Recent Decisions Regarding Creditors Committees

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Mar 2002

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Although the Bankruptcy Code is silent with respect to the right of a creditors'
committee to file an adversary proceeding, almost all of the courts that have
considered this issue have been unanimous in recognizing that such a right exists.
However, most courts have required that the committee obtain prior court approval as
a condition precedent to the initiation of suit. A debtor may have a number of valid
reasons why it believes that a suit should not be instituted, particularly within the
context of a reorganization. These reasons, however, must be balanced against the
creditors' interests in recovering property of the estate, which implies that the
committee must establish some "benefit to the estate" in pursuing the claims. Assuming
bankruptcy court approval, there have been few challenges to the committee's institution
of suit.

<h3>Creditors' Committee Standing to File Adversary Proceedings Refined</h3>

In a recent case, In re Together Development Corp.,<a href="#1" name="1a">1</a> the debtor and the
creditors' committee entered into a stipulation authorizing the committee to institute
preference and other claims against the debtor's principals. This arrangement was approved
by the bankruptcy court after proper notice. After the committee filed suit, the
defendants filed a motion to dismiss, contending, among other things, that the Supreme
Court's decision in Hartford Underwriters Ins. Co. v. Union Planters Bank N.A.
(the Hen House case),<a href="#2" name="2a">2</a> which conferred standing to recover a surcharge under
§506(c) of the Code only on "the trustee," precluded the committee from continuing
to prosecute its action.

The bankruptcy court, in rejecting the defendants' argument, noted that the Supreme
Court, in a footnote to its Hen House opinion, stated that it was not addressing
the issue of allowing other parties to act on the trustee's behalf under provisions
other than §506(c). Bankruptcy Code §§1103(c)(5) and 1109(b) allow
bankruptcy courts to pragmatically deal with conflicts arising between insiders and
corporate bankruptcy debtors. Secondly, the court stated that the situation where a
creditors' committee had brought an action could be distinguished from Hen House. In
the former instance, the action was being brought on behalf of all creditors, not
merely on behalf of a sole creditor seeking a recovery for its own benefit. Finally,
the court concluded that to hold that only a "trustee" could bring an action would
allow insiders to easily manipulate the bankruptcy process to limit their own exposure.
Such manipulation, the court reasoned, would run contrary to the "utilitarian,
time-tested process which has evolved in bankruptcy law and under the Bankruptcy Code
in order to ensure that appropriate lawsuits proceed in cases where debtor's counsel has
some reason not to pursue all potential assets of the estate due to a conflict of
interest, be that conflict real or perceived." The court asserted that the creditors'
committee must guard against "gaps" created by conflicts of interest in the handling of
the debtor's estate.

In In re Commodore International Ltd., et al.,<a href="#3" name="3a">3</a> the Second Circuit Court
of Appeals considered the standing of a creditors' committee to institute an adversary
proceeding where foreign liquidators had approved and stipulated to the committee's
action, and the bankruptcy court had initially granted its approval. The liquidators
of two Bahamian corporations, which had also filed for chapter 11 protection in the
United States, originally consented to an order authorizing the unsecured creditors'
committee to file suit against the debtor's former officers to recover substantial funds
that had allegedly been improperly transferred to them. The debtor's former officers
then contended, in the Bahamian court, that the liquidators had breached their
statutory duties by authorizing the U.S. creditors' committee to institute suit against
them. Upon a determination by the Bahamian court that the liquidators had breached
their statutory duties by authorizing the creditors' committee's suit against the former
officers, the liquidators instituted an almost identical suit against the same defendants
in the Bahamian court.

The defendants then sought to dismiss the suit instituted by the creditors'
committee, contending that, based on the decision in In re STN Enterprises,<a href="#4" name="4a">4</a> a
creditors' committee only has standing to sue when the debtor unjustifiably fails to
bring suit or abuses its discretion in not bringing suit. The creditors' committee
contended that it had standing based on the debtor's consent and bankruptcy court
approval. The bankruptcy court held that the liquidator's subsequent suit acted to
divest the creditors' committee of standing to pursue claims against the debtor's former
officers. On appeal, the Second Circuit concluded, in a matter of first impression,
that a debtor-in-possession may stipulate to the institution of litigation by an
unsecured creditors' committee "so long as the bankruptcy court exercises its judicial
oversight and verifies that the litigation is indeed necessary and beneficial and in the
best interest of the bankruptcy estate." The court said "this approach permits a
reasoned and practicable division of labor between the creditors' committee and the
debtor-in-possession or trustee, while also providing the bankruptcy courts with
significant authority both to manage the litigation and to check any potential for abuse
by the parties." The court reasoned that, since the liquidators in Commodore had
instituted suit, the creditors' committee action was no longer "necessary and beneficial"
to the estate, and accordingly, the case was dismissed.

