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Ousting the Debtor in Possession: The Good, the Bad and the Ugly of Replacing a Debtor’s Management with a Chapter 11 Trustee

The mere act of filing a chapter 11 bankruptcy petition significantly alters the relationship between a debtor and its creditors, yet, perhaps surprisingly, the filing does not automatically trigger removal of the very management team that led (or maybe drove) the debtor into bankruptcy in the first place.  Why?  Because, in enacting the Bankruptcy Code, Congress recognized that pre-bankruptcy management’s familiarity with the debtor and its operations may be crucial to the debtor’s ability to reorganize — the paramount goal of chapter 11.

Creditors seeking to replace management are not entirely without recourse, however.  Under certain circumstances, the bankruptcy court may appoint a chapter 11 trustee to assume responsibility for day-to-day operational control of the debtor as well as the reorganization process.[i]  But, because of the drastic consequences of a change in management to a debtor and its operations, bankruptcy courts impose a high burden on parties seeking this extraordinary remedy, which some courts call “the nuclear option.”  Nevertheless, the ability to oust management, or even a credible threat to file a motion seeking to oust management, can be a powerful tool for creditors.

Creditors and other stakeholders, therefore, should understand the potential benefits and pitfalls of displacing management and the likelihood of success of moving to appoint a trustee.  The first half of this article is devoted to strategic considerations, the second to the statutory requirements for ousting the DIP and getting a chapter 11 trustee appointed.

Appointment of a Chapter 11 Trustee: Strategic Considerations

There is a trade-off associated with replacing management with a trustee.  On the one hand, the debtor’s estate may benefit from a trustee’s independence, reorganization experience, and professional familiarity with the bankruptcy process, all of which may help him or her bring order–and even consensus–to the chapter 11 case.  On the other hand, a trustee’s lack of specialized knowledge of or expertise in the debtor’s operations may threaten value and hobble the debtor’s ability to reorganize, and may signal to creditors and the market that the debtor is not going to emerge as a viable business. Unfortunately, there is no litmus test for weighing the trade-off — the particular facts of each case drive the analysis.

Certain situations cry out for the appointment of a trustee, such as when there is strong evidence of fraud or dishonesty, or that management has made unauthorized asset transfers of debtor’s cash or other property, placed assets beyond the reach of creditors, or sabotaged or otherwise grossly mismanaged the debtor’s operations.[ii]  Seeking the appointment of a trustee may also be appropriate if the interests of management conflict significantly with the interests of the debtor’s estate and creditors such as, for example, when the DIP refuses to prosecute valuable estate claims against insiders.

Even in the absence of clear fraud, gross mismanagement or obvious conflicts of interest, management’s entrenchment in the debtor’s operations, and perhaps more significantly, the corporate culture, may prevent the debtor from getting the full benefit of the chapter 11 process.   For instance, entrenched management may be too reluctant to sever ties with favored suppliers or customers or to revamp inefficient operations, while an informed and impartial trustee can more objectively evaluate a debtor’s operations and eliminate inefficiencies and unprofitable business relationships.  Free of any conflicts with a debtor’s officers and directors or other insiders, an independent trustee is also more likely to prosecute potentially valuable estate claims against those insiders or cronies.

Divesting management of control does not guarantee a successful reorganization or even the particular outcome a creditor may have been hoping to achieve.  Significant risks can arise from changing horses mid-stream.  First, a trustee coming in cold may burn valuable time becoming sufficiently familiar with the business – and adept at running it — at a time when the enterprise itself may be teetering on the edge of collapse.  Further, appointment of a trustee increases the costs to the debtor, for the trustee’s time and the fees and expenses of the professionals he or she retains are chargeable to the estate.  These costs (most likely borne by the creditors) may outweigh any potential benefits.  The appointment of a trustee may also have other, less quantifiable disadvantages, such as engendering a lack of cooperation or loyalty by long-term employees and business partners.

Finally, a cautionary note on strategic aims.  A party may move, or threaten to move, for the appointment of a trustee to advance its own particular goals rather than to preserve the value of the debtor’s estate for the benefit of all stakeholders.  For example, a creditor may use a motion to appoint a chapter 11 trustee as a tactic to speed the DIP toward plan confirmation, irrespective of possibly good reasons for the DIP’s slower pace (such as resolving thorny issues with particular creditors in the hope of enhancing value for all).  In another scenario, a creditor may seek the appointment of a trustee in an effort to seize the initiative in proposing a plan of reorganization.  Appointment of a trustee terminates the DIP’s exclusive right to file a plan (the Bankruptcy Code grants exclusivity only to a “debtor in possession”), and therefore paves the way for the creditor to propose a plan.[iii]  A party may also use the threat of appointment of a trustee to prod the debtor for information, or to improve the terms of treatment of the creditor’s claim under a plan.

