The Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) is the federal legislation that was enacted to provide a special bankruptcy framework for Puerto Rico. 48 U.S.C. §§2101 et seq. An important component of PROMESA is the establishment of a Financial Oversight and Management Board (FOMB) with oversight authority over the financial affairs of Puerto Rico and sole authority over the Puerto Rico bankruptcy cases. 28 U.S.C. §§2121(b), 2121(d), and 2124(j)(1).
The FOMB has retained McKinsey and Company (McKinsey) as its strategic consultant. McKinsey is advising the FOMB on Puerto Rico’s debt restructuring. Mary Williams Walsh, McKinsey Advises Puerto Rico on Debt. It May Profit on the Outcome, The New York Times (Sept. 26, 2018). After McKinsey was retained, it was revealed that McKinsey, through its affiliates, holds at least $20 million of Puerto Rico’s debt. Id.
McKinsey’s creditor status is significant because it is a central figure in the formulation of Puerto Rico’s fiscal and debt repayment plans. McKinsey is charged with determining how much Puerto Rico can afford to pay its creditors and the extent of the reduction of government services. McKinsey is a position to benefit by proffering a repayment that is generous to creditors and that simultaneously emphasizes government austerity. Professor Lynn LoPucki of the U.C.L.A. Law School has stated that McKinsey has a conflict of interest. Id.
When Congress enacted PROMESA it omitted Bankruptcy Code §327(a) and the related retention provisions that were intended to disqualify entities that had conflicts of interest from serving as fiduciaries for a bankruptcy estate. Id. Bankruptcy Code §327(a) states:
(a) Except as otherwise provided in this section, the trustee, with the court’s approval, may employ one or more attorneys, accountants, appraisers, auctioneers, or other professional persons, that do not hold or represent an interest adverse to the estate, and that are disinterested persons, to represent or assist the trustee in carrying out the trustee’s duties under this title.
11 U.S.C. §327(a). Federal Rule of Bankruptcy Procedure 2014(a) requires an applicant to file a verified statement setting forth all of its connections with the bankruptcy case. Fed. R. Bankr. P. 2014(a).
The U.S. Court of Appeals for the Second Circuit has made the following comments concerning the requirements of Bankruptcy Code §327(a):
Subsection (a) sets out a general, two-part test governing employment of all professionals. Under subsection (a), the trustee may hire only those professionals that (1) “do not hold or represent an interest adverse to the estate,” and (2) are “disinterested persons.” 11 U.S.C. §327(a).
Victory Oil Co. v. Coan (In re Arochem Corp.), 176 F.3d 610, 621 (2d Cir. 1999).
In order to be retained pursuant to Bankruptcy Code §327(a), a professional cannot hold or represent any interest adverse to the estate. Vouzianas v. Ready & Pontisakos (In re Vouzianas), 259 F.3d 103, 107 (2d Cir. 2001). The following comments have been made concerning the term adverse interest:
Generally stated, the adverse interest test is objective and precludes “any interest or relationship, however slight, that would even faintly color the independence and impartial attitude required by the Code and Bankruptcy Rules.” Granite Partners, 219 B.R. at 33; see also In re Angelika Films 57th, Inc., 227 B.R. 29, 38 (Bankr. S.D.N.Y.1998) ( “The determination of adverse interest is objective and is concerned with the appearance of impropriety.”) (citation omitted). Further, courts have recognized that a professional has a disabling conflict if it has “either a meaningful incentive to act contrary to the best interests of the estate and its sundry creditors—an incentive sufficient to place those parties at more than acceptable risk—or the reasonable perception of one.”
In re JMK Construction Group, Ltd., 441 B.R. 222, 229-30 (Bankr. S.D.N.Y. 2010).
The Second Circuit has adopted the following definition of adverse interest:
“(1) to possess or assert any economic interest that would tend to lessen the value of the bankruptcy estate or that would create either an actual or potential dispute in which the estate is a rival claimant; or (2) to possess a predisposition under circumstances that render such a bias against the estate.”
Victory Oil Co. v. Coan (In re Arochem), 176 F.3d 610, 623 (2d Cir. 1999).
