Corporate Governance after Reorganization Do Those with the Gold Make the Rules

Journal Issue

May 2006

Column Name

On the Edge

Citation

ABI Journal, Vol. XXV, No. 4, p. 12, May 2006

Bankruptcy Code

1123

1129

Topic Tags

Corporate Governance

Creditors' Committee

Plan Confirmation

Journal HTML Content

In many bankruptcies, the creditors receive much
or all of the equity in the reorganized business. The issuance of
equity to creditors raises a host of corporate governance issues,
namely: Who decides the size and composition of the board of
directors? Who selects the directors? Who drafts the corporate
charter and bylaws? What happens to current management? Who sets
compensation for management in the reorganized company? 
Almost invariably, these issues are negotiated and consensually
resolved as part of the plan negotiations between the debtor and
creditor constituencies. In the recent United Air Lines
case,1 the issues reached an unusually advanced stage.
There, the company's proposed plan contemplated that the
post-confirmation board would be selected almost entirely by the
nominating committee of the existing board of directors. The existing
board had been elected in May 2002—about seven months before
the bankruptcy filing and nearly four years before the confirmation
hearing—by the then-shareholders whose equity interests (to
the extent they hadn't been sold) would be extinguished pursuant to
the plan. The plan also proposed to set aside up to 15 percent of
the reorganized company's stock for a management equity incentive
program (MEIP), which would reward incumbent senior management by
the issuance of restricted stock and stock options conservatively valued
at $285 million. The creditors' committee, though generally
supportive of the reorganization plan, objected to the provisions
for selection of directors and to the proposed MEIP. The committee
argued that the plan failed to provide for any input by the creditor
constituencies into the selection of officers and directors, even
though the plan provided that creditors were to receive substantially
all of the stock in the reorganized debtor. The committee also objected
to a provision in the proposed corporate charter that would have
authorized the issuance of "blank check preferred stock,"
which could be used for a variety of purposes including the adoption
of a poison pill that would deter any hostile takeover of the
company. The dispute was resolved during the pendency of the
confirmation hearing. By agreement, the committee appointed five
directors and the company appointed five directors, with two other
directors appointed by unions pursuant to collective bargaining
agreements. The company also agreed that the corporate bylaws would
prohibit the adoption of a poison pill without shareholder approval. It
further agreed to limit the number of shares available for the MEIP
to 8 percent, which still allowed awards of more than $150 million.
The bankruptcy court overruled objections by the unions to the
modified MEIP. Because these issues usually are resolved
consensually, it is not surprising that the case law addressing
corporate governance issues in the plan confirmation context is
sparse. Nonetheless, the negotiation of these issues does not occur
in a legal vacuum, but rather takes place within the context of the
requirements for proposing and confirming a plan of reorganization.
This article summarizes the law and concludes with some observations
on how the chapter 11 process drives the negotiating leverage of the
various constituencies. The Legal Framework: Selection of
Officers and Directors Sections 1123(a)(7) and 1129(a)(5)
of the Bankruptcy Code govern the disclosure and selection of
post-confirmation officers and directors. Section 1123(a)(7)
provides that a reorganization plan must: <blockquote>

<blockquote> contain only provisions that are consistent with
the interests of creditors and equity security-holders and with
public policy with respect to the manner of selection of any
officer, director or trustee under the plan and any successor to
such officer, director or trustee. </blockquote> </blockquote>
A plan that fails to satisfy this provision cannot be confirmed
because it does not "compl[y] with the applicable
provisions" of the Code, as required by
§1129(a)(1).2 Section 1129(a)(5)(A) provides
that, as a condition to confirmation, the bankruptcy court must
find: <blockquote> <blockquote> (i) The proponent of
the plan has disclosed the identity and affiliations of any
individual proposed to serve, after confirmation of the plan, as
a director, officer or voting trustee of the debtor...or a successor to
the debtor under the plan; and (ii) the appointment to, or
continuance in, such office of such individual, is consistent
with the interests of creditors and equity security-holders and
with public policy. </blockquote> </blockquote> Taken
together, these provisions impose both procedural and substantive
requirements. Procedurally, the plan proponent must disclose prior
to confirmation the identity and affiliations of persons who
initially will serve as directors and officers of the reorganized
debtor. Substantively, the court must determine that both (1) the
appointment to or continuance in office of the initial officers and
directors, and (2) the provisions regarding manner of selection of both
the initial officers and directors and their successors, "are
consistent with the interests of creditors and equity
security-holders and with public policy."3

