New and Emerging Chapter 11 Issues in Bankruptcy Administration

Journal Issue

Feb 2002

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After declining for almost a decade, chapter 11 filings increased 7 percent, from
9,835 to 10,519, during the 12-month period ending September 2001.
The magnitude of cases has increased as well. Last year, a wave of major filings
such as those by FINOVA Group, PG&E, Bethlehem Steel and PSINet was capped
off by Enron Corp.'s filing of the largest corporate reorganization in American
history.

The increasing chapter 11 caseload does not so much present new issues for U.S.
Trustees as raise some difficult issues with greater frequency and in jurisdictions that
have not encountered them before. Issues seen only rarely if at all by a U.S.
Trustee, or issues that seemed peculiar to cases filed in Delaware or the Southern
District of New York, now have a nationwide scope. As a result, U.S. Trustees
will be examining those issues more closely, and coordinating with each other to
develop new policies, practices and procedures over the coming months.

The following is a discussion of some of those issues. It is by no means
exhaustive. In addition, each of these issues has emerged in the midst of significant
changes to chapter 11 practice over the past 10 years. In the past, the
professionals employed in a chapter 11 bankruptcy case were primarily attorneys and
accountants. Other professionals may have been retained for particular purposes (e.g.,
auctions, sale or valuation of assets of the company, or financing). However, the
overall planning and structuring of the reorganization was left largely to accountants
and attorneys.

Over the past decade or so, an increasing array of new advisory services have become
involved in chapter 11 reorganizations as cases have become more complex and as more
sophisticated strategies are employed. Investment bankers, crisis or turnaround specialists
and financial consultants are now involved in all aspects of the troubled company's
operation, both before and after bankruptcy. Their terms of employment and compensation,
the standards governing their impartiality and conflicts of interest, their relationship
to affiliated or subsidiary companies and their involvement in trading of claims or other
bankruptcy-related services all challenge traditional practices under the Bankruptcy Code.

The provisions of the Code<a href="#2" name="2a">2</a> that govern professionals retained in a bankruptcy case
were drafted against a backdrop of the practices and ethical rules that govern
attorneys.<a href="#3" name="3a">3</a> The requirements of hourly billing, conflict-of-interest rules, restrictions
on the types of business that can affiliate with a professional and other ethical
restrictions are familiar to law firms and accounting firms. Workout specialists,
financial advisors and other bankruptcy consultants may operate under different rules.
Following are some of the resulting "big case" chapter 11 issues that U.S. Trustees
are now regularly confronting.

<blockquote><blockquote>
<hr>
<big></big><center>
<big>The growing role and profile of non-lawyer
professionals and advisory services in chapter 11
bankruptcy cases has required them to consider new
risks and liability associated with this work.

</big></center><big></big>
<hr>
</blockquote></blockquote>

<h3>Crisis Managers and Disinterestedness</h3>

Often, a financially troubled business will seek advice from these experts before
the commencement of a bankruptcy case, and will want to retain their services after
filing a chapter 11. The debtor may want the expert to become part of the firm's
management. However, the Bankruptcy Code imposes limits on the extent to which
"professionals" can be retained under §101(14) and (31) and §327 when they
have served the debtor, have connections with parties related to the debtor or
creditors prior to the commencement of the case, or are part of management.

This problem became the focus of litigation brought by the U.S. Trustee in In
re Harnischfeger Industries Inc., No. 99-2171 (PJW) (Bankr. D.
Del.), and In re Safety-Kleen Corp., No. 00-2303 (PJW) (Bankr. D.
Del.). In these cases the U.S. Trustee brought a disgorgement action against a
crisis manager. Settlement discussions led to consideration of the Code's restrictions
on professionals and the role that crisis managers and turnaround specialists play in
management of a troubled company.

As a result, a set of protocols were developed that would permit
debtors-in-possession (DIPs) to employ the expertise of crisis managers as part of
their management, but still provide safeguards of notice and opportunity to allow
creditors and other parties in interest to object to the employment of the firm.

Under the protocols, the crisis management firm can allow one of its members to
serve as an officer or director of the DIP, or the crisis management firm can be
retained as a professional. It cannot serve in both capacities. If the crisis
manager supplies an individual to serve as an officer or director, that person and
the crisis management firm will be subject to <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §363</a> (use, sale or
lease of property) and will be required to provide disclosures of any relationship with
the debtor, creditor, lenders and others. If the crisis manager is to provide
non-management advisory services, the firm will apply for retention as professionals
under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §327</a>.

