Rule 9011 provides that all documents within its scope require the lawyer's certification of proper purpose, warranted by law or a non-frivolous argument for extension or reversal of the law, and evidentiary factual support. Bankruptcy Rule 9011(b). Sanctions accordingly require only a showing of objectively unreasonable conduct, or alternatively, a subjective determination of an improper purpose.

In contrast, sanctions may be imposed under the inherent power of the court and Code § 105 only upon a finding of "bad faith." This concept "contemplates a state of mind affirmatively operating with furtive design or ill will," or a "defiling of the very temple of justice."

There are other sources for sanctions authority as well. Bankruptcy Rule 7037 sanctions failure to cooperate in discovery, and Bankruptcy Rule 7016 sanctions failure to comply with court scheduling and pretrial orders or cooperate in discovery and pretrial practice. 28 U.S.C. § 1927 also prohibits unreasonable and vexatious litigation. Incompetent representation, not complying with the Bankruptcy Code and Rules, may also be sanctioned through denial of court approval of employment. Obnoxious and abusive behavior toward opposing counsel, parties or the judge may likewise be sanctioned under Rule 9011 and the court's inherent authority. The federal bankruptcy court must apply federal sanctions laws, however, not state counterparts.

II. Ethical Obligations of Counsel for a Debtor Filing Documents.

Ethics rules are in accord with Rule 9011. Ethically and legally, counsel can only advise the debtor, who makes the decisions. But counsel exerts some or even considerable influence on bankruptcy strategy. Counsel can and should develop "client control" through advising the client on the parameters of available alternatives and remedies, and not allowing a client to dictate activity in a case inconsistent with legal requirements. Lawyers can and must take care to assure that representations to the court are accurate.

Vigorous advocacy is ethical and appropriate in bankruptcy as in other cases, as long as it meets Rule 11 standards with a good faith basis for the facts and law asserted on positions taken for reasons other than harassment or delay. In Chapter 11 cases, good faith turns in part on whether reorganization is still possible. Thus, acquiescing in and carrying out a client's "scorched earth" strategy or otherwise assisting insiders in actions detrimental to the estate and creditors, if it is shown that counsel knows reorganization is hopeless, likely would not meet the good faith standards of ethics and Bankruptcy Rule 9011. Pursuing a plan that benefits insiders, at the considerable expense of the arms-length creditors, may also exceed the boundaries of good faith in some circumstances, and be considered DIP self-dealing. Acquiescing in DIP management self-dealing, without any attempt at counseling and without full disclosure to the court and creditors of insider involvement in (and benefit from) transactions, is a breach of DIP counsel's duties. Advocating a sale agreement with a "no shop" clause instead of seeking or entertaining other offers to maximize the estate's value, especially if the clause is not disclosed, violates fiduciary duties.

A thorough analysis of the legal theories underpinning -- and delimiting -- the fiduciary duties of DIP counsel is found in Hansen, Jones & Leta, P.C. v. Segal. The court explains that DIP counsel's client is the DIP, not the "estate," and identifies the duties counsel owes to the DIP and to the court. The court further explains why DIP counsel does not owe duties to the DIP client's beneficiaries, the equity holders and creditors who have conflicting interests. The court holds that estate interests are protected when the court focuses on whether DIP counsel breached counsel's fiduciary duty to the client DIP, violated Code obligations or failed to provide services that benefit the estate (instead of insiders). The rights and powers vested in creditors and other parties in interest provide further protection. Another excellent analysis of DIP and DIP counsel fiduciary duties is set forth in In re Water's Edge Ltd. Partnership.

