Huge Fees, Many Conflicts In PG&E; Case

When a big bankruptcy case comes along, so does the bankruptcy gang.

After PG&E; Corp.’s Pacific Gas & Electric Co. filed for protection from creditors in April, major law firms and other high-priced professionals queued up and began billing.

PG&E;’s lead counsel already has charged $2.65 million in the first two months of a case that some experts say could stretch into years. A financial advisor asked for as much as $350,000 a month and once considered seeking a “success fee” of $20 million if the company’s reorganization panned out. A financial consultant of the PG&E; creditors committee has proposed a $1.5-million fee for six months’ work.

The PG&E; case offers an extraordinary view of an arcane field usually outside the limelight.

Total court-approved fees in the bankruptcy filing--the third-largest in U.S. history--could amount to at least $470 million, said UCLA law professor Lynn LoPucki, a leading expert on bankruptcy practice.

“The bigger the case, the bigger the fees,” he said. But even that figure, LoPucki said, could go higher because of the regulatory and public policy issues involved in the case, which he described as “one of the most complex cases ever.”

Along with those huge fees come complex potential conflicts. Ethical problems have long haunted the bankruptcy field, despite repeated efforts at reforms that have followed scandals involving prominent firms. Though the PG&E; bankruptcy case is in its earliest stages, entanglements that experts say could present ethical issues already have arisen as several prominent firms were approved by the bankruptcy judge:

* PG&E;’s main law firm also represents banking interests that are tied to one of the utility’s biggest debts, a nearly $1-billion credit arrangement.

* PG&E;’s accounting firm has done unrelated work for more than 80 companies involved in the PG&E; bankruptcy case, including some of the utility’s creditors.

* The law firm for the official committee of PG&E; creditors represents a $400-million Arizona power project being developed by an arm of PG&E;’s parent company.

* The accounting firm for the committee does work for PG&E; and its parent company, a corporate relationship being examined by the state’s utility regulator.

For shareholders or creditors of a company in bankruptcy proceedings, conflicts can create serious problems. The complex legal and accounting issues that arise in a bankruptcy case provide numerous opportunities for professional firms to alter outcomes in ways that benefit a favored company and harm the client relying on their advice.

Experts say the sheer size of today’s professional firms and the vast reach of PG&E;, whose business activities touch virtually every sector of California, make conflicts almost inevitable.

“Very few people have the expertise for high-profile, high-stakes bankruptcies, so you have a small pool from which to draw representation, and that’s where . . . potential conflicts come up,” said Nancy B. Rapoport, a University of Houston law professor and a leading bankruptcy ethics expert.

“Today,” LoPucki said, “it’s not a question of whether there’s a conflict, it’s how big it is.”

Dozens of Firms Vying for Contracts

The bankruptcy case of PG&E;, with a reported $31.5 billion in assets, is big, indeed. Only two cases from the late 1980s, Texaco Inc. and Financial Corp. of America, surpass it when measured by the dollar value of the assets at stake.

Records show that about a dozen firms are in line for lucrative contracts with either PG&E; or the official committee representing thousands of the utility’s unsecured creditors. So are dozens of other firms that have continuing legal work for the company.

All will be paid from the PG&E; bankruptcy estate, if Judge Dennis Montali approves their employment.

To become eligible for legal, accounting and consulting work, each firm must convince the judge that it is qualified to do the job and does not have unmanageable conflicts of interest.

Many firms in the PG&E; case have worked with one another or represent parties with a financial interest in the outcome, such as lenders and creditors, in matters outside the case.

With the limited number of bankruptcy specialists, “naturally you have lawyers and others working both sides of the fence,” said Mary Josephine Newborn Wiggins, professor at the University of San Diego School of Law. “There are bound to be some situations where it gets sticky.”

Time and again, firms acknowledged in disclaimers filed with Bankruptcy Court that they have so many ties to other companies that they may not have unearthed all connections and potential conflicts. Some addressed potential conflicts by erecting “ethical walls” within their own firms or having clients sign waivers that absolve the professionals of conflicts of interest.

