By Nick Brown 

NEW YORK, Feb 19 (Reuters) - Law firm Kaye Scholer will give up $1.5 million it earned as bankruptcy counsel to GSC Group Inc, in the latest settlement in a dispute over a failure to disclose relationships between bankruptcy advisers.

The law firm, which steered investment manager GSC through its Chapter 11 bankruptcy in 2010, failed to disclose long-term professional and personal ties to Robert Manzo, the chief restructuring officer in the case, the Justice Department had argued in court papers.

The firm also failed to disclose the fact that Manzo was an independent contractor, not an employee of Capstone Advisory Group, the financial adviser with which he was affiliated, the department said.

The settlement with the Justice Department, announced on Friday, follows settlements the department reached last Tuesday with Capstone and Manzo. Capstone will hand over $1 million in fees and withdraw a pending request for another $2.75 million. It will also resign, along with Manzo, from its remaining role in the case. Manzo, in addition to resigning, must forgo $175,000 in accrued but unpaid fees.

The latest settlement is subject to approval by the U.S. Bankruptcy Court in Manhattan, which has scheduled a hearing for April 22.

In addition to forfeiting money, Capstone must hire an independent monitor to review its disclosure policies, while Kaye Scholer must hire an outside expert to assist in a self-review of its policies.

Kaye Scholer, which had made more than $5 million from the case, said it agreed to the settlement "to avoid the distraction of a trial," and had not acknowledged any wrongdoing.

"It remains undisputed that Kaye Scholer contributed to the exponential enhancement of the value of the GSC estate," Aaron Rubinstein, the firm's general counsel, said in a statement on Friday.

In a statement last Wednesday, Capstone said the GSC case "represents the best of what Capstone does." The company noted that it helped get $235 million for an asset sale to lender Black Diamond Capital Management, when an initial bid had come in as low as $5 million.

A lawyer for Manzo declined to comment.

THE DISPUTE

The U.S. Trustee Program, the Justice Department's bankruptcy watchdog, had sought to strip Kaye Scholer, Capstone and Manzo of more than $10 million in fees accrued in the case.

The trustee said Capstone Executive Director Ed Ordway and Kaye Scholer partner Michael Solow made public statements calling Manzo a Capstone employee when he was actually a contractor working for his own limited liability company.

That made Manzo a separate professional entity, the trustee argued, and required him to make certain disclosures under bankruptcy laws designed to guard against conflicts of interest.

The trustee said Manzo could have conflicts of interest because he had a longstanding professional and friendly relationship with Solow.

The arrangement also violated a bankruptcy law that prohibits fee sharing between firms, the trustee argued.

As chief restructuring officer, Manzo was in charge of liquidating certain of GSC's assets in the wake of its sale.

The case was a big moneymaker for Manzo, earning him around $4 million, court papers show. He was entitled to nearly all of the fees he billed, as well as 15.5 percent of the fees billed by Capstone.

Such fee-sharing arrangements can result in higher fee costs for the bankrupt company, though it is not clear that that happened in GSC's case. Capstone says it paid more to Manzo than the GSC estate paid to it.

But in an indication of a hard-line approach to disclosure issues, Trustee Director Cliff White said in a statement last week his office will take "vigorous enforcement action when we uncover evidence that experienced professional firms have failed to satisfy their bedrock obligations to provide true and complete facts."

White could not be reached for comment on Friday.

Capstone has argued that its relationship with Manzo falls under an exception that allows fee sharing with advisers who are "members, partners or regular associates" of the firm.

The distinction comes down to "whether the person is under the control of the firm," said George Kuney, a professor at the University of Tennessee at Knoxville's College of Law.

"Does the firm tell them what to do and how to do it?" Kuney said in an interview with Reuters. "If not, then they are an independent contractor."

Captone said Manzo was an employee in all but title and worked exclusively for the firm.

Manzo's contractor status means Capstone probably cut him a check directly, as opposed to paying him a salary and providing him a W-2 tax form at the end of the year, Kuney said.

Manzo is one of a handful of restructuring professionals with the resume to arrange such a contract. An industry veteran of more than 25 years, he has worked on major cases including fallen brokerage firm Refco and auto giant Chrysler.

According to court papers, Manzo felt a contractor relationship was best due to his history with Capstone advisers. Manzo in 2000 sold his own firm, Policano & Manzo, to FTI Consulting. When left FTI in 2004, was subject to two years' leave in which he could not work on related matters, a person close to the GSC case said.

While he was gone, the group that had followed him from Policano spun themselves off from FTI to form Capstone.

When Manzo went back to work in 2006, he wanted to affiliate with his old colleagues, now working at Capstone, said the person close to the matter, who declined to be named because they were not authorized to speak to the media. But he requested a contractor set-up because he did not feel comfortable reporting to or managing his former underlings, the person said.

Contractor status, while not necessarily the norm, is not unheard of, Kuney said.

"At that high level of the game, everything is a custom arrangement," he said.

Capstone, Manzo and Kaye Scholer conceded that, while they felt Manzo would have been exempted from making disclosures as a professional entity, they should have acknowledged his contractor status. That they didn't, they claimed, was an honest mistake.

"Mistakes were made," Kaye Scholer said in court papers.

Capstone, for its part, said executive director Ordway "incorrectly" called Manzo an "employee."

Approval of the settlements is not a sure bet: According to a person close to the matter, Black Diamond, the lender that acquired GSC's assets, will likely make a formal objection to the settlement before the hearing.

In a letter last week to the court, Black Diamond said the settlements were flawed because they release the parties from an overly-broad swath of potential legal claims that could improve creditor recoveries.

Black Diamond declined to comment.

The case is In re GSC Group Inc, U.S. Bankruptcy Court, Southern District of New York, No. 10-14653.

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