AMERICAN BANKRUPTCY INSTITUTE

JOURNALIssues and Information for the Insolvency Professional control the business. The basis for the strong Creditors force out the old management Chapter 11 - presumption against appointing a trustee is before the chapter 11 begins, and so the two-fold. First, there is often no need for nominal “DIP” is someone in whom “101” one; DIPs have a fiduciary duty to act in the creditors have faith, sent in to clean up the best interest of creditors and other mess that others left behind. stakeholders, are typically motivated to 2 maximize value and usually don’t engage in Chapter 11 Examiners Bad Words to a The Code states that a court may appoint significant wrongdoing or malfeasance. an examiner after a party in interest or U.S. Second, the DIP is usually familiar with the Trustee requests the appointment.3 One Debtor’s Ear business it had been managing pre-petition, reported decision has indicated that a Contributing Editors: often making it the best party to conduct bankruptcy court has authority to appoint an Prof. John D. Ayer operations during the reorganization. (It is examiner sua sponte. An examiner is to be University of California at Davis; Chico, Calif. worth noting that in many other countries appointed if the court determines that such [email protected] there is not a presumption that current appointment is in the interests of creditors management will continue to run the Michael L. Bernstein and other stakeholders or if the debtor’s business in bankruptcy, perhaps borne of a Arnold & Porter LLP; Washington, D.C. unsecured non-insider debts exceed $5 desire to get rid of the managers who ran the [email protected] million. See Code §1104(c)(2). company into bankruptcy.) Section §1104(c) provides that the court Jonathan Friedland The burden is on the moving party to may order the appointment of an examiner Kirkland & Ellis LLP; Chicago demonstrate by clear and convincing “to conduct...an investigation of the debtor.” [email protected] evidence that appointment of a chapter 11 In fact, courts have stretched the language of trustee is appropriate. Although the second hapter 11 debtors typically remain in this rule a bit; several courts have used part of the standard (best interest of creditors control of their estates as debtors-in- “examiners” in complicated cases to try to and other stakeholders) would seem possession (DIPs), often seeing their leverage out-of-court settlements. In other C somewhat easier to satisfy, as a practical case to completion through confirmation of cases, examiners have been appointed to matter it is very difficult to get a trustee a chapter 11 plan. But it doesn’t always go evaluate causes of action the estate may appointed without showing some level of this way. The Bankruptcy Code also have. Cases with examiners are also incompetence and/or malfeasance by the provides that the court may: uncommon, but are probably more common debtor’s management. • appoint a trustee than chapter 11 trustees. In a complicated Aside from the presumption in favor of • appoint an examiner case where the court is reluctant to impose current management and the high standard • convert the case to chapter 7 the costs and inconvenience of a trustee—but for appointment of a trustee, another reason • dismiss where the judge wants more comfort than he you don’t see many chapter 11 trustees is that • end exclusivity. gets from the DIP—an examiner may be the where you really do need a trustee—such as Another “bad word” for many troubled ticket. companies, is “involuntary bankruptcy.” We where management has destroyed the touch on that this month as well. business—the case may convert to chapter 7 Conversion and Dismissal first. If a chapter 11 trustee is appointed, Code §1112 authorizes conversion or Chapter 11 Trustees he/she basically has the same obligations as dismissal. On the motion of a party in The Bankruptcy Code says the court the DIP, including running the business and interest, the court may order conversion or may order the appointment of a trustee “for filing a reorganization plan. See Code §1106. dismissal for any of 10 reasons itemized in cause, including fraud, dishonesty, incom- The trustee is typically appointed by the Code §1112(b). These include: petence or gross mismanagement of the Office of the U.S. Trustee, usually after • “continuing loss to or diminution of the affairs of the debtor” or “if such appointment consultation with major creditors. There is, estate and absence of a reasonable is in the interests of creditors, any equity however, a provision that permits election of likelihood of rehabilitation” security-holders and other interests of the the trustee. See Code §1104(b).1 • “inability to effectuate a plan” estate....” See Code §1104(a). Appointment Even without forcing the appointment of • “unreasonable delay by the debtor that of a trustee is mandatory in chapter 7, 12 and a trustee, creditors may get control of the is prejudicial to creditors.” 13 cases. However, the appointment of a debtor by forcing a change of management. 2 For a comprehensive discussion of trustees and examiners in chapter trustee in a chapter 11 case is an extra- Indeed, in a great many public-company 11, see Friedland, Jonathan; Khokha, Tasneem and Nylen, Sven, “The Failure of Corporate Stewardship and the Rise of the Statutory ordinary remedy. A request for the chapter 11s (including some of the most Fiduciary: Examiners and Trustees in Chapter 11,” The Annual Survey appointment of a trustee must overcome the notorious), this is exactly what happens: of Bankruptcy Law (2003). 