Reversing the bankruptcy court in Delaware, the Third Circuit ruled that appointment of an examiner is mandatory in the reorganization of FTX Trading Ltd.

While the Philadelphia-based appeals court held that the bankruptcy court has no discretion to deny appointment of an examiner when someone has filed a motion and the debt is more than $5 million, the Third Circuit noted how the bankruptcy court does have “broad discretion” in defining the “scope, degree, duration, and cost” of the investigation.

In his January 19 opinion, Circuit Judge L. Felipe Restrepo observed that FTX “suffered a catastrophic decline in value” when “industry reports” suggested that the company was “financially compromised” by “multiple corporate failures,” including software that concealed “the funneling of FTX customer funds into [affiliate] Alameda Research.” In “a few days,” he said, customers withdrew “billions of dollars.”

Afterwards, Judge Restrepo said that “criminal investigations into FTX have unearthed evidence of widespread fraud and the embezzlement of customers’ funds.” He noted that FTX’s chief executive Sam Bankman-Fried has been convicted on seven criminal counts, including wire fraud.

Denial of the Examiner Motion

Judge Restropo noted that Bankman-Fried resigned but appointed John J. Ray, III, as chief executive and that Ray has conducted a wide-ranging investigation after putting FTX and affiliates into chapter 11. However, the U.S. Trustee filed a motion for appointment of an examiner under Section 1104(c) “within weeks of the filing.”

The U.S. Trustee reasoned that Ray could focus on stabilizing the business while an examiner would investigate the loss of $10 billion in customers’ assets. The debtor and the official creditors’ committee opposed appointment of an examiner.

The motion turned on the interpretation of Section 1104(c). On “request of a party in interest or the United States trustee” if no chapter 11 trustee has been appointed, the subsection says that “the court shall order the appointment of an examiner to conduct such an investigation of the debtor as is appropriate,” if “the debtor’s fixed, liquidated, unsecured debts . . . exceed $5,000,000.” [Emphasis added.]

Judge Restrepo characterized the bankruptcy judge as having reasoned that the words “as is appropriate” gave the court discretion to appoint an examiner despite the statute’s use of the word “shall.” For reasons given from the bench, the bankruptcy judge denied the motion for an examiner. The U.S. Trustee appealed, and the Third Circuit accepted a direct appeal.

Does ‘Shall’ Mean ‘May’?

Judge Restrepo stated the question on appeal as “whether the plain text of Section 1104(c)(2) requires a bankruptcy court to appoint an examiner” when there is a motion and the debt exceeds $5 million.

Quickly, Judge Restrepo noted how “Congress made plain its intention to mandate the appointment of an examiner by using the word ‘shall.’” Interpreting “shall” to mean “may,” he said, “would require us ‘to abandon plain meanings altogether,’” quoting Third Circuit authority.

To the contrary, the debtor argued that “as is appropriate” modifies “shall,” to make the outcome discretionary. Judge Restrepo rejected the argument, based on the last-antecedent rule of statutory construction. The rule, he said means that “as is appropriate” modifies “to conduct such an examination.”

Judge Restrepo said that appointing an examiner is not unconstrained. There must be a motion, and debt must exceed $5 million. He noted the U.S. Trustee’s comment that the government had sought examiners only 10 times nationwide in a recent fiscal year.

While appointment may be mandatory, Judge Restrepo said that “the phrase ‘as is appropriate’ in Section 1104(c) means the court ‘retains broad discretion to direct the examiner’s investigation,’ including its scope, degree, duration, and cost,” quoting the Norton treatise.

On appeal, the debtor and the committee argued that having an examiner would be duplicative and wasteful given their own investigations. Judge Restrepo responded, saying, “Neither position is relevant, given our holding that the appointment of the examiner is mandatory under the Code.”

Judge Restrepo reversed and remanded with instructions to appoint an examiner.