In In re Congoleum Corp., 2005 US App. Lexis 22066 (3rd Cir. 2005), the Court reversed a bankruptcy court decision authorizing the retention of a law firm that acted as counsel for the debtor pre-petition in negotiating settlement arrangements. The Court concluded that conflicts existed which precluded the firm’s retention under the Rules of Professional Conduct and the Bankruptcy Code.

In this matter, Gilbert, Heintz & Randolph, LLP (”Gilbert”) acted as Congoleum’s counsel pre-petition. Gilbert negotiated a settlement of numerous asbestos claims with Joseph Rice and Perry Weitz, two plaintiff’s lawyers.

In October 2002, Weitz recommended that Congoleum retain Gilbert to assist in solving insurance coverage for Congoleum’s asbestos liability. At the time of the recommendation, Weitz had existing co-counsel relationships with Gilbert in other asbestos related proceedings. The arrangements were that Gilbert would represent the claimants in seeking recovery form the insurers of asbestos defendants.

Congoleum filed a “pre-packaged” Chapter 11 bankruptcy on December 31, 2003 and on January 23, 2004, applied for approval to retain Gilbert as “special insurance counsel.” The application stated that Gilbert “would be primarily responsible for strategic advice on insurance issues, including but not limited to insurance-related settlement negotiations, and the representation of the Debtors with respect to insurance issues arising in the context of Chapter 11 cases.”

Some of Congoleum’s liability insurers who had not participated in the formulation of the plan objected to the application to employ Gilbert. They alleged conflict because of the Gilbert’s co-counsel relationship with the plaintiff’s firm Weitz. The insurers said that Gilbert’s relationship with Weitz and Rice in other asbestos matters violated the disinterestedness requirement of Section 327(a) of the Bankruptcy Code and Rules of Professional Conduct.

Gilbert contended that its pre-petition conduct was not relevant because the interests of the individuals it represented as co-counsel with Weitz were aligned with Congoleum’s interests to obtain recovery from the insurers.

The bankruptcy court granted the application and held that the standards in Sect. 327(e) applied rather than the Sect. 327(a) standards and thus, the disinterestedness requirement was not pertinent. The bankruptcy court also said that Gilbert’s “pre-petition behavior cannot carry the day on a post-petition retention application for different services.”

The district court affirmed the bankruptcy court.

The 3rd Circuit concluded that Gilbert’s employment was contrary to Sect. 327. The Court stated that Gilbert’s retention was far too expansive to be appropriate for a Sect. 327(e) special purpose employment and therefore falls under Sect. 327(a). This is the key legal distinction since under Sect. 327(a) the disinterestedness standard applies.

The Court ruled that Gilbert’s pre-petition relationship cannot meet the Code’s requirement of disinterestedness under Sect. 327(a). Its status as co-counsel to Weitz as well as other factors prevent Gilbert from being completely loyal to Congoleum’s interests. The Court also adds that waivers under Sect. 327(a) are ordinarily not effective.

Ray