Commodore is troubling since it did not require the bankruptcy court to revisit its
earlier decision in light of the liquidator's change in position. The mere existence
of the initial stipulation indicates that the liquidators originally believed that the
creditors' committee could more effectively pursue the litigation. The bankruptcy court
should have been directed to determine whether continuing the creditors' committee's suit
was "necessary and beneficial to the estate." The committee's suit, for example, may
have been more beneficial to the estate by including counts that were absent from the
liquidators' suit. Further, the creditors' committee's suit may have been ready for
trial, while the liquidators' suit may not have been. The liquidators' trial
preparations may have been duplicative and may have unnecessarily diminished the estate.
The Commodore court should have remanded the matter to the bankruptcy court to
determine which party's suit, considering all the circumstances, was in fact more
beneficial to the estate and allowed that party to proceed.

<h3>Nature and Extent of a Committee Member's Fiduciary Duty</h3>

While case law clearly recognizes that a member of a creditors' committee owes a
"fiduciary duty" while performing his or her committee responsibilities, recent court
decisions have articulated the nature and extent of that fiduciary duty and to whom
the fiduciary duty is owed.

In Westmoreland Human Opportunities Inc v. Walsh,<a href="#5" name="5a">5</a> a chapter 11 trustee of
a nonprofit housing facility instituted suit against a member of the unsecured creditors'
committee. The trustee contended that the committee member's failure to disclose its
status as the successor recipient of the debtor's grant from the Department of Housing
and Urban Development constituted a breach of that member's fiduciary duty, resulting
in liability of that member in the amount of $135,000. The committee member
had defended the suit on the basis that it did not violate its fiduciary duty since
the interest in the grant relationship was not property of the debtor's bankruptcy
estate. The Third Circuit Court of Appeals, after an extensive discussion, concluded
that while the debtor's grant relationship was not property of the estate, that fact
alone was not an absolute defense to the charge that the committee member had breached
its fiduciary duty. The court remanded the case to determine whether the member's
failure to disclose the existence of the interest in the grant relationship to either
the bankruptcy court or to the creditors' committee materially undermined the ability of
the bankruptcy court to take the grant relationship into account in formulating a
comprehensive chapter 11 plan for the debtor's reorganization.

In Picciotto v. Schreiber,<a href="#6" name="6a">6</a> an unhappy unsecured creditor instituted a proceeding
against participants in an earlier bankruptcy case, including counsel for the unsecured
creditors' committee and a member of the unsecured creditors' committee. The unsecured
creditor contended that those parties had breached their fiduciary duties to the
creditor. In dismissing the action, the court held that committee members and counsel
for the committee owe no fiduciary duty to any specific unsecured creditor. The court
stated, in a footnote, that "...holding an unsecured creditor and member of an
unsecured creditors' committee personally liable for breach of a fiduciary duty to another
unsecured creditor would violate public policy, as it would discourage creditors from
serving on the committee and would interfere with the committee's activities."

In In re Dow Corning Corp.,<a href="#7" name="7a">7</a> the district court considered not only the
nature of the fiduciary duty owed by a member of a creditors' committee, but also
the propriety of plan provisions that released the committee members from liability for
any actions undertaken as a member of the committee. The court, citing from several
cases, held that the fiduciary duty required of a creditors' committee member extends
to the class of unsecured creditors as a whole and not to its individual members.
The court stated that creditors' committee members have a qualified immunity from suit
that corresponds to and is intended to further the performance of the committee's
statutory duties. To overcome the immunity, the party alleging a breach of fiduciary
duty must prove that the committee or committee members engaged in willful misconduct
or in "ultra vires activities." The court found that no evidence of any misconduct
had been introduced.

<h3>Committee Member Legal Fees Disallowed</h3>

In First Merchants Acceptance Corp. v. J.C. Bradford & Co.,<a href="#8" name="8a">8</a> the Third
Circuit Court of Appeals considered whether the 1994 amendment to §503 of the
Bankruptcy Code allowed a creditor to obtain administrative expense reimbursement for
professional services performed by its personal counsel with the knowledge of, and at
the request of, the committee's counsel and members of the committee. The court held
that the plain meaning of §§503 (b)(3)(F) and 503(b)(4) expressly
permits a member of the creditors' committee to recover reasonable compensation for
professional services incurred in its capacity as a member of the committee. The court
noted that §503(b)(4) authorized claims for attorneys' and accountants' fees
incurred by all entities who are allowed to claim administrative expenses under
§503(b)(3). The court held that, under the plain meaning of the statute, a
member of a creditors' committee was a §503(b)(3) "entity" entitled to recover
as administrative expenses its actual and necessary expenses.

