Appeals Court Revives Case Against McKinsey for Widespread Bankruptcy Court Fraud

It appears the rule of law is not entirely dead in the US. In a 3-0 ruling, the Second Circuit reversed Southern District of New York judge and Obama appointee Jesse M. Furman on a suit by Jay Alix, founder and major shareholder of the bankruptcy boutique Jay Alix & Co, against McKinsey and a gaggle of its affiliates for perjury and fraud on the bankruptcy court that Alix said hurt it commercially.¹

We’ve embedded the Second Circuit ruling at the end of this post and strongly suggest you read it in full. Aside from being unusually well drafted, it will help educate readers on why filing civil RICO suits is not such a hot idea and therefore not often done despite the prospect of treble damages. We’ve mentioned before that they have a high bar for proof and the filing goes a bit into how courts evaluate civil RICO claims.

While the decision also provides a tidy recap of Alix’s allegations, we thought we’d turn the mike over to always-lively Dealbreaker, which wrote up the original case:

Being a fiduciary is a real drag, Just ask the asset management industry, which tried like hell to avoid such a designation but who now labor under its onerous terms.

At least money managers only have to balance their own pecuniary interests against those of their clients! Consultants have to do that, too, but also balance the competing interests of their clients, also known as “conflicts of interest.” It’s really, really hard to be a gigantic consultancy and not have these. And yet, if a consultancy wishes to do some lucrative bankruptcy consulting, boom! It’s a fiduciary. Which is why the average Chapter 11 bankruptcy filing includes hundreds of pages of disclosures about potential conflicts of interest on the part of the professional firms working on those restructurings. By contrast, McKinsey & Co., one of the very largest such firms, averages all of five disclosures per filing. Five! he average is 117; one firm disclosed more than a thousand potential conflicts in American Airlines’ 2011 filing.

This didn’t sound right to one person. Or rather, it did. Because that person is Jay Alix, founder and namesake of consulting firm AlixPartners, which has been losing ground the McKinsey for years. Jay Alix suspected the precious few McKinsey disclosures were not the result of McKinsey’s near-total lack of potential conflicts, but the result of McKinsey just deciding not to disclose the universe of potential conflicts that come with being McKinsey. Among other improprieties, even! And now, Jay Alix is saying so in lawsuit form.

Mr. Alix, the founder of the consulting firm AlixPartners, filed suit under the federal Racketeering Influenced and Corrupt Organizations Act, saying McKinsey “knowingly and intentionally submitted false and materially misleading declarations under oath” in cases where it had been hired as a bankruptcy consultant.

The declarations allowed McKinsey “to unlawfully conceal its many significant connections to ‘interested parties’” in the bankruptcies, according to the complaint. Had the connections been known, it said, McKinsey would have been precluded from working on those cases.

The complaint also accused McKinsey of offering “pay to play” deals to various bankruptcy lawyers, in which McKinsey would offer “to refer its vast network of consulting clients” to them if in exchange they would refer their bankruptcy clients to McKinsey’s restructuring business.

It gets even better.  Alix met with McKinsey managing partner Dominic Barton. The second time, Barton told Alix he was shocked, shocked, that  he’d found out the bankruptcy team was playing naughty, and volunteered that McKinsey was also engaging in pay to play with bankruptcy law firms, and McKinsey’s own lawyers told him that was illegal.

Barton then told Alix to be patient, the managing director elections were nigh, and once Barton was (presumably) reinstalled, he’d deal with it.  When Alix didn’t hear from Barton and asked for another meeting. Barton temporized and offered Alix a bribe in the form of referrals for bankruptcy work.

This ruling comes in a thorny area of law, but even so, some experts decried the trial court decision. For instance, an Emory Law Journal article argues that the courts needed to clean up the standards for what it took to be disinterested for the purpose of representation of parties in the bankruptcy process, and who was subject to those tests. Even so, in a departure from normal law journal practice, one of its four recommendations was “the court should…rule for Jay Alix in his case against McKinsey & Co.”

Note that Elizabeth Warren has also cleared her throat about yet more McKinsey bankruptcy shenanigans, where it engaged in clear self-dealing in acting at the lead bankruptcy advisor for Puerto Rico when its fund management arm held Puerto Rico bonds…which benefitted handsomely from the deals McKinsey cut. Please find her letter embedded at the end of the post.

Alix had initially had his case dismissed for not showing a connection between McKinsey’s alleged misconduct and Alix loss of revenues. The appeals court disagreed:

The district court held that Alix failed to meet RICO’s proximate cause requirement. We disagree. We hold that the amended complaint plausibly alleges proximate cause with respect to all 13 bankruptcies in which McKinsey filed false statements as well as the pay-to-play scheme. Accordingly, we VACATE and REMAND for further proceedings.