But neither Congress nor the courts have provided much guidance
regarding the scope of this review. In In re Machne Menachem
Inc.,4 the debtor was a New York-based nonprofit
corporation that ran a summer camp for Hasidic youths. Under the
proposed plan, the debtor's existing board would be replaced with a
three-person board that included one Yaakov Spritzer, who had been
removed from the board before the bankruptcy pursuant to an
intracorporate dispute, and two of his supporters. The bankruptcy
court explained that §1123(a)(7) derives from §216(11) of
the former Bankruptcy Act,5 and was incorporated into the
Code without comment: <blockquote> <blockquote> The
Senate Report accompanying the Chandler Act stated, with respect
to §216(11), that such provision "directs the scrutiny of the
court to the methods by which the management of the reorganized
corporation is to be chosen, so as to ensure, for example,
adequate representation of those whose investments are involved
in the reorganization." The provision was originally
suggested by the Securities and Exchange Commission and was
intended to make certain that discredited management will not be
perpetuated, and that provision will be carried in the plan for the
selection—at least for the mechanics or means of selecting the
managements which will carry forward the reorganization in the
interest of the parties.6 </blockquote>

</blockquote> Despite the overwhelming support of creditors, the
court refused to confirm the plan because the replacement of the
existing board with Spritzer and his colleagues failed to comply
with the New York Not-for-Profit Corporation Law (NFP). That
statute, the court found, codified New York's public policy, and
"the removal or selection of debtor's directors in a manner
contrary to New York's public policy, as codified in its NFP, would
directly violate §§1123(a)(7) and 1129(a)(1) and (2) of
the Code."7 In construing the "public
policy" requirement of §1123(a)(7), the court went on to
say: "'Public policy' may also allude to a concern that this
debtor should not be reorganized under the direction of an individual
that was severely chastised [by a judge in prepetition litigation] for
failure to abide with statutory requirements in administering the
pre-petition debtor..."8 Similarly, in In
re Mahoney,9 the court denied confirmation for
failure to comply with §§1123(a)(7) and 1129(a)(1). In this
case, the debtor, an individual, sought to confirm a chapter 11 plan
pursuant to which his business assets would be transferred to a
California corporation to whose board the debtor would be appointed
for a five-year term. The court found that the debtor's proposed
board structure violated California law and "decline[d] to
confirm a plan which disregards California's public policy as
embodied in [the applicable corporate law]."10
In In re Acequia Inc.,11 Clinton, a 50 percent
shareholder of the debtor, had been charged with concealing
information and mismanaging the debtor. The plan provided that
Clinton's ex-wife and her two sons would manage the reorganized
debtor and sit on the board, and precluded shareholders from voting
to remove or elect directors post-confirmation. Clinton argued that
these provisions violated Idaho corporate law. The court of appeals
disagreed and affirmed the bankruptcy court order confirming the
plan.12 Though the threshold issue was the plan's
compliance with state corporate law, the court also appeared to
recognize a bankruptcy court's broad discretion to review selection
of the board and management: "[C]ourt[s] scrutinize any plan
which...establishes management in connection with a plan of
reorganization... In analyzing these provisions in plans
(i.e., regarding manner of selection of officers and
directors), we believe that a court should consider, inter
alia, the shareholders' interests in participating in the
corporation, the desire to preserve the debtor's reorganization and
the overall fairness of the [plan] provisions."13