III. Sanctionable Filings in Bankruptcy Cases

A. Serial Cases

Courts all over the country have found multiple filings to frustrate secured creditor foreclosure efforts to be sanctionable by orders prohibiting additional filings by the same debtor or a related debtor holding the collateral. Bankruptcy Code § 349(a) authorized the court to dismiss a bankruptcy case with prejudice, and Code § 109(g) prohibits individual and family farmer repeat filings within 180 days of a case dismissal for either willful failure to abide by court orders, or a voluntary dismissal after a stay relief request. Code § 109(g) underscores Congress' distaste for bad faith serial filings, and the public policy in favor of sanctions for such abuses. It does not preclude comparable or more severe relief for debtors falling outside its express provisions. The Code's broad grant of equitable power in § 105 has also been cited as authority for such prohibitions on re-filing of bankruptcy cases.

Not every serial filing is wrongful. The United States Supreme Court has held a serial filing of chapter 7 and chapter 13 cases is not categorically foreclosed. The test for a bad faith filing is "whether a debtor is attempting to unreasonably deter and harass creditors or attempting to effect a speedy, efficient reorganization on a feasible basis."

It is incumbent on bankruptcy counsel to know the law on bad faith serial filings. Counsel may be sanctioned along with her client when the bankruptcy case is found to be a bad faith serial filing. A lawyer is not excused by purportedly not knowing this aspect of bankruptcy law. The lawyer must "closely inquire and determine the true intent and honesty of purpose of the debtor's new petition and financial capacity to consummate a plan and overcome the prior reasons for termination of the stay and/or dismissal". Counsel should undertake the easy task of checking for previous bankruptcies via Pacer, instead of simply accepting the client's representations of no previous filings.

B. Otherwise Legally Unsupportable Cases

Serial cases are not the only ones that may be filed in bad faith. First-time filers, too, may proceed solely to delay a creditor with no realistic possibility of reorganizing a debtor under Chapter 11, or file merely to resolve a two-party dispute. Section 707(b) of the Code specifically authorizes the court to dismiss petitions by consumer debtors that are considered a "substantial abuse" of Code provisions. Counsel are ethically obliged not to file such petitions, and may be sanctioned for doing so.

  • The Debtor Cannot Reorganize. A chapter 11 case may be filed by a corporation whose charter has been revoked. Under state law, the corporation continues as a "body corporate" only for the limited purpose of winding up its affairs. A revoked corporation may be a debtor, but it is only eligible for liquidation. The Prism court analyzed the various decisions addressing bankruptcies of corporations with revoked charters and the relevant state statutes on rights of dissolved entities. It concluded that "[t]he Bankruptcy Court is not empowered to continue a corporation's existence through reorganization as a going concern when state law dictates that it no longer exists. . . State law provides, however, that after revocation a corporation may continue to act to preserve and pursue assets and claims and settle liabilities, and accordingly the Debtor may liquidate under the Bankruptcy Code, either via a liquidating Chapter 11 plan or under Chapter 7." The debtor also may be unable to reorganize as a practical matter, having no employees or operations or likelihood of rehabilitation. Sanctions may be imposed under Rule 9011 on counsel filing a chapter 13 case when the chapter 13 debtor is ineligible to proceed with his or her plan. The integrity of the chapter 13 system rests in the first instance with the debtors' bar, and courts expect them to make responsible judgments about eligibility of debtors before filing chapter 13 petitions, in compliance with Rule 9011. The fact that a chapter 13 debtor is unable to confirm a plan does not necessarily mean the case was filed or pursued in bad faith, however, especially if the debtor otherwise complies with all Code requirements.
  • Case Filed for Improper Purpose. A chapter 7 case may have no reasonable basis to proceed, just like a reorganization. The estate may have no assets to protect, or no need to discharge debts, and be filed merely to serve a non-economic motive, generally delaying a creditor. A bankruptcy case may be filed simply to forum-shop when undesirable results are reached in state court. Or a "new debtor" entity may be created in to file a bad faith case.
  • Solvent Estate. When an estate is solvent, DIP fiduciary duties may preclude a bankruptcy filing at all. Insolvency and inability to pay debts are not prerequisites for bankruptcy relief under the Code. However, bankruptcy cannot be a mere tactical device for litigation leverage. If a solvent debtor is not suffering any adverse financial or operational effects, a bankruptcy petition may be deemed filed in bad faith, under chapter 11 or 7. Even if the filing is proper, a solvent DIP may not use avoidance powers to obtain a windfall for the equity holders at the expense of the non-insider creditors.

