Third Circuit Confirms That Bankruptcy Code Governs Retention of Debtor’s Counsel and Recognizes That Bankruptcy Court Has Considerable Discretion

Two years after the bankruptcy court approved retention of debtor’s counsel in Boy Scouts over the objection of one of debtor’s insurers, the U.S. Court of Appeals for the Third Circuit affirmed. In re Boy Scouts of Am., No. 21-2035, 2022 U.S. App. LEXIS 13926 (3d Cir. May 24, 2022). Although the Court of Appeals determined that the insurer had standing to pursue an appeal seeking disqualification, it denied the insurer’s request to disqualify counsel for alleged violations of the Rules of Professional Conduct. The court concluded that the potential disgorgement of counsel’s fees prevented mootness and reasoned that prudential bankruptcy appellate standing requirements are less stringent in the context of retention orders. Indeed, the court characterized the retention of counsel as integral to the “integrity of the bankruptcy court proceeding,” and recognized that “absent immediate appeals, meaningful review of potentially serious ethical issues might never occur.” Id. at *9. The insurer appellant urged the Court of Appeals to adopt a rule that would require bankruptcy courts to consider applicable Rules of Professional Conduct in retention of counsel. The Third Circuit declined to do so, concluding that Bankruptcy Code §327 provides the correct test for evaluating whether debtor’s counsel has a disabling conflict. Its reasoning underscored that the primary concern should be counsel’s ability to effectively represent the debtor in its bankruptcy case.

According to the Third Circuit, absent an “actual conflict” under §327, disqualification is discretionary and never automatic because the power to disqualify stems from the court’s “inherent disciplinary power over the advocates appearing before it.” Id. at *15. The decision highlighted as relevant factors the ability to retain loyal counsel of choice, ability of attorneys to practice without undue restriction, preventing the use of disqualification as a litigation strategy and preventing unfair prejudice. There was no dispute that disqualification would harm the debtor. The Court of Appeals concluded that the bankruptcy court’s denial of disqualification was “nowhere close to an abuse of discretion,” Id. at *19-20, observing that the use of special counsel to handle the debtor’s insurance matters in conjunction with effective screening to ensure that lawyers working for the debtor did not receive any confidential or privileged information from lawyers who had performed work on behalf of the insurer strongly supported the bankruptcy court’s decision regardless of whether counsel ran afoul of the Rules of Professional Conduct.

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