Parties seeking appointment of the trustee to advance a selfish goal risk losing credibility with the court, – remember, it is regarded by some courts as the nuclear option – which may affect their fortunes otherwise in the case.  Bankruptcy courts have admonished parties for seeking appointment of a trustee when the appointment would merely serve the ulterior motive of the movant, rather than the interests of creditors generally, or when the evidence wholly fails to justify such relief.[iv]

The appointment of a chapter 11 trustee, and even a motion for the appointment of a trustee (particularly if filed by a reputable and sophisticated stakeholder), inevitably changes the landscape of the chapter 11 case.  In considering whether to seek the appointment of a chapter 11 trustee, a creditor must balance the potential benefits of appointment to the moving creditor and the creditor body-at-large against the ramifications of seeking to appoint a trustee (and oust management) not only on the debtor, but also on the moving creditor’s credibility with the court, in light of the likelihood of success on the merits in filing the motion.

Appointing a Chapter 11 Trustee: Statutory Requirements

The standards for the appointment of a chapter 11 trustee are set forth in section 1104(a) of the Bankruptcy Code. [v]  That section requires that the bankruptcy court appoint a chapter 11 trustee if either (1) cause exists or (2) such appointment “is in the interests of creditors, any equity security holders, and other interests of the estate[,]”[vi]  The statute’s concepts of “cause” and “interests of creditors” are non-specific and thus require fact-intensive analysis on a case-by-case basis.  Further, because the appointment of a trustee is an extraordinary remedy, most bankruptcy courts impose a heightened evidentiary standard, requiring the moving party to satisfy its burden by “clear and convincing evidence” rather than the customary “preponderance of the evidence” standard.  As a result, appointment of a chapter 11 trustee is relatively rare.

A. Appointing a Trustee “For Cause” Under Bankruptcy Code Section 1104(a)(1)

Section 1104(a)(1) authorizes the appointment of a trustee “for cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs by current management, either before or after the commencement of the case…”[vii]  Note the use of the word “including.”  The list of examples of cause is not meant to be exhaustive and courts have rejected attempts to limit the “for cause” analysis to enumerated items.[viii]  The statute thus implicitly authorizes the court to determine whether the unique facts of each case satisfy the “for cause” requirement.

Among the bases identified in the statute, “fraud” and “dishonesty” require a showing of deceitful conduct that harms the debtor’s estate or creditors.  “Gross mismanagement,” as the term suggests, requires a showing of more than mere underperformance by management.  As one court observed:

If local case participants could get Chapter 11 trustees appointed because of their stated distrust of a debtor’s board or its management and their claim of lack of ‘confidence’ in the personnel whom the [Bankruptcy] Code authorizes to run [the] debtor’s businesses, Chapter 11 as we know it, could not function.[ix]

Thus, to prove “gross mismanagement,” parties must show actual (and not merely suspected) and egregious mishandling of the debtor’s affairs – either before or after the beginning of the case – that would cause stakeholders to reasonably lose faith in management’s ability to lead the reorganization efforts.

Going beyond the bases for “cause” listed in section 1104(a)(1), courts have authorized the appointment of a trustee under section 1104(a)(1) where the debtor commingled assets, engaged in self-dealing, made unauthorized payments, or failed to provide accurate information to the United States trustee.[x]  Other courts have found “cause” where the debtor was found to have irreconcilable conflicts with affiliated entities and failed to collect payments from those affiliates.

The fluidity of the notion of “cause” may at times serve to undermine its proof.  Because any number of bad acts or other circumstances may constitute “cause,” courts have substantial flexibility to consider extenuating circumstances presented by a debtor.  The fact-intensive nature of the inquiry into “cause” may lead to a waste of scarce estate resources as the DIP defends against unwarranted trustee motions.

B. Appointing a Trustee Under the “Best Interests” Standard of Bankruptcy Code Section 1104(a)(2)

Under section 1104(a)(2), a court must order the appointment of a chapter 11 trustee “if such appointment is in the interests of creditors, any equity security holders, and other interests of the estate . . .”[xi]  Although the “best interests” standard may appear to be less stringent than the “cause” standard, it is difficult to find situations that satisfy one but not the other.  Where the best interests of creditors, etc. would be served by appointment of a chapter 11 trustee, cause for such appointment almost always exists, and vice-versa. Indeed, the balancing test some courts employ reveals the extensive overlap between the two.  Under the “best interests” balancing test, courts consider:  (i) the benefits to be derived by appointing a trustee compared to the costs of appointment; (ii) a debtor’s performance and its rehabilitation prospects; (iii) the debtor’s trustworthiness; and (iv) confidence of creditors and the business community in current management.[xii]  The court thus may consider the same elements under the “best interests” standard – e.g., , is the debtor trustworthy and competent, etc. — as it might under the “cause” standard.  Courts have also authorized the appointment of a trustee under the “best interests” standard where the debtor failed to keep adequate records or where the debtor did not disclose material financial information or other information about the company’s reorganization prospects.[xiii]

Conclusion

The appointment of a chapter 11 trustee can have a profound impact on the direction of a reorganization case.  Yet that impact often is difficult to determine at the time creditors deliberate as to whether to seek the appointment of a trustee.  These factors underscore the importance of carefully weighing the benefits, and costs, of the appointment of a trustee prior to seeking this extraordinary

[i] A “chapter 11 trustee” is not the same thing as a chapter 7 trustee or the United States Trustee.  For brief descriptions of each such officer, please see the Glossary.