C. Inadequate Schedules

In addition to Bankruptcy Rule 9011 requirements, counsel is obligated both ethically and as an officer of the court not to file schedules and other disclosure documents he believes inaccurate. Thus, courts have cautioned that before filing a petition, schedules, etc., it is incumbent upon counsel to "take all possible steps to assure himself that the information listed in his client's petition is correct . . . inquire as to amounts owed [secured by any assets] and to explain the requirements of full disclosure . . . ." This means that a lawyer cannot simply accept his client's statement that he does not know the value of an asset, but must ask follow-up questions. Concepts such as "market value" entail legal judgments and the advice of experienced counsel. Counsel must explain the matter to the extent necessary to permit the debtor client to make informed decisions about the information set forth in the schedules.

Even if a lawyer is negligent in initially omitting an asset from schedules, he may be sanctioned if he has subsequent opportunities to review and correct them. The obligation to correct errors in filed documents is a continuing duty. A supervising attorney has a specific obligation to correct an assistant's failures, especially since a material error can support a conviction for bankruptcy fraud. It is also critical that counsel not participate in deliberately scheduling assets for less than their known market value, or omitting creditors and claims.

The duty to disclose assets on schedules includes disclosure of all potential causes of action. That includes causes of action against the debtor's principals for negligence, mismanagement, and breach of fiduciary duty, when such a suit would be beneficial for the estate (albeit not the debtor's insiders). Failure to disclose potential fraudulent transfer claims against insiders may be deemed a fraud on the court.

While counsel has an obligation to encourage disclosure, the creditors should not have to pay more for an incompetent or deceptive debtor who thwarts disclosure, through shouldering increased counsel fees. Courts have suggested guidelines for counsel working with debtors on disclosure to resolve this tension:

  1. Explain the requirement of full, complete, accurate and honest disclosure of all information required of the debtor;
  2. Ask probing and pertinent questions designed to elicit full, complete, accurate and honest disclosure from the debtor;
  3. Check the debtor's responses in the petition, statements and schedules to be sure they are internally and externally consistent, and follow up if they are not; check readily available Pacer information for previous bankruptcies;
  4. Demand of the client full, complete, accurate and honest disclosure of all information required by the debtor prior to the attorney's signature being placed upon the document, or before filing the client-signed document;
  5. Seek relief from the court of the client representation in the event that the attorney learns he has been misled by the client.

The debtor's counsel should also take heed of objections and motions by creditors, which may disclose serious problems and concerns with the DIP's operations and representations to counsel.

D. Compensation and Conflict Disclosures

There are far too many cases in which counsel have claimed to be disinterested when seeking court approval of employment as DIP counsel, without disclosing the ties of firm members to the debtor, its management, or the creditors. It is not for the DIP or its counsel to determine unilaterally whether a connection is relevant; the court is to review all connections and decide whether there are any disqualifying conflicts. Disclosures must be sufficiently detailed to enable the court to understand the magnitude of the connections and potential conflicts, and must be strictly accurate. An employment application with full disclosure must be made for each professional firm employed; undisclosed subcontracting is impermissible. Disclosure through the schedules and statement of affairs, an exhibit to the petition, testimony at the first meeting of creditors, or monthly operating report entries is inadequate. The court has no duty to search the file and ferret out information on conflicts.

Disclosure is an ongoing responsibility. If potential conflicts arise after the initial application and disclosure, they should be brought to the court's attention promptly.