The court concluded that the plan provisions met that
test.14 The case law also makes clear that the
officers and directors of the reorganized entity must meet some
minimal standard of competence and integrity. As one court put it:
"Continued service by prior management may be inconsistent with
the interests of creditors, equity security-holders and public policy
if it directly or indirectly perpetuates incompetence, lack of
discretion, inexperience or affiliations with groups inimical to the
best interests of the debtor."15 Because
these decisions typically have involved small corporations that were
closely held or not-for-profit, and focused on the fitness of a
particular person who may have engaged in misconduct to serve on the
reorganized company's board, it is difficult to extrapolate how the
courts will apply the statute to a reorganized debtor that will be a
publicly held corporation. At one extreme, the debtor in United
Air Lines argued that the bankruptcy court's review is limited
to whether the proposed officers and directors meet minimal competence
standards and whether the corporate charter and bylaws comply with
state corporate law. It characterized the composition of the board
as nothing more than a "deal point" in pre-confirmation
negotiations between the company and creditor constituencies. This
view seems consistent with the Collier commentary, which
opines that the court should not have to make a "substantive
judgment" that the post-confirmation service of officers and
directors is consistent with the interest of creditors: 
<blockquote> <blockquote> The identities of the individuals
will be disclosed during the balloting stage. As a consequence,
creditors and equity-holders will have the opportunity to factor
in the character and history of the management in their vote. To
give the bankruptcy court the power to second-guess the interests of
such entities seems somewhat out of place in the general scheme of
confirmation.16 </blockquote> </blockquote>

This view, however, puts enormous stress on the creditors' vote on
the plan, particularly given the limited disclosures required by
§§1123 and 1129 and the fact that—contrary to the
assumption in the Collier commentary—the management and
board of the reorganized company often are not disclosed until after
the disclosure statement has been distributed and the creditors have
voted. It also requires a very narrow reading of the statutory
language, which requires independent findings that the ongoing service
of the officers and directors and the method of selection of officers
and directors comport with the interests of creditors regardless of
how the creditors vote on the plan. If Congress had intended to
limit the necessary finding to compliance with state law, it could
have said so.17 But if it is true that the
bankruptcy court has discretion to review the board composition of
the reorganized company, there is virtually no guidance as to how
the court should exercise that review.18 In United,
the committee argued that it, as the representative of the creditors,
should be permitted to determine the size of the new board,
determine its committee structure and select its members.
Buttressing its argument with the testimony of a corporate
governance expert, the committee argued that its input was critical
because the new board would determine the compensation of management,
including the terms and allocation of incentive-based equity ownership
under the MEIP, and that without the committee's input the new board
would be selected de facto by existing management. Further,
the new board would determine whether to implement a poison pill and
other provisions that could entrench management. The issue became
moot when the bankruptcy court approved a settlement providing for
the committee and debtor to appoint an equal number of board
members. The Legal Framework—Management
Compensation Section 1129(a)(5)(B) of the Code requires
that a plan disclose "the identity of any insider that will be
employed or retained by the reorganized debtor, and the nature of
any compensation for such insider."19 On its face,
this provision requires the disclosure of compensation but does not
address the reasonableness of compensation. Does the bankruptcy court
have the power to consider whether a compensation package for
ongoing management is excessive? The implementation of
management compensation plans has engendered extraordinary
controversy in recent years, particularly as companies continue to use
chapter 11 to renegotiate collective bargaining agreements and
vendor agreements, and to extract concessions from lenders. In the
course of the chapter 11, the debtor-in-possession (DIP) must seek
court approval to implement such plans under §363 of the
Code.20 Ordinarily, this requires the debtor to show that
the plan comports with reasonable business judgment, but many courts
have held that, to the extent the compensation plan covers
"insiders" such as senior executives, they are subject to
heightened scrutiny.21 Further, the new amendments to the
Code circumscribe a debtor's ability to implement a key employee
retention program.22 In United Air Lines, the
opponents argued that §1129(a)(1) of the Code requires
compliance with §363, and thus that a plan compensating
insiders should be subject to the same heightened standard of review as
would a compensation plan for senior management of a
DIP.23 There appears to be no authority, however,
applying that standard of review to confirmation of a plan. The
court in United addressed the issue orally in overruling the
unions' objections to confirmation after the committee and debtor had
settled their disputes. The court concluded that §363 governs the
conduct of a DIP, not that of a reorganized debtor, and thus is
inapplicable to whether the plan may be confirmed.24 The
court ruled that its review was limited to determining whether the
proposed plan fell broadly within general market standards:

