Former Officers and Directors as Members of the Unsecured Creditors Committee Who Is Serving on Your Committee

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Nov 2003

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Today's headlines are full of stories of corporate glut and abuse by officers and directors. Officers and directors are
more often the subject of class action lawsuits based on corporate mismanagement, whether negligent or
intentional. Often, such claims are without merit, and the officers and directors are taking the heat for industry-wide problems. Other officers
and directors have helped themselves to the corporate coffers and purchased homes, golf courses, jets and small
islands.

These extravagances are in addition to a typically enormous salary. And considering the millions of dollars of
compensation already paid, it is hard to sympathize with the unfunded pension account and/or unpaid severance
package.

Because of the circumstances surrounding their termination, such officers and directors may have large unsecured
claims against their former employers. These claims stem from a variety of matters, including personal loans,
unfunded severance packages and/or tort claims. Often such claims are quite large, placing them in the 20-largest
unsecured creditors. As such, when committees are formed, a U.S. Trustee might appoint a former officer and
director to the official committee of unsecured creditors. In fact, some former officers and directors have sought and
obtained such appointment despite the U.S. Trustee's initial reluctance.

Apparently, some debtors take issue with their former fiduciaries' service on an official committee. These ungrateful
debtors take issue with their former fiduciaries' special knowledge and insight, and even question the motives of
former fiduciaries that serve on official committees. And due to the questionable motivations of some fiduciaries,
one court has recently held that former officers and directors are not appropriate for service on an official committee
of unsecured creditors.

<h3>Committee Formation</h3>

In drafting the Bankruptcy Code, Congress intended for unsecured creditors to have a role in a chapter 11 case.
See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… U.S.C. §§1102</a> and 1103. To give unsecured creditors a louder voice, Congress enacted provisions for the
establishment of a committee of unsecured creditors. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… U.S.C. §1102</a>. Pursuant to §1102(a)(1), the U.S.
Trustee may form one or more committees of creditors. Such committees should include creditors with substantially
similar claims, choosing among the largest of those creditors with such claims. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… U.S.C. §1102(b)(1)</a>.

After formation, the U.S. Trustee retains administrative authority over committee members. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… U.S.C.
§1102(a)(1)</a>; see, also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9… re First RepublicBank Corp., 95 B.R. 58, 60 (Bankr. N.D. Tex. 1988)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… re Barney's
Inc., 197 B.R. 431, 438-39 (Bankr. S.D.N.Y. 1996)</a>. As such, issues and disputes concerning committee
membership, including removal for cause, are properly directed to the <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…. Trustee. See First RepublicBank., 95
B.R. at 60</a>.

In fact, Congress intended for the U.S. Trustee to determine the removal and/or addition of committee members
after formation as evidenced by the 1986 repeal of §1102(c). See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; 197 B.R. at 438-39</a>. Section 1102(c)
authorized the bankruptcy court to change the membership or size of a committee if it determined that the existing
committee members did not represent the different kinds of claims to be represented. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… U.S.C. §1102(c)</a> (repealed); see, also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5… re Salant Corp., 53 B.R. 158 (Bankr. S.D.N.Y. 1985)</a>. As part of
the expansion of the U.S. Trustee program, Congress intended to sever much of the administrative duties in a
bankruptcy case, such as the formation of creditors' committees, from judicial tasks. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; 197 B.R. at
438-39</a>; citing H.R. Rep. No. 99-764, 99th Cong., 2d Sess. 18 (1986), reprinted in 1986 U.S.C.C.A.N. 5227,
5230.

In fact, the only express provisions for a bankruptcy court's review of a committee is for committees whose
members were chosen prior to the petition date. See Fed. R. Bankr. P. 2007. Nonetheless, most courts have held
that the U.S. Trustee's decision regarding committee formation and membership remains subject to review by the
court's equitable powers granted by 11 <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…. §105(a). See In re Venturelink Holdings Inc., No.
02-80906-SAF-11, 2003 WL 22229410 (Bankr. N.D. Tex. Sept. 2, 2003)</a>; citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9… RepublicBank Corp., 95
B.R. at 60</a>. However, the court is not to substitute its judgment, but instead review the U.S. Trustee's actions to
determine whether the U.S. Trustee acted arbitrarily and capriciously. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; 2003 WL 22229410</a>, at *2;

citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Fas Mart Convenience Stores Inc., 265 B.R. 427, 431 (Bankr. E.D. Va. 2001)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9… RepublicBank, 95
B.R. at 60</a>.