In response, the trustee argued that a plain meaning interpretation of the statute
would allow committee members to retain, in effect, private committee counsel without
prior review by the court and without notice to the committee or other creditors. The
court, while admitting that there was a "potential for abuse," discounted the trustee's
argument by reasoning that the bankruptcy court would retain its "power to ensure that
only those fees that are demonstrably incurred in the performance of the duties of the
committee...are reimbursed." The bankruptcy court, as required by statute, must
in each case conduct a review of the fee application to determine whether the fee was
reasonable and whether the services were necessary.

In light of the holding in First Merchants Acceptance Corp, it might be imagined
that lower courts in the Third Circuit would be more likely to approve legal fees
submitted by individual members of the creditors' committee. In practice, however,
lower courts appear to be taking the view that such fees are almost never reasonable
or necessary. In In re Worldwide Direct Inc.,<a href="#9" name="9a">9</a> for example, the court found
that, in the absence of unusual circumstances, it would be "difficult to conclude that
it is necessary for committee members to hire individual counsel to assist them in the
performance of their duties as committee members when committee counsel and other
committee professionals are available to assist them." The court stated that performing
a committee task by a professional retained by an individual member might be justified
where there was a conscious and restricted division of labor that would not result in
inappropriate duplication of effort. In such a case, the fees incurred by counsel
for the members would be a necessary expense of the committee.

Some other courts have disagreed completely with the holding in First Merchants.
In In re First Plus Financial Inc.,<a href="#10" name="10a">10</a> for example, the court held that fees
of an attorney for an individual member of a creditors' committee were not compensable
despite the language in §503(b)(4) because they were for services that solely
benefited the creditor and did not benefit the estate or the committee. While
acknowledging that the literal language of §503(b)(4) appears to permit such a
result, the court stated that the Supreme Court has made an exception to the "plain
language" construction tool in rare cases where the "literal application of a statute
will produce a result demonstrably at odds with the intention of its drafters, and
those intentions must be controlling." To hold otherwise would unduly burden the debtor
and decrease the return to creditors. Relying on the same legislative history that the
Third Circuit refused to consider in First Merchants, the court held that Congress
did not intend in the 1994 amendment to the language of §503(b)(4) to
include the expenses and fees of an attorney that may be hired by each individual
member of the committee in addition to the fees and expenses awarded to the committee's
counsel.

<h3>Committee Counsel Legal Fees Incurred Before Appointment of Unsecured Creditors'
Committee Allowed</h3>

In In re S.W.G. Realty Assoc. II L.P.,<a href="#11" name="11a">11</a> a law firm filed an
involuntary chapter 7 petition on behalf of certain creditors. Subsequently, the debtor
successfully moved to convert the chapter 7 case into a chapter 11 proceeding.
Eventually, the same law firm received court approval to represent the creditors'
committee. After the debtor's reorganization plan was approved, committee counsel filed
an application for allowance of fees charged throughout the course of its representation
of the creditors. The application included fees for services connected with the
involuntary filing and other work done prior to the conversion to chapter 11 and the
formation of the creditors' committee.

The debtor argued that §330, the Code provision that authorizes the payment of
fees to attorneys who represent the creditors' committee, only contemplates the payment
of fees for services rendered to the creditors' committee in connection with the
performance of the committee's functions. The debtor argued that it was impossible for
the committee counsel to collect fees for services before the committee was formed.
However, the court, following Third Circuit precedent, held that under the proper
interpretation of §330, the test is not whether the services rendered benefitted the
committee, but rather whether the services rendered were for the benefit of the
estate. Here, the court accepted the applicant's reasoning that, but for counsel's
initiation of the bankruptcy proceedings, the estate would not have existed and no
creditor would have received relief.

<h3>Release Provisions in Plan Approved</h3>

In In re PWS Holding Corp.,<a href="#12" name="12a">12</a> the Third Circuit considered the propriety of
release provisions in a debtor's plan, which released committee members and their
professionals from any liability except for willful misconduct or gross negligence. Two
creditors appealed the order confirming the reorganization plan, which included provisions
releasing committee members. They contended that the inclusion of the release violated
§524(e) of the Bankruptcy Code. Section 524(e) provides that a debtor's
proceeding does not affect the liability of a third party for a debtor's debt. The
court, applying current interpretations of §1103(c), which grants the committee
broad authority to formulate a plan and provide "such other services as are in the
interest of those represented," held that creditors' committee members have a fiduciary
duty to committee constituencies and to committee members that gives them a limited
grant of immunity from claims arising from actions within the scope of their duties.
As a result, the liability of a committee member is limited to willful misconduct
or ultra vires acts. This limited immunity protects committee members and the entities
that provide services to the committee in the event that they are sued for their
participation in the reorganization plan. The court found that the contemplated release
did not affect the liability of another entity on a debt of the debtor within the
meaning of §524(e). In fact, the release provision in the debtor's plan was no
more expansive than that suggested by §1103(c). As a result, the court concluded
that the release in the debtor's reorganization plan was proper and outside the scope
of §524(e) of the Code.

