Waiting for a Decision from the Eleventh Circuit: Will Chapter 11 Trustee Appointments Be Back in Vogue?
By: David L. Barrack
Fulbright & Jaworski L.L.P.; New York
Mark C. Haut
Fulbright & Jaworski L.L.P.; New York
Jaclyn Rabin
Fulbright & Jaworski L.L.P.; New York
Editor's Note: After the publication of this article, ABI learned that the U.S. Trustee recently dismissed his appeal in the Blue Stone case. Thus, the matter is no longer pending before the 11th Circuit. The article, however, is still relevant to an ongoing substantive debate occurring across the country and contains a thoughtful analysis and discussion.
Not so long ago, when a company filed for bankruptcy, if there was a trail of fraud or serious mismanagement, a trustee would be appointed and unsecured creditors would have an opportunity to elect a permanent trustee. In 2003, one Florida bankruptcy court stated that its interpretation of the Bankruptcy Code’s requirement to appoint a trustee is as follows: “[The] Bankruptcy Code expressly provides for appointment of a trustee when a debtor’s management is replaced. The Code does not contemplate the appointment of a ‘Responsible Person’ to perform the duties of a Trustee.” 1 But some six years later, another Florida bankruptcy court in ruling on a motion to appoint a chief restructuring officer (CRO) that had been filed in response to a trustee motion, acknowledged that the debtor sought the retention of a CRO in response to a motion to appoint a trustee stating, “[t]he change [in management] was initiated by the Debtors in possession as a reasonable reaction (indeed, one that a United States Trustee should be proud of provoking) to concerns raised by the United States Trustee.” 2
In recent years, in cases where the debtor has committed fraud or mismanagement, there has been a paradigm shift away from the appointment of a chapter 11 trustee toward the retention of CROs. By retaining a CRO, making other management changes and even modifying corporate governance documents just prior to or contemporaneous with the bankruptcy filing, a corporate debtor can remain in possession notwithstanding its prepetition conduct. In cases of debtor fraud or other misconduct, the ability to cleanse the debtor of its past misconduct through the retention of a CRO has the danger of rendering superfluous §1104(a)(1) of the Bankruptcy Code, which governs the appointment of a chapter 11 trustee for cause. Some recent cases provide a roadmap to chapter 11 constituents of a company that has committed fraud and/or misconduct to avoid the appointment of a chapter 11 trustee.3 The U.S. Trustee (UST) argues that this in essence allows the debtor to handpick its own trustee, instead of having an interim trustee appointed by the UST and then an election through which the unsecured creditors vote for a permanent trustee. The result of these decisions may severely restrict the applicability of §1104(a)(1) to those few cases where the debtor fails to follow this roadmap.
Perhaps the new paradigm may be in for a roadblock. In a recent decision from the U.S. Bankruptcy Court for the Middle District of Florida, the debtor moved for the appointment of a CRO after the UST filed a motion for the appointment of a chapter 11 trustee. In re Blue Stone Real Estate, Const. & Dev. Corp., 392 B.R. 897 (Bankr. M.D. Fla. 2008). The court initially granted the CRO motion, but in a subsequent decision, certified an appeal directly to the Eleventh Circuit as to whether the bankruptcy court should be prohibited from approving the appointment of a CRO when a motion to appoint a chapter 11 trustee is pending. In re Blue Stone Real Estate, Constr. & Dev. Corp., 396 B.R. 555 (Bankr. M.D. Fla. 2008). If the Eleventh Circuit upholds the court’s decision, debtors will have new precedent for appointing a CRO to take the place of a chapter 11 trustee even when it is clear that the CRO application was filed in response to a motion to appoint a chapter 11 trustee. However, if the Eleventh Circuit overturns the bankruptcy court’s decision, the days of blatantly appointing a CRO to avoid a chapter 11 trustee could soon come to an end.
Chapter 11 Trustee vs. CRO
Section 1104(a) provides, in relevant part, that the court shall order the appointment of a chapter 11 trustee for: “(1)…cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management, either before or after the commencement of the case, or similar cause….” 11 U.S.C. §1104(a)(1). Prior to 2005, the UST had discretion as to whether to move to appoint a chapter 11 trustee. However, the Bankruptcy Abuse and Prevention Act of 2005 amended the Code to require the UST to move for the appointment of a chapter 11 trustee providing that:
if there are reasonable grounds to suspect current members of the governing body of the debtor, the debtor’s chief executive or chief financial officer, or members of the governing body who selected the debtor’s chief executive or chief financial officer, participated in actual fraud, dishonesty or criminal conduct in the management of the debtor or the debtor’s public financial reporting.
