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MEMORANDUM

TO: National Bankruptcy Review Commission
Professor Elizabeth Warren
Stephen H. Case

FROM: Professor Lawrence P. King
Elizabeth I. Holland

DATE: August 19, 1997

RE: Revised Personal Liability Standard for Bankruptcy Trustees

The Bankruptcy Code provides that the trustee [ FN: The term "trustee " or "bankruptcy trustee " when used throughout this memorandum means chapter 7, chapter 12, and chapter 13 trustees. Chapter 7 trustees are the most prone to suit due to the broad nature of their duties . The proposal addresses the personal liability standard for chapter 11 trustees separately.] is the representative of the estate and can sue and be sued. [ FN: 11 U.S.C. §323 (1994). 28 U.S.C. §959(a) also permits a suit against a trustee, without leave of the appointing court, for "any of their acts or transactions in carrying on business connected with such property. " 28 U.S.C. §959(a).] A trustee must "manage and operate" estate property according to applicable law, the same as an owner of the property. [ FN: 28 U.S.C. §959(b) (1994).] Some courts require compliance with applicable nonbankruptcy law when a trustee manages estate property and not when the trustee only is liquidating estate property. [ FN: Section 959(b) has generally not been applied to liquidating trustees. See, e.g.In re N.P. Mining Inc., 963 F.2d 1449 (11th Cir. 1992);In re Valley Steel Prods. Co., 157 B.R. 442 (Bankr. E.D. Mo. 1993).] Despite this distinction, courts have had difficulty obtaining chapter 7 or 11 trustees "where there are environmental problems under federal or state laws which impose personal liability on ‘owners or operators’ and have had to dismiss such cases." [ FN: 2 Collier on Bankruptcy ¶ 323.02, 323-6 ( Lawrence P. King et al. eds. 15th ed. 1996) citing In re FCX Inc., 96 B.R. 49, 55 (Bankr. E.D.N.C. 1989);In re Charles George Reclamation Trust, 30 B.R. 918, 921 (Bankr. D. Mass. 1983) (U.S. trustee unwilling to become chapter 7 trustee);In re Commercial Oil Service Inc., 58 B.R. 311, 317 (Bankr. N.D. Ohio 1986);In re Mattiace Indus. Inc., 76 B.R. 44 (Bankr. E.D.N.Y. 1987) (chapter 11 trustee).]

