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BAD BOY GUARANTIES: CONFLICTS THAT ARISE IN DUAL REPRESENTATION

By:  John C. Hoard and Jonathan Dickey

October, 2013[1]

 

            A “springing recourse guaranty” is a guaranty by a third party that springs into effect as to the guarantor upon the occurrence of some act by the entity, such as the filing of a bankruptcy petition. Informally referred to as a “bad boy” guaranty, these are usually required to be signed by directors or officers (an “insider”) and have been upheld by the courts in a number of different contexts, including the filing of bankruptcy by the corporation. As a result, “bad boy” guaranties have become an increasingly popular tool for lenders and create potential ethical dilemmas for commercial lawyers.

Lichtenstein

 A recent case from New York highlights the potential minefield of “bad boy” guaranties for a transactional attorney. In Lichtenstein, et al. v. Willkie Farr & Gallagher LLP, et. al.,[1] the New York State Supreme Court addressed a “bad boy” guaranty arising out of a bankruptcy filing. David Lichtenstein, together with other investors, purchased Extended Stay Inc. (ESI) for approximately $8 billion. Lichtenstein was the manager of ESI, as well as its CEO and board chairman. Lichtenstein signed guaranties that provided for $100 million in personal liability in the event that ESI filed for bankruptcy.

In 2008, ESI was faced with a liquidity crisis and hired Weil, Gotshal & Manges LLP as counsel, which referred Lichtenstein to Willkie Farr & Gallagher to represent him in his capacity as board chairman. Weil advised ESI to file for bankruptcy to prevent ESI’s waste of assets. Willkie agreed but cautioned Lichtenstein that a failure to authorize and file a corporate bankruptcy subjected him to potential uncapped liability for breach of his fiduciary duty in exposing its assets to waste, thereby diminishing the recovery of creditors. After ESI filed for bankruptcy, the lenders filed a suit to enforce the “bad boy” guaranties. Lichtenstein then brought a suit against Willkie, which alleged breach of fiduciary duty and legal malpractice in advising Lichtenstein to support the corporate bankruptcy filing. Willkie filed a motion to dismiss for failure to state a cause of action.

The court held in Willkie’s favor after finding that the firm provided reasonable legal advice when they notified Lichtenstein of the potential uncapped liability for waste. As a result, the complaint failed to state a claim and was dismissed. Although the result for Willkie was favorable, the Lichtenstein case emphasizes the serious conflict issues raised by “bad boy” guaranties. One such ethical dilemma for a transactional practitioner is whether an attorney should represent both an insider and a corporate entity when a lender demands a springing recourse guaranty as part of a financing.

Is Representation of Both an Insider and the Entity Appropriate in Connection with a Springing Recourse Guaranty?

 Pursuant to Rule 1.13 of the Model Rules of Professional Conduct, an attorney may represent both an organization and any of it directors, officers, employees, members, shareholders or other constituents subject to the provisions of Rule 1.7. Model Rule 1.7 states that if “there is a significant risk that the representation of one or more clients will be materially limited by the lawyer’s responsibilities to another client,” the representation should be declined unless the following four criteria are met:

(1) the lawyer reasonably believes that he or she will be able to provide competent and diligent representation to each affected client;

            (2) the representation is not prohibited by law;

(3) the representation does not involve the assertion of a claim by one client against another client represented by the lawyer in the same litigation or other proceeding before a tribunal; and

(4) each affected client gives informed consent, confirmed in writing.

If a lawyer cannot meet any of the first three criteria, the conflict is nonconsentable.[2] However, common representation is permissible where the clients are generally aligned in interest even though there is some difference in interest among them.[3] A concurrent conflict can be waived if the clients give informed consent in writing, including providing the clients with a reasonable opportunity to seek the advice of independent legal counsel.[4]

If a lender is pushing for a “bad boy” guaranty, there is a concurrent conflict because the guaranty creates a disincentive for an Insider to consent to a bankruptcy if a corporate entity is in distress. That conflict, however, is a future conflict. When the loan is originated, the interests of the insider and the entity are usually aligned for the purpose of making the loan. Accordingly, the origination of the loan is a consentable conflict and one that can be waived by informed consent. Identifying the potential future conflict in writing and providing both the entity and insider with a reasonable opportunity to seek the advice of independent counsel should be sufficient to allow the attorney to represent both the entity and the insider for the limited purpose of originating the note.

The attorney may, however, be barred from representing either the corporation or the insider in the event of future financial distress. In the event that the corporation struggles, as ESI did in the Lichtenstein case, the “bad boy” guaranty puts the insider and the corporation in direct conflict. The entity’s best interest might be a bankruptcy filing, but the guaranty that springs into effect is, on its face at least, not in the insider’s best interest. While the Lichtenstein court ultimately held that under Delaware law, the best interest of the insider and the entity were aligned due to potential uncapped liability on an insider for waste of assets, when a guaranty punishes an insider for making a decision in the entity’s best interest, it is still likely that Rule 1.7 would forbid the representation of both parties at that point.

Conclusion                 

Representing both the borrowing corporation and its insiders as the corporation obtains financing represents a present consentable conflict as soon as a guaranty is on the table because while the financing may be in the corporation’s best interest, the guaranty has negative potential repercussions to the insider. This consentable conflict can become nonconsentable in the event that the corporation suffers future financial distress because the negative ramifications personally to the insider are in conflict with his or her duty to the corporation. While the initial conflict may be waived by informed consent, attorneys should identify the potential future risks of default to both the corporation and the insider in the event of default, in addition to the present conflict, in the informed consent letter. It might be worth retaining independent counsel for the insiders at the outset of the loan and guaranty negotiations in order for corporate counsel to remain free from the conflict and ensure counsel’s ability to represent the entity in the event of future financial distress.

Endnotes:

 [1] 652092/12, NYLJ 1202597925188, at *1 (Sup., N.Y., decided April 22, 2013).

 [2] Van Kirk v. Miller, 869 N.E.2d 534, 543 (Ind. Ct. App. 2007) (citingProf. Cond. R. 1.7 cmt. 14).

 [3] Id.

 [4] Smith-Canfield v. Spencer, 2011 Bankr. LEXIS 1822 (Bankr. D. Or. 2011).

Disclaimer

These materials are intended for general informational purposes only.  Accordingly, they should not be construed as legal advice or legal opinion on any specific facts or circumstances.   Instead, you are urged to consult counsel on any specific legal questions you may have concerning your situation.

RUBIN & LEVIN, P.C.    |    342 Massachusetts Avenue    |   Indianapolis, IN  46204     |  www.rubin-levin.com

 

[1] This article was originally published in the Ethics & Professional Compensation Committee Newsletter for the American Bankruptcy Institute, Vol. 10, Number 5 / August 2013, and is available at http://www.abiworld.org/committees/newsletters/ethics-and-professional-compensation/vol10num5/arise.html

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