How, Why, and When to Seek the Appointment of a Chapter 11 Trustee

by Robert S. Bernstein, Esquire
Bernstein-Burkley, P.C.

Appointing a Chapter 11 trustee is certainly not a panacea, according to author Robert Bernstein. But is certainly can be a helpful tool in reorganizing a troubled business. In his article, Bernstein explores some of the strategy considerations involved with such an appointment. He also looks at the advantages and disadvantages of taking this action.

A lender faced with a debtor in Chapter 11 has a wide range of possible responses. These actions include:

  • Seeking the dismissal of the case.
  • Converting the case to a liquidation.
  • To the extent that the lender is secured, seeking relief form the automatic stay, which enables the lender to enforce its state law rights and remedies against its collateral.

Seeking the appointment of a Chapter 11 trustee is another possible response. An appointed Chapter 11 trustee essentially becomes the CEO of the debtor, exercising such day-to-day control as he or she deems appropriate. The trustee, therefore, essentially displaces the management that got the debtor in its financial predicament.

SENATE VERSION OF CHAPTER 11

Chapter 11 is the result of Congress’s decision to create a single reorganization chapter out of the pre-1978 Bankruptcy Act Reorganization Chapters X, XI, and XII. Chapter X involved the reorganization of corporations whose creditors included holders of publicly issued debt securities. That chapter provided for the mandatory appointment of a trustee if liquidated and non-contingent debt was $250,000 or more. The Senate version of Chapter 11 sought to carry over this mandatory appointment of a trustee in the case of public companies. The Senate version of Chapter 11 ultimately enacted, however, completely did away with mandatory appointments.

The final version of Chapter 11 evidences the policy that the debtor should be permitted to remain in possession absent some cause. As observed in the House report:

…very often the creditors will be benefited by continuation of the debtor in possession, both because the expense of a Trustee will not be required, and the debtor, who is familiar with his business, will be better able to operate it during the reorganization case. A Trustee frequently has to take time to familiarize himself with the business before the reorganization can get underway.

FINAL VERSION OF CHAPTER 11

Notwithstanding this congressional presumption in favor of leaving the debtor in possession, it was recognized that there are instances when a trustee is needed because of fraud or gross mismanagement. Thus, the final version of Chapter 11 allowed the courts to decide on a case-by-case basis whether a Chapter 11 trustee would be appropriate.

HOW

Circumstances Under Which Courts Will Appoint Chapter 11 Trustees

The Bankruptcy Code provides the statutory authority under which a Chapter 11 trustee may be appointed. Normally the creditor or other party interested in appointing a trustee brings the matter before a court by filing a motion. There are, however, instances of a court appointing a trustee sua sponte (on its own motion) if a basis for making the appointment should become apparent to the court during some proceedings.

Two Justifications for Appointing a Trustee

The Bankruptcy Code provides two justifications for the appointment of a trustee. The first is the appointment for “cause,” which includes fraud, dishonesty, incompetence, or gross mismanagement either before or after the bankruptcy filing. The second is less objective. Under it, the appointment is made if it is found to be in the interests of “creditors, any equity security holders, and other interest of the estate.”

Court Discretion

While the Code provides the court “shall” appoint a trustee if either of the two requisites are satisfied, the courts take the position that the general terms “cause” and “interest” used in the section leave considerable room for court discretion. It is also recognized that concepts such as fraud, dishonesty, incompetence, or gross mismanagement cover a wide spectrum of conduct.

The courts will tolerate some degree of mismanagement and some disregard of oversight or statutory provisions. As observed by one court:

…whether cause exists to appoint a Trustee is largely a matter of degree. In most bankruptcy cases there will be some display of mismanagement, some disregard or oversight of statutory provisions, and some legitimate concerns raised by creditors that creditor interest would be better served by replacing current management. The question becomes whether these concerns rise to the level justifying extraordinary relief.

A survey of the cases under which the courts have found “cause” justifying the “extraordinary relief” of the appointment of a Chapter 11 trustee is beyond the scope of this article. Suffice it to say the cases turn on the specific facts of each individual case. The more egregious the conduct that is claimed to constitute “cause” for the trustee appointment, the more likely the court will order the appointment.

In circumstances where the conduct in question is only poor business judgment or failure to comply with the technical requirements of the Bankruptcy Code, the court is unlikely to appoint a trustee if the creditors can otherwise effectively monitor the administration of the bankruptcy case. Conversely, when the debtor transfers significant assets to other companies under common control and away from the reach of creditors, strips the debtor of cash, fails to cure operating losses after Chapter 11 filing, and fails to maintain a bookkeeping system that could accurately report month-to-month profit or loss, a Chapter 11 trustee is likely to be appointed.