Trustees’ may be liable in their individual capacity as well as in their representative capacity. The Bankruptcy Code does not provide a personal liability standard for bankruptcy trustees. Since 1978, the courts that have addressed this issue have come to contrary conclusions. Under what has been described as a "crazy quilt" of decisions, [ FN: See David W. Allard on behalf of the National Association of Bankruptcy Trustees, Bankruptcy Trustees Should be Provided a Uniform Standard of Care Governing Personal Liability - Support for a Revision of the United States Bankruptcy Code (on file with the National Bankruptcy Review Commission).] trustees are held to standards of care ranging from personal liability for negligence [ FN: SeeIn re Gorski, 766 F.2d 723, 727 (2d Cir. 1985)(personal liability for mere negligence); Red Carpet Corp. of Panama City Beach v. Miller, 708 F.2d 1576, 1578 (11th Cir. 1983) (same);In re Cochise College Park Inc., 703 F.2d 1339, 1357 (9th Cir. 1983) (same);In re Tremont Corp., 143 B.R. 989 (Bankr. W.D.N.Y. 1992) (same);In re Consupak Inc., 87 B.R. 529, 542 (Bankr. N.D. Ill. 1988) (same);In re Sturm, 121 B.R. 443 (Bankr. E.D. Pa. 1990) (court reluctantly followed old 3^rd Circuit precedent, but failed to find that the trustee had acted negligently.).] to personal liability for willful and intentional acts in violation of the trustee’s duties. [ FN: McGahren v. First Citizens Bank & Trust (In re Weiss), 111 F.3d 1159, 1168 (4th Cir. 1997) (trustee may be held personally liable for willful or intentional misconduct only);In re San Juan Hotel Corp., 847 F.2d 931, 937 (1st Cir. 1988)(trustee has personal liability only for willful and deliberate violations of the trustee ’s duties);In re Chicago Pacific Corp., 773 F.2d 909, 929 (7th Cir. 1985)(same); United States, etc. v. Sapp, 641 F.2d 182, 185 (4th Cir. 1981)(same).] Some courts also find that trustees have derived judicial immunity for acts taken within the scope of their authority. [ FN: Bennett v. Williams, 892 F.2d 822, 823 (9th Cir. 1989) (trustee has broad immunity for acts taken within scope of authority, but still may be liable for intentional or negligent violations); Yadkin Valley Bank & Trust v. McGee, 819 F.2d 74, 76 (4th Cir. 1987)(trustee has derived judicial immunity); Lonneker Farms Inc. v. Klobucher, 804 F.2d 1096, 1097 (9th Cir. 1986)(trustee entitled to derived judicial immunity); Boullion v. McClanahan, 639 F.2d 213, 214 (5th Cir. 1981)(same).] The only Supreme Court decision in this area, Mosser v. Darrow, held a trustee personally liable for allowing his agents to profit at the estate’s expense. [ FN: 341 U.S. 267 (1951).] Unfortunately, Mosser has not provided much guidance to subsequent courts and has been cited for a broad range of positions. [ FN: Compare San Juan Hotel, 847 F.2d at 936 (surcharging trustee 3.4 million; citing Mosser for proposition that a trustee may only be held for an intentional breach of fiduciary duty) and Gorski, 766 F.2d at 726 (citing Mosser for proposition that trustee may be held personally liable for negligent conduct). See also,In re Tucker Freight Lines Inc., 62 B.R. 213, 217 (Bankr. W.D. Mich. 1986) (listing divergent Mosser authorities). One commentator noted that "Mosser v. Darrow is cited almost exclusively as the font of all authority on the subject of trustees ’ breach of fiduciary duty. " James I. Shepard, Damage Control or The Art of Avoiding Personal Liability, 3 (1996) (on file with the National Bankruptcy Review Commission).]

Any attempt to codify a standard for personal trustee liability runs the risk that some measures would provide too little protection and some measures would provide too much protection. Too little protection might expose a trustee to excessive personal liability and dissuade capable people from becoming trustees. [ FN: This risk is particularly acute where possible environmental liability exists: It may seem to impose a hardship upon the trustee that he should be held personally liable, and it is arguable that where he is not at fault he should be liable only to the extent to which he can obtain indemnity out of the trust estate. On the other hand, there is no reason why the victim of the tort should be denied relief merely because the estate is insufficient to indemnify the trustee. The risk of personal liability in tort is a risk that the trustee runs in undertaking the administration of the trust. Ordinarily he can protect himself by taking out liability insurance and paying premiums out of the trust estate. Charles F. Lettow & Joyce E. McCarty, Courts, Congress Address Potential Superfund Liability of Fiduciaries, 13 No. 8 Banking Policy Report, *7 (April 18, 1994) (citing 3A Scott on Trusts §264 (4th ed. 1988)).] Too much protection will not encourageresponsible decision making on difficult estate management issues. The balance sought by the Proposal is to protect trustees from personal liability where warranted while encouraging responsible administration of estate assets.

Proposal

Trustees appointed in cases under chapter 7, 11, 12 or 13 of the Bankruptcy Code should not be subject to suit in their individual capacity for acts taken within the scope of their duties as delineated in the Bankruptcy Code or by order of the court, as long as the applicable order was issued on notice to interested parties and there was full disclosure to the court.

Chapter 7, 12 and 13 trustees should only be subject to suit in the trustee’s representative capacity, and subject to suit in the trustee’s personal capacity only to the extent that the trustee acted with gross negligence in the performance of the trustee’s fiduciary duties. Gross negligence should be defined as reckless indifference or deliberate disregard of the trustee’s fiduciary duty.

A chapter 11 trustee should only be subject to suit in the trustee’s representative capacity, and subject to suit in the trustee’s personal capacity only to the extent that the trustee has violated the standard of care applicable to officers and directors of a corporation in the state in which the chapter 11 case is pending.

Debtors in possession should remain subject to suit to the same extent as currently exists under state or federal law.

