Recommending Turnaround Managers Ensuring that a Good Deed Goes Unpunished

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Dec/Jan 2004

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In today's lending
world, where lenders often market themselves as their borrowers'
partners, lenders increasingly attempt to be part of the solution
rather
than simply be a borrower's main problem when a loan goes south. In
their role as problem-solvers, lenders are encouraging (and
sometimes
insisting) that their borrowers take certain actions, such as hiring
a
turnaround manager, as a condition for the lender's providing
forbearance or cooperation.

The questions then arise: Can a lender require a
borrower to hire a specific turnaround manager as a condition of
forbearance, and how much other control can a lender properly assert
over a
debtor?

<h4>Equitable Subordination: The Penalty for Stepping over the
Line</h4>

In a bankruptcy context, the most common relief
requested to remedy a lender's undue influence over a debtor is
equitable subordination under 11 U.S.C. §510(c). Section 510(c)

authorizes a court to subordinate an allowed claim to the interest
of
another or to order a lien securing an allowed claim to be
transferred to
the estate. 11 U.S.C. §510(c).

Generally, a creditor has no fiduciary obligations to
a debtor. In re WT Grant Co., 699 F.2d 599, 609 (2d Cir.
1983). A creditor may use its
bargaining power, "including [its] ability to refuse to make further

loans needed by the debtor, to improve the status of [its] existing
claims." Id. at
610.

<h4>Testing the Limits</h4>

In cases where equitable subordination of a secured
creditor's claim is sought, courts have examined the extent to which

a lender can condition the forbearance of its rights and its
post-petition
financing on its ability to make decisions for the debtor company,
require
new management or even appoint a specific professional. A
three-pronged
test, enumerated under the Bankruptcy Act (prior to 1978), is
recognized as
the applicable standard in determining the propriety of equitable
subordination:

<ol>
<li>The claimant must have engaged in some type of
inequitable conduct;

</li><li>The misconduct must have resulted in injury to the
creditors of the bankrupt or confirmed an unfair advantage on the
claimant;
and

</li><li>Equitable subordination of the claim must not be
inconsistent with the provisions of the Bankruptcy Act (prior to
1978).
</li></ol>

In re Mobile Steel Co.,
563 F.2d 692, 699-700 (5th Cir. 1977) (citations omitted). The third

element of the equitable-subordination test has been adopted by
courts
since the enactment of the Bankruptcy Code. See,
e.g., In re Clark Pipe Supply Co. Inc., 893
F.2d 693, 699 (5th Cir. 1990).

<big><center>
Secured lenders will be allowed a fair amount of latitude in their
involvement with the operations of a debtor company, such as giving
advice on operational and other key decisions and even requiring the
hiring of a lender-approved manager.
</center></big>
<hr>
</blockquote></blockquote>

The bankruptcy court for the Western District of
Michigan addressed the issue of equitable subordination in the
Auto Specialties Mf'g. Co. case and applied the Mobile
Steel test. In re Auto Specialties
Mf'g. Co., 153 B.R. 457 (Bankr. W.D.
Mich. 1993) The court noted the higher standard of conduct to which
a
fiduciary is subject and stated that a "lender may become a
fiduciary
of the debtor and possibly the debtor's creditors if it uses its
leverage to take over operation of the company and thus step into
the shoes
of the traditional corporate fiduciaries." Id. at 478. A
creditor assumes the
fiduciary duties of a debtor's officers and directors when it has
operating control of the debtor's business. Id., quoting In re
Badger Freightways, 106 B.R. 971, 977 (Bankr. N.D. Ill. 1989).

<h4>Cross the Line from Recommendations to Control</h4>

The Auto Specialties case involved a chapter 7 trustee who
sought equitable
subordination of a fully secured creditor's claim, claiming that the

bank assumed the duty of the debtor's fiduciary by conditioning
further lending for an attempted reorganization on the debtor's
firing its president and chairman and replacing a second board
member with
an outside manager to be approved by the bank. Auto
Specialties at 465.

The court cautioned that a lender who merely offers
advice or closely monitors the debtor's activities is not subject to

fiduciary obligations. Id. at 479. However, "the line between
debtor and lender is
crossed where the lender exercises control over all or substantially
all
aspects of the finances and operations of the debtor." Id.,
quoting In re American Lumber Co., 7 B.R. 519, 529 (Bankr. D. Minn.
1979). Moreover, that the
bargaining power is skewed heavily in favor of the lender is not
sufficient
evidence of control. Auto Specialties at 480. The lender must
"supplant management"
to have control of the debtor. Id. at 481.