Among the various arbitrary and capricious actions that a U.S. Trustee may take is the refusal to remove a
committee member that is also a former fiduciary of the debtor. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; 2003 WL 22229410</a> at *2-3.

<h3>Venturelink Holdings</h3>

In Venturelink, the U.S. Trustee, at the urging of certain unsecured creditors, appointed an official committee of
unsecured creditors. Among the members appointed to the committee in this multi-debtor, jointly administered case
was a former officer of one debtor who was also a former director of certain other debtors. This officer was one of
the largest unsecured creditors, asserting claims for payments due under an unfunded severance agreement, as well as
a personal loan.

The debtors requested removal of the officer, asserting that the former officer and director had received millions of
dollars in cash, as well as a house in Mexico, just prior to the petition date, but the U.S. Trustee refused. Instead,
the U.S. Trustee expanded the committee by adding new members. Unsatisfied, the debtors sought relief from the
bankruptcy court. The bankruptcy court determined that §105(a) empowered the bankruptcy court to review a U.S.
Trustee's formation and/or addition and/or removal of members of a committee for arbitrary and capricious actions.
Id. at *2.

In making its determination, the bankruptcy court took note of the status of current affairs in the bankruptcy
community. Specifically, the court commented on the numerous high-profile cases where the actions of current and
former officers and directors were the focal point of the bankruptcy case. Id. at *3.

In addition, since a committee will necessarily analyze the performance of both current and former officers and
directors, an inherent conflict exists. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; Indeed, a former officer/director will "tend to steer a committee's focus
away from their performance," if at all possible. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; Similarly, a committee will also scrutinize the receipt by
officers and directors of large sums of money in connection with their positions, and the natural tendency of any
person is to retain that money, potentially to the detriment of other creditors. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…;

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[O]ne court has recently held that former officers and directors are not appropriate for service on an official committee of unsecured creditors.
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Additionally, pursuant to Bankruptcy Rule 2004, current and former officers and directors are frequently a source of
information for creditors regarding the administration of the estate. Thus, the conflict inherent in discovering
information from oneself for the benefit of all creditors is unavoidable. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…;

Consequently, the fiduciary nature of the officer or director's former employment is at odds with the fiduciary duty
that committee members owe their constituents. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; While not all conflicts are disqualifying conflicts, which the
bankruptcy court defined as those that call into question the creditor's ability to honor his fiduciary duty to all
unsecured creditors, conflicting fiduciary duties create a disqualifying conflict. Disqualifying conflicts also include
the appearance of a breach of that fiduciary duty, as the bankruptcy process must both be fair and appear fair. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…;;
citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… re Allied Texas Invs. Inc., No. 389-30056-SAF-11, 1989 WL 265432 at *1 (Bankr. N.D. Tex. Oct. 16,
1989)</a>.

Based thereon, the bankruptcy court held that a "U.S. Trustee would act arbitrarily and capriciously if he refused to
remove a committee member who held a conflict of interest amounting to a breach of the fiduciary duty owed by the
creditors to the creditors represented by the committee or who appeared to hold such a conflict." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; Thus, as a
matter of public policy, a former officer or director of a debtor should not be a committee member. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…;

<h3>Conclusion</h3>

Certainly, most officers and directors that are appointed to a committee act with the best interests of their
constituents, and in full compliance with their fiduciary duties. Some, however, have ulterior motives such as
revenge against their former employer, or in directing attention away from potential D&O claims and causes of
action.

While Venturelink appears to be the only case of its kind, surely more will follow. With the current status of
matters, and the daily news of wrongdoing by management, another former officer/director will find his/her way on
to a committee while his former employer screams foul play.

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Saturday, November 1, 2003 - 12:00

Bankruptcy Rule

2003