Bad Words to a Debtors Ear

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Mar 2005

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Bankruptcy Code

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Chapter 11 debtors typically remain in
control of their estates as debtors-in-possession (DIPs), often seeing
their case to completion through confirmation of a chapter 11 plan. But
it doesn't always go this way. The Bankruptcy Code also provides that
the court may:

<ul>
<li>appoint a trustee
</li><li>appoint an examiner

</li><li>convert the case to chapter 7
</li><li>dismiss
</li><li>end exclusivity.
</li></ul>

Another "bad word" for many troubled companies, is "involuntary
bankruptcy." We touch on that this month as well.

<h4>Chapter 11 Trustees</h4>

The Bankruptcy Code says the court may order the appointment of a
trustee "for cause, including fraud, dishonesty, incompetence or gross
mismanagement of the affairs of the debtor" or "if such appointment is
in the interests of creditors, any equity security-holders and other
interests of the estate...."See Code §1104(a). Appointment
of a trustee is mandatory in chapter 7, 12 and 13 cases. However, the
appointment of a trustee in a chapter 11 case is an extraordinary
remedy. A request for the appointment of a trustee must overcome the
presumption that the debtor will continue to control the business. The
basis for the strong presumption against appointing a trustee is
two-fold. First, there is often no need for one; DIPs have a fiduciary
duty to act in the best interest of creditors and other stakeholders,
are typically motivated to maximize value and usually don't engage in
significant wrongdoing or malfeasance. Second, the DIP is usually
familiar with the business it had been managing pre-petition, often
making it the best party to conduct operations during the
reorganization. (It is worth noting that in many other countries there
is not a presumption that current management will continue to run the
business in bankruptcy, perhaps borne of a desire to get rid of the
managers who ran the company into bankruptcy.)

The burden is on the moving party to demonstrate by clear and
convincing evidence that appointment of a chapter 11 trustee is
appropriate. Although the second part of the standard (best interest of
creditors and other stakeholders) would seem somewhat easier to satisfy,
as a practical matter it is very difficult to get a trustee appointed
without showing some level of incompetence and/or malfeasance by the
debtor's management.

Aside from the presumption in favor of current management and the
high standard for appointment of a trustee, another reason you don't see
many chapter 11 trustees is that where you really do need a
trustee—such as where management has destroyed the
business—the case may convert to chapter 7 first. If a chapter 11
trustee is appointed, he/she basically has the same obligations as the
DIP, including running the business and filing a reorganization plan.
See Code §1106. The trustee is typically appointed by the
Office of the U.S. Trustee, usually after consultation with major
creditors. There is, however, a provision that permits election of the
trustee. See Code §1104(b).<a href="#1" name="1a">1</a>

Even without forcing the appointment of a trustee, creditors may get
control of the debtor by forcing a change of management. Indeed, in a
great many public-company chapter 11s (including some of the most
notorious), this is exactly what happens: Creditors force out the old
management before the chapter 11 begins, and so the nominal "DIP" is
someone in whom creditors have faith, sent in to clean up the mess that
others left behind.

<h4>Chapter 11 Examiners<a href="#2" name="2a">2</a></h4>

The Code states that a court may appoint an examiner after a party in
interest or U.S. Trustee requests the appointment.<a href="#3" name="3a">3</a> One reported decision has
indicated that a bankruptcy court has authority to appoint an examiner
sua sponte. An examiner is to be appointed if the court
determines that such appointment is in the interests of creditors and
other stakeholders or if the debtor's unsecured non-insider debts
exceed $5 million. See Code §1104(c)(2).

Section §1104(c) provides that the court may order the
appointment of an examiner "to conduct...an investigation of the
debtor." In fact, courts have stretched the language of this rule a bit;
several courts have used "examiners" in complicated cases to try to
leverage out-of-court settlements. In other cases, examiners have been
appointed to evaluate causes of action the estate may have. Cases with
examiners are also uncommon, but are probably more common than chapter
11 trustees. In a complicated case where the court is reluctant to
impose the costs and inconvenience of a trustee—but where the judge
wants more comfort than he gets from the DIP—an examiner may be the
ticket.

<h4>Conversion and Dismissal</h4>

Code §1112 authorizes conversion or dismissal. On the motion of
a party in interest, the court may order conversion or dismissal for any
of 10 reasons itemized in Code §1112(b). These include:

<ul>
<li>"continuing loss to or diminution of the estate and absence of a
reasonable likelihood of rehabilitation"
</li><li>"inability to effectuate a plan"
</li><li>"unreasonable delay by the debtor that is prejudicial to creditors."
</li></ul>

Translated, we think this means: "Your honor, this case is going
nowhere, and it is time to put a bullet through the poor beast." If
nothing more can be accomplished in chapter 11—because of the
debtor and its circumstances and/or because of the limits of what
chapter 11 cases achieve—then dismissal may be warranted.

Where the grounds exist, the judge has the choice of dismissal or
conversion, so which one should one ask for? If you go for conversion,
you are still stuck with the bankruptcy process—a chapter 7
trustee, notice to creditors, all that sort of thing. On the other hand,
you have the benefit of judicial supervision and you preserve avoidance
actions that may bring money into the estate. If you go for dismissal,
you get to shed of all that encumbrance—but so does the debtor. So
you save the costs and inconvenience of bankruptcy, but you also lose
the protections. There isn't any general rule here. The point is that in
an individual case, you are going to have to weigh the costs and
benefits of staying in versus getting out.