Despite the Emory Law Journal article correctly fingering the rather murky standards for who is subject to conflict of interest reporting and how stringent those tests should be, that was not why the Alix case was initially tossed out. It was because the lower court deemed he hadn’t made a case that met the standards for a civil RICO filing.

The appeals court reversed for two reasons. One was that they found the lower court had not applied the required standard of interpreting the plaintiff’s factual claims in the most favorable light, as in if he could prove they were true in discovery, would he prevail? But the second, and far more interesting leg of their analysis was that because McKinsey was charged with perpetrating what sure sounded like an egregious and systematic fraud on the court, the RICO damage analysis also had to allow for what amounted to denial of due process (lawyers feel free to correct me on nomenclature here). From the ruling:

McKinsey moved to dismiss the complaint under Rule 12(b)(6) and the district court granted the motion, while nevertheless noting that Alix’s allegations were “indeed concerning.” Still, the district court, in a careful opinion navigating a body of case law that, charitably speaking, is less than pellucid, found the allegations insufficient to satisfy RICO’s proximate cause requirement…

The court concluded that “independent intervening decisions” of the trustees and the bankruptcy court rendered the causal connection between the alleged misconduct and injury “too remote, contingent, and indirect to sustain a RICO claim.” As to the pay-to-play allegations, the court concluded that they too failed to meet the pleading standards and suffered from the same defects as the allegations concerning fraudulent disclosures because they did not sufficiently narrow the gap between the alleged fraud and the alleged resulting injury….

To establish a RICO claim, a plaintiff must prove: (1) a violation of the RICO statute, (2) an injury to business or property, and (3) that the injury was caused by the RICO violation. Cruz v. FXDirectDealer, LLC, 720 F.3d 115, 120 (2d Cir. 2013); 18 U.S.C. § 1962. This appeal implicates the causation element, pursuant to which a plaintiff must plausibly allege that the RICO violations were (1) “the proximate cause of his injury, meaning there was a direct relationship between the plaintiff’s injury and the defendant’s injurious conduct”; and that they were (2) “the but-for (or transactional) cause of his injury, meaning that but for the RICO violation, he would not have been injured.” UFCW Loc. 1776 v. Eli Lilly & Co., 620 F.3d 121, 132 (2d Cir. 2010). The dispositive issue here is whether Alix plausibly alleges proximate cause.

The district court concluded that Alix failed to allege proximate cause for three reasons. First, the alleged harm to AlixPartners, it concluded, was directly caused by the decisions of the various debtors’ trustees not to hire AlixPartners rather than by McKinsey’s misconduct. Second and relatedly, the court concluded that the existence of several intervening factors rendered the relationship between the alleged fraud and injury too indirect and remote. Lastly, the court believed that there was “at least one ‘better situated’ party,” such as the U.S. Trustee, “who can seek appropriate remedies for the most direct consequences of McKinsey’s alleged misconduct.”

We disagree with the district court’s analysis and conclusions as to the thirteen engagements. In general, we conclude that its analysis conflated proof of causation and proof of damages and that it did not draw all reasonable inferences in Alix’s favor. More specifically (and more importantly) we believe the district court gave insufficient consideration to the fact that McKinsey’s alleged misconduct targeted the federal judiciary. As a consequence, this case requires us to focus on the responsibilities that Article III courts must shoulder to ensure the integrity of the Bankruptcy Court and its processes. Litigants in all of our courts are entitled to expect that the rules will be followed, the required disclosures will be made, and that the court’s decisions will be based on a record that contains all the information applicable law and regulations require. If McKinsey’s conduct has corrupted the process of engaging bankruptcy advisors, as Alix plausibly alleges, then the unsuccessful participants in that process are directly harmed. The fact that this case invokes our supervisory responsibilities makes our resolution of it sui generis and of little, if any, application to “ordinary” RICO cases where these responsibilities are not front and center. But
in light of these special considerations, we hold that Alix has plausibly alleged proximate cause with respect to all thirteen engagements.

With a ruling underscoring that McKinsey looks to have violated the integrity of bankruptcy processes on a broad basis, and that courts have a duty to stomp on that behavior, it looks like Alix will get to root around in the firm’s file cabinets and depose the firms on the receiving end of those pay to play arrangements. Pass the popcorn.

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¹ Barrington Parker, a Bush appointee, wrote the Second Circuit decision.

00 Alix v. McKinsey appeal ruling