In Re Sonicblue

Facts

P designs and markets consumer electronic products. Pillsbury Winthrop Shaw Pittman LLP (PWSP) served as P's longtime general corporate and litigation counsel. In April 2002, P raised financing in a private placement issuance of $75 million in senior secured subordinated convertible debentures. Three institutional bondholders, Portside Growth & Opportunity Fund Ltd., Smithfield Fiduciary LLC, and Citadel Equity Fund Ltd., acquired the senior debentures at a discount for $62.5 million. The senior debentures were also partially secured by P's interest in shares of United Microelectronic Corporation (UMC), a Taiwanese company. In its capacity as counsel to P, on April 22, 2002, PWSP issued to the senior bondholders a written opinion as to the enforceability of the debentures. It stated 2. . . . Each of . . . the Purchase Agreement, the Registration Rights Agreement, the Indenture, the Pledge and Security Agreement, and the Option Agreement, when duly executed and delivered by the Buyers, will each constitute a valid and binding agreement of the Company, enforceable against the Company in accordance with its terms. 3. The issuance and sale of the Debentures have been duly authorized. Upon issuance and delivery against payment therefore in accordance with the terms of the Indenture and the Purchase Agreement, the Debentures will constitute valid and binding obligations of the Company, enforceable against the Company in accordance with their terms. 9. . . . (b) Our opinion in paragraph 2 above is subject to and limited by (i) the effect of applicable bankruptcy, insolvency, reorganization, fraudulent conveyance, receivership, conservatorship, arrangement, moratorium, or other laws affecting or relating to the rights of creditors generally. . . . The bankruptcy limitation in paragraph 9 referenced only paragraph 2 and not paragraph 3 of the opinion letter. Six months after the issuance of the senior debentures, P was unable to meet its maturing financial obligations and entered into a retainer agreement for PWSP to 'represent it in its effort to restructure its obligations to certain of its existing debt under Chapter 11. P and the subsidiaries filed chapter 11 petitions on March 21, 2003. On April 11, 2003, PWSP filed an employment application accompanied by a verified statement pursuant to Bankruptcy Rule 2014, which disclosed: 3. The Firm has been engaged as P's corporate and litigation counsel since approximately 1989. During that time, the Firm has provided legal representation to P in a variety of areas, including corporate and securities matters, mergers and acquisitions, litigation, and intellectual property matters. The Firm has been working with P in connection with their restructuring since approximately October 25, 2002, when the Firm was retained to provide advice concerning the restructuring of P's liabilities and business operations. PWSP failed to disclose its connection resulting from the issuance of the opinion letter to the senior bondholders. As part of its continuous disclosure obligation, PWSP stated, 'The Firm will continue to monitor its relationship with the creditors and other parties in interest in these cases and, as it discovers additional information requiring disclosure, will promptly supplement this application with any appropriate disclosures.' The court-appointed PWSP as counsel and PWSP diligently filed supplemental disclosures on May 30, 2003, January 23, 2004, October 27, 2004, July 13, 2005, July 27, 2005, November 4, 2005, and June 5, 2006, none of which mentioned the opinion letter. The court-appointed PWSP as counsel and PWSP diligently filed supplemental disclosures on May 30, 2003, January 23, 2004, October 27, 2004, July 13, 2005, July 27, 2005, November 4, 2005, and June 5, 2006, none of which mentioned the opinion letter. The senior bondholders effectively control approximately two-thirds of the claims in these cases. P holds nearly $ 80 million in funds for distribution and anticipates receiving an additional $ \6 million from preference settlements. Secured claims have been paid in full from the proceeds of the sale of 3 of P's subsidiaries, and a distribution of 33% to unsecured creditors is anticipated. On April 21, 2005, some of the junior bondholders filed a complaint asserting claims for breach of fiduciary duty and constructive fraud in connection with the issuance of the senior debentures in 2002. They assert that the entire transaction was improperly authorized and entered into while P was in the zone of insolvency and hopelessly unable to honor its long-term bond obligations. They further assert that by pledging its UMC stock in the transaction, P rendered a significant asset unavailable to junior bondholders in a liquidation. VIA and S3 Graphics filed duplicate proofs of claim for $70 million each on July 17, 2003, based on a breach of the joint venture agreement. Substantially all assets of P have been liquidated. PWSP has been prosecuting avoidance actions and objections to claims. It has divided and shared the work with LNBRB, however, PWSP retained the more complex litigation or litigation requiring some knowledge of the background of the debtor's operations. PWSP examined the claims of the senior bondholders and the junior bondholders. It expended 49.50 hours, incurring $ 23,237.50 in legal fees, to complete its analysis of the senior bondholders' claims, including research on the applicability of fraudulent transfer law and usury law to the transaction. It identified a significant problem with the original issue discount granted the bondholders, the difference between the face amount and the amount actually paid for the debentures. The senior bondholders also received other consideration in the transaction, including the UMC stock, that rendered the valuation of the original issue discount more complex. P asserts that the original issue discount constituted unamortized interest as of the petition date that is subject to disallowance under Bankruptcy Code § 502(b)(2). On August 24, 2006, it came to light that PWSP had issued the opinion letter to the bondholders in connection with the issuance of the debentures. The bondholders claimed reliance on the opinion letter as assuring that their claims were allowable in a subsequent bankruptcy case. The bondholders demanded that PWSP defend and indemnify them for any losses resulting from P's challenge to their claim. They demanded indemnification on September 5, 2006, with a letter to the managing partner of PWSP. They intended to pursue PWSP for negligent misrepresentation and negligence, among other claims. PWSP did not file a supplemental Bankruptcy Rule 2014 disclosure to address the claim of the senior bondholders. When it filed its eighth interim application for compensation with the court on October 18, 2006, PWSP did address the analysis of and potential objection to the claim of the senior bondholders. It disclosed, 'The matter was turned over to the Creditors' Committee for prosecution.' More than six months after the senior bondholders first asserted their claims against PWSP, and only after the United States Trustee filed the motion for disqualification, PWSP filed a supplemental Bankruptcy Rule 2014 disclosure on March 5, 2007. Before the court is the motion of the United States Trustee to disqualify P’s counsel and to appoint a Chapter 11 trustee.

Issues

Rule of Law

Holding and Decision

Legal Analysis

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