Reasons for the Change

Under the Proposal, trustees (including chapter 11 trustees) would not be subject to suit in their individual capacity for acts taken within the scope of their statutory or court-ordered authority, as long as the applicable court order was issued on notice to interested parties and full disclosure to the court. Outside that scope of authority, trustees would be personally liable for gross negligence in the performance of their fiduciary duties. Thus, in order to hold a trustee personally liable for damages, a plaintiff would have to show (i) that the trustee was not acting within the scope of authority granted under the Bankruptcy Code or by court order; and (ii) that the trustee was grossly negligent in the performance of the trustee’s fiduciary duties. TheProposal defines gross negligence as reckless indifference or deliberate disregard of the trustee’s fiduciary duty. [ FN: See, e.g., W. Page Keeton et al., Prosser and Keeton on Torts 209, 212 (5th ed. 1984) (defining gross negligence as "a failure to exercise even that care which a careless person would use. Several courts, however, dissatisfied with a term so nebulous, and struggling to assign some more or less definite point of reference to it, have construed gross negligence as requiring willful, wanton, or reckless misconduct, or such utter lack of care as will be evidence thereof -- sometimes on the ground that this must necessarily have been the intent of the legislature. "); Leite v. City of Providence, 463 F. Supp. 585, 591 (D.R.I. 1978) (distinguishing ordinary and gross negligence in that "one requires only a showing of unreasonableness while the other demands evidence of near recklessness or shockingly unjustified and unreasonable action ").] This definition is consistent with the definition of gross negligence in other civil liability contexts. [ FN: See, e.g., Potter v. Pohlad, 560 N.W.2d 389, 392 (Minn. Ct. App. 1997) ( "Delaware courts have repeatedly defined gross negligence as ‘reckless indifference to or a deliberate disregard ’ . . . or actions which are ‘without the bounds of reason. ’ " citing Smith v. Van Gorkum, 488 A.2d 858, 873 n.13 (Del. 1985)).]

1. Codifying Current View on Derived Judicial Immunity

A majority of circuits find that trustees have derived judicial immunity for actions taken within the scope of their duties. [ FN: Bennett v. Williams, 892 F.2d 822, 823 (9th Cir. 1989) (trustee has broad immunity for acts taken within scope of authority, but still may be liable for intentional or negligent violations); Yadkin Valley Bank & Trust v. McGee, 819 F.2d 74, 76 (4th Cir. 1987)(trustee has derived judicial immunity); Lonneker Farms Inc. v. Klobucher, 804 F.2d 1096, 1097 (9th Cir. 1986)(trustee entitled to derived judicial immunity); Boullion v. McClanahan, 639 F.2d 213, 214 (5th Cir. 1981)(same).] The scope of a trustee’s duties includes any action (including a business judgment) [ FN: Hon. Susan Pierson Sonderby & Lisa Ramsden, Current Developments: Trustees/Examiners and U.S. Trustees Liability/Immunity, 617 PLI/Comm 893, 903 (April-June 1992) ( "The courts consistently grant the trustee immunity for business judgments provided the trustee was acting within lawful authority pursuant to court order or other statutory duty. If the trustee claims he was acting pursuant to court order, then the order must have been granted following full disclosure and notice. A trustee will also not be held liable for the negligence of agents unless the trustee negligently supervised the agents. ")] taken pursuant to statute or court order. [ FN: See, e.g., Gregory v. United States Bankruptcy Court, 942 F.2d 1498, 1500 n.1 (10th Cir. 1991) ( "absolute quasijudicial immunity for a lawyer serving as a trustee and merely executing the bankruptcy judge ’s orders concerning the collection and disposition of estate property is essential for the efficient functioning of the bankruptcy court. ") cert. denied , 504 U.S. 941 (1992).] Often times, a party that is dissatisfied with the result of a court order disposing or otherwise administering an estate asset will attempt to collaterally attack the order by suing the trustee personally. [ FN: One recommendation to the Commission cited "the ‘militia movement ’ and similar anti-government groups " as creating "an environment which encourages litigation whenever anyone is disappointed by the outcome of a case. " Henry C. Seals, Trustees Need Relief, Suggestions for the National Bankruptcy Review Commission, 4 Amer. Bankr. Inst. L. Rev. 548 (recommending that trustees be given relief from these nuisance suits with "legislation specifying the scope and extent of their immunity. ")] Under thesecircumstances, a trustee should have derived judicial immunity from suit. [ FN: See, e.g., Gordon v. Bunker (In re XRX Inc.), 77 B.R. 797, 798 (Bankr. D. Nev. 1987) (trustee has judicial immunity for acting pursuant to court order and making erroneous disbursement to administrative expense creditor); Weissman v. Hassett, 47 B.R. 462, 466 (S.D.N.Y. 1985) (dismissing action against trustee for damages arising out of preparation and dissemination of report on debtor ’s possible fraud; "[j]ust as receivers and trustees are immune from suit for actions taken to assemble a bankruptcy estate ’s assets, so too a reorganization trustee should be immune for an investigation and report furthering the same purposes. ") ]

