Bankruptcy Court Weighs in on Conflicts of Interest in Business Transactions

A recent decision of the U.S. Bankruptcy for the District of Massachusetts in the adversary proceeding Cruikshank v. Dixon, in which the Court denied a motion to dismiss claims asserted against a law firm and two of its lawyers (the “Law Firm Defendants”), is the latest in a series of cases that emphasize the need for business attorneys to closely examine actual and potential conflicts of interest before and during transactions, especially when representing a closely held entity.

The case, brought by the Trustee of the Chapter 7 debtor, Blast Fitness Group, LLC (“BFG”), alleged that the Law Firm Defendants, among other things, committed malpractice, breach of fiduciary duty and unfair and deceptive practices by taking direction from BFG’s sole manager and member, Harold Dixon, to the detriment and harm of BFG, including its other members.  The Law Firm Defendants moved to dismiss on statute of limitations grounds and that it was not a conflict to represent both the entity and its controlling equity holder.

The Court disagreed, holding that notwithstanding that one of the transactions in question had closed more than three years prior, the statute of limitations against the Law Firm Defendants could be tolled because the complaint stated a claim for fraudulent concealment.  Specifically, the complaint alleged sufficient facts that the Law Firm Defendants owed and violated fiduciary duties to BFG by, for example, knowingly assisting Dixon in purchasing real estate with BFG assets without transferring any ownership to BFG.  As such, the statute of limitations on BFG’s claims against the Law Firm did not start to run until the disinterested members of BFG had actual knowledge that they had been harmed.  The Court, citing the adverse domination doctrine, held that Dixon’s knowledge of his own wrongdoing could not be imputed to BFG and therefore, the statute of limitations for BFG’s claims were tolled while it was under the control of Dixon.

The Court also held that the despite the fact that it is common for attorneys to simultaneously represent a company and its controlling equity holder, the complaint set forth sufficient facts that the Law Firm Defendants could not do so in this situation because they knew that Dixon was self-dealing and not acting for the benefit of BFG.  In other words, assuming the facts in the complaint were true, the Law Firm Defendants engaged in an impermissible, unwaivable conflict of interest, which caused harm to BFG.

The problems with conflicts arising in transactions was also highlighted in a 2017 Appeals Court decision, Baker v. Wilmer Cutler Pickering Hale & Door LLP, which reversed the dismissal of claims brought by minority members of an entity against the entity’s lawyers, who had allegedly, at the direction of the majority members, assisted in stripping the minority of their rights and equity in the company.  The Court, pointing to provisions in the company’s operating agreement that gave specific rights to the minority members to participate in management, held that in certain circumstances, counsel to an entity will owe duties not only to the entity, but also to the minority members, notwithstanding the potential for conflicting duties.  In the 2016 case of Bryan Corp. v. Abrano, the Supreme Judicial Court affirmed the disqualification of a law firm from representing minority shareholders because the law firm had failed to withdraw from also representing the company at a time when there was a conflict or at least a potential for conflict between the shareholders and the company.

As these cases demonstrate, representing an entity can become difficult when duties to the entity conflict with duties to the majority and minority members or shareholders.  Attorneys must always be wary of where their duties lie and when a conflict might arise and cannot merely rely on the direction of the controlling equity holder.  Attorneys can avoid the serious consequences of conflicts between clients by well-crafted engagement letters, disengagement letters and by seeking guidance on their duties when the potential for conflict exists.