<blockquote> <blockquote> [I]f the debtor's compensation
package is consonant with what's being done in the marketplace,
then it's very difficult to have the court say that it's
excessive, and if excessive, to what extent it's excessive.
There's no yardstick that can be applied, other than the length of the
chancellor's foot... It may well be that we have a culture in this
country that overcompensates management... But United is just
one enterprise that operates in that general environment, and if
there is some skewing that's taking place generally, United
can't stand against that tide....25 </blockquote>
</blockquote> The court concluded on the basis of the factual record
that the MEIP was reasonable within the context of the
industry.26 The Negotiating Framework
 A fundamental premise of chapter 11 is that the plan proponent
determines the content of the plan. This means that the proponent,
usually the DIP, drafts the corporate charter and bylaws, selects
the directors, decides whether to keep management in place or to
select new management, and decides how much to pay management.

Once the plan has been proposed, the creditors' committee essentially
has two tools at its disposal. It may recommend that the unsecured
creditors vote to reject the plan, and it may oppose confirmation of
the plan. But these are blunt instruments, and if carried out they
can be injurious to all the interested parties. Delay in confirming
a plan may be, if not fatal to reorganization, strongly detrimental
to creditor recoveries. Creditors may be better off with a
reorganized company with overpaid management and poor corporate
governance than with the risk that the company's value will
deteriorate following the court's denial of confirmation. 
These courses of action also have procedural limitations. Even if the
class of unsecured creditors votes to reject the plan, the court may
confirm the plan under the cramdown provisions of §1129(b). As
a practical matter, an order denying confirmation is likely to
precipitate negotiations leading to a more favorable result for
creditors. But neither the committee nor the bankruptcy court has
the power to modify the plan; that is something only the proponent
can do. In the context of a plan-confirmation hearing, the
dynamics are likely to favor a finding that the corporate-governance
provisions are consistent with the interests of creditors and
equity-holders and with the public interest. Absent the most
egregious circumstances, most bankruptcy judges are reluctant to
risk the ongoing value of the business and the jobs of the debtor's
employees by denying confirmation based on what it likely would
perceive are tangential issues. Equally important, creditors
opposing a plan cannot point to a bright-line test as to why
particular corporate governance provisions do not satisfy the
statutory standards. As shown above, the limited cases denying
confirmation under §§1123(a)(7) and 1129(a)(5) typically
have involved egregious misconduct by management or failure to
comply with state law. The ruling in the United case by Hon.
Eugene Wedoff, a thoughtful and respected judge, is
instructive. He approved what under any standard is an enormously
generous compensation package to existing management. Despite the facts
that the package included no ongoing performance criteria and that
the unions who had made billions of dollars of concessions to
support the reorganization vehemently opposed it, the court
concluded that the package fell within the broad contours of the
market. Given the plan proponent's enormous leverage, the
creditors' position is significantly enhanced if they have the power
to submit a competing plan. In other words, the extension of
exclusivity plays a significant role in the debtor's ability to
dictate post-reorganization corporate governance. Once exclusivity
is terminated, the committee and other parties in interest can
propose their own plans with provisions less likely to favor incumbent
management.27 Often, governance issues have been
incorporated into negotiations only as the debtor is about to file
its plan or after the plan has been proposed. From the creditors'
perspective, the preferred course may be to raise those issues
earlier in the process, and incorporate them into negotiations for
any extension of exclusivity. <h3> Footnotes</h3> 1 In re
UAL Corp. et al., No. 02-B-42191 (Bankr. N.D. Ill.).