The working group discussion on trustee liability focused on the myriad difficult decisions that can face a trustee trying to administer an estate.

In fact, trustees are commonly faced with decisions to either take action or not, whether it be to file a complaint, a motion to set aside a judgment, or to assume or reject a lease or other contract with virtually no notice. Sometimes trustees have only hours to make such decisions and are faced with the unenviable duty of preserving the status quo under the threat of rule 11 sanctions or being sued personally for failure to preserve and protect an intangible asset of the estate. Other decisions trustees face frequently include the decision whether or not to close a business in chapter 11 or an operating chapter 7, whether or not to attempt to sell assets or surrender them to secured creditors, whether to administer or abandon causes of action, and a myriad of other decisions which trustees must make upon conflicting, second-hand information being provided by the debtor and creditor groups, as well as professionals upon whom the trustee relies. Despite all this, trustees are expected to make such decisions in a timely manner. A trustee, unlike the debtor who often purchased the assets and created the problems which caused the filing, never holds a "full deck of cards to play." [ FN: Allard, supra note 6, at 4-5.]

The Proposal intends to alleviate this burden by protecting a trustee who is acting pursuant to a court order or a statute. The Supreme Court in Mosser noted that seeking instructions from the court is a means by which a trustee can resolve a difficult decision and also avoid personal liability. [ FN: Mosser v. Darrow, 71 S. Ct. 680, 683 (1951) ( "The practice is well established by which trustees seek instructions from the court, given upon notice to creditors and interested parties, as to matters which involve difficult questions of judgment. . . . It is hardly probable that a candid disclosure to creditors, to the court, and to interested parties would have resulted in instructions to have pursued this course; but had it been authorized, at least the assenting creditors might have found themselves estopped to question the transaction. ")]

Full disclosure of all relevant facts to the court and interested parties is required for judicial immunity to cover actions taken in furtherance of a court order. One court described the scope of immunity as depending "upon the totality of the circumstances in which an order isdrawn." [ FN: In re Sundance Corporation Inc., 149 B.R. 641, 654-55 (Bankr. E.D. Wash. 1993). ] To the extent that the trustee seeks court authorization in a fully disclosed and informed process with notice and a hearing, derived judicial immunity will attach. [ FN: Id.] Failure to "analyze the risks inherent in the various known options and bring the risks to the attention of the court and the parties for their consideration" will result in a lack of immunity. [ FN: Id.] Under these circumstances, a trustee would have to defend an action on the basis of whether it was within a reasonable business judgment. [ FN: Id.]

By providing immunity from suit under these circumstances, the Proposal encourages trustees to seek guidance from the court on difficult estate issues. A court order in this context would require notice to creditors, the debtor, and other parties in interest, and these parties would not be able to collaterally attack the order by suing the trustee personally after the fact. Thus, the Proposal (i) encourages trustees to seek court approval of difficult estate decisions, (ii) gives them immunity for actions taken to implement such decisions, and (iii) requires diligence on the part of interested parties to seek direct review of these orders rather than collaterally attacking the order later by bringing a personal suit against the trustee.

