Upholding a rational standard for disinterestedness in Puerto Rico

By Ronald Barliant

In the article, “PROMESA and McKinsey’s Lack of Disinterestedness,” N.Y.L.J. (Jan. 4, 2019), Carlos J. Cuevas incorrectly charges McKinsey with having a conflict of interest that should disqualify it from continuing to act as adviser to the Financial Oversight and Management Board (FOMB) for Puerto Rico. McKinsey asked me to look into the matter and, if I thought it appropriate, write a response. I most certainly think it appropriate to do so because in my opinion Mr. Cuevas got it completely wrong.

Mr. Cuevas’s conclusion that McKinsey is unfit to serve as FOMB’s adviser is based on his assertion that, “[a]fter McKinsey was retained, it was revealed that McKinsey, through its affiliates, holds at least $20 million of Puerto Rico’s debt.” Thus, Mr. Cuevas says that it is McKinsey itself that holds the debt, albeit, through affiliates, and he at least implies that McKinsey knew it held that debt when it was retained. As McKinsey has explained to me, those are not the facts, nor does Mr. Cuevas get the law right.

According to McKinsey, its consulting operations are separate and distinct, both legally and operationally, from MIO Partners (MIO). MIO manages pension and post-tax funds invested by over 30,000 current and former employees of McKinsey. For the vast majority of assets under MIO’s management, decisions about specific investments are made by third-party asset managers retained by MIO. Those third-party managers exercise their own investment discretion. MIO-dedicated professional staff manage the remaining minority of assets. I also understand from McKinsey that while the MIO board includes McKinsey consultants, none of those consultants work on FOMB matters, and while the MIO board exercises general oversight over MIO, the MIO board (1) does not decide which investment managers will receive investments, (2) plays no role in the investment decisions of those managers, and (3) operates under policies that prohibit the use of McKinsey client information for investment purposes and MIO investment information for consulting purposes.

It was MIO, not McKinsey’s consulting operations, that held the Puerto Rican debt as a tiny part of MIO’s $12 billion investment portfolio. In addition, McKinsey consulting operations and MIO have in place various safeguards to ensure separateness between McKinsey’s consultants and MIO, including: (1) that MIO’s professionals make independent investment decisions for MIO, (2) McKinsey consultants are not informed about MIO’s underlying investment decisions, and (3) as mentioned, with respect to the vast majority of assets under management, MIO invests through third-party asset managers who have complete discretion over the assets they manage. There is, in short, a wall between McKinsey consulting and MIO.

Importantly, Mr. Cuevas mistakenly bases his argument on §327 of Title 11 of the United States Code (the Bankruptcy Code), which is the provision that governs the employment of estate professionals in bankruptcy cases. However, Puerto Rico is not being reorganized under the Bankruptcy Code and, therefore, §327 is not relevant to McKinsey’s work for the FOMB.

McKinsey serves the FOMB under the Puerto Rico Oversight, Management, and Economic Stability Act, Title 48, Chapter 20 (PROMESA) framework that Congress established for Puerto Rico to adjust its debts. Congress did not incorporate §327 when enacting PROMESA, although several other sections of the Bankruptcy Code were incorporated. While the Federal Rules of Bankruptcy Procedure were included wholesale in PROMESA, Bankruptcy Rule 2014, which governs retention of estate professionals in bankruptcy cases, only applies to those retained under §§327, 1103 or 1114 of the Bankruptcy Code, which McKinsey is not. Therefore, all of Mr. Cuevas’s arguments that McKinsey should not have been retained under §327(a) and Bankruptcy Rule 2014 are irrelevant (in addition to being incorrect on the facts).

The only relevant requirements are the provisions of PROMESA, which do not include a standard for retention of consultants such as McKinsey. Congress chose to give the FOMB latitude in its selection of such consultants. Incorporating the stringent standards of the Bankruptcy Code would directly contradict and defeat Congressional intent.

Congress did include a standard for the retention of attorneys, however. Section 2128(b) of PROMESA states that “[i]n any action brought by, on behalf of, or against the Oversight Board, the Oversight Board shall be represented by such counsel as it may hire or retain so long as the representation complies with the applicable professional rules of conduct governing conflicts of interests.” Even if McKinsey consulting operations were subject to the same standard as litigation attorneys, there is no conflict of interest: MIO owned the Puerto Rican bonds along with $12 billion of other assets, and McKinsey consultants did not make investment decisions regarding those bonds.

