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The law firm of Jones, Day, Reavis & Pogue just might be disqualified from handling the Pillowtex Inc. bankruptcy now that a federal appeals court has ordered hearings on the question of whether the firm suffers from a conflict of interest due to the nearly $1 million in fees it took in from Pillowtex Inc. in the 90-day period leading up to its bankruptcy filing. A unanimous three-judge panel on Monday ruled that U.S. District Judge Sue L. Robinson of the District of Delaware was too quick to reject the U.S. Trustee’s argument that Jones Day may have received a “preference” payment that could disqualify it from serving as debtor’s counsel. “Although a bankruptcy court enjoys considerable discretion in evaluating whether professionals suffer from conflicts, that discretion is not limitless. A bankruptcy court does not enjoy the discretion to bypass the requirements of the Bankruptcy Code,” 3rd Circuit Judge Dolores K. Sloviter wrote. In bankruptcy law, the preference rule prevents debtors from depleting the estate to pay favored creditors with assets that otherwise would have been apportioned among all creditors according to the prioritization scheme of the Bankruptcy Code. Jones Day argued that it sought payment from Pillowtex of its outstanding bills in order that it would not be a creditor at the time of the bankruptcy, as that would have disqualified it from retention as counsel. Court records show that Kannapolis, N.C.-based Pillowtex paid Jones Day more than $2 million in fees for legal work in the year leading up to the bankruptcy, nearly $1 million of which was paid within the 90 days immediately preceding the bankruptcy filing. When the U.S. Trustee originally asked for hearings on the issue of whether any of the payments were a preference, Robinson refused and instead adopted Jones Day’s argument that none of the fee payments raised any suspicion. On appeal, Jones Day argued that all bankruptcy lawyers find themselves with past due bills from putative debtors on the eve of bankruptcy and seek to clear the accounts so that they are qualified to serve as counsel for the debtor. At oral argument, Jones Day attorney Fordham E. Huffman told the judges that if the court were to hold that such payments may be avoidable preferences which must be determined before retention can be approved, the decision’s effect would be to disrupt the already hectic period after bankruptcy filing when the bankruptcy court is occupied with first-day orders and the parties are meeting to form creditor committees. Sloviter disagreed, saying “we believe that some accommodation can undoubtedly be made between the need of counsel for payment of appropriate fees and the explicit provisions of the [Bankruptcy] Code.” Justice Department attorney Anne Murphy, arguing on behalf of the U.S. Trustee, contended lawyers entering bankruptcy cases protect themselves from the preference issue by obtaining a retainer, and then draw down on the retainer during the 90-day period in order to avoid raising the issue of whether or not they received preferential payments. Murphy said bankruptcy counsel typically waive past fees due, but that Jones Day received payments for past bills which enabled it to receive 100 percent of all past due bills rather than waiving those for earlier work. “Paying hundreds of thousands of dollars of accrued fees on the eve of bankruptcy was not typical,” Murphy wrote in her appellate brief. Sloviter, in an opinion joined by 3rd Circuit Judges Jane R. Roth and Theodore A. McKee, found there wasn’t enough evidence to decide whether the payments were preferential. “The record does not show how much of the fee Jones Day received within the 90 days before bankruptcy was for bankruptcy preparation, how much was for legal work done years earlier, and what the ordinary practice was in Jones Day’s billings to Pillowtex and Pillowtex’s payments,” Sloviter wrote. Jones Day had argued before Robinson that a hearing was expensive and unnecessary, and proposed that she could avoid any possible conflict by authorizing retention of Jones Day subject to two conditions — that the firm return any preference it is determined to have received, and that it waive any claim resulting from the preference. But Sloviter found that Robinson’s order failed to “resolve the question whether Jones Day received an avoidable preference and was therefore not disinterested and whether it should have been disqualified.” Robinson’s error, Sloviter said, was her failure to hold a hearing. “Because there has never been a judicial determination whether Jones Day received a preference, it is unclear at this time whether the preference, if there were one, presents a conflict which would require Jones Day’s disqualification,” Sloviter wrote. “We hold that when there has been a facially plausible claim of a substantial preference, the district court and/or the bankruptcy court cannot avoid the clear mandate of the statute by the mere expedient of approving retention conditional on a later determination of the preference issue.” Sloviter found that, based on the record before her, Robinson “could not adequately evaluate the alleged conflict and was not in a position to conclude that any preference did not pose a conflict with Pillowtex’s estate or a material conflict with the other creditors.”

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