Currently the protocols apply to cases filed in U.S. Trustee Region 3 (the Third
Circuit, comprising Pennsylvania, Delaware and New Jersey). However, they have been
shared with all U.S. Trustees to use as guidance in cases in other parts of the
country and with different crisis managers or turnaround specialists. The experience
gained may result in the development of a national set of U.S. Trustee policies and
procedures to govern the employment and retention of turnaround specialists.

<h3>Indemnification</h3>

The growing role and profile of non-lawyer professionals and advisory services in
chapter 11 bankruptcy cases has required them to consider new risks and liability
associated with this work. In re Merry-Go-Round<a href="#4" name="4a">4</a> served as a wake-up call for
bankruptcy specialists. In this case, a major accounting and consulting firm was sued
by the bankruptcy trustee after the case converted from a chapter 11 reorganization
to a chapter 7 liquidation. The trustee claimed that the reorganization failed because
of a number of mistakes by the consulting firm. On the eve of trial, the consulting
firm agreed to settle the litigation for $185 million.

Fearing exposure to similar claims, specialists employed in bankruptcy cases have
sought indemnification by the company filing the bankruptcy case. In essence, these
specialists are saying, "We will advise a company in bankruptcy, but if that company
decides to sue us, a bankruptcy trustee decides to sue us, or a creditor in the
case sues us because of the work we do, the company has to pay the costs of defense
and any judgment or settlement resulting from the litigation."

U.S. Trustees have opposed bankruptcy professionals' efforts to obtain
indemnification for claims arising from their work in the case. The U.S. Trustee's
position is that these professionals have a fiduciary obligation to the bankruptcy estate
and their service requires a high degree of skill and care, based on special learning
and advanced knowledge. All professionals should therefore be held to high standards
of care analogous to those applicable to lawyers and underwriters.

In addition, indemnification undermines the DIP's fiduciary duty to the bankruptcy
estate. A claim by a DIP against its professionals would be an asset. In the
event the company prevailed on any claim against a professional, indemnification would
vitiate any recovery: Any money recovered from the professional would have to be paid
back to the professional as part of the indemnification. An attempt by a DIP to
indemnify a person for negligence in advance, without any possible way of ascertaining
what harm might be done, is inconsistent with the duties of the DIP to the
creditors.

The issues and problems posed by indemnification have led the U.S. Trustee Program
to urge the Third Circuit Court of Appeals in In re United Artists<a href="#5" name="5a">5</a> to adopt
a per se prohibition against indemnification of professionals appointed under §327 of
the Bankruptcy Code. Oral argument in this case was held on Dec. 4, 2001,
and the case is now under consideration.

<h3>Section 328 Retentions</h3>

This issue sometimes arises in context of indemnification, but may arise in other
contexts as well. Professionals propose to be retained under §328, as opposed to
§327, to limit the court review of any compensation they receive under §330.

This position threatens to read the safeguards of §§327 and 330 out of the
Code. Advocates of this position argue that for a professional retained under
§328, reviewing compensation is limited to determining whether the "terms and
conditions" of the compensation were "improvident in light of developments not capable
of being anticipated at the time of the fixing of such terms and conditions." This
standard is a more narrow standard than the "reasonableness" standard under §330.<a href="#6" name="6a">6</a>

However, §328 does not create a standard separate from the standard under
§§327 and 330 for reviewing compensation, but is an integral part of the
structure for retention and compensation under the Bankruptcy Code. Section 327
provides the authority and limits for retention of professionals in a bankruptcy case;
§328 provides that any reasonable terms are permissible once agreed to and approved
by the court; and §330 provides that, whatever the terms, the compensation paid
to the professionals must meet a test of reasonableness.

The typical lawyer's fee arrangement provides a simple illustration of the operation
of these three provisions. Section 327 authorizes the retention of the lawyer as
long as the lawyer does not hold an "interest adverse to the estate" and is
disinterested. Section 328 governs the terms and conditions of the lawyer's
employment, including the hourly rate that the attorney will be paid. Once the court
approves the hourly rate and other terms as "reasonable," it cannot go back and change
those terms unless they "prove to have been improvident in light of developments not
capable of being anticipated at the time of the fixing of such terms and
conditions."<a href="#7" name="7a">7</a> However, the total compensation that the lawyer seeks must ultimately
meet the test of reasonableness under §330. Section 328 limits the court's ability
to adjust the hourly rate. Nevertheless, under §330 the total compensation awarded
can be less than what is requested.

Of course, the arithmetic may come out the same regardless of whether the court
adjusts the hourly rate or orders the reduction of the overall compensation request.
The distinction between the terms of compensation and the total compensation ultimately
awarded becomes more clear when a structured fee arrangement is approved. For example,
a contingency fee for a personal injury lawyer or a success fee for an investment
banker must satisfy the test of reasonableness under §328, and the ultimate
compensation awarded must satisfy the test of reasonableness under §330.

