April 30, 2012 Articles

Privilege-Waiver Issues in Bankruptcy after MF Global

Management's fiduciary duty prior to bankruptcy is to the shareholders, but afterward, the trustee's role is to administer the estate for the benefit of creditors

by Meryl B. Vinocur and Catherine G. Pappas

In late October 2011, it was discovered that MF Global, Inc., a major commodities broker-dealer, had transferred $700 million from customer accounts to the broker-dealer and made a loan of $175 million in customer funds to its U.K. subsidiary to cover massive liquidity shortfalls. Customer accounts were frozen, and the parent company, MF Global Holdings, Ltd., with certain of its subsidiaries, including the broker-dealer, filed for bankruptcy on October 31, 2011. These events have led to a teaching moment concerning waiver of the corporate attorney-client privilege by the debtor's trustee and the effect of waiver on the debtor's officers and directors and those of the debtor's subsidiaries.

Countless questions have been raised regarding the mismanagement of client funds at MF Global, and investigations have been launched by, among others, the Commodity Futures Trading Commission, the Securities and Exchange Commission, and James Giddens, the trustee appointed by the Securities Investor Protection Corporation (SIPC) to liquidate MF Global under the Securities Investor Protection Act (SIPA). As part of the investigations, these entities have requested from parent MF Global Holdings, now a debtor in bankruptcy, communications relating to customer accounts and other business operations. Louis Freeh, former Federal Bureau of Investigation director and the Chapter 11 trustee appointed to manage MF Global Holdings' assets in bankruptcy, initially denied these requests, claiming that such communications were protected by the attorney-client privilege. Freeh's refusal to provide such communications was not well received by the various constituencies clamoring to marshal MF Global's assets in the wake of its rapid collapse. Yet, Freeh was within his rights to do so, even if it conflicted with the interests of the SIPC trustee of the subsidiary broker-dealer.

Whereas management's fiduciary duty prior to a bankruptcy filing is to the corporation's shareholders, the duty after a bankruptcy filing runs to general creditors as well as equity holders. The trustee's role in bankruptcy, generally, is to administer the estate for the benefit of all creditors. By contrast, the role of a SIPC trustee in a SIPA liquidation generally consists of recovering funds for wronged customers of the brokerage firm. For that reason, the sometimes competing interests of the respective trustees can invite tension in delicate situations like MF Global, where communications are shielded and privilege is asserted by one trustee to the frustration of the other. Nonetheless, the privilege was Freeh's to assert (or waive) on behalf of MF Global Holdings, the debtor in bankruptcy.

The Impact of Weintraub
In Commodity Futures Trading Commission v. Weintraub, 471 U.S. 343, 358 (1985), the U.S. Supreme Court ruled that a debtor corporation's bankruptcy trustee controls the debtor's attorney-client privilege and thus can waive that privilege. In Weintraub, the Commodity Futures Trading Commission (CFTC) subpoenaed a bankrupt corporation's former counsel, seeking evidence of suspected misappropriation of funds by company insiders. Although the attorney asserted the corporation's attorney-client privilege, the CFTC was able to obtain a waiver of that privilege from the bankruptcy trustee, and the Supreme Court held that such a waiver was valid. Because corporate directors fail to retain any managerial power in a bankruptcy reorganization where a trustee has been installed, the Supreme Court held that management also should not retain control over the attorney-client privilege. Therefore, a trustee in bankruptcy may waive the attorney-client privilege of a corporate debtor for communications made prior to the declaration of bankruptcy. Communications between corporate officers and in-house or outside counsel, which would generally remain protected and confidential outside of bankruptcy, are likewise subject to waiver and disclosure by the trustee.

Notably, the Weintraub Court also rejected the idea that the interest against self-incrimination of former officers and directors trumps the trustee's capacity to waive the privilege, holding that the goal of uncovering insider fraud "would be substantially defeated if the debtor's directors were to retain the one management power that might effectively thwart an investigation into their own conduct." Id., 471 U.S. at 353–54.