11 U.S.C. §1104(e). Congress did not alter the standards for the appointment of a chapter 11 trustee, but this new section “underscore[d] congressional concern that untrustworthy management be removed in favor of a trustee.” Norton Bankruptcy Law and Practice 2d §79.3 (2007). Thus, under this section, the UST is required to seek appointment of a chapter 11 trustee even where the court has already approved the appointment of a CRO, since the CRO “was selected” by the fraudulent debtor. 4
Several courts have recently held that the CRO appointment can provide for new management that is not tainted by old management, fraud or misconduct, thereby immunizing the debtor against the appointment of a chapter 11 trustee under §1104(a). Hence, the statutory test is not met and a trustee appointment is not mandatory. In In re 1031 Tax Group LLC, 374 B.R. 78 (Bankr. S.D.N.Y. 2007), and In re 1031 Tax Group LLC, No. 07-1448 (MG), 2007 WL 2085384 (Bankr. S.D.N.Y. July 17, 2007), the debtor moved for the appointment of a CRO and then moved for approval of an “irrevocable delegation agreement,” which purported to give up management authority and the debtor’s ability to terminate the CRO. The court approved the appointment of the CRO and entry of the agreement. When the UST moved for the appointment of a chapter 11 trustee, the court found that “cause” did not exist under subsection (a)(1) because the CRO was not tainted by the former debtor’s misdeeds. The court acknowledged that the debtor’s actions in seeking the appointment of the CRO and approval of the “irrevocable delegation agreement” “were unquestionably done, at least in part, to avoid the appointment of a chapter 11 trustee.” In re 1031 Tax Group LLC, 2007 WL 2085384, at *2 n.2. Nevertheless, the court found that cause did not exist under §1104(a)(1) because current management was not tainted by the fraud committed by past management.5
Similarly, in In re Blue Stone Real Estate, Construction & Development Corp., 392 B.R. 897 (Bankr. M.D. Fla. 2008), and In re Blue Stone Real Estate, Construction & Development Corp., 396 B.R. 555 (Bankr. M.D. Fla. 2008), the UST moved to appoint a trustee based on allegations of fraud and mismanagement. In response, the debtor moved for the appointment of a CRO. The court acknowledged that this was the debtor’s motivation in seeking the CRO appointment, stating that “[t]he change [in management] was initiated by the Debtors in possession as a reasonable reaction (indeed, one that a United States Trustee should be proud of provoking) to concerns raised by the United States Trustee.” 396 B.R. at 561 n.5.
The UST argued against the appointment of the CRO, asserting that under the Code only the UST has the explicit authority to the appoint a chapter 11 trustee, and that by granting the CRO expansive power, the CRO would be a de facto trustee. The court dismissed the UST’s argument that the CRO application was an “end-run” around §1104 and found it “disappointing” that the UST “has shown more regard for its ‘turf’—its territorial or organizational interests—than the larger interests of the bankruptcy system it is designed to serve.” 392 B.R. at 906. The court appointed the CRO under §1107 of the Code and provided the CRO with the same powers of a debtor-in-possession. Subsequent to that decision, the bankruptcy court certified an appeal directly to the Eleventh Circuit of the CRO appointment order. The issue on appeal is whether it is appropriate to appoint a CRO when a motion to appoint a chapter 11 trustee is pending.6
Similar issues were recently briefed in In re Salander-O’Reilly Galleries LLC, Case No. 07-30005 (Bankr. S.D.N.Y. 2007). In that case, the debtor allegedly sold artwork, which it did not own, without the consent or knowledge of the owners of the artwork. The debtor hired a CRO when an involuntary petition was filed against it, and the court approved the appointment of the CRO. The UST, joined by the creditors’ committee and several creditors, moved for the appointment of a chapter 11 trustee, arguing that there would be little doubt that “cause” would exist for the appointment of a chapter 11 trustee “but for” the appointment of the CRO. As in the 1031 and the Blue-Stone cases, the UST argued that the debtor should not be permitted to appoint its own trustee or to blunt cause by appointing a CRO. The debtor responded by arguing that there is no fraud by current management and that the deeds of prior management do not warrant cause to appoint a chapter 11 trustee.
