Health Diagnostic Laboratory, Inc.: Must a Liquidating Trustee Be Disinterested?

What is an interested party? Consider these everyday scenarios: An unsupervised child encounters a take-one-piece-only Halloween bucket; a teacher administers a your-bonus-rides-on-these-results test; or a football team pays a doctor to conduct in-game concussion evaluations. These conflicts raise concerns about the ability of the conflicted party to be fair and impartial.

In bankruptcy, avoiding conflicts is paramount to the propriety of the process to ensure that professionals employed or compensated by the estate have no adverse interest, as well as to provide undivided loyalty to the estate. This has led to the development of requirements for disinterestedness of certain parties, including trustees and estate professionals.

But does the liquidating trustee of a post-confirmation liquidating trust need to be “disinterested”? In Health Diagnostic Laboratory Inc., the U.S. Bankruptcy Court for the Eastern District of Virginia addressed this issue of first impression and said “no.”[1]

The Importance of Disinterestedness

A disinterested party is a person who is not a creditor, equity security-holder or insider to the business engaged in bankruptcy proceedings.[2] Section 1104(a) of the Bankruptcy Code allows for the appointment of a trustee after the commencement of a case but before the confirmation of a plan for cause or if it is in the best interest of the creditors. The disinterestedness of a trustee is crucial if appointed before the confirmation of a plan because the trustee must remain impartial to the business to protect the interests of the creditors. Further, if the trustee is authorized to run the company during its reorganization, a disinterested trustee can make unbiased business decisions or changes in management that an interested party might be reluctant or unwilling to make.[3]

But is a liquidating trustee subject to this same requirement? A liquidating trustee is a “representative of the estate” appointed under a confirmed chapter 11 plan.[4] Section 1123(b)(3)(B) of the Bankruptcy Code makes clear that a liquidating trustee as a “representative of an estate” is distinct from a chapter 11 trustee.[5] Judge Huennekens addressed this question in Health Diagnostic Laboratory.

Background of Health Diagnostic Laboratory

Richard Arrowsmith was a member of a professional services firm hired by Health Diagnostic Laboratory, Inc. (HDL) to serve as financial advisor both before and during HDL’s chapter 11 bankruptcy case.[6] Arrowsmith initially functioned as HDL’s chief restructuring officer (CRO).[7] In May 2016, the court confirmed HDL’s chapter 11 plan, which created a liquidating trust, and Arrowsmith was appointed as interim liquidating trustee.[8] As interim liquidating trustee, Arrowsmith filed a complaint against 100 defendants, alleging breach-of-fiduciary-duty claims (the “D&O Complaint”).[9] After he filed the D&O Complaint, three of the named defendants objected to a motion filed by the plan oversight committee to appoint Arrowsmith as permanent liquidating trustee — claiming that because Arrowsmith was a pre-petition financial advisor of HDL, participated in meetings of HDL’s board and functioned as HDL’s CRO, he was not a “disinterested party” and had conflicts of interest.[10] The heart of the argument made by the objectors was that “Arrowsmith [was] suing them for acts they claim were undertaken based upon advice he gave them as members of HDL’s Board.”[11]

A Liquidating Trustee Need Not Be Disinterested

After reviewing the applicable statutory sections, the bankruptcy court declined to extend the “disinterested person” standard to the liquidating trustee because a liquidating trustee is a representative of an estate whose actions are limited by the confirmed plan.[12] The court noted that § 1104 of the Bankruptcy Code only applies when the trustee is appointed before a plan is confirmed.[13] As a representative of an estate post-plan confirmation, a liquidating trustee is not subject to the same “disinterested person” standard of a chapter 11 trustee because the liquidating trustee’s power is restricted by the confirmed plan.[14] The liquidating trustee is not proposing a plan but simply carrying out the plan already filed by the debtor and approved by the creditors and the court.[15] In short, a liquidating trustee need not be a disinterested party when a pre-approved plan restricts its decision-making.

The court also found that Arrowsmith was a lawful selection because the objecting parties approved of Arrowsmith as interim liquidating trustee and there was no distinction in duties between the interim and permanent liquidating trustee.[16] Under the plan, Arrowsmith could exercise no further power as a permanent liquidating trustee than he could as an interim liquidating trustee.[17] The plan gave authority to the oversight committee to select the permanent liquidating trustee, and the debtors provided a list of potential candidates to pick from.[18] But the debtors agreed to give the oversight committee the ability to appoint someone outside the list — such as Arrowsmith — if the oversight committee exercised reasonable business judgment.[19] The oversight committee decided on Arrowsmith after observing his ability while serving as interim liquidating trustee.[20] This decision was deemed reasonable.[21]

Finally, the court noted that Arrowsmith lacked any “debilitating conflicts of interest” that would affect his ability to function as permanent liquidating trustee.[22] Notably, the objectors provided no evidence that Arrowsmith’s firm gave improper advice, such as attempting to prove that HDL was solvent.[23] Also, Arrowsmith had sued the objectors for breach of fiduciary duty for investing in two companies called G3 and C3Nexus.[24] The objectors claimed, however, that Arrowsmith’s firm improperly advised the objectors about those investments.[25] But the board meeting minutes proved that the objectors made those investments with no input from Arrowsmith’s firm.[26] Each argument the objectors asserted about Arrowsmith’s possible conflicts was either unfounded or contradicted by the evidence.[27]

The Objectors

All of the objecting parties approved the appointment of Arrowsmith as interim liquidating trustee,[28] and the court-approved plan authorized Arrowsmith — as the interim liquidating trustee — to prosecute claims on behalf of the trust.[29] Only three parties objected to elevating Arrowsmith from interim to permanent liquidating trustee: three parties being sued by Arrowsmith.[30] Interesting timing. Were the objectors motivated to take action against Arrowsmith in retaliation for the D&O Complaint? If so, did the objectors have their own conflict?

Although a liquidating trustee’s actions are restricted by a confirmed plan, Arrowsmith functioned as chief restructuring officer while the future confirmed plan was in the works.[31] Just how restricted was Arrowsmith by a plan he helped create? Still, the creditors approved the plan, and if the objecting parties were concerned about Arrowsmith’s conflicts of interest, they should have objected to his involvement earlier in the process — such as when he was appointed as interim liquidating trustee.

Conclusion

In sum, the court approved the appointment of Arrowsmith as permanent liquidating trustee.[32] In addressing this issue of first impression, the court examined whether a statute or contract prohibited this appointment. Neither did, and the objectors could prove no disqualifying conflicts. Thus, the court relied on the business judgment of the committee that appointed Arrowsmith to make him a permanent selection.