Statutory Construction Governs the Appointment of an Examiner

The Third Circuit Court of Appeals’ recent ruling in the FTX bankruptcy case severely limits a bankruptcy court’s discretion to deny the appointment of an examiner in a bankruptcy case.[1] In FTX, the U.S. Trustee filed a motion to appoint an examiner. The bankruptcy court denied the motion. After a direct appeal to the Third Circuit Court of Appeals, the Third Circuit ruled that the appointment of an examiner is mandatory if requested by a party in interest or the UST, where the debtor’s unsecured debts exceed $5 million.

Background

In November 2022, FTX’s value collapsed over the course of roughly a week’s time. Samuel Bankman-Fried was the primary owner of FTX, a cryptocurrency company, and a substantial owner of Alameda Research, a cryptocurrency hedge fund. In November 2022, industry reports claimed that Alameda Research was financially compromised, and questions arose regarding a conflict of interest between Alameda Research and FTX. Subsequently, the public learned that FTX was using software to conceal the funneling of FTX customer funds to Alameda Research to bolster Alameda Research’s balance sheet. These revelations caused a run on FTX where customers withdrew billions of dollars over just a few days. The massive withdrawals caused a severe liquidity crisis and FTX’s collapse. Subsequent criminal investigations showed evidence of fraud and embezzlement of FTX’s customers’ funds.

After FTX’s collapse, Bankman-Fried appointed John J. Ray, III to replace him as CEO of FTX and its numerous affiliates (“FTX Group”). Ray authorized multiple chapter 11 filings for FTX Group. An experienced bankruptcy practitioner, Ray stated in his debtor-in-possession report that “he had never before ‘seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information.’”[2] He further identified more mismanagement issues, including that many of the companies within FTX Group failed to produce audited financial statements, FTX Group did not keep an accurate list of its bank accounts, and FTX Group had incomplete books and records to track billions of dollars in noncryptocurrency assets. Ray also discovered that corporate funds had been used to purchase real estate and personal items for employees in the Bahamas, and that instead of a proper cash-management system, the companies utilized a chat platform where payment requests might be granted with an emoji.

Shortly after the bankruptcy filings, the UST filed a motion for the appointment of an examiner pursuant to 11 U.S.C. § 1104(c). The UST argued that an examiner’s public report of findings could reveal the wider implications that FTX’s collapse had on the cryptocurrency industry. The UST also argued that the Bankruptcy Code mandates that the bankruptcy court appoint an examiner upon request and where the debtor’s unsecured debts exceed $5 million.

The unsecured creditors committee, the Joint Provisional Liquidators of FTX Digital Markets LTD and the debtors filed objections to the Motion, arguing that appointing an examiner would duplicate work already in progress, interfere with efforts to stabilize FTX Group, hurt creditors by increasing costs to the bankruptcy estate, and pose a security risk to cryptocurrency codes. The bankruptcy court agreed with the objectors and ruled that the appointment of an examiner was discretionary. The bankruptcy court ruled that while FTX Group’s unsecured debts far exceeded $5 million, the phrase “as is appropriate” in § 1104(c) gave the court discretion. The UST appealed to the district court and moved to certify the order on direct appeal to the Third Circuit Court of Appeals, which was granted.

Analysis

The Third Circuit accepted the direct appeal to determine whether the plain text of § 1104(c)(2) required a bankruptcy court to appoint an examiner if requested by the UST or a party in interest and the debtor’s unsecured debts exceeded $5 million.

Statutory Construction

The Third Circuit was asked to interpret § 1104(c)(2), which provides, in pertinent part:

(c) If the court does not order the appointment of a trustee under this section,…, 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 an examiner to conduct such an investigation of the debtor as is appropriate, including an investigation of any allegations of fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the affairs of the debtor of or by current or former management of the debtor, if —

(1) …; or

(2) the debtor’s fixed, liquidated, unsecured debts, other than debts for goods, services, or taxes, or owing to an insider, exceed $5,000,000.[3]

To interpret § 1104(c)(2), the court presumed “that intent is expressed through the ordinary meaning of the statute’s language.”[4] To that end, if the meaning of the text is clear, the role of the courts is to enforce the statute “according to its terms,” as long as it would not create an absurd result.[5]

The court looked at the statute’s use of the word “shall” and, citing to a previous holding, stated that the word “shall” is a signal that the statute’s directive must be followed regardless of whether a court agrees with the result.[6] Accordingly, the statute’s use of the word “shall” created a mandatory obligation on the bankruptcy court to appoint an examiner. The court further found that the bankruptcy court’s reliance on the phrase “as is appropriate” to justify its discretion was misplaced.

Instead, relying on the last-antecedent rule of statutory construction, the court held that the phrase “as is appropriate” modified the words immediately preceding it, which were “to conduct such an examination of the debtor” and not “shall order the appointment of an examiner.”[7] As noted by the court, the wording “as is appropriate” refers to the nature of the investigation and not the appointment of the examiner, which is further bolstered by the list of topics that would merit investigations.

Moreover, the court reasoned § 1104(c)(2) must be read to contrast with § 1104(c)(1), which allows a court to consider the interests of creditors, securityholders and other interests of the estate before appointing an examiner. Noting that § 1104(c)(1) does allow for the bankruptcy court to consider the interests of other interested parties, the court agreed with the Sixth Circuit’s conclusion that “the contrast between the two subsections could not be more striking.”[8] That contrast mandated reading discretion out of subsection (c)(2).

Congressional Intent

The court further found that its interpretation was consistent with direct evidence of Congress’s intent. The court noted that the congressional record from the passage of the Bankruptcy Code included the Senate floor manager’s explanation that the public interest in large cases justified the automatic appointment of an examiner in such cases to ensure that an adequate investigation of the debtor is conducted.[9] Thus, the court determined that refusing to give effect to the mandatory language of § 1104(c)(2) would run contrary to the legislative intent to protect the public interest in larger bankruptcy cases.

While the Court did note that Congress tempered the mandatory language of § 1104(c)(2) by making the request for the examiner and the scope of the investigation discretionary (an examiner is not automatically appointed in cases with more than $5 million in unsecured debts), the potential for abusive examiner requests was not sufficient to deem Congress’s grant of discretion absurd. Finally, although the bankruptcy court has no discretion in appointing an examiner if the debt amounts are met, the “scope, degree, duration and cost” of the examiner’s investigation remains within the bankruptcy court’s broad discretion.[10] Accordingly, the bankruptcy court can tailor the examiner’s scope such that efforts are not duplicated.

Conclusion

The ruling in FTX makes clear that in the Third Circuit, the appointment of an examiner is mandatory upon the request of a party in interest or the UST if the debtor’s unsecured debts exceed $5 million. Left open for parties to negotiate or litigate is the scope of the examiner’s duties.