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A judge kicked Pillsbury Winthrop Shaw Pittman off a bankruptcy case for a conflict that may end up costing the firm its $4 million in fees. Citing a “complete breakdown of creditor confidence” due to a conflict the firm had failed to disclose, San Jose U.S. Bankruptcy Judge Marilyn Morgan granted a motion Monday to disqualify Pillsbury in the bankruptcy case of SonicBlue, an electronics maker that went belly up in 2003. She also ordered the appointment of a Chapter 11 trustee, but put off any discussion of disgorging the fees Pillsbury has earned as debtor’s counsel. A 2002 letter promised three hedge funds who were investing in a $75 million bond issue by client SonicBlue that they’d be repaid in full even if SonicBlue declared bankruptcy. Lawyers for Pillsbury call that assurance a “scrivener’s error,” but in September the senior note holders threatened to sue unless the firm indemnified them for their full investment. The U.S. trustee said in court papers that Pillsbury was conflicted because “for every dollar the senior note holders’ claim was reduced, [Pillsbury]‘s corresponding exposure would increase.” The conflict didn’t come to light until January because Pillsbury didn’t make the required supplemental disclosure to the court, though it did hand the matter off to lawyers for the creditors committee soon after. Bernard Burk, the Howard, Rice, Nemerovski, Canady, Falk & Rabkin lawyer who appeared for Pillsbury at a hearing on the motion to disqualify last week, called the failure to disclose “inadvertent,” but Judge Morgan scoffed at that characterization. “As of late August 2006, [Pillsbury] knew it had a disabling conflict of interest because it immediately sought the aid of [committee counsel] in an attempt to resolve the conflict,” Morgan wrote. “Yet, [Pillsbury] failed to apprise the court of these facts. [Pillsbury]‘s attempt to characterize its failure as inadvertent oversight rings hollow in the face of its previous history of supplemental disclosures.”
Bankruptcy lawyers say a disqualification from a case, especially so late in the game, is not par for the course.

Morgan wrote that Pillsbury argued in court that “the partner in charge ‘assumed’ a supplemental disclosure had been made, but the firm has not offered any evidentiary foundation for that assumption.” She wrote that she found no indication that Pillsbury partner William Freeman, who said in his declaration that he’d signed or delegated someone to sign the previous disclosures, undertook the responsibility of preparing a disclosure after the hedge funds’ threat. Either way � intentional or inadvertent � the failure to disclose the conflict “in any reasonable fashion mandates immediate disqualification of [Pillsbury] from its representation in this case,” Morgan wrote. Pillsbury did not respond to requests for comment on Monday afternoon, but Burk hinted at last week’s hearing that the firm wouldn’t fight disqualification. “We would like to be guided by the preferences of our client and the court,” Burk told the court. The court first took notice of the conflict in January � more than four months after the hedge funds’ threat � when claims traders challenged a Pillsbury disclosure statement. Scott McNutt, partner at San Francisco bankruptcy boutique McNutt & Litteneker, was representing one of the claims traders at the time. “Our firm is saddened that circumstances required us to be one of the first to bring this conflict to the court’s attention,” he said on Monday. At issue is a paragraph in Pillsbury’s opinion letter that included a caveat about bankruptcy, but explicitly referring to only one of two paragraphs about repayment. The hedge funds argue that the other paragraph assured repayment even in the event SonicBlue became insolvent. Bankruptcy lawyers say a disqualification from a case, especially so late in the game, is not par for the course. “It’s a very unusual event,” said Frederick Holden Jr., a veteran bankruptcy attorney with Orrick, Herrington & Sutcliffe. Morgan did not address the topic of disgorgement, saying that it would be addressed “after review by the appointed trustee.”

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