2. Immunity Consistent with Environmental Liability Under CERCLA and Other State Clean-up Laws

Possible personal liability for environmental clean-up costs under CERCLA and other state clean-up laws has been cited as an impediment to obtaining a trustee to administer a bankruptcy estate. [ FN: "The potential for personal liability of the trustee is nowhere more graphically illustrated than in the ‘hazardous waste ’ cases. " Irving Sulmeyer, 1995 Collier Handbook for Trustees and Debtors in Possession, §4.08, 4- 16.] At least one court has held in the bankruptcy context that Congress did not abrogate judicial immunity for trustees and other estate administrators when it enacted CERCLA. [ FN: In re Sundance Corporation Inc., 149 B.R. 641 (Bankr. E.D. Wash. 1993).] In Sundance, the debtor and a creditor brought a strict liability action against the state receiver/bankruptcy custodian [ FN: At the time the chapter 11 petition was filed, the state receiver was permitted to continue in possession, under the control of the bankruptcy court under section 543(d). Id. at 649.] for the clean-up costs associated with the use of certainpesticides on the debtor’s fruit orchard during the receiver’s tenure. [ FN: Id., at 647-48.] The court held that the receiver cannot be held strictly liable for actions taken within the scope of its judicial authority, even if those actions may have been unlawful. [ FN: Id., at 652. The Sundance court agreed with State of Wisconsin v. Better Brite Plates Inc., 483 N.W.2d 574, 582 (1992) (concluding that a violation of state law may not necessarily be outside the scope of a receiver ’s authority).] The Proposal would preserve immunity from environmental clean-up costs resulting from conduct within the scope of a trustee’s duties. To the extent that a trustee acts outside the scope of the trustee’s authority and in gross negligence of the trustee’s fiduciary duty, the trustee should be individually liable under CERCLA or other relevant state environmental clean-up law.

3. Immunity Consistent with Administering an Estate’s Tax Obligations

Personal liability for failure to adequately administer a bankruptcy estate’s tax obligations is another lurking risk for bankruptcy trustees. As part of the Bankruptcy Reform Act of 1978, trustees under title 11 were exempted from liability to the federal government for paying claims prior to paying unpaid government claims. [ FN: Shepard, supra note 11, at 26 ( " ‘A representative of a person or an estate ( except a trustee acting under title 11) paying any part of a debt of the person or estate before paying a claim of the government is liable to the extent of the payment for unpaid claims of the government. ’ " 31 U.S.C. §3713(b) (emphasis supplied); The Bankruptcy Reform Act of 1978, Pub. L. No. 95-598, §322(b), 92 Stat. 2679 (1978)).] This provision (31 U.S.C. § 3713(b)) has been interpreted literally, to bar personal trustee liability

imposed by section 3713 and does not exempt them from liability from other sources; it merely relieves the trustee from liability from the federal priority statute and no other. In other words, the relief from liability under section 3713 is very limited, trustees may be held personally liable for the unpaid taxes of the estates they administer if such liability can be grounded on any other law, such as breach of fiduciary, breach of official duty, or possibly even negligence or, were there any, some other statutory source of liability. [ FN: Shepard, supra note 11, at 27.]

Certain statutory provisions impose liability, notwithstanding the exemption in section 3713(b). For example, personal liability for administrative tax penalties is imposed on "responsible persons who fail to withhold and pay federal employment taxes." [ FN: Shepard, supra note 11, at 23 (citing I.R.C. §6672(a)). See also,In re San Juan Hotel Corp., 847 F.2d 931, 937 n. 37 (1st Cir. 1988);In re Joplin, 882 F.2d 1507 (10th Cir. 1989).] Similarly, trustees have been found liable for the capital gains taxes on the sale of estate property. [ FN: Sulmeyer, supra note 24, at ¶ 4.09, 4-17 (citing United States v. Sampsell, 266 F.2d 631 (9th Cir. 1959)).]

Trustees should be encouraged to determine the tax effects of estate administration. Compliance with the provisions of section 505(b) will exempt a trustee (among others) from any liability associated with such tax. [ FN: 11 U.S.C. §505(b) (1994)(outlining the procedure to determine a tax liability of the estate and gain a discharge from the liability associated with the tax).] The Proposal would not preempt the section 505 procedure for determination and discharge of an estate’s tax liability. The Proposal would also not alter a trustee’s statutory liability for nonpayment of trust fund taxes. As stated above, to the extent that a bankruptcy trustee is acting pursuant to a court order, the trustee should have derived judicial immunity from personal liability resulting from the trustee’s performance. Similarly, if the trustee is acting outside the scope of the trustee’s authority and acts in gross negligence of the trustee’s fiduciary duty, the trustee should be personally liable for tax liabilities or penalties incurred as a result.