Experts say ethical walls amount to honor systems with no outside monitoring and that waivers sometimes are granted without the client’s full understanding of the potential conflicts.

They also point out that not all connections between adversarial interests constitute conflicts, and not all conflicts are serious enough to disqualify a firm from a case.

The fact that so many issues arise in cases of this magnitude has meant that the bankruptcy system is forced to make accommodations for big firms with overlapping clients.

“By traditional conflict standards, the large firms could not participate in the cases,” LoPucki said. “There has been a huge shift in what is acceptable. It is more lenient. A firm is allowed to represent [clients] today where they would not have been allowed 20 years ago.”

‘Ethical Walls’ Used to Avoid Conflicts

The complexity of the entanglements--and the manner in which the system has adapted to them--can be seen in the roles played in the PG&E; case by two of the nation’s largest accounting firms, Deloitte & Touche and PricewaterhouseCoopers, and one of its most prominent law firms, Milbank, Tweed, Hadley & McCloy.

When PG&E; proposed hiring Deloitte & Touche for a base fee of $855,000 and an hourly rate of $450 to $650 for partners, the U.S. trustee in the case, Linda Ekstrom Stanley, objected.

The U.S. trustees office is an arm of the Department of Justice that Congress created in 1978 to help combat what critics derisively dubbed bankruptcy rings. The trustees administer bankruptcy cases and are instructed to guard against abuses and profiteering by professionals.

So far in the PG&E; case, Stanley’s office has weighed in against the appointments of several major companies, voicing objections ranging from excessive fees to conflicts. Her office succeeded in preventing the creditors committee from hiring a public relations firm, and it won a tentative ruling that would prevent PG&E; from indemnifying a financial consulting firm against negligence claims arising from its work.

The investment banking firm, Dresdener, Kleinwort & Wasserstein, has stopped working for PG&E; because of the lack of indemnification. PG&E; is hunting for a new financial consultant.

In the case of Deloitte & Touche, Stanley’s office seized on the company’s disclosure that it had worked not only for PG&E; but also for its parent company and for another subsidiary, PG&E; National Energy Group. The accounting firm had performed $14.4 million in work last year for the three PG&E; entities.

The trustee said that work posed a potential conflict because the California Public Utilities Commission was reviewing PG&E;’s controversial transfers of funds to its parent company.

Deloitte & Touche argued successfully that its relationships with three PG&E; entities did not compromise the company’s ability to fairly represent PG&E; in the bankruptcy.

In the interest of full disclosure, Deloitte & Touche reported it formerly employed a daughter of Judge Montali. The firm also said it employs the wife of another bankruptcy judge in San Francisco. She logged fewer than 50 hours of tax consulting work last year for PG&E;’s parent, the firm said.

Ethics experts said such personal connections generally would not be enough to prompt a judge to disqualify a firm. “It’s obviously an interesting relationship,” Rapoport said. “It comes down to . . . how much of an appearance of too much closeness he wants to put up with.”

Issues involving the second accounting firm, PricewaterhouseCoopers, arose when the committee representing PG&E;’s creditors proposed hiring the firm as its accountant and financial advisor. Stanley’s office objected that the firm, like Deloitte & Touche, works for PG&E; and its parent.

“Professionals . . . must have no conflict of interest . . . and owe undivided loyalty to the creditors committee,” the trustees office said.

“It is not beyond imagining that [PG&E; and its parent] could influence [PricewaterhouseCoopers] through these continuing relationships, the promise of future engagements and other intangibles,” the trustee said in one filing.

PricewaterhouseCoopers said it would build an ethical wall within the firm to avoid problems or other dicey situations in which PG&E;, its parent or affiliates are adversaries. The judge approved the hiring.

Rapoport said such ethical walls do not necessarily prevent improper communications within firms. “I don’t think you can rely on an honor system or an internalized moral compass. That is why we have rules in the first place,” she said.

As its legal counsel, the PG&E; creditors committee received permission to hire Milbank. The law firm disclosed that it represented some of PG&E;’s creditors in matters unrelated to the bankruptcy. The firm also represents a $400-million Arizona power plant project being developed by a subsidiary of PG&E; Corp.’s National Energy Group.