Full disclosure of all aspects of fee arrangements is also required. Even if an attorney limits her representation to prepetition advice or even petition preparation alone, a Rule 2016 statement must be filed. The absence of full disclosure of fee payment arrangements in a chapter 13 case means the client's plan disclosures are likewise erroneous, impairing the client and creating a conflict. Complete disclosure of prepetition payments "in connection with" and "in contemplation of" bankruptcy must be disclosed, in addition to disclosure of retainer arrangements.

Rule 9011 applies to employment applications and affidavits. Thus, attorneys are obliged to inquire into and analyze the factual and legal elements of every document signed and filed. A half-hearted inquiry into conflicts among firm members is inadequate. It is counsel's responsibility to ensure complete disclosure. Special counsel cannot simply rely on the DIP's primary bankruptcy counsel to handle necessary filings. Committee counsel may be sanctioned like debtor's counsel for inadequate disclosures. A secured creditor's counsel may likewise be sanctioned for misrepresenting fee arrangements when seeking fees as part of a secured claim under Code § 506(b).

The most common consequence of non-disinterestedness or inadequate fee disclosure is fee denial or disgorgement of interim payments, but termination of the representation is not infrequent, and sanctions have extended to suspension from practice, disbarment, and even criminal convictions for blatant non-disclosure violations. The court may disqualify counsel from representing the DIP based upon an objective standard, evaluating the facts of each case, regardless of the integrity or intent of the attorney. An evidentiary hearing is not required before a court requires disgorgement of fees on grounds of disqualification.

E. Frivolous and Bad Faith Adversary Litigation

In addition to administrative filings, adversarial litigation is rife with sanctions rulings, from frivolous adversary proceeding complaints to bad faith objections, frivolous motions and appeals, and failing to cooperate with discovery requests. Burdensome, unnecessary discovery requests may likewise be deemed sanctionable. And counsel for the debtor all too often acquiesces in his client's request to list all claims as disputed on the schedules, or file blanket objections to claims, which creditors may not dispute only because economically infeasible to do so. Strategies designed to make opponents capitulate because litigation is prohibitively expensive may result in sanctions against counsel as well as adverse consequences to clients. Irresponsibly drafted and inflammatory language in pleadings may show their improper, sanctionable purpose.

Counsel may also be sanctioned under Rule 9011 for pursuing or agreeing to reaffirmation agreements without having first ensured that the debtor is informed as to the legal effects and consequences of the reaffirmation, and verified that the reaffirmation will not impose an undue hardship.

IV. Reacting to Client Misconduct

What should counsel do when she learns that her client has lied or her client asks her to lie or otherwise circumvent bankruptcy law restrictions? Rather than carrying out client directions exceeding good faith boundaries, the debtor's attorney has ethical obligations to counsel her client with respect to its fiduciary duties. As stated in the comment to Model Rule of Professional Conduct 1.6, "The lawyer is part of a judicial system charged with upholding the law. One of the lawyer's functions is to advise clients so that they avoid any violation of the law in the proper exercise of their rights."

If the operating head of the DIP entity fails to act in compliance with the DIP's fiduciary responsibilities, the lawyer may have to refer the matter higher up the chain of command to the chief executive officer or board of directors. The lawyer is to consider the seriousness of any illegality and its consequences in deciding what to do within the organization, however, and is to minimize any disruption to the entity and the risk of revealing information to outsiders. If a lawyer "develops material doubts about whether a proposed course of action in fact serves the estate's interests, he must seek to persuade his client to take a different course or, failing that, resign." DIP counsel may in some cases be obligated to bring the DIP's breaches of fiduciary duty to the attention of the court.

Thus, counsel is to urge the DIP to meet its fiduciary duties to creditors, but is to abide by the client's decisions as long as there is a nonfrivolous basis for doing so. If the attorney and client disagree, it is not the attorney's prerogative to act on her own as she believes best for the estate, but rather to refrain from filing bad faith or frivolous pleadings, and to withdraw if the high standards for withdrawal are met. If the attorney fails to appropriately counsel the client and carries out an abusive client strategy, her fees may well be subject to attack–refunds of previously allowed interim payments have been mandated where the court has found unethical conduct.