4. Personal Liability for Gross Negligence Outside Scope of Trustee’s Authority

The Proposal contemplates that personal liability would attach only to the extent a trustee acted with gross negligence outside the scope of the trustee’s Bankruptcy Code or court-ordered authority. Actions for mere negligence could still be asserted against the trustee as the representative of the estate, but not in the trustee’s personal capacity. However, in order to hold a trustee personally liable, it would be necessary to demonstrate that (i) the trustee’s conduct was outside the scope of judicial authorization in administering the estate or managing the debtor’s business; and (ii) the complained of conduct was grossly negligent of the trustee’s fiduciary duties. Gross negligence is defined as reckless indifference or deliberate disregard of the trustee’s fiduciary duties.

The National Association of Bankruptcy Trustees ("NABT") recommended a "willful and intentional" standard for personal trustee liability. [ FN: See Allard, supra note 6.] Specifically, the NABT proposal would add section 323(c), to provide that

(c) The trustee in a case under this title may only be sued in the trustee’s representative capacity, unless the trustee has committed willful and intentional acts in violation of the trustee’s fiduciary duties. [ FN: Id. at 3.]

While the NABT provided good arguments to support its proposal, the working group believed that in some instances, it would provide too much protection for trustees and does not encourage trustees to seek court approval of difficult estate administration decisions.

A good example of circumstances in which a "willful and intentional" standard would provide too much protection is Mosser v. Darrow. [ FN: 341 U.S. 267 (1957).] In Mosser, the bankruptcy trustee permitted his assistants to trade extensively in bonds issued by the debtor’s subsidiaries, often selling their holdings to the trustee at a profit as part of the debtor’s sinking fund program. [ FN: Id. at 269.] During the course of administration, the trustee never had any interest in the profits made by his employees. [ FN: Id. at 275.] Over eight years of trusteeship, the trustee filed one accounting for one of the debtor-corporations and none for the other. [ FN: Id.] When the trustee finally resigned and filed his accounts and request for fees, the Securities and Exchange Commission objected as did the successor trustee. The district court agreed with the special master’s report and surcharged the trustee $43,447.46. The court of appeals disagreed and found that "principles of negligence applied and that a trustee could not be surcharged . . . unless guilty of ‘supine negligence.’" [ FN: Id. at 272.] The court of appeals was further persuaded by the argument that "this surcharge creates a very heavy liability upon a man who enjoyed no personal profit and must be condoned ‘so as not to strike terror into mankind acting for the benefit of others and not for their own.’" [ FN: Id. at 273 (quoting Mosser v. Darrow, 184 F.2d 1, 8 (1950).]

The Supreme Court disagreed, finding that personal liability was the "most effective means" of encouraging diligent administration of bankruptcy estates. [ FN: Id. at 273-74.] The Mosser Court noted that a trustee could obtain protection from personal liability by "seek[ing] instructions from the court, given upon notice to creditors and interested parties, as to matters which involve difficult questions of judgment." [ FN: Id. at 274.] The trustee in Mosser did not willfully and intentionally violate his fiduciary duties, and would arguably not be found personally liable under the NABT standard. [ FN: In discussing the trustee ’s intent, the Mosser Court stated In fairness to the trustee, it is to be noted that there is no hint or proof that he has been corrupt or that he has any interest, present or future, in the profits he has permitted these employees to make. For all that appears, he was simply misled into thinking these persons indispensable, but he entered into an arrangement which courts cannot sanction unless they are to open the door to practices which would demoralize trusteeships and discredit bankruptcy administration. Id. at 275.] The facts in Mosser are the type of circumstances in which the Proposal would impose personal liability, without making trustees personally liable for mere negligence.

In chapter 11 cases, the debtor is normally retained in possession to manage its property and conduct its business. The scope of liability of management, officers and directors of a corporation is set by appropriate state law. The Proposal recognizes that the debtor in possession should be held to the same standard of care as existed prepetition with regard to the debtor. When a trustee is appointed in a chapter 11 case, the trustee acts in place of the debtor in possession and should be subject to the standard of care for officers and directors set forth by the state where the chapter 11 case is pending. The Proposal perpetuates that result.