[ii] See e.g., Tradex Corp. v. Morse, 339 B.R. 823 (D. Mass. 2006) (affirming bankruptcy court finding of cause based on “questionable business practices with related companies”); In re V. Savino Oil & Heating Co., Inc., 99 B.R. 518 (Bankr. E.D. N.Y. 1989) (holding debtor’s unauthorized postpetition transfer of its most valuable asset constituted “cause” to appoint a trustee); In re Main Line Motors, Inc., 9 B.R. 782 (Bankr. E.D. Pa. 1981) (finding debtor’s manager grossly mismanaged debtor when he withdrew funds from operations and diverted them to other corporations under common ownership).

[iii] 11 U.S.C. § 1121(c) (“Any party in interest . . . may file a plan if and only if (1) a trustee has been appointed under this chapter . . . “).  See also In re Hoffinger Inds., Inc., 292 B.R. 639 (B.A.P. 8th Cir. 2003) (noting that appointment of a chapter 11 trustee terminates the debtor’s exclusivity period).

[iv] See In re WineCare Storage, LLC, Bankr. S.D.N.Y. Case No. 13-10268 (REG), 6/24/13 Hearing Tr. 25:5-26:2 (Court:  “There seems to be a notion amongst some of the members of the bankruptcy community and their counsel, that aggressive tactics including . . . filing a motion to appoint a chapter 11 trustee are an acceptable way of achieving one’s agenda in a chapter 11 case . . . I want to underscore for the entirety of the bankruptcy community what a big deal a motion for appointment of a chapter 11 trustee is.  It should not be used as a mechanism for being a squeaky wheel or for getting a debtor’s management to run the business, or to propose a plan, or to do any of the other things that I’ve seen people use chapter 11 trustee motions for to advance a litigant’s agenda.”).

[v] The full text of 11 U.S.C. § 1104(a) is as follows:

At any time after the commencement of the case but before confirmation of a plan, on request of a party in interest or the United States trustee, and after notice and a hearing, the court shall order the appointment of a trustee—

(1) for cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management, either before or after the commencement of the case, or similar cause, but not including the number of holders of securities of the debtor or the amount of assets or liabilities of the debtor; or

(2) if such appointment is in the interests of creditors, any equity security holders, and other interests of the estate, without regard to the number of holders of securities of the debtor or the amount of assets or liabilities of the debtor.

[vi] 11 U.S.C. § 1104(a)(1) & (2).

[vii] 11 U.S.C. § 1104(a)(1).

[viii] See In re Casco Bay Lines, Inc., 17 B.R. 946, 950 n. 4 (B.A.P. 1st Cir. 1982) (noting that “[t]he Code ‘includes’ some examples of ’cause,’ but does not restrict the term to those examples”).

[ix]  See note iv above at 25:14-19.

[x] See, e.g., In re Oklahoma Refining Co., 838 F.2d 1133 (10th Cir. 1988) (recognizing that transactions with affiliated companies may constitute cause for appointment of a trustee);  In re Embrace Sys. Corp., 178 B.R. 112, 128-29 (Bankr. W.D. Mich. 1995) (finding that debtor’s conflict of interest arising from its interest in company attempting to acquire certain of its technology assets constituted “cause”);  In re Ford, 36 B.R. 501 (Bankr. W.D. Ky. 1983) (holding that debtor’s failure to submit periodic financial reports and obtain permission for transfer of assets warranted appointment of a trustee); In re Deena Packaging Inds., Inc., 29 B.R. 705, 707-08 (finding that debtor’s unjustified failure to include material financial information in post-petition schedules constituted “cause” to appoint a trustee).

[xi] 11 U.S.C. § 1104(a)(2).

[xii] In re Ionosphere Clubs, Inc., 113 B.R. 164, 168 (Bankr. S.D.N.Y. 1990).

[xiii] See, e.g., In re Celeritas Technologies, LLC, 446 B.R. 514 (Bankr. D. Kan. 2011) (finding appointment of trustee was in best interests of creditors where debtor failed to disclose material information regarding improved finances and changes in ownership).

About Lawrence V. Gelber

Lawrence V. Gelber is a partner in the Business Reorganization group of Schulte Roth & Zabel LLP, practicing in the areas of distressed M&A and financing, corporate restructuring, creditors’ rights, debt and claims trading, and prime brokerage insolvency/counterparty risk, with a focus on representation of investment funds and other financial institutions in distressed situations. His…

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Lawrence V. Gelber

About Aaron Wernick

Aaron Wernick practices in the areas of bankruptcy, corporate restructuring, distressed investment and creditors’ rights. He represents debtors, secured and unsecured creditors, debtor-in-possession lenders and others in complex Chapter 11 and cross-border insolvency cases. Aaron earned his J.D., cum laude, at Boston University School of Law, where he was an editor of the Review of…

Read Full Bio »   •   View all articles by Aaron »

Aaron Wernick
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