It is increasingly common for financial advisers in bankruptcy proceedings to require indemnification by the estate in their engagement agreements.  The indemnification sought typically extends to claims arising from the adviser’s own negligence in the performance of its duties.  Such arrangements collide head on with the interests of creditors and the policy of the Office of the United States Trustee, which views them as unreasonable and violative of the Bankruptcy Code, public policy and basic tenets of professionalism.

In the eagerly awaited decision, In re United Artists Theatre Company, 315 F.3d 217 (3d Cir. 2003), filed on Jan. 9, 2003, the Third U.S. Circuit Court of Appeals held that an agreement requiring the debtor to indemnify a financial adviser for its negligence was reasonable.

This ruling will significantly impact retention agreements and plan provisions dealing with professional negligence, and raises important issues as to its application.

Negligence Conundrum

In United Artists, the U.S. District Court for the District of Delaware approved the debtor’s retention of Houlihan Lokey Howard & Zukin as its financial adviser over the objection of the United States Trustee.  The retention agreement required the debtor to indemnify Houlihan for claims of negligence (as opposed to gross negligence) that might be asserted against it.

Shortly after the retention was approved, the debtor’s Chapter 11 plan was confirmed.  Although the United States Trustee did not object to several plan provisions that released the debtor, Houlihan and others from liability, it thereafter appealed the retention order.

Initially, the court rejected Houlihan’s arguments that the U.S. Trustee lacked standing and that the appeal was moot by virtue of confirmation of the plan.  Turning to the merits of the appeal, the court noted that the permissibility of the subject indemnification provisions was an issue of first impression in the Third Circuit.  The issue framed was whether the debtor’s agreement to indemnify Houlihan, despite its own negligence, is appropriate under §328(a) of the code, which allows for approval of a professional’s employment on any “reasonable” terms and conditions.

The U.S. Trustee argued that allowing professionals to obtain indemnity for their own negligence cannot be reasonable since it would encourage a standard that is both lax and inconsistent with their fiduciary obligations to creditors.  Houlihan countered that failure to approve the indemnification would lead to “Monday-morning quarterbacking” and second-guessing by courts of mistaken decisions that seemed attractive at the time.  This, Houlihan argued, would cause a disservice to the debtor’s estate because financial advisers would then be constrained and overly cautious in their advice.

In determining whether Houlihan’s retention terms were reasonable, the court referenced §330, which uses a “market-driven” approach in determining the reasonableness of compensation for professionals employed by the estate.  In light of the settlement of a $4 billion negligence claim brought against the estate’s accountants in In re Merry Go Round Enterprises, Inc., the court noted that indemnification of financial advisers is becoming a common market occurrence.

This fact, however, does not automatically make indemnification provisions “reasonable” under §328.  Instead, the court borrowed from Delaware corporate law and based the reasonableness determination on “traditional negligence/gross negligence analysis,” an approach that examines the level of care used by the financial adviser in the process of obtaining results rather than the results themselves.  Delaware corporate law was found to be a useful guide because it offered “time-tested insights” as to how to best evaluate the issue and because Delaware’s law often “cues the market.”

Directors and officers in Delaware may obtain indemnity for their own negligence pursuant to § 145(a) of Delaware General Corporation Law provided that they acted in good faith and in a manner reasonably believed to be consistent with the best interests of the corporation.

Noting a 1986 amendment to §145(b) of the Delaware statute, the court indicated that Delaware tolerates ordinary negligence and requires that corporate fiduciaries not be grossly negligent.  Critical of distinctions between “negligence” and “gross negligence” in the area of corporate governance, the court recognized that Delaware courts resolved this “negligence conundrum” by focusing on the process by which boards reach decisions rather than the final result of those decisions.

In Delaware, a finding of gross negligence, therefore, is appropriate when a board fails to inform itself of all material information reasonably available.  The court likened Houlihan’s role with that of a director, which, while not a surety of success, can be held accountable for not advising with the level of care or loyalty expected.

