The Toolbox: Fiduciary Duties in Bankruptcy

This month I want to talk about a key concept necessary to the proper working of the Bankruptcy Code (the “Code”) ¹11 U.S.C. §§101 et seq.. This is the fiduciary role played by principal actors in bankruptcy cases.

Some fiduciaries in a bankruptcy case accept their appointments with a good appreciation for their role. Persons serving as trustees in Chapter 7, 11, 12 or 13 cases, or as examiners understand they have fiduciary responsibilities, as do ombudsmen or legal representatives appointed as contemplated by Code Section 524(g). For others, however, the fiduciary mantle comes as a bit of a surprise with its imperative that the fiduciary act in the interests of others.

The most obvious - and in many ways oddest - of the statutory fiduciaries (by which I mean those whose roles are explicitly delineated in the Code) is the debtor in possession. In Chapter 11 (and in Chapter 12) the debtor ordinarily retains control over its estate and the conduct of its business. In doing so, it assumes the role of a trustee of the estate with the obligation to manage it for the best interests of its creditors and equity owners. ²Commodity Futures Trading Comm’n. v. Weintraub, 471 U.S. 343, 355, 105 S. Ct. 1986, 1994 (1985) (stating that “[The] willingness of courts to leave debtors in possession ‘is premised upon an assurance that the officers and managing employees can be depended upon to carry out the fiduciary responsibilities of a trustee.’”) (quoting Wolf v. Weinstein, 372 U.S. 633, 649-52, 83 S. Ct. 969 (1963)); PW Enterprises, Inc. v. North Dakota Racing Commission (In re Racing Services, Inc.), 540 F.3d 892, 901 (8th Cir. 2008) (“The [trustee or] debtor in possession has an obligation to pursue all actions that are in the best interests of creditors of the estate.”) (quoting Commodore Int’l. Ltd. v. Gould (In re Commodore Int’l Ltd.), 262 F.3d 96, 99 (2d Cir. 2001)); In re Count Liberty, LLC, 370 B.R. 259, 275 (Bankr. C.D. Cal. 2007) (noting that “a chapter 11 debtor in possession stands in the shoes of a trustee and is a fiduciary for the estate and its creditors”). These fiduciary responsibilities are essential - as is observance of them by the debtor and its management - to the proper working of the rehabilitation chapters of the Code. If a debtor’s management does not properly appreciate the fiduciary obligations of a debtor in possession, the Code cannot operate as Congress intended.

The other principal category of statutory fiduciaries is official committees. An official committee owes the duty of a fiduciary to each of the constituencies it represents, ³Official Comm. of Equity Security Holders of Adelphia Commc’ns Corp. v. Official Comm. of Unsecured Creditors of Adelphia Commc’ns Corp. (In re Adelphia Commc’ns Corp.), 544 F.3d 420, 424 n.1 (2d Cir. 2008) (“a committee owes a fiduciary duty to the class it represents, but not the debtor, other classes, or the estate.”) (quoting In re Smart World Techs., LLC, 423 F.3d 166, 175 n.12 (2d Cir. 2005)); In re Venturelink Holdings, Inc., 299 B.R. 420, 423 (Bankr. N.D. Tex. 2003) (“a committee member owes a fiduciary duty to all creditors represented by the committee.”). whether or not that constituency is in fact represented on the committee. That means each committee member, nominated for the role by his or her creditor-employer, must disregard the interests of that creditor-employer to the extent those interests are inconsistent with the needs of the committee’s constituency and instead focus on the creditor classes represented by the committee.

However, not only fiduciaries formally recognized by the Code are subject to the limitations imposed on committees and debtors in possession. Informal committees or even individual creditors may assume a fiduciary role where they purport to represent the interests of a larger body of creditors. The Code specifically recognizes two instances where creditors are not free to pursue their own interests once they have undertaken pursuit of a particular remedy. Code Section 303(j) ensures that petitioning creditors cannot trade dismissal of an involuntary petition for payment of their debts at least without notice to all creditors and a hearing. Similarly, a complaint objecting to a debtor’s discharge may not be dismissed without notice. See Fed. R. Bankr. P. 7041. Thus, individual creditors are prevented from using remedies meant to benefit all creditors as weapons to help only themselves.

But these two instances of statutory limitations are not the only times a party may find itself in a fiduciary role. In Young v. Higbee Co., the Supreme Court held that parties that appealed a confirmation order as improper vis-à-vis their class could not dismiss the appeal in exchange for consideration running only to themselves. ⁴324 U.S. 204, 65 S. Ct. 594 (1945). Rather that consideration had to be shared with the entire class due to their assumption of the role of class representatives. While Young is an old case, it has never been overruled and parties undertaking litigation on the basis of general rights must assume that in doing so they assume a fiduciary responsibility to serve the general good.

