Liquidation Trustee Liability What You Cant See Can Hurt You

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Feb 2002

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As chapter 11 filings increase, so will the number of chapter 11 liquidations.
Indeed, filing chapter 11 does not equate to reorganization. A chapter 11 orderly
liquidation is often the result of a failed reorganization attempt. In fact, debtors
often file chapter 11 petitions intending to file and confirm a liquidating plan.

Regardless, the increase of chapter 11 liquidation plans will result in the
increased use of liquidation trusts. Liquidation trusts typically allow for a larger
return than a "fire sale" of the debtor's assets, which are transferred into a trust
for the benefit of creditors upon confirmation of a liquidating plan. A liquidating
plan usually contemplates establishing a liquidation trust, assigning assets and causes
of action, and appointing a liquidation trustee.

After confirmation and appointment, the liquidation trustee then serves as the
liquidation trust's representative and is responsible for complying with the trust
agreement (and confirmation order), liquidating the assets and making distributions to
trust beneficiaries. The liquidation trustee in essence has the duties and
responsibilities of a state law trustee, including fiduciary duties to the liquidation
trust. As such, candidates for liquidation trustee positions must consider the exposure
potential to liabilities for acts and omissions occurring while administering the
liquidation trust.

<h3>The Basis for Liquidation Trust Liability</h3>

The potential liability for a liquidation trustee takes many forms. For example,
liquidation trustees not only have duties to the liquidation trust itself—and therefore
its beneficiaries—they also have potential government liability, and potential liability
for the expenses of administering the liquidation trust. Indeed, trustees can be
exposed to personal liability for acting outside of their official capacity and for
breaches of fiduciary duty. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Brite, 483 N.W.2d at 578-79</a>.

The fiduciary duty standard of care, however, is not clear, and the case law is
split over the applicable standard. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Huff (In re Smyth), 207
F.3d 758, 761 (5th Cir. 2000)</a> (discussing willful and deliberate,
gross negligence and negligence standards); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Brite, 483 N.W.2d at 579</a>

(discussing both willful and negligent breaches); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Powers (In re
Powers), 112 B.R. 178, 181 (Bankr. S.D. Tex. 1989)</a> ("Trustees
of an estate in bankruptcy are subject to personal liability for willful violations of
fiduciary duties."). This necessitates a liability policy and/or an indemnity agreement
to protect the liquidation trustee from errors and omissions.

Liability for such errors and omissions is not necessarily limited to such insurance
proceeds. Other penalties may be imposed, such as reducing the liquidation trustee's
compensation or imposing a surcharge on the liquidation trustee. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Norton Bankr.
L. & Prac. 2d §79.21 (2001)</a>. To avoid such personal liability, trustees
must take the utmost care in their duties, particularly considering the differing causes
of action that could accrue.

<h3>Potential Causes of Action</h3>

As a "trustee," a liquidation trustee has potential exposure for numerous liabilities.
For example, the U.S. Supreme Court held that under the Internal Revenue Code,
a liquidation trustee must "pay the tax due on the income attributable to the corporate
debtors' property because [26 U.S.C.] §6012(b)(3) requires him to make a
return as the 'assignee' of the 'property...of a corporation.'" <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Corp. v.
Smith, 503 U.S. 47, 52 (1992)</a>. Therefore, "[a]s the assignee of 'all'
or 'substantially all' of the property of the corporate debtors, the trustee must file
the returns that the corporate debtors would have filed had the plan not assigned their
property to the trustee." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 54</a>.

While <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §1146(c)</a> provides that "The issuance, transfer or exchange
of a security, or the making or delivery of an instrument of transfer under a plan
confirmed under §1129 of this title, may not be taxed under any law imposing a
stamp tax or similar tax," failing to pay other taxes could create personal liability
for the liquidation trustee if the liquidation trust's assets are depleted. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
States v. Hemmen, 51 F.3d 883 (9th Cir. 1995)</a>.

In Hemmen, the Ninth Circuit held a chapter 7 trustee personally liable for
failing to honor an IRS notice of levy against the allowed administrative expense claim
of a corporate debtor's president. The trustee received notice of the levy and then
paid the debtor's president's allowed administrative claim from the liquidation funds of
the estate. The court held the trustee personally liable under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §6332</a>
for failing to honor the levy, even though the trustee notified the government that
he was going to disburse the funds and the IRS raised no objection at that time.

Although the trustee in Hemmen was not held personally liable for taxes, it is
an example of the caution a liquidation trustee must exercise in administering the
liquidation trust.

Additional liability may result from the requirement to pay quarterly fees to the
U.S. Trustee "until the case is converted or dismissed." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C.
§1930(a)(6)</a>. A liquidation trustee is generally required to pay
post-confirmation quarterly fees out of the funds of the trust. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re CSC Indus.
Inc., 226 B.R. 402, 404 (Bankr. N.D. Ohio 1998)</a>; see, also,
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Hudson Oil Co., 200 B.R. 52 (Bankr. D. Kan. 1996)</a> (dicta
indicating that the liquidation trust would have been liable if amendments to 28
U.S.C. §1930(a)(6) had occurred before plan confirmation). One court
addressing this issue held that because "Congress intend[ed] such fees be paid by
chapter 11 debtors prior to conversion or dismissal...," and because the trust has
"essentially stepped into the shoes of the original debtor," then the trust is "liable
for any such fees which may be imposed." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re CSC Indus. Inc., 226
B.R. at 404</a>. Considering quarterly fees to be an "administrative expense for
which the liquidation trust was responsible," the court found that "imposing
post-confirmation quarterly fees upon the liquidation trust [was] neither an attempt to
modify the plan nor a violation of separation of powers...." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 407</a>.

Although liquidation trustees have not generally been held personally liable for
environmental damage, the potential exists under federal and state law. See 6
Collier on Bankruptcy ¶721.05[3] (15th ed. rev. 1996). Specifically,
if a liquidation trustee engages in activities that could constitute managing or
operating of trust property under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §959(b)</a>, then environmental
liability could arise. The Fifth Circuit has held that a bankruptcy trustee,
although not personally liable, was obligated to plug wells in Texas and that failing
to do so created an administrative expense priority claim. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Lowe (In
re H.L.S. Energy Co.), 151 F.3d 434, 437 (5th Cir.
1998)</a>.

Furthermore, the U.S. Supreme Court, in a case dealing with whether a
trustee could abandon estate property under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §554(a)</a>, held that
"a trustee may not abandon property in contravention of a state statute or regulation
that is reasonably designed to protect the public health or safety from identified
hazards." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Nat'l. Bank v. New Jersey Dep't. of Envtl. Prot., 474
U.S. 494, 507 (1986)</a>. The relevance of this decision to a liquidation
trustee operating under a confirmation order and trust agreement is questionable, yet
it could be a basis for making such assertions.

<h3>Conclusion</h3>

The potential liabilities that a liquidation trustee could face are limitless.
Although only a few reported cases detail the basis for a liquidation trustee's
liability, there are a number of causes of action to consider and protect against,
e.g., distributing all assets prior to resolving all claims objections, the costs
of administering the liquidation estate and general malpractice actions, just to name
a few.

Nonetheless, liquidation trustee position can be lucrative. For those considering
the position, however, the potential for personal liability is an issue to consider
and safeguard against.

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Friday, February 1, 2002 - 12:00

Bankruptcy Rule

2002