While the 1031, Blue Stone and Salander-O’Reilly cases have allowed the CRO appointments in the face of fraud or misconduct, other courts have rejected their reasoning. For instance, in In re Freelander Inc., 86 B.R. 66 (Bankr. E.D. Va. 1988), the debtor moved for an expedited hearing on the application to approve substitution of management, arguing that if the court granted the relief it would moot the UST’s pending motion to appoint a chapter 11 trustee. The court denied the request for an expedited hearing, reasoning that the court “is obligated by the terms of §1104(a) to order the appointment of a trustee if this section is violated….” The court noted that to do otherwise “would lead to a most anomalous situation where every time a motion to appoint a trustee arose, current management could arrange to be replaced by one of its own choosing in order to avoid the possibility of a trustee being appointed.” Id. at 68. In In re Microwave Products of America Inc., 102 B.R. 666 (Bankr. W.D. Tenn. 1989), the debtor argued that the installation of new management overcame any of the prior management’s deficiencies, and therefore, a trustee should not be appointed. However, the court noted that the debtor could easily terminate the management contract, and as such, the court granted the motion to appoint a chapter 11 trustee. In In re SunCruz Casinos LLC, 298 B.R. 821 (Bankr. S.D. Fla. 2003), the UST and the secured lenders moved for the appointment of a chapter 11 trustee, which was opposed by the debtors and the creditors’ committee. The court rejected the committee’s suggestion that a CRO be appointed in lieu of a trustee, stating that “[t]he Bankruptcy Code expressly provides for appointment of a trustee when a debtor’s management is replaced. The Code does not contemplate appointment of a ‘Responsible Person’ to perform the duties of a trustee.” Id. at 832.
Conclusion
The bankruptcy court in the Blue Stone case certified an appeal directly to the Eleventh Circuit for the issue of whether the bankruptcy court is prohibited from approving the appointment of a CRO when a motion to appoint a chapter 11 trustee is pending. The court noted the importance of this question, recognizing that in many instances, the decision as to who operates the debtor has a significant impact on whether the debtor will successfully emerge from chapter 11.
This decision could have drastic ramifications for cases in which debtors that have committed fraud or similar misconduct and the constituents who seek CRO appointments. If the Eleventh Circuit upholds the bankruptcy court’s decision, debtors could potentially always prevent a chapter 11 trustee from being appointed under §1104(a)(1) by filing a CRO application immediately after the filing of a chapter 11 trustee motion. There will never be “cause” to appoint a chapter 11 trustee because the current management, i.e., the CRO, will never be guilty of “fraud, dishonesty, incompetence, or gross mismanagement.” On the other hand, if the Eleventh Circuit reverses the bankruptcy court, it could be the beginning of the end of CRO appointments for the purpose of avoiding a chapter 11 trustee.
1 In re SunCruz Casinos LLC, 298 B.R. 821 (Bankr. S.D. Fla. 2003).
2 In re Blue Stone Real Estate, Constr. & Dev. Corp., 396 B.R. 555, 561 n.5 (Bankr. M.D. Fla. 2008).
3 See Shai Y. Waisman & John W. Lucas, The Role and Retention of the Chief Restructuring Officer, Americas Restructuring and Insolvency Guide, 200, 205 (2008/2009) (“From the point of view of debtors and their stakeholders, a CRO provides an attractive alternative to a trustee, which is regarded as a far more drastic remedy with attendant uncertainty.”).
4 The 1031 court analyzed the new §1104(e) and found that the new provision created a burden-shifting mechanism, stating that “where the U.S. Trustee establishes a prima facie case that a tainted current member of the governing body has selected or appointed new management shortly before or after chapter 11 filing, a court should apply heightened scrutiny in reviewing whether new management is also tainted…[t]he burden then shifts to the debtors to demonstrate that the new management is unconflicted….” In re 1031 Tax Group LLC, 374 B.R. 78, 87-88 (Bankr. S.D.N.Y. 2007).
5 The court also found that subsection 1104(a)(2) did not warrant the appointment of a trustee because, among other things, the creditors’ committee did not support the appointment of the trustee.
6 The question of whether pursuant to Section 1107(a) of the Code the bankruptcy court may supplement the debtor-in-possession’s rights such that the CRO has the sole authority to manage the debtor-in-possession has also been certified for appeal to the 11th Circuit.