Judge Silverstein Rejects Retention of Willkie Farr as Bankruptcy Counsel to Franchise Group Based on Conflict Created by Representation of Former CEO; Concerns Over Setting Case Back ‘Cannot Outweigh’ Conflict

In a significant blow to the Franchise Group debtors this afternoon, Judge Laurie Selber Silverstein denied the debtors’ heavily contested application to retain Willkie Farr & Gallagher as primary bankruptcy counsel. The judge, ruling from the bench, found that Willkie’s prepetition representation of the debtors’ former CEO Brian Kahn precluded the firm from handling a central issue in the case: the negotiation and treatment of the debtors’ potential claims against Kahn.

The debtors “need counsel that can advise on all aspects of a plan,” the judge reasoned; Willkie, she concluded, “cannot draft portions of the plan that touch upon claims against Kahn and itself.” The judge conceded that her ruling would likely “set the case back” but held that when it comes to retention decisions, such “concerns cannot outweigh conflict.”

Judge Silverstein noted as an aside today that Willkie’s knowledge of the debtors’ operations may position it well to act as corporate counsel, with another firm serving as restructuring counsel, but that was neither the chosen path nor before the court at this time.

As a result of the ruling, the debtors’ disclosure statement hearing has been adjourned to Wednesday, Feb. 19, at 10 a.m. ET from tomorrow, Thursday, Feb. 13. The debtors may elect to turn the Feb. 13 hearing into a status conference if they are not prepared to go forward, but debtors’ counsel told the judge they will make “all efforts” to move forward with the DS hearing next Wednesday. Young Conaway is co-counsel in the case. Debtors’ counsel noted at the conclusion of today’s hearing that the board will need time to “digest” Willkie’s retention denial, but the debtors have already begun “inquiries” regarding replacement lead bankruptcy counsel.

Judge Silverstein took the contested retention application under advisement after presiding over an evidentiary hearing on the matter on Feb. 6. That hearing focused on Willkie’s representation of Kahn in the company’s 2023 take-private transaction, and at the hearing’s conclusion, the judge promised she would rule on the “messy,” “time-sensitive” issue “as soon as” possible.

The take-private transaction is the subject of two independent investigations in the chapter 11 cases: an investigation being conducted for the operating debtors by the law firm Petrillo Klein Boxer and an investigation by independent director Michael Wartell, who is being advised by Akin Gump. The transaction is also the subject of a separate litigation.

The debtors’ proposed plan would funnel certain claims related to the take-private transaction, Kahn and others into litigation trusts, but the mechanics of how the trusts would be established and which claims would be included has been a focal point for the “Freedom Lenders” – a group that holds the debtors’ holdco and second lien debt.

In her ruling today, the judge noted that she had not yet had time to consider the debtors’ most recent amended plan – filed earlier today – and therefore her ruling only considered the debtors’ prior plan. Both plans contemplate equitization of the first lien debt and the trusts discussed above. Although the debtors insisted that the equitization transaction and the deleveraging of the debtors should be viewed as the sole central goal of the case, Judge Silverstein disagreed.

Instead, the judge determined that the plan issues related to Kahn – who she said was “synonymous” with the case, the take-private transaction and related claims – were so “central to the case” that it precluded Willkie’s retention.

The judge rejected the debtors’ arguments that conflicts counsel and the appointment of Wartell as an independent investigator could cure any issues with Willkie’s representation. Distinguishing the Franchise Group case from FTX, which the debtors relied on in their briefing, Judge Silverstein said she had no evidence that conflicts counsel was utilized “in a point and time where it might have alleviated any concerns.” To the contrary, the judge said that Willkie had primarily negotiated the plan, and no independent counsel dealt with the treatment of the claims and causes of action that were and are central to the case.

Rather, Judge Silverstein likened the case to Enviva where Judge Brian F. Kenney in the Eastern District of Virginia rejected the debtors’ retention of Vinson & Elkins as bankruptcy counsel after concluding that the firm’s concurrent representation of 43% equityholder Riverstone Investment Group in unrelated matters created an “actual conflict of interest” for the firm. Judge Silverstein explained that in Enviva, Judge Kenney reasoned that proposed debtors’ counsel would have negotiated an equitization plan premised on an RSA that contemplated consideration for the debtors’ equityholders, and such negotiations would have involved all key constituencies in the case, including the official committee of unsecured creditors. Those negotiations were so central to the case that it precluded a conflicts counsel cure.

Judge Silverstein also rejected the debtors’ argument that Willkie Farr’s ethical walls could resolve any retention-related issues here. The judge explained that ethical walls are put in place under the professional rules of conduct so that the knowledge gleaned from the firm’s representation is not imputed to the entire firm. However, Judge Silverstein observed that here, Willkie Farr did not establish a wall for the take-private transaction until after it had concluded, and therefore, the knowledge gained during the firm’s representation of Kahn in connection with the transaction is “imputed to the firm as a whole.”

The judge further reasoned that even if Willkie Farr had complied with the model rules of professional conduct such that the knowledge acquired would not be imputed to the entire firm, that does not necessarily equate to compliance with section 327(a)’s disinterestedness requirement. The fact that Kahn did not object to Willkie’s retention is also irrelevant, added Judge Silverstein.

The court appeared to sympathize with the loss of Willkie’s entrenched knowledge of the debtors’ business and noted testimony from David Orlofsky, the debtors’ chief restructuring officer, that denial of Willkie’s retention would “set the case back,” including by likely causing the debtors to miss milestones and default under the RSA and by potentially negatively affecting the sale process. “Unfortunately, these concerns cannot outweigh the conflicts that exist,” remarked the judge.

Finally, Judge Silverstein found that the applicant bears the burden of proof in retention situations. She distinguished the Delaware District Court’s Boy Scouts decision by pointing out that Boy Scouts dealt with a traditional two-party dispute. In Boy Scouts, the district court ruled that the objector to retention of Sidley Austin as debtor’s counsel had the burden of proving that the proposed representation violated section 327 of the Bankruptcy Code. However, the district court did so by providing a conclusory statement without explaining its rationale, said Judge Silverstein.

The judge added that she would limit the district court’s Boy Scouts decision to section 327(c) of the Bankruptcy Code, and to the extent not so limited, she would “respectfully” disagree with the decision and follow Enviva and other cases which place the burden on the applicant. “It only makes sense” that the debtor – as the applicant – has the burden of proof to show that its proposed counsel meets the standard under section 327, concluded the judge.