2 See, e.g., Mabey v. SW Elec. Power Co. (In
re Cajun Elec. Power Coop. Inc.), 150 F.3d 503, 513 n. 3
(5th Cir. 1998), cert. denied, 526 U.S. 1144 (1999). 3 11 U.S.C.
§§1123(a)(7), 1129(a)(5)(A)(ii). 4 304 B.R. 140
(Bankr. M.D. Pa. 2003). 5 11 U.S.C. §616(11) (repealed
1978). 6 304 B.R. at 142-43 (quoting Collier on
Bankruptcy §1123(a)(7) (15th ed. rev. 2003) (citing

S. Rep. No. 1916, 75th Cong., 3d Sess. 35 (1938) and Hearings on
H.R. 6439, 75th Cong., 1st Sess. 143 (1937)). 7 Id. at
143. 8 Id. 9 80 B.R. 197 (Bankr. S.D. Cal.
1987). 10 Id. at 201. 11 787 F.2d 1352 (9th
Cir. 1986). 12 Id. at 1360 (emphasis in original).

13 Id. at 1361-62 (citing S. Rep. No. 1917, 75th Cong.,
3d Sess. 7, 35 (1938)). 14 Id. 15 In re
Beyond.com Corp., 289 B.R. 138, 145 (Bankr. N.D. Cal. 2003)
(finding §1129(a)(5) not satisfied where there had been
insufficient disclosure to permit an "intelligent
analysis" of whether continuance of management was consistent
with interests of creditors, equity-holders and public policy);
see, also, e.g., In re Rusty Jones Inc.,
110 B.R. 362, 375 (Bankr. N.D. Ill. 1990) (finding continuation in
office of the officers and directors was not consistent with the
interests of creditors because debtors continued to operate in red
as a result of their expenditures and governance). 16
Collier on Bankruptcy |1129.03[5][b] (A. Resnick et al. eds.,
15th ed. rev. 2006). 17 Compare, e.g., 11
U.S.C. §1129(a)(6), which requires that any rates of the debtor
have been approved by any governmental regulatory authority with
jurisdiction, or that any prospective rate change is conditioned on
such approval. 18 In In re Washington Group Int'l. Inc.,
the bankruptcy court findings in support of its confirmation order
included: "Because the Steering Committee for the Lenders and
the Creditors' Committee will be entitled to designate a majority of
the board of reorganized WGI...the manner of selection of the
initial directors and officers of the reorganized debtors and the manner
of selection of successor directors and officers of the reorganized
debtors...are consistent with the interests of the holders of claims
and interests and public policy." 2001 Bankr. LEXIS 2150, at *
24-25 (Bankr. D. Nev. 2001). The issue in that case, however, was
not contested. 19 11 U.S.C. §1129(a)(5)(B). 20 11
U.S.C. §363(b). 21 See, e.g., In re
Regensteiner Printing Co., 122 B.R. 323 (N.D. Ill. 1990)
(reversing approval of employment agreements with senior executives
for failure to scrutinize the insider transactions to ensure that
the proposed transactions were fair); In re US Airways Inc., 329
B.R. 793, 801 (Bankr. E.D. Va. 2005); In re America West Airlines
Inc., 171 B.R. 674, 678 (Bankr. D. Ariz. 1994). 22 11
U.S.C. §503(c), as amended by Bankruptcy Abuse Prevention and
Consumer Protection Act, Pub. L. No. 109-8, §331 (2005).

23 Opponents also argued that because the MEIP was excessive the plan
was not filed in good faith. 11 U.S.C. §1129(a)(3). 24
In re United Air Lines, No. 03-B-48191 (Bankr. N.D. Ill.),
Transcript of Hearing Jan. 18, 2006, at 41. 25 Id.
at 61-62. 26 Id. at 63-64. 27 The Code now
limits the debtor's exclusive period to 18 months to file a plan and
20 months to have a plan accepted. 11 U.S.C. §1121(d)(2).

Journal Authors

Thomas D. Goldberg

Journal Date

Monday, May 1, 2006 - 12:00

Bankruptcy Rule

2006

none