From a practitioner’s perspective, it is important to ensure that a client knows that a given route undertaken for tactical reasons may give rise to complications because of assumption of fiduciary duties to others who are similarly situated. It is a good rule of thumb that where a party pursues a course that is premised on general rights or harm that such duties may be being assumed.

The practitioner also faces a problem in conveying to statutory fiduciaries—a debtor in possession or a committee—their fiduciary responsibilities. Guidance prior to filing provided to the management of a debtor in possession (preferably in writing) is critical in this regard in debtor representations. Similar guidance and a clear set of bylaws that fosters attention to fiduciary duties is also necessary to indoctrinate committee members. Thus, mechanisms for member recusal, rules for claims trading and systems for testing decisions against the needs of orphan constituencies are important parts for a good set of bylaws.

It is appropriate, then, to review the fiduciary duties of a debtor in possession and a committee in order to define counsel’s task.

Generally speaking, the debtor in possession is charged with preserving and protecting the estate created by the filing of the case, operating its business in the ordinary course with a prudent regard for the importance of avoiding diminution of the estate, and ensuring that all those entitled to benefit from the estate are treated fairly and consistently with the priorities established by Congress.

As for a committee, a committee is charged with the duty of ensuring that each of its constituents is treated fairly and receives in the case the return it is entitled to under the Code; and with ensuring that the estate created at the filing of the case is not unnecessarily diminished through the misconduct of other parties or the committee’s intentional conduct.

Stating the fiduciary duties of debtors in possession and committees is a good deal easier than dealing with the problems that arise when there is a conflict between the agenda of debtor’s management or a committee’s membership and counsel’s perception of his or her client’s fiduciary obligations. What follows is a review of common instances where counsel may have to deal with a fiduciary client to prevent a breach of its fiduciary duty.

Turning first to the debtor, the ordinary rules applicable to a debtor in possession may be awkward for the debtor, but, once explained, management and ownership (for the most part) will find them easy enough to understand and apply. For example, the requirement of court approval of sales outside the ordinary course, assumption of (or entry into) contracts, retention of professionals and settlement of lawsuits constitute no more than an added layer of paperwork and bureaucratic hassle to the administrative process. Similarly, non-payment of prepetition debt, restriction on use of cash collateral, the need to deal with utilities, reporting requirements and schedules are, at worst, irritating inconveniences.

Observance of these and other rules that constrain or mandate a debtor in possession, however, are an important part of the debtor in possession’s role as a fiduciary. ⁵See, e.g., In re Cardinal Indus., Inc., 109 B.R. 755 (Bankr. S.D. Ohio 1990). Thus, it is counsel’s duty to ensure the debtor in possession complies with these rules. Providing written guidance to the debtor (especially if counsel ensures the debtor reads and follows it) not only will avoid problems that might cost the debtor the creditors’ or even the court’s confidence, it also reduces or focuses the questions the debtor’s personnel will need to direct to counsel about how to operate in Chapter 11.

On the other hand, if it is rarely difficult to persuade debtor’s management not to pay prepetition vendors, and management usually takes calmly the news that professionals may be employed only with court authority (and sometimes are conflicted out of the case by provisions of the Code, however sensible their employment may be), it is quite another matter when counsel must explain that an executive’s prepetition expense account must remain unpaid, that bonus or severance provisions for senior management have been abrogated by Code §503(c), relegated to the status of an unsecured claim, or that the creditors’ committee is demanding an end to executive perks like first class airfare or club memberships.

There are other areas where management may find Chapter 11 burdensome and even vexatious. Sharing information (and, to some degree, decision-making power) with committees may rankle management. Allowing others (a lender or committee) input as to changes in management will often be greeted similarly. The requirements of disclosure in connection with a plan (or even in the statement of financial affairs) may irk management of a nonpublic company.

There are more serious issues that management will face, and counsel must ensure those issues are dealt with in a manner consistent with the debtor in possession’s fiduciary duties. Many cases involve several related debtors. Whether by reason of inter-company debt, diverse creditor mix or another sort of conflict, there will be situations in which management will be faced with a decision likely to benefit one debtor—and so its creditors—at the expense of another debtor and its creditors. This raises the question of which debtor should be favored. Management will thus have a conflict of fiduciary duties in how it resolves this potential dispute within the family of debtors. ⁶This assumes the decision-makers are the same for all debtors (either directly or indirectly).