The definition of “disinterested” is contained in Bankruptcy Code §101(14). 11 U.S.C. §101(14). Bankruptcy Code §101(14) states:
The term “disinterested person” means a person that—
(A) is not a creditor, an equity security holder, or an insider;
(B) is not and was not, within 2 years before the date of the filing of the petition, a director, officer, or employee of the debtor; and
(C) does not have an interest materially adverse to the interest of the estate or of any class of creditors or equity security holders, by reason of any direct or indirect relationship to, connection with, or interest in, the debtor, or for any other reason.
11 U.S.C. §101(14).
The latter provision of Bankruptcy Code §101(14) is commonly referred to as the “catch-all clause” is sufficiently broad to encompass any professional with an interest or relationship that would even faintly taint the independence and impartial attitude required by the Bankruptcy Code. Kravit, Gass & Weber, S.C. v. Michel (In re Crivello), 134 F.3d 831, 835 (7th Cir. 1998).
Under Bankruptcy Code §327(a) it is presumed by this provision that an entity who is a creditor is incapable of exercising the impartial judgment required of a professional in the conduct of a case under the Bankruptcy Code. In re Boro Recycling, 67 B.R. 3, 4 (Bankr. E.D.N.Y. 1986). Courts have routinely held that an entity that is a creditor is prohibited from being retained by a debtor pursuant to Bankruptcy Code §327(a). E.g., U.S. Trustee v. Price Waterhouse, 19 F.3d 138 (3d Cir. 1994); In re LKM Industries, 252 B.R. 589 (Bankr. D. Mass. 2000); In re Jaimalito’s Cantina Associates Ltd. Partnership, 114 B.R. 1 (Bankr. D.D.C. 1990).
An important case concerning Bankruptcy Code §327(a) and the disinterestedness requirement is U.S. Trustee v. Price Waterhouse, 19 F.3d 138 (3d Cir. 1994). The debtor owed Price Waterhouse (PW) $875,894.15 for prepetition services. The debtor sought to retain PW as its accountant. The Third Circuit, in an opinion written by then Circuit Judge Samuel Alito, held that Bankruptcy Code §327(a) prohibited the debtor from retaining PW. The court stated:
Under Section 101(14), a “disinterested person” must be a person who “is not a creditor.” The Code defines the term “creditor” as meaning any “entity that has a claim against the debtor that arose at the time of or before the order for relief concerning the debtor,” 11 U.S.C. §101(10)(A), and the commencement of each of the debtor’s chapter 11 cases constituted an order for relief. See 11 U.S.C. §301. These provisions, taken together, unambiguously forbid a debtor in possession from retaining a prepetition creditor to assist it in the execution of its Title 11 duties.
Id. at 141.
The FOMB’s engagement of McKinsey is problematic. McKinsey, through its affiliates, has filed claims in the amount of 20 million dollars. Nevertheless, McKinsey is the FOMB’s restructuring advisor, and it has played a major role in the Puerto Rico bankruptcy cases. Puerto Rico’s fiscal plan has been criticized as flawed because it is premised upon unrealistic assumptions such as economic growth and increased revenues despite increased fiscal austerity and declining federal aid. Martin Guzman & Joseph E. Stiglitz, Disaster Capitalism Comes to Puerto Rico, Project Syndicate (Nov. 18, 2018). Puerto Rico’s debt restructuring plan has been critiqued as being too generous to creditors. Antonio Weiss, Brad W. Setser, and Desmond Lachman, Puerto Rico Needs a Better Debt Deal, Bloomberg Opinion (Oct. 9, 2018). Despite a consensus among economists that Puerto Rico needs a radically different economic and debt restructuring plan, the FOMB has chosen a different path. Guzman & Stiglitz, supra.
The fact that McKinsey is not disinterested has produced the appearance of a conflict of interest, which casts a specter of doubt on the legitimacy of Puerto Rico’s bankruptcy case. McKinsey is an estate fiduciary, and it is required to be unbiased. Congress has sought to disqualify professionals with the appearance of a conflict of interest as well as those who have actual conflicts of interest. Smith v. Marshall (In re Hot Tin Roof), 205 B.R. 1000, 1003 (Bankr. 1st Cir. 1997). Under these circumstances, there are grave reservations as to whether McKinsey should continue as the FOMB’s strategic consultant. U.S. Trustee v. Price Waterhouse, 19 F.3d 138 (3d Cir. 1994).
Carlos J. Cuevas is a solo practitioner in Yonkers, N.Y., and a research associate at the University of Houston School of Law.