Best Interest Test

Distinct from the “cause” basis is the “interests” test. This test does not require demonstration of any specific instances of fraud, dishonesty, incompetence, gross mismanagement, or anything similar but rather requires only evidence that the reorganization effort’s benefit exceeds the additional costs imposed by the appointment of the trustee. While this may seem a less stringent standard than evidence of some “cause,” it is often difficult to establish that the benefit outweighs cost where there is no evidence of some fraud, dishonesty, incompetence, or gross management of a sufficient level otherwise to justify the appointment.

If the court orders the appointment of a Chapter 11 trustee, the U.S. Trustee’s Office first consults with the parties-in-interest, including the party actually making the motion for the appointment. The Office then appoints a disinterested individual (or corporation) to serve as the trustee in the case. The appointment is subject to court approval. While the Office of the U.S. Trustee ordinarily recommends the appointment of a member of its Chapter 7 Trustee Panel to the position, nothing precludes appointing an individual familiar with the debtor’s business.

The appointment procedure itself suggests circumstances under which the lender may establish that the appointment’s benefit outweighs its cost. If a specific individual sought to be appointed as Chapter 11 trustee can take control of a reorganization case that is stagnating, the lender may be able to convince that court that the benefits of the appointment outweigh the cost. This is especially true if the individual can replace current management and thereby reduce some of the debtor’s operating costs.

The 2005 Amendments to the Bankruptcy Code also provide for appointment of a trustee if grounds exist to convert or dismiss the case, but appointments of a trustee or examiner is more in the interests of the creditors and the estate.

WHY

Strategy Considerations

Knowing the conditions under which a court is likely to appoint a Chapter 11 trustee is a necessary precondition to identifying why and when the appointment should be sought. As previously noted, courts will appoint a trustee only in extraordinary circumstances. Courts ordinarily will presume that current management, albeit responsible for the current predicament, is still best suited to rehabilitate the business. Accordingly, seeking the appointment of a trustee is not necessarily a substitute for the other actions a lender can take in a case. It is, however, a viable option in those circumstances where the lender cannot get relief from stay and cannot effect a conversion or dismissal of the bankruptcy case but otherwise believes that the status quo is detrimental to its interests.

Useful First Step

The obvious reasons that support the appointment of a Chapter 11 trustee have been previously discussed. In the absence of evidence likely to convince the court to appoint a trustee, the threat or actual filing of such an option may prod the debtor to move forward with a reorganization plan or, at least, make additional information available to the lender. When the lender obtains the appointment, the debtor’s exclusive right to file a plan is terminated–if that right has not previously expired. Thus, seeking the appointment may be a useful first step for a lender contemplating its own plan. Furthermore, when the lending institution is contemplating its own plan, the appointment of the trustee may be necessary to ensure the debtor’s current management does nothing to sabotage the business during the Disclosure Statement and plan confirmation process.

WHEN

When is tied to the why and how. When to file the motion is driven by the evidence and reasons available to present and support the motion. One significant time consideration is the fact that courts are typically more biased toward leaving the debtor in possession early in the case. This bias tends to disappear as the bankruptcy case drags on.

DISADVANTAGES

There are several disadvantages to appointing a Chapter 11 trustee:

  1. The courts generally will give a newly appointed trustee a grace period, allowing him to her to become familiar with the bankruptcy case. Possible results include the prolongation of the case or a continuation of the lender’s other pending matters such as motions for relief from stay and motions to convert.
  2. Depending on the lender’s strategy, most trustees appointed from the U.S. Trustees’s panel are unlikely to have the time or the skills to operate the business. Practically speaking, many Chapter 11 trustees shut down the business soon after their appointment and convert the case to a liquidation. If the lender truly seeks reorganization, it should be prepared to find a qualified operator to act as trustee.
  3. Under the Bankruptcy Code, the collateral of a secured creditor may be assessed the cost of its preservation. Thus, the secured creditor who seeks the appointment of a trustee, particularly a secured creditor who has a security interest in all of the assets of the debtor, may be forced to bear the expense of the trustee, if for no other reason than because it sought the appointment. Cases in which the lender fears the rapid depreciation of its collateral if the debtor’s current management continues, however, may justify the risk and expense.

CONCLUSION

Seeking appointment of a Chapter 11 trustee has its pros and cons. The “how, why, and when” aspects presented here are designed to introduce the lender to the appointment option. The appointment is not a panacea; rather, it is considered an extraordinary remedy. It is, nevertheless, a valuable tool in certain circumstances, particularly where incompetent or dishonest management destroys an otherwise viable business. It is necessary to consider the option of seeking the appointment of a Chapter 11 trustee in relation to the specifics of each reorganization case to determine whether or not it is appropriate.

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