Critics of this interpretation would argue that it introduces the very uncertainty
that structured fee arrangements are intended to eliminate. However, relying on §328
to avoid this uncertainty itself creates certain anomalies. It is hard to see why
certain fee arrangements are subject only to review under an "improvidence" standard in
§328, while a request for compensation based on hourly billing rates is subject to
a test of reasonableness under §330.

As the bankruptcy system faces different structures for compensation from other types
of professionals, measurements that reflect the experience of the usual hourly fee
arrangements of lawyers and accountants may need to be adjusted. The challenge is to
develop a more sophisticated measure of what "reasonable" compensation entails.

<h3>Creditors' Committees and Claims Trading</h3>

A simplistic picture of the Bankruptcy Code's reorganization process might depict
a locked room with a rectangular table in the center, with the debtor's representatives
seated along one side and the creditors' representatives seated along the other. The
parties cannot leave the room until they agree how to divide up a pot of money that
sits in the middle of the table, and that represents all the debtor is able to
commit to the reorganization.

This picture assumes a fixed cast of characters among the creditor body. Creditors
who have claims at the time of the commencement of the case are stuck—hence the locked
room—and have little alternative but to work with the debtor for reorganization or push
for liquidation of the debtor's assets.

This picture's static view of a reorganization's cast of characters fails to account
for the fact that the creditor body can change during the course of a case, because
creditors can and do sell their claims. Claims purchasers are not a new phenomenon,
but they are assuming a larger and more important role in the reorganization
process.<a href="#8" name="8a">8</a> Their increasing role raises a number of new issues.

An acquaintance of mine recently described a situation in which he was creditors'
committee counsel. In the course of the case, all of the committee members sold
their claims, leaving in essence a shell of a committee. In the past, the U.S.
Trustee could handle the occasional sale of claims by a creditors' committee member on
a case-by-case basis. As claims trading becomes more active, it will become
increasingly important to monitor the change in ownership of claims, and to develop
procedures to ensure trading does not interfere with the duty that committee members owe
to the entire creditor body.

This list of issues is not exhaustive. It probably represents only a small portion
of the new issues emerging during the current cycle of chapter 11 filings.
Furthermore, these are not all new issues. Turnaround specialists, investment bankers
and other advisors have been appointed in bankruptcy cases in the past; there are
several reported cases dealing with indemnification from the early 1990s,<a href="#9" name="9a">9</a> and a
market for claims against insolvent debtors has existed for years, if not decades.
These issues have become more critical in bankruptcy administration today because they
are arising more frequently and in more jurisdictions.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> The views expressed in this article are those of the author and do not necessarily represent, and should not be attributed to,
the Executive Office for U.S. Trustees, the U.S. Trustee Program or the Department of Justice. <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.C. §§327-330</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=…, Robert J. III, and Higdon, James R., "A Primer on 11 U.S.C. §328(a)</a> and Its Use in Alternative Billing
Methods in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 50 Mercer L. Rev. 537, 542-43 (1999)</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Merry-Go-Round Enterprises Inc., 244 B.R. 327 (Bankr. D. Md. 2000)</a>; Snider, Anna, "Ernst
Pact Spells Caution in Bankruptcy," N.Y.L.J., May 6, 1999, at 1. <a href="#4a">Return to article</a>

<a name="5">5</a> Walton v. Houlihan Lokey Howard & Zukin Capital (In re United Artists), Case No. 00-1351 (3d Cir. 2001). <a href="#5a">Return to article</a>

<a name="6">6</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re B.U.M. Intern., 229 F.3d 824 (9th Cir. 2000)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re National Gypsum, 123 F.3d 861
(5th Cir.1997)</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=… U.S.C. §328(a)</a>. <a href="#7a">Return to article</a>

<a name="8">8</a> Thornton, Emily, "The Return of the Wall Street Vultures," Business Week, Sept. 10, 2001, at 108. <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=… re Gillett Holdings Inc., 137 B.R. 452, 458 (Bankr. D. Colo. 1991)</a> (entirely improper and
unacceptable); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Drexel Burnham Lambert Group Inc., 133 B.R. 13, 27 (Bankr. S.D.N.Y. 1991)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Mortgage

& Realty Trust, 123 B.R. 626, 631 (Bankr. C.D. Cal. 1991)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Allegheny Int'l. Inc., 100 B.R.
244, 247 (Bankr. W.D. Pa. 1989)</a>. <a href="#9a">Return to article</a>

Journal Authors

Joseph A. Guzinski

Journal Date

Friday, February 1, 2002 - 12:00

Bankruptcy Rule

2002