Bankruptcy courts across the United States, following the Supreme Court's ruling in Weintraub, have permitted trustees to waive the attorney-client privilege and disclose relevant communications that, at the time they were made, were protected. In the case of MF Global Holdings, Chapter 11 trustee Freeh followed suit and, on February 14, 2012, agreed to turn over thousands of emails and documents to the federal authorities and to the SIPC trustee, which will likely provide a far more detailed look at what went wrong in the days leading up to MF Global's collapse and bankruptcy filing. Significantly, the disclosure of these documents could lead investigators to those within MF Global who committed wrongdoing and consulted with MF Global's attorneys, despite their likely understanding at the time that such communications would be protected by privilege and would never be revealed to outside parties.

As the current economic crisis continually spawns civil and criminal investigations into failing companies, corporate officers must be mindful that the waiver of privilege may ultimately be decided not by those in power at the time those communications were made, but by a trustee or receiver appointed at a later time. Attorneys representing individuals targeted in federal criminal investigations should be aware that, after bankruptcy or the initiation of a receivership proceeding, their clients' prior communications with company counsel (in-house or outside counsel), even communications involving the legal implications of the conduct at issue in the investigation, may be disclosed to government investigators.

The attorney-client privilege exists to facilitate free and open communication between the client and the attorney and is vital to our legal system. The privilege is designed to protect the vulnerable party from producing documents that are otherwise damaging to its case. Courts may refuse to apply the privilege in circumstances that perpetuate a criminal act, such as fraud. Lifting the privilege, however, can also expose the debtor to harm by chilling communication between attorney and client.

The Supreme Court was careful not to extend its holding in Weintraub to cases involving individual debtors, which has led to a split of authority on the question of whether a trustee can unilaterally waive the attorney-client privilege in an individual bankruptcy case. The absence of guidance from the Supreme Court on that point has led lower courts to three different outcomes on the privilege issue in the individual context. Some courts have held that the attorney-client privilege of an individual debtor passes to the bankruptcy trustee by operation of law. In re Smith, 24 B.R. 3, 5 (Bankr. S.D. Fla. 1982). Others have held that a trustee may not waive an individual debtor's attorney-client privilege. In re Hunt, 153 B.R. 445, 454 (Bankr. N.D. Tex. 1992). Finally, some courts have taken a functional approach that balances the equities and weighs the trustee's need for the information against the harm the disclosure would cause to the debtor. In re Miller, 247 B.R. 704, 710 (Bankr. N.D. Ohio 2000).

In MF Global Holdings' corporate bankruptcy, however, the privilege was squarely Freeh's to waive. In doing so, Freeh presumably had to consider not only the threat that the bankruptcy estate would be depleted by the claims of government authorities if certain wrongdoings were uncovered but also the possibility that exposure of wrongdoing may also reveal avoidance action claims that Freeh may later pursue to bring assets back into the bankruptcy estate. Freeh likely also sought sufficient time to review the communications with his own professionals on behalf of the bankruptcy estate before making those communications available to those with similar and possibly competing interests.

Important Considerations
Concerns of privilege are paramount in any bankruptcy case, particularly in those where a trustee is appointed. These concerns should be carefully considered prior to a company filing for bankruptcy protection. After Weintraub, and in light of the current financial crisis, it is important for attorneys to be aware of the possible implications for their clients. In cases where companies have already filed for bankruptcy, counsel representing individuals must be mindful that their clients' prior communications—both factual information disseminated to company counsel and company counsel's legal advice on the conduct under investigation—may be turned over to the government. For companies on the precipice of bankruptcy or receivership, counsel for individuals must be aware that current communications with corporate counsel may be subject to waiver upon the filing of the bankruptcy petition or receivership proceeding. Therefore, while counseling corporate clients prior to the bankruptcy or receivership filing, attorneys should remind their clients that any communications between individuals in management and corporate counsel may later be used against them in their personal capacity or, at a minimum, may be subject to review by third parties.

Recent news reports have indicated that criminal prosecution of MF Global's management may not be likely, based on preliminary reviews of communications and documentation provided by the debtor. Nevertheless, the issues of privilege and waiver that have figured so prominently in the case are important to remember for effective representation of corporate clients and corporate debtors in similar situations.

Keywords: litigation, commercial, business, privilege waiver, bankruptcy, trustees, attorney-client privilege


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