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Creditors gain leverage in election of trustees.

In a Chapter 11, the question of who will manage the debtor is critical and controversial. Creditors holding substantial claims or creditors' committees (collectively, "creditors") must decide whether to leave pre-Chapter 11 management in control to continue managing the debtor or, instead, to move for the appointment of a trustee. For creditors, this can be one of the most critical decisions concerning the ultimate results achieved in a case. Congress designed Chapter 11 to allow the debtor-in-possession to remain in control of its financial affairs unless creditors or other parties in interest can establish that appointment of a trustee is warranted.

Because a trustee takes control of the debtor's assets and serves in the capacity of chief executive officer, creditors are afforded many benefits, including the avoidance of fraud and dissipation of assets. The trustee is an independent party, free of conflicts, whose duties include maintaining the books and records of the debtor and cooperating with creditors to negotiate a plan of reorganization. However, absent fraud or other criminal activity, creditors of an operating enterprise that has been poorly managed by a debtor-in-possession often defer moving for the appointment of a trustee out of uncertainty as to who will be selected. While creditors may have candidates to serve as trustee who are more capable of managing the debtor than current management, creditors often find that the candidate selected may not be the type they had in mind when a trustee was sought.

Chief among creditors' concerns is that trustees typically do not have the business expertise or particular industry experience to complement a debtor's ongoing operations, especially where the debtor is a large, complex enterprise. Rather, trustees are usually attorneys (often at the top end of the hourly rate scale) selected from a panel comprising Chapter 7 trustees who delegate many of their duties to the professionals they employ, attorneys, and accountants. A trustee, lacking the managerial skills necessary to operate an ongoing enterprise, often retains pre-Chapter 11 management to run the business (the very management creditors litigated to oust at great expense and disruption to the business).

Creditors are stuck with a person with authority over all aspects of a debtor's business yet too often with no understanding of how the business operates.

On October 22, 1994, the Bankruptcy Reform Act of 1994 (the "Reform Act") was signed into law. One of the amendments to the Bankruptcy Code which is potentially significant to the situation described above is a provision of the Reform Act that vests unsecured creditors with the right to elect Chapter 11 trustees (the "Amendment"). Such an election is in lieu of selection by the Office of the United States Trustee ("U.S. Trustee"). A minority of bankruptcy courts have been critical of the U.S. Trustee's selection process of trustees. These courts complained that the U.S. Trustee failed to consult properly with parties in interest, failed to have a sufficient pool of trustees ready to serve as Chapter 11 trustees when needed, and failed to ferret out trustees with skills that would complement the enterprise they were to operate.

Interested parties may now request the U.S. Trustee to convene a meeting of creditors to elect a disinterested person to serve as a Chapter 11 trustee within 30 days of the order appointing an operating trustee. Where there is such a timely request for a meeting, only votes of unsecured creditors are relevant in selecting a trustee and the views of the debtor, secured creditors, equity holders, and other parties in interest are no longer considered in the selection process. According to one involved with the passage of the Amendment, vesting creditors with authority to select trustees ". . . was done to redress the imbalance so that people with money at stake will have a say if the selection is done cavalierly." (MacLachlan, "Bankruptcy Bill: Trimmed, Safe and a Crowd Pleaser," National Law Journal, Oct. 24, 1994, at B1.)

May Elect Trustees Who Understand the Business

The Amendment may affect the Chapter 11 "playing field" in several ways. Creditors should gain leverage in their dealings with debtors. Creditors will likely more closely examine debtor's management and question their tenure, since the uncertainty surrounding an alternative to management (e.g. who will serve as trustee) is alleviated because creditors may be able to elect a trustee with experience in the debtor's business. This may lead to more motions for the appointment of Chapter 11 trustees, or, at least, the threat of such motions. Indeed, the threat of such motions during prepetition negotiations between the debtor and its creditors may keep certain debtors out of Chapter 11 and in an out-of-court workout to avoid displacement of management, or the debtor itself may substitute management just prior to a bankruptcy filing in an attempt to defeat grounds for the appointment of a trustee. The Amendment may also lead to more examinations of debtors, in order for creditors to gather facts necessary to establish the basis for appointment of a trustee. The Amendment should result in creditors' preferring the appointment of a trustee, as opposed to appointment of an examiner, for with the appointment of a trustee creditors should be able to elect a candidate who supports their views on the significant issues in the case. This could lead to secured creditors being "squeezed" by the trustee to leave some value to junior creditors in an otherwise insolvent estate.

Accordingly, this may lead secured creditors to prefer the appointment of an examiner, as opposed to appointment of a trustee, as secured creditors may not participate in the selection of a trustee. The Amendment may also affect the market for trading in claims. Parties may be inclined to purchase claims to enhance their leverage over the election of a trustee which may enhance their leverage over a debtor.

While the Amendment has not revised the basis for the appointment of a trustee under the Bankruptcy Code, a court's analysis may be altered in certain cases in determining whether grounds exist for the appointment of a trustee as a result of the creditors' right to select a trustee. The Bankruptcy Code contains two alternative grounds for the appointment of a trustee: (1) "cause," which may include fraud or gross mismanagement by the debtor; or (2) the "interests of creditors" test. Under the "interests of creditors" test, courts have generally adopted a "cost benefit" analysis in balancing whether appointment of a trustee is in the best interest of the estate.

For example, the Amendment may result in courts altering their analysis under the cost-benefit analysis. With creditors ferreting out an industry expert or workout consultant to serve as trustee, the trustee's learning curve of the business, and the costs associated therein, may be substantially reduced. Also, since the candidate will likely be a capable manager, exposed to crisis situations, the candidate may not be inclined to delegate management responsibilities. Thus, the candidate would actually replace debtor's management, as opposed to employing it.

Should Realize Estate Savings

Likewise, such a candidate is likely not to delegate its responsibilities to the professionals it employs, which could also provide a savings to the estate. Accordingly, creditors may now seek to stress in their motions for appointment of a trustee that, because of their candidate's particular skills, a trustee will likely maximize the value of the debtor's assets by operating the debtor in a more efficient manner, and will increase the prospects for reorganization. Under this analysis, the benefits of a trustee may outweigh the costs associated with such appointment.

The adoption of the Amendment has a broad implication: it may trigger fundamental issues of who will manage the debtor. Because creditors now have some measure of control over who will serve as trustee, creditors may more frequently "take the plunge" and incur the costs and initial disruption of seeking a trustee where management is performing poorly. The Amendment sends a warning to debtors' management that creditors will not sit idle. The Amendment should result in better qualified trustees, as the creditors, whose money is at stake, are motivated to appoint the most qualified candidate.

Scott E. Blakeley is an associate in the Los Angeles office of Bronson, Bronson & McKinnon where he practices exclusively in the area of bankruptcy and creditors' rights law.
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Author:Blakeley, Scott E.
Publication:Business Credit
Date:Jun 1, 1995
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