The attorney is to explain legal requirements to the extent reasonably necessary to permit the client to make informed decisions. But the lawyer may not follow client instructions if they would operate to defraud, and may not knowingly make or affirm a false statement of material fact or law to others or fail to disclose a material fact necessary to avoid defrauding others. A disclosure statement, motion to approve a settlement or sale, or the like may well entail an evaluation of facts and law for use by third persons often unrepresented themselves. Counsel is to disclose any limitations on information used in making the valuation, and not state or imply that the lawyer is disinterested rather than the advocate of her DIP client.

Despite her diligence, an attorney nonetheless may discover that her client has committed perjury on his schedules and statement of affairs by concealing assets or asset transfers, or deliberately omitting creditors or misrepresenting important facts. Counsel also may learn that the client has lied in testimony, or misrepresented facts to the attorney that were the basis of positions taken on his behalf. The attorney must preserve client confidences, but not to the extent of implicitly sanctioning illegality. Counsel may not further the illegal purpose, including by suggestions of concealment, nor may counsel continue assisting in conduct discovered to be criminal or fraudulent. The client must be warned that he may forfeit his discharge, be liable under the bankruptcy crimes statute and criminal perjury statute, and that a trustee will likely be appointed if not already serving. The client must also be warned that the attorney-client privilege does not protect criminal plotting or statements made to counsel about it, and that counsel may be obliged to turn over all books and records.

The client should be counseled to rectify the situation as much as possible, such as by supplemental filings mailed to affected parties. If the client is unwilling to do so, the attorney must withdraw and, if necessary to remedy the situation or the attorney cannot withdraw, he may have to reveal the misrepresentations to the court. Counsel may withdraw or disaffirm any document, which would probably be deemed necessary to remedy the filing of a misleading document with his signature, such as a disclosure statement, and perhaps also to remedy the filing of fraudulent schedules and statements of affairs signed by the client.

Client failures to communicate or otherwise cooperate with counsel, insistence on pursuing an objective the lawyer considers improper, or client conduct which renders effective representation unreasonably difficult may also warrant a court request for withdrawal. It may also become clear that there are insufficient unencumbered assets to pay counsel, making the representation unreasonably financially burdensome. Although the ethical rules authorize a request for withdrawal in such circumstances, it may not be allowed. In the event of withdrawal, counsel must take reasonable steps to protect the client's interests, such as giving the client notice and an opportunity to employ other counsel, turning over the client's papers and property, and refunding unearned retainers.

V. Procedures for Obtaining Sanctions.

Until the 1997 modification of Rule 9011, upon any violation the court was required to impose an appropriate sanction; it exercised discretion only in deciding what sanction was appropriate under the circumstances. Now, sanctions are discretionary, and there is a safe harbor procedure for serving a sanctions motion and giving an opportunity to withdraw the offensive document before filing the motion. The safe harbor does not apply to the filing of a bankruptcy petition, however, given its immediate and serious consequences. Otherwise, it is a mandatory requirement for a Rule 9011 sanctions motion.

Sanctions generally take the form of attorneys' fees awards to opponents; in some cases attorneys and clients have been held jointly liable for the opponent's fees and doubled costs, or additional monetary amounts. Rule 9011 now includes a provision on the nature and limitations of sanctions. A sanction imposed for violation of that rule is to be limited to what is sufficient to deter repetition of the conduct by the one sanctioned or others similarly situated. It may consist of non-monetary directives, a court penalty, or an order to pay reasonable attorneys' fees and costs incurred as a direct result of the violation. Sanctions may also include disgorgement of retainers or interim fees previously awarded to DIP counsel. A chapter 7 attorney may likewise be precluded from recovering compensation for a petition filed in bad faith. Sanctions under other authority than Rule 9011, including the inherent power of the court, may be stiffer, as described in section I, infra.

