Houston Court Questions the Utility of the J. Alix Protocol in Retaining Turnaround Advisors and their Firms

In In re McDermott International, Inc., et al., Case No. 20-30336 (Bankr. S.D. Tex. May 20, 2020) [Dkt. No. 916], Judge Jones called into question the usefulness of the J. Alix Protocol in retaining turnaround advisors and their firms during a bankruptcy case.  According to Judge Jones:

While innovative at its inception, the Alix Protocol has become a tool to avoid transparency and create inequity.

But, notwithstanding these comments, this was not a case where the professionals, AlixPartners, LLP (“FA“) and its affiliate, AP Services, LLC (“AP“), faired poorly.  Indeed, they were eventually retained and paid in full.  Thus, the observations in McDermott primarily serve to provide future guidance to professionals as well as open up the debate about the utility of the J. Alix Protocol.

Facts

The Opinion arises from the recent bankruptcy case of McDermott International, Inc. and its affiliates (collectively, the “Debtors“), filed in January 2020.  Prior to the filing, the Debtors had retained the FA and AP to assist them in their restructuring efforts, including appointing an employee of AP, John Castellano, to be the Debtors’ chief transformation officer (“CTO“).

After the filing, the Debtors sought to employ AP to continue its advisory services, including allowing the CTO to continue as the chief transformation officer and allowing other professionals of AP and FA to assist him.

After some prodding by the Court early on, the FA and AP amended their proposed retention, by filing two new retention applications; one under section 327(a) of the Bankruptcy Code for the FA and one under section 363(b) of the Code for the AP.  Each application also described the separate services of each professional.

No party filed a formal objection to either application, and the Court, in fact, observed at the confirmation hearing (which followed shortly after the filing) that the “success experienced by McDermott in the case was due, in no small part, to the extraordinary talent and skill of [the CTO] and his team.”

In a bizarre turn of events, however, the US Trustee commented on both retention applications, contending that (a) neither the FA or AP could be retained under section 327(a) on grounds that both were not disinterested due to their affiliation with the CTO, but (b) both could be retained under section 363(b), which does not have a disinterestedness requirement.  The US Trustee appeared to be requesting that the Court employ what has been widely known as the J. Alix Protocol. 

Professional Retentions

Traditionally

The employment of professionals in a bankruptcy case is generally governed by 11 U.S.C. § 327(a), which provides that “the trustee [or debtor-in-possession], with the court’s approval, may employ one or more attorneys, accountants, appraisers, auctioneers, or other professional persons . . . to represent or assist the trustee [or debtor-in-possession] in carrying out the trustee’s duties under this title.”  11 U.S.C. §327(a).  Bankruptcy Rule 2014 contains additional requirements, including requiring an explanation of the professional services to be rendered, compensation arrangements, and the professional’s connections with the debtor, its creditors and other parties in interest.  FED. R. BANKR. P. 2014.

To be eligible for employment under § 327(a), a professional also must show that it (i) is disinterested; and (ii) does not hold or represent an interest adverse to the bankruptcy estate.  See In re American Int’l Refinery, Inc., 676 F.3d 455, 461 (5th Cir. 2012).  Section 1107 of the Code provides, however, that “a person is not disqualified for employment under section 327 . . . solely because of such person’s employment by or representation of the debtor before the commencement of the case.”  11 U.S.C. § 1107(b).

J. Alix Protocol

In addition to section 327(a), section 363(b) of the Code has been used as an alternative means of retaining certain turnaround professionals, like a chief restructuring officer (“CRO“), even though this provision does not specifically address professional retentions.

As early as 2001, the United States Trustee Program began the implementation of a national settlement protocol to resolve its objections to debtors’ applications to retain CROs and their firms in cases where the CRO had served in the role prior to the bankruptcy filing.  See In re Safety-Kleen Corp., Case No. 00-2303, Docket Nos. 2825, 2920 (Bankr. D. Del. 2000).  The idea behind the protocol was that when a financial advisory firm is disqualified under section 327(a) due to a lack of disinterestedness imputed on the firm by the CRO’s prepetition role, section 363(b) could still be used to authorize employment.

The employment of the J. Alix Protocol has become so common place that the US Trustee has even changed its policies and procedures to incorporate this protocol.  See https://www.justice.gov/ust/file/volume_3_chapter_11 case_administration.pdf/download.

Analysis

The Court noted that in recent years, professionals have been abusing the J. Alix Protocol by, among other things, selectively complying with its requirements; utilizing separate entities to circumvent normal retention guidelines; and pushing more work under the auspices of section 363(b) to limit judicial oversight and public scrutiny of professional fees.  The Court further noted that even the US Trustee has been confused in the application of the protocol in cases where the title of the professional is not strictly designated as a CRO.  See, e.g., In re Nine West Holdings, Inc., 588 B.R. 678 (Bankr. S.D.N.Y. 2018).

The Court then explained why the original proposed retention in McDermott illustrated why a “reexamination of the process is required.” Among other things that caused concerns, (a) the original retention of AP did not specifically mention the role of the FA in assisting the CTO, (b) the proposed retention of AP required no fee applications (as it was under section 363(b)), and (c) it was unclear whether any success fee by FA or AP would require future court approval.

The Court noted that its concerns were partially alleviated when the FA and AP filed separate retention applications, making most of the necessary disclosures under Rule 2014, including the $5 million success fee.  According to the Court, “[t]he unbundling of the triangular relationship between the parties added a much appreciated level of transparency to the process.”

The US Trustee comments were essentially intended to have the Court apply the J. Alix Protocol, based on the contention that the CTO’s prepetition status as an officer and/or director of the Debtors disqualified not only himself but also the affiliated FA and AP.

With respect to the CTO, the Court noted that since this individual–as opposed to his firm (AP)–had never been directly employed by the Debtors, he could still be characterized as disinterested under section 101(14) of the Code.  With respect to the FA and AP, the Court observed that, assuming arguendo that the CTO was not disinterested,  this status was not automatically imputed on the FA and AP.

Relying on a prior decision in the Southern District of Texas–which the majority of courts appear to agree with–Judge Jones held that there should be no per se “rule imputing a single member’s disinterestedness to the member’s firm.”  In re Cygnus Oil and Gas Corp., No. 07-32417, 2017 WL 1580111 (Bankr. S.D. Tex. 2007) (Isgur, J.).  In doing so, the Court rejected the approach used in In re Essential Therapeutics, Inc., 295 B.R. 203 (Bankr. D Del. 2003), which utilized a per se rule based on the “current climate of distrust of officers and directors.”

Finding no evidence that (a) the FA and AP were creditors, equity holders or insiders of the Debtors, (b) the CTO’s disinterestedness, if any, should be imputed on the FA and AP or (c) the FA or AP held any material adverse interest to the Debtors or their creditors and interestholders, the Court held that the FA and AP were disinterested under section 101(14) and approved their modified retention applications pursuant to section 327(a); but not section 363(b).

Takeaway

Judge Jones seemed to be concerned with how the misuse of the J. Alix Protocol has skirted the primary goals of section 327(a):  ensuring impartiality and oversight of compensation.  By rejecting a per se rule to the imputation of disinterestedness, the Court also left future cases involving CRO-type engagements to the discretion of the court.  In the end, while the Court fell short of completely rejecting the J. Alix Protocol in McDermott, professionals in future cases in the Southern District should heed Judge Jones’ comments.

 

Partner at FisherBroyles, LLP