Another problem counsel may face occurs when the debtor is losing money such that continued operation of the business is not in the best interest of creditors. While losses can be expected in the early days of a Chapter 11, if the debtor cannot turn its business around it, as a fiduciary, should shut down operations and perhaps convert to Chapter 7. While management’s estimate of the situation—and its projections of future operations—are entitled to considerable deference, absent an alternative (e.g., a potential buyer with synergies that could make it worthwhile to save the debtor) there may come a time when counsel can no longer in good faith, as him or herself a fiduciary, represent the debtor in a continuing effort at reorganization. In this situation, if the debtor cannot be persuaded to cease operations, counsel may have no choice but to withdraw from the representation.

A debtor’s management or owners will sometimes ask counsel for the debtor in possession to undertake tasks that are inconsistent with his or her role as counsel to a fiduciary. Two common examples of these tasks are negotiating severance or future employment arrangements on behalf of management and negotiating a return for equity owners of an insolvent debtor. ⁷In the case of a publicly held company where there is no equity committee and management is prepared to overlook shareholder interests in favor of its own future thus leaving equity owners with no one advocating their interests, debtor’s counsel is justified in making whatever case is available on behalf of equity. This, however, does not include forcing equity participation under a plan through the use of the tools given the debtor by the Code. For example, the exclusivity provisions of section 1121 should not be used (through extensions) to force creditors to accept terms less favorable than those to which they are entitled. See, e.g., In re
Dow Corning Corp., 208 B.R. 661, 665 (Bankr. E.D. Mich. 1997). In these cases, management or equity should act through its own counsel, though counsel to the debtor in possession may serve as a useful mediator between management or equity and a creditors’ committee or acquiring party.

There are circumstances in which counsel can justify aiding management. The classic example is seeking injunctive relief under Section 105 to stay litigation against management. ⁸See, e.g., In re TRS, Inc., 76 B.R. 805 (Bankr. D. Kan. 1987). These and other cases where the direct beneficiary of counsel’s work is a manager or owner require that benefit or elimination of potential harm to the debtor or estate be shown as a basis for the relief sought.

From a fiduciary perspective, representing a creditors’ committee is less of a problem than representing a debtor. There is less likelihood that committee members will become confused about whom counsel (and the committee) represents. There are instances where counsel will be the only voice for some of the committee’s constituencies. For example, in a multi-debtor case where there is a single committee, the creditors of one or more debtors may not have representation on the committee, or in a case with many types of creditors, a particular class of creditors (e.g., tort claimants) may not be represented.

Similarly, sometimes one constituency will control the committee, thus risking the short-changing of other constituencies. In addressing these problems, counsel is assisted by the requirements for confirmation of a plan. Counsel will be able to advise committee members that ignoring the rights and priorities of a class risks its dissent and a resulting inability to confirm. ⁹A multi-debtor plan may fail if any class of any debtor’s creditors rejects it. A “short changed” class is protected by Section 1129(b) of the Code both as to unfair discrimination among equals ((b)(1)) and priority ((b)(2)). Obviously the best remedy to an absence of representation is to add members from unrepresented constituencies to the committee. The addition in the 2005 amendments to the Code of Section 1102(a)(4) will make the process of adding additional committee members easier.

Counsel must also advise the committee of the fiduciary duty each member assumes. One court has stated that “the individuals constituting a committee should be honest, loyal, trustworthy and without conflicting interests, and with an undivided loyalty and allegiance to their constituents.” ¹⁰In re
Johns-Manville Corp., 26 B.R. 919, 925 (Bankr. S.D.N.Y. 1983). Thus committee members who use their position (which will typically include access to inside information) for their own benefit (or the benefit of the creditor by reason of whose claim they serve) risk liability for breach of their duty. ¹¹In re REA Holding Corp., 8 B.R. 75 (Bankr. S.D.N.Y. 1980). This case involved individuals working for competitors of the debtor who sat on the committee and used their position to steal customers from the debtor. The principle of this case (and other authority) also dictates that committee members not engage in claims trading.

At least one court has held a committee potentially liable to a debtor for taking over management of the debtor and mismanaging it. ¹²Fahringer v. Bohne (
In re
Victor Distrib. Co., Inc.), 11 B.R. 242 (Bankr. E.D. Va. 1981). While this would seem an egregious result, the committee certainly owes the debtor’s estate a duty not to harm it willfully or intentionally.

All of these issues are best addressed by counsel through appropriate education of committee members. To the extent the potential for conflicts within a committee arises (e.g., the debtor proposes to enter into a contract with a committee member), bylaws or ad hoc committee action can address the problem (e.g., by refusal of input on that issue from the interested member). In a worst-case scenario, a committee member may be removed ¹³See In re Am. W. Airlines, 142 B.R. 901 (Bankr. D. Ariz. 1992) (United States trustee has the authority to remove as well as appoint committee members). or new committees created to ensure “individual loyalty and allegiance to their constituents.” ¹⁴Johns-Manville, supra, n.10; Section 1102 allows for appointment of multiple committees where appropriate.