The party seeking sanctions has a duty to mitigate its damages by using reasonable efforts to resolve disputes by inexpensive means, but need not take actions that would impair its rights. The sanctioned attorney and affected parties may stipulate to a settlement; the court may approve it or may impose more draconian sanctions. The court imposing sanctions is to consider the ability to pay of the sanctioned party or attorney, but only if limited ability to pay is raised in a timely manner.

Counsel is entitled to a meaningful opportunity to explain his conduct before sanctions are awarded, generally but not necessarily at a "show cause" hearing. An evidentiary hearing is not required, however. An opportunity to respond by brief or oral argument may suffice. A sanctions award must specify how the fees and expenses were calculated, and how they were caused by the conduct of the parties sanctioned, so the appellate court has sufficient basis to review the decision. Adequate notice is important before any sanctions hearing, but especially important if the severe sanction of disbarment from the bankruptcy court is to be considered. The prerequisites of adequate notice are:

  1. the fact that sanctions are under consideration,
  2. the reasons why (i.e. the conduct alleged to be sanctionable), and
  3. the form of sanctions under consideration, generally including the legal rule on which sanctions will be based.

If inadequate notice is given, the error may be cured by an immediate stay of the results and a scheduled reconsideration hearing.

Rule 11 motions for sanctions, like all other motions, must be filed in good faith. Rule 11 does not mandate punishment just because an adversary's theory is rejected at trial, and is not intended to "kill an attorney's enthusiasm or creativity." Courts generally evaluate whether an objectively reasonable basis for the attorney's contentions was asserted, in deciding on sanctions requests, even if the attorney ultimately lost on the merits. Sanctions may not be imposed against counsel merely because the court finds the client's testimony not credible, or objects to the form of a respectful communication. But a sanctions motion that is itself replete with vituperation and abuse will not be tolerated, even if it asserts a colorable claim. Mitigating and aggravating factors bearing on the type of sanctions to impose include the degree of willfulness involved, the person's expertise and prior history and ability to pay, the nature and extent of prejudice and expense suffered by the offended person, and burdens on the court system.

VI. Collateral Consequences – at the Bar and in the Prison

Other possible sanctions include a reprimand, reference to bar disciplinary authorities, an order precluding the introduction of evidence or litigation of certain issues, default judgment or dismissal, injunctive relief limiting future access to the courts to a party or attorney, or mandatory legal education, generally in the areas of bankruptcy and legal ethics.

Several courts have imposed sanctions in the form of suspension or disbarment from practice in the bankruptcy court. Pro hac vice status may likewise be revoked. The suspension may last only until sanctions are fully paid, but may last for years. The suspension may even be permanent until and unless a reapplication is accepted. The bankruptcy court or appellate court may refer its sanctions determination to the state professional disciplinary authority, commencing a state disciplinary process. While counsel may introduce mitigating evidence bearing on appropriate punishment at the state hearing, either applicable state rules or the doctrine of offensive non-mutual collateral estoppel may prevent the lawyer from re-litigating the facts or law relating to sanctioned conduct. A state supreme court's suspension or disbarment typically results in the same discipline being imposed in the federal courts where the attorney practices.

Worse still, sanctionable activity may warrant a criminal conviction. The lawyer enabling false and misleading schedules to be filed may be convicted of aiding and abetting the fraudulent concealment of property from the bankruptcy trustee. If so, status as an attorney may warrant a sentence enhancement. Filing a false and misleading Rule 2014/2016 statement of disinterestedness, and confirming it in court, may result in conviction on counts of bankruptcy fraud and perjury. Failing to obey a court sanctions order may be deemed criminal contempt. The bankruptcy court or district or circuit court on appeal of a bankruptcy order may refer its disciplinary decision to the United States Attorney to consider prosecution.

*© Copyright Susan M. Freeman, 2002.

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