<h4>Exclusivity</h4>

Finally, a background note: Underlying all these issues is the
question of who (if anyone) may propose a chapter 11 plan. Code
§1112 provides that only the debtor may propose a plan in
the first 120 days of a chapter 11 case. In a corporate case, "debtor"
means the managers of the debtor corporation, controlled ultimately by
the shareholders. We think this rule is a linchpin of chapter 11 that is
often underappreciated; it allows old equity-owners to use chapter 11 as
a "second bite at the apple" to give them one last chance before they
lose control to the creditors.

The immediate relevance is that the rule goes away if conversion,
dismissal or the appointment of a trustee occurs, so this critical power
of "debtor exclusivity"—a linchpin of the chapter 11
case—vanishes if any of these events comes to pass.

<h4>Involuntary Bankruptcy</h4>

Now, a word about involuntary bankruptcy. There is an irony
here. Five hundred years ago, when bankruptcy was young, the idea of
"voluntary bankruptcy" was pretty much of an oxymoron: Bankruptcy was a
creditor's remedy, and a debtor wouldn't volunteer for it. Bankruptcy
began to look attractive to the debtor only after the introduction of
the first primitive discharge rule in 1705. And indeed, it wasn't until
after World War II that we observe large numbers of debtors voluntarily
filing for bankruptcy with the discharge in view.

The Code still permits creditors to begin an involuntary case
(see Code §303). Only a very small number of involuntary
cases show up on the docket—and if anything, we suspect this tiny
number is larger than it should be. We think that involuntary
bankruptcy, in keeping with its antiquarian roots, is pretty much like a
muzzle-loading weapon: occasionally lethal and as likely as not to blow
up in your face.

The first problem is the threshold: It's not easy to start an
involuntary case. You need three or more creditors holding claims that
"aggregate at least $11,625 more than the value of any lien." This means
that before you begin, you have to find at least two other creditors
just as motivated as you are.<a href="#4" name="4a">4</a> An involuntary case cannot be commenced
against a nonprofit business.

In a voluntary case, the filing of the petition begins the
bankruptcy. In an involuntary case, the filing just begins a contested
matter. That is, if the debtor challenges the petition, then the
creditor has to prove either one of these bankruptcy predicates:

<ul>
<li>The debtor is generally not paying such debtor's debts as such debts
become due; or
</li><li>Within 120 days before the date of the filing of the petition, "a
custodian...was appointed or took possession."
</li></ul>

Translated, this means that if the debtor makes an assignment for the
benefit of creditors at state law, then you can put him into an
involuntary bankruptcy. Code §303(h). As a plaintiff in the
involuntary case, you get your involuntary order if and only if you win
this contested matter—and that may not be the end of it. Because of
the potency of involuntary bankruptcy, the Code affords businesses
protection against creditors that seek to improperly invoke its power.
For example, Code §303(i) sets out remedies in cases in which an
involuntary petition is dismissed other than on consent of all
petitioners and the alleged debtor.

Until the court enters an "order for relief" finding that the grounds
for involuntary bankruptcy have been satisfied, the "alleged debtor" is
in what's known as the "gap period." During this period, the debtor is
allowed to operate its business and use, sell or lease its assets as if
it were not in bankruptcy. (If there is a risk of loss to the estate
during this period, the court may appoint a trustee during the gap
period.)

So filing an involuntary petition is chancey and potentially
hazardous. But even ignoring chance and hazard, there is a more
fundamental question: Do you need it? Consider this classic case: Your
client is one of many creditors of the debtor and is morally certain
that the debtor is dissipating assets.

On the one hand, there are non-bankruptcy remedies available that may
enable you to collect your debt and prevent dissipation of assets. These
may be quicker and cheaper than bankruptcy and may enable you to collect
amounts owed in full without sharing with other creditors.

On the other hand, once you file the involuntary petition, you've
bought yourself a whole new set of enemies. The involuntary case is a
bell you can't un-ring: Once you file, you can't dismiss without giving
notice to all other creditors. If you win the involuntary adjudication,
there will be a trustee who may or may not act as your ally, and there
will be lots of other creditors who will want to share pro rata
anything that is available—and some of whom may have a statutory
priority in bankruptcy.

The cases where involuntary bankruptcy is most worthy of
consideration are those where (1) the debtor is mishandling or
dissipating assets and there does not appear to be any quick and
effective way to stop it other than the court supervision that comes
with bankruptcy, or (2) cases where a significant transfer has been made
that would be avoidable if the transferor were put into bankruptcy.
Consequently, there are cases where involuntary bankruptcy can be
effective, but it is a weapon of last resort, and you'd better think it
through carefully before you take your client's bad situation and make
it worse.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> There is a similar
provision for chapter 7 trustees, although it is not commonly utilized
under either chapter. <a href="#1a">Return to article</a>

<a name="2">2</a> For a comprehensive
discussion of trustees and examiners in chapter 11, see
Friedland, Jonathan; Khokha, Tasneem and Nylen, Sven, "The Failure of
Corporate Stewardship and the Rise of the Statutory Fiduciary: Examiners
and Trustees in Chapter 11," The Annual Survey of Bankruptcy Law
(2003). <a href="#2a">Return to article</a>

<a name="3">3</a> Section 1104(c). "Party
in interest" is defined in §1109 as including the debtor, trustee,
creditor's committee, an equity security-holder's committee or any
indenture trustee. <a href="#3a">Return to article</a>

<a name="4">4</a> The Code does say that if
the debtor has fewer than 12 creditors in total, you can get away with
just one petitioner—but most debtors have more than 12 creditors,
so in the usual case you will need three petitioners. <a href="#4a">Return to article</a>

Journal Authors

John D. Ayer

Jonathan P. Friedland

Michael L. Bernstein

Journal Date

Tuesday, March 1, 2005 - 12:00

Bankruptcy Rule

2005

none