Thus, the court transposed the traditional “business judgment rule” from its corporate ambit to bankruptcy, and held that advice by financial advisers should not be interfered with when they:  (1) have no personal interest; (2) have a reasonable awareness of available information after prudent consideration of alternative options; and (3) provide advice in good faith.

Because there was no evidence before the district court that tended to disqualify Houlihan under these principles, the court held that the district court did not abuse its discretion in finding that the indemnification provision was reasonable.  It reasoned that since courts are free to evaluate the process by which advice is given, where appropriate steps are taken to arrive at a result, agreements to indemnify financial advisers for their negligence are therefore reasonable under §328(a).

The court reached this result with two caveats.  First, it ruled that Houlihan’s attempt to supplement the retention agreement with a provision indemnifying it for even gross negligence, if not solely the cause of damages, would violate public policy.  Second, the court ruled that it would be improper for Houlihan to be indemnified not only for acting in its professional capacity, but for breach of its contract with the debtor.

Case-by-Case

In a concurring opinion, Circuit Judge Marjorie Rendell also agreed with the result of the district court, but pointedly rejected the majority’s ruling on the merits.  The concurring opinion stated that the majority actually ignored the issue presented on appeal - whether there should be a per se ban on provisions granting indemnity to financial advisers for negligence or whether such provisions should be permissible and examined on a case-by-case basis.

Rendell believed that it was inappropriate to fashion an “open-ended” good faith business judgment rule based on Delaware corporate law as the test for “reasonableness” where the agreement was governed by New York rather than Delaware law, and where it governed a relationship with the debtor’s financial adviser, whose status is not analogous to that of a director.

The concurring opinion also highlighted the difficulty with applying the second prong of the majority’s test, since it would be difficult to establish that a financial adviser does not have a reasonable awareness of available information after prudent consideration of alternative options.

Additionally, §328(a) envisions that the court’s determination of reasonableness is made at the time of retention, while a process-oriented analysis can only occur after the financial adviser has performed its work.  Rather than creating a new test, Rendell favored affirmance by disavowing the notion of a per se ban against indemnifying a professional for its own negligence, and applying the factors that courts have examined in considering “reasonableness” on a case-by-case basis under §328.

Lack of Clarity

The holding in United Artists, and the starkly divergent views in the majority and concurring opinions, raise interesting implications for practitioners.  It is foreseeable that opponents of indemnification agreements governed by state law that is less protective of directors than that of Delaware, would try to distinguish the Third Circuit’s ruling on that basis.

The opinion also leaves open the possibility that other professionals, such as attorneys, should be afforded the same indemnification protections in their retention agreements.  Arguably, attorneys are as integral as financial advisers in helping to shape the course of a debtor’s reorganization, and are thereby equally analogous to the role of a director under the majority’s reasoning.

Also unclear is whether the decision will stifle market competition rather than enhance it.  While a financial adviser might be more competitive if it doesn’t require indemnification from the estate for its negligence, it will have little incentive to do so if the estate serves as the adviser’s insurance company.

Creditors will also have little incentive to make claims against financial advisers for their negligence, since any recovery would come out of their own pocket.

Moreover, it is questionable whether the “safe harbor” provision of §328(a), which allows the court to reconsider its approval of employment terms, will provide meaningful relief to the estate where a post hoc analysis reveals that the process used by the financial adviser was inappropriate.  This is because §328(a), on its face, permits the court only to allow compensation different than that provided under the retention agreement, rather than to eliminate the indemnification provisions.

Additionally, financial advisers will argue that the possibility of finding an impropriety in the process they employed is something that is always capable of being anticipated when the terms of retention are approved.  It would appear relatively simple for every retention application seeking indemnification for a financial adviser’s own negligence to be approved by the court so long as the adviser lays out facts demonstrating its “reasonable awareness of available information after prudent consideration of alternative options.”

Where it is clear in the retention application that the financial adviser has no personal interest and will provide advice in good faith, thereby satisfying the two other prongs of the majority’s test in United Artists, it is hard to imagine a scenario where the indemnification provision will not be approved.