In In re Dow Corning, supra, the court also considered whether it could approve
release provisions in a debtor's plan. The court, using the same statutory
interpretation suggested by PWS Holding Corp., approved release provisions pertaining
to attorneys' activities on behalf of a tort claimants' committee. The court concluded
that it had the authority to approve release provisions for committee members since any
claims against the committee would most likely give rise to indemnification or
contribution claims against the debtor. These claims, the court reasoned, would
implicate the debtor's assets. Therefore, court approval of committee release provisions
was justified.

<h3>The U.S. Trustee's Power to Appoint Committees</h3>

In In re Pacific Gas & Electric Co.,<a href="#13" name="13a">13</a> the U.S. Trustee (UST), in
addition to appointing an Official Committee of Unsecured Creditors, appointed an
Official Committee of Ratepayers in order to protect the interest of the utility
ratepayers and give them a voice in the chapter 11 proceeding. Shortly after, the
debtor filed a motion to vacate the appointment of this committee. The trustee argued,
under §1102(a) of the Code, that the court lacked the authority to review the
trustee's discretionary appointment of the ratepayers' committee.

The court, following the majority view as elaborated in In re Pierce,<a href="#14" name="14a">14</a> held
that despite the fact that it lacked specific statutory authority to review the
trustee's discretionary committee appointments, it had general authority, under
§105(a), to review the trustee's appointment under an abuse-of-discretion standard.
The court reasoned that appointments by the trustee, an administrative officer, must
be reviewable in some manner, otherwise "there would be no means for judicial review
of the UST's actions, even if the UST exceeded her authority and acted contrary to
law."

The court, interpreting §1102(a), the Code provision granting the trustee the
power to appoint committees, held that the ratepayers were not "creditors holding
unsecured claims" as contemplated under that provision. The court noted that a
"creditor," under §101(10), is an entity that has a "claim against the debtor
that arose at the time of or before the order for relief." Here, the ratepayers
had no claim on the petition date that could justify the creation of a creditors'
committee composed of ratepayers. The ratepayers were not "creditors" for §1102(a)
purposes, therefore, their appointment to a creditors' committee was an abuse of
discretion by the trustee.

<hr>

<h3>Footnotes</h3>

<a name="1">1</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. 586 (Bank. D. Mass. 2001)</a>. <a href="#1a">Return to article</a>

<a name="2">2</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S., 120 S.Ct. 1942, 147 L.Ed. 2d1 (2000)</a>. <a href="#2a">Return to article</a>

<a name="3">3</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. 3d ___, 2001 WL 897138, (2nd Cir. 2001)</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F. 2d 901 (2nd Cir. 1995)</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F. 2d 901 (2nd Cir. 1995)</a>. <a href="#5a">Return to article</a>

<a name="6">6</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. 242 (D. Mass. 2001)</a>. <a href="#6a">Return to article</a>

<a name="7">7</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. 445 (E.D. Mich. 2000)</a>. <a href="#7a">Return to article</a>

<a name="8">8</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d 394 (3rd Cir. 1999)</a>. <a href="#8a">Return to article</a>

<a name="9">9</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. 56 (D. Del. 2001)</a>. <a href="#9a">Return to article</a>

<a name="10">10</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. 888 (N.D. Tex. 2000)</a>. <a href="#10a">Return to article</a>

<a name="11">11</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. 534 (E.D. Pa. 2001)</a>. <a href="#11a">Return to article</a>

<a name="12">12</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d 224 (3rd Cir. 2000)</a>. <a href="#12a">Return to article</a>

<a name="13">13</a> Bankruptcy Case No. 01-30923DM, Memorandum Decision Regarding Motion for Order Vacating Appointment of Committee of
Ratepayers (May 18, 2001). See Resnick, Alan N. and Scheler, Brad Eric, "From the Bankruptcy Courts, Limitations on the U.S.
Trustee's Power to Appoint Committees: Lessons from PG&E," From the Bankruptcy Courts, 34 UCC L.J. 215 (2001). <a href="#13a">Return to article</a>

<a name="14">14</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. 748 (Bankr. E.D. Cal. 1999)</a>. <a href="#14a">Return to article</a>

Journal Authors

Lawrence K. Snider

Journal Date

Friday, March 1, 2002 - 12:00

Bankruptcy Rule

2002