The Auto Specialties court examined the chapter 7
trustee's allegations,
including, inter alia, that the bank was "intimately
involved" in key
operational decisions, made the debtor hire a specific manager,
refused to
allow the debtor to fire that manager and required the manager to
make
decisions with bank approval. Id. The court failed to find
sufficient evidence that the bank
constantly directed the debtor's day-to-day business decisions.

Id. at 482. The court also
failed to find sufficient evidence of control via the hiring of a
specific
manager. Id. at
483. It noted that requiring replacement management "has long been a

legitimate condition of forbearance, the exercise of which will not
subject
a lender to a fiduciary duty," and held that there was no direct
support of the trustee's allegation that the bank controlled the
debtor by selecting the specific manager hired. Id.
Ultimately, the court declined to
subordinate the bank's claim. The Auto
Specialties court also evaluated whether
the bank was subject to equitable subordination under the
non-fiduciary
standard—egregious conduct proven with particularity—and
again
held equitable subordination to be inappropriate.

The Auto Specialties court did not need to determine
whether a lender can
require the appointment of a specific manager. However, given the
facts and
findings in this case, it can be reasonably inferred that a lender
may
require the hiring of replacement management and even recommend a
specific
manager, but that it is inadvisable for the lender to insist on a
specific
individual to serve as the replacement manager.

The Auto Specialties court looked to Badger, 106
B.R. 971, in evaluating when a lender exercises control
through an outside manager. Auto Specialties at 485. In

Badger, two outside managers with a preexisting relationship with

the lender were hired at the lender's recommendation. Badger
at 978. The Badger court held that, absent
allegations showing "the existence of an arrangement to
control" the debtor, the lender's recommendation of the
managers and subsequent management of the debtor was insufficient to

establish dominion and control. Id. The Auto
Specialties court agreed that evidence of an arrangement is
necessary
for the lender to survive summary judgment on the issue of equitable

subordination. Auto Specialties at 485.

In opposition to the Auto
Specialties case and with reasoning
specifically rejected by the Auto Specialties court, Auto
Specialties at 481, In re Aluminum Mills held that the
unsecured creditors committee's
equitable subordination claim would survive the lender's motion to
dismiss in spite of the absence of day-to-day control. In re
Aluminum Mills Corp., 132 B.R.
869 (Bankr. N.D. Ill. 1991). The Aluminum Mills case involved
allegations that the lender controlled the
debtor by effectively making several key decisions, including the
replacement of the debtor's president and other officers, the
payment
of certain obligations, and consulting and management fees, and by
controlling such things as the debtor's rights and abilities to make

investments, enter into contracts, borrow money and compensate
employees. Id. at 895. The court allowed
the equitable subordination claims to stand, holding that "operating

control does not necessarily mean day-to-day control, but may simply
be
control over the decisions that a corporate fiduciary is expected to

make." Id. at
895.

Secured creditors concerned with the potential
subordination of their claim should also consider In re American
Lumber Co., 5 B.R. 470
(D. Minn. 1980), a case decided under the Bankruptcy Act (prior to
1978).
The court stated it could think of "few cases where application of
the doctrine of equitable subordination is more appropriate."

Id. at 479. In American Lumber, the court
reviewed the lender's appeal of the bankruptcy court's finding
that the debtor's transfers of certain security interests to the
bank
were voidable as preferences and fraudulent transfers, entitling the
U.S.
Trustee to subordination on the bank's claim. Id. at 472.

As evidence of the bank's control of the
debtor, the court found, inter alia, the following: The bank
had a right to controlling interest
in the debtor's stock; the bank placed the debtor in its coercive
power by refusing to honor its payroll checks; the bank's
foreclosure
of certain security interests deprived the debtor of its only source
of
operating cash, forcing the debtor to take further loans; the bank
forced
the debtor to execute security agreements on its only remaining
assets; and
the bank allowed the debtor to pay only those creditors that would
benefit
the bank's position. Id. at 478. The Minnesota District Court
held that this control
constituted inequitable conduct under the Mobile
Steel test and was intended to
"perpetrate a fraud upon the general unsecured creditors of [the
debtor]." Id. at
478-79.

<h4>Conclusion</h4>

Secured lenders will be allowed a fair amount of
latitude in their involvement with the operations of a debtor
company, such
as giving advice on operational and other key decisions and even
requiring
the hiring of a lender-approved manager. However, a fine line exists

between these actions and those that constitute "inequitable
conduct," the crossing of which may result in considerable
penalties.

Journal Authors

John R. Clemency

Keriann M. Atencio

Journal Date

Wednesday, December 1, 2004 - 12:00

Bankruptcy Rule

2004