3 Section 1104(c). “Party in interest” is defined in §1109 as including the presumption that the debtor will continue to 1 There is a similar provision for chapter 7 trustees, although it is not debtor, trustee, creditor’s committee, an equity security-holder’s commonly utilized under either chapter. committee or any indenture trustee. The American Bankruptcy Institute 44 Canal Center Plaza, Suite 404, Alexandria, VA 22314-1592 • 703 739 0800 Translated, we think this means: “Your The Code still permits creditors to begin Consider this classic case: Your client is one honor, this case is going nowhere, and it is an involuntary case (see Code §303). Only a of many creditors of the debtor and is time to put a bullet through the poor beast.” very small number of involuntary cases morally certain that the debtor is dissipating If nothing more can be accomplished in show up on the docket—and if anything, we assets. chapter 11—because of the debtor and its suspect this tiny number is larger than it On the one hand, there are non- circumstances and/or because of the limits of should be. We think that involuntary bankruptcy remedies available that may what chapter 11 cases achieve—then bankruptcy, in keeping with its antiquarian enable you to collect your debt and prevent dismissal may be warranted. roots, is pretty much like a muzzle-loading dissipation of assets. These may be quicker Where the grounds exist, the judge has weapon: occasionally lethal and as likely as and cheaper than bankruptcy and may the choice of dismissal or conversion, so not to blow up in your face. enable you to collect amounts owed in full which one should one ask for? If you go for The first problem is the threshold: It’s without sharing with other creditors. conversion, you are still stuck with the not easy to start an involuntary case. You On the other hand, once you file the bankruptcy process—a chapter 7 trustee, need three or more creditors holding claims involuntary petition, you’ve bought yourself notice to creditors, all that sort of thing. On that “aggregate at least $11,625 more than a whole new set of enemies. The involuntary the other hand, you have the benefit of the value of any lien.” This means that case is a bell you can’t un-ring: Once you judicial supervision and you preserve before you begin, you have to find at least file, you can’t dismiss without giving notice avoidance actions that may bring money into two other creditors just as motivated as you to all other creditors. If you win the the estate. If you go for dismissal, you get to are.4 An involuntary case cannot be involuntary adjudication, there will be a shed of all that encumbrance—but so does commenced against a nonprofit business. trustee who may or may not act as your ally, the debtor. So you save the costs and In a voluntary case, the filing of the and there will be lots of other creditors who inconvenience of bankruptcy, but you also petition begins the bankruptcy. In an will want to share pro rata anything that is lose the protections. There isn’t any general involuntary case, the filing just begins a available—and some of whom may have a rule here. The point is that in an individual contested matter. That is, if the debtor statutory priority in bankruptcy. case, you are going to have to weigh the challenges the petition, then the creditor has The cases where involuntary bankruptcy costs and benefits of staying in versus to prove either one of these bankruptcy is most worthy of consideration are those getting out. predicates: where (1) the debtor is mishandling or • The debtor is generally not paying dissipating assets and there does not appear Exclusivity such debtor’s debts as such debts to be any quick and effective way to stop it Finally, a background note: Underlying become due; or other than the court supervision that comes all these issues is the question of who (if • Within 120 days before the date of the with bankruptcy, or (2) cases where a anyone) may propose a chapter 11 plan. filing of the petition, “a custodian...was significant transfer has been made that Code §1112 provides that only the debtor appointed or took possession.” would be avoidable if the transferor were put may propose a plan in the first 120 days of a Translated, this means that if the debtor into bankruptcy. Consequently, there are chapter 11 case. In a corporate case, makes an assignment for the benefit of cases where involuntary bankruptcy can be “debtor” means the managers of the debtor creditors at state law, then you can put him effective, but it is a weapon of last resort, corporation, controlled ultimately by the into an involuntary bankruptcy. Code and you’d better think it through carefully shareholders. We think this rule is a linchpin §303(h). As a plaintiff in the involuntary before you take your client’s bad situation of chapter 11 that is often underappreciated; case, you get your involuntary order if and and make it worse. ■ it allows old equity-owners to use chapter 11 only if you win this contested matter—and as a “second bite at the apple” to give them that may not be the end of it. Because of the Reprinted with permission from the ABI one last chance before they lose control to potency of involuntary bankruptcy, the Code Journal, Vol. XXIV, No. 2, March 2005. the creditors. affords businesses protection against The immediate relevance is that the rule creditors that seek to improperly invoke its The American Bankruptcy Institute is a goes away if conversion, dismissal or the power. For example, Code §303(i) sets out multi-disciplinary, non-partisan orga- appointment of a trustee occurs, so this remedies in cases in which an involuntary nization devoted to bankruptcy issues. critical power of “debtor exclusivity”—a petition is dismissed other than on consent of ABI has more than 10,500 members, linchpin of the chapter 11 case—vanishes if all petitioners and the alleged debtor. any of these events comes to pass. representing all facets of the insolvency Until the court enters an “order for field. For more information, visit ABI Involuntary Bankruptcy relief” finding that the grounds for World at www.abiworld.org. Now, a word about involuntary involuntary bankruptcy have been satisfied, bankruptcy. There is an irony here. Five the “alleged debtor” is in what’s known as hundred years ago, when bankruptcy was the “gap period.” During this period, the young, the idea of “voluntary bankruptcy” debtor is allowed to operate its business and was pretty much of an oxymoron: Bank- use, sell or lease its assets as if it were not in ruptcy was a creditor’s remedy, and a bankruptcy. (If there is a risk of loss to the debtor wouldn’t volunteer for it. Bank- estate during this period, the court may ruptcy began to look attractive to the debtor appoint a trustee during the gap period.) only after the introduction of the first So filing an involuntary petition is primitive discharge rule in 1705. And chancey and potentially hazardous. But even indeed, it wasn’t until after World War II ignoring chance and hazard, there is a more that we observe large numbers of debtors fundamental question: Do you need it? voluntarily filing for bankruptcy with the 4 The Code does say that if the debtor has fewer than 12 creditors in total, you can get away with just one petitioner—but most debtors have discharge in view. more than 12 creditors, so in the usual case you will need three petitioners. The American Bankruptcy Institute 44 Canal Center Plaza, Suite 404, Alexandria, VA 22314-1592 • 703 739 0800