As a former bankruptcy judge who was required to disclose and recuse myself from any case involving a firm in which I had even a small investment, I have a deep understanding of what it means to have a disqualifying conflict of interest. Soon after I became a bankruptcy judge, I moved my meager investments to mutual funds. The primary reason was that I was not required to report the individual holdings of mutual funds or recuse myself if one of the companies held by the funds appeared before me. This sensible rule for judges is established in the Guide to Judiciary Policy, Vol. 2D, Ch. 3 Pages 6, 7, §315.30 Identification of Assets in the following way:

1) A filer [i.e., a judge] is not required to list the individual holdings of a widely-held investment fund, which is defined as a money market fund, mutual fund, or other such portfolio: Thursday, January 17, 2019

(A) that is publicly traded or whose assets are widely diversified, and

(B) over whose financial interests the filer neither can nor does exercise control (i.e., the filer is unable to select the specific stocks, bonds, or other assets).

It strikes me that MIO functions similar to a fund of funds where investors put money into a fund which, in turn, invests in other types of funds. Through this approach, an investor gains exposure to a portfolio that includes a wide range of underlying assets instead of investing directly in bonds, stocks and other types of securities. With this approach, the investor often has no visibility into the underlying assets in each of the funds—whether bonds, stocks, or other types of securities. McKinsey has also made it clear that neither its consulting operations nor employees can or do “exercise control” over MIO’s funds or the specific underlying investments in those funds. Similar to judges who own mutual funds, I can think of no reason why McKinsey would not be able to fairly advise FOMB, let alone why we would apply a more stringent standard to a consultant.

Moreover, even under the Bankruptcy Code, putting aside the separateness of McKinsey consulting operations and MIO which makes disclosure of MIO connections unnecessary, everyone agrees that “de minimis” connections would not have to be disclosed or require disqualification. The $20 million in bonds at face value referred to by Mr. Cuevas represents less than 0.17 percent of the total MIO assets under management. So, even if the McKinsey personnel who worked with the FOMB knew about the holdings, they would also have known that nothing they did that might affect the market value of the bonds could have more than a nearly imperceptible effect on their pensions or other investments. Consequently, even under the (inapplicable) standards of §327(a) of the Bankruptcy Code that Mr. Cuevas discusses, McKinsey would be disinterested. The test that the First Circuit (the circuit that hears appeals from the U.S. District Court for the District of Puerto Rico) applies is whether the professional holds a materially adverse interest to the estate (i.e., a meaningful incentive to act contrary to the best interests of the estate). In re Martin, 817 F.2d 175, 180 (1st Cir. 1987); In re El San Juan Hotel, 239 B.R. 635, 646-47 (B.A.P. 1st Cir. 1999), aff'd, 230 F.3d 1347 (1st Cir. 2000); 11 U.S.C. 101(14)(C). Given the wall of separation between McKinsey consulting operations and MIO and the de minimis size of any individual consultant’s interest (if any) in Puerto Rico’s bond debt, McKinsey clearly does not have “a meaningful incentive to act contrary to the best interests of [FOMB].”

McKinsey is being singled out, but the implications of Mr. Cuevas’s argument are far reaching. If McKinsey is conflicted then so are the countless other professionals in bankruptcy cases who use mutual funds or other asset managers for personal investments, or have affiliated investment firms. Such a rule would only lead to the disqualification of many competent professionals seeking to act for the benefit of distressed debtors and their creditors. It would also prevent much-needed professionals from acting for the benefit of FOMB and the Commonwealth of Puerto Rico.

Ronald Barliant is a former judge in the Northern District of Illinois, of counsel at Goldberg Kohn’s bankruptcy and creditors’ rights group, and an expert consultant to McKinsey.

Reprinted with permission from the January 17, 2019 edition of the “NEW YORK LAW JOURNAL”© 2019 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. ALMReprints.com – 877-257-3382 - reprints@alm.com.”