Some bankruptcy experts said there was a potential for conflict, but the firm said the connection was tangential.

In addition, the firm worked for the California Power Exchange, the now-bankrupt entity that under California’s deregulation plan served as the state’s energy marketplace. Milbank resigned that post several weeks before the Power Exchange filed its own bankruptcy petition in March. The resignation, Milbank said, was “due to certain potential conflicts with creditors” of the exchange.

One of Milbank’s clients is Enron Corp., which, using other counsel, sued the Power Exchange, trying to get back collateral held by the exchange to ensure power deliveries.

Enron now sits on the PG&E; creditors committee represented by Milbank. Another of PG&E;’s creditors is the Power Exchange, which is seeking nearly $2 billion for energy companies that sold electricity to the utility but were not paid. Records show Milbank has filed a claim of about $373,000 against the exchange for legal work.

George Sladoje, president and chief executive of the Power Exchange, said he was shocked when Milbank, its longtime counsel, quit. “It was very difficult to find [new] counsel,” he said. “There were conflicts all over the place” among law firms because so many did legal work for PG&E; and Southern California Edison.

Ed Feo, managing partner of Milbank’s Los Angeles office, said the company did its best to avoid conflicts in both bankruptcy cases--by dropping representation of a client in one and fully disclosing its connections in the other.

As for Milbank’s role in the PG&E; case, Rapoport said that representing creditors and a creditors committee is “OK as long as their interests do not diverge.”

However, she said, “Bankruptcy is like the Chinese game of Go. Moves have ramifications 20 steps later.”

Disclosure Often Is Safest Legal Course

As a practical matter, the safest course legally in a bankruptcy case is to try to disclose every connection and let the judge decide whether to allow a firm to participate.

“Disclosure cures a multitude of ills,” said Lawrence Gottesman, chairman of the bankruptcy practice at Brown, Raysman, Millstein, Felder & Steiner in New York City. By contrast, he said, “the penalty for working with an undisclosed conflict can be severe.”

Milbank learned that three years ago, when John G. Gellene, once a lawyer with the firm, was sentenced to 15 months in prison and fined $15,000 for failing to disclose during a bankruptcy case that he also was working for a creditor in separate litigation. Before the sentencing, the firm had returned $1.9 million in legal fees and fired Gellene.

To ferret out potential conflicts, firms rely heavily on the computer. Those involved in the PG&E; case, for example, usually checked their computerized client lists against the biggest 100 PG&E; creditors and other players, such as other professional firms, the trustee’s staff and the judge.

Even then, there are limits. The computerized checks did not touch tens of thousands of smaller PG&E; creditors. And the firms themselves commonly issue disclaimers, saying they might not have turned up all their potential conflicts.

If a law firm finds it has a troubling conflict, it also can seek a conflict waiver from its existing client, which essentially gives the firm permission to pursue dual representation.

PG&E;’s lead counsel, Howard, Rice, Nemerovski, Canady, Falk & Rabkin, reported receiving $1.9 million from the company in the year before the Chapter 11 filing and it billed $2.65 million in fees and expenses for the two months after that.

Among the firm’s potential conflicts was its representation of an affiliate of Bank of America Corp. The bank participates in a revolving credit agreement that allows PG&E; to borrow up to $1 billion. PG&E; listed Bank of America as the agent for a $938-million claim.

The law firm said its relationship with the Bank of America affiliate was “sufficiently attenuated” that it did not need a conflict of interest waiver from its client. But the firm sought and received conflict waivers from a second bank and the affiliate of a third bank involved in the credit agreement.

There was no objection by the trustees office, and the judge approved hiring the firm. “We see if [a firm has] a disqualifying connection and, if not, we let it go,” said Stanley, the U.S. trustee.

Indeed, if every potential conflict were examined closely, some say, the bankruptcy system would grind to a halt.

“It would be horrendous,” said Daniel Bogart, a law professor at Chapman University. “There are conflicts that matter and those that don’t. The parties have to reach a level of comfort quickly.”