Distressed Firms Deserve Impartial, Transparent Investigations

Independent directors are critical for maintaining corporate governance and transparency, particularly in times of financial distress. Internal investigations have become a common responsibility for independent directors—especially when Chapter 11 bankruptcy is anticipated.

A well-executed internal investigation can help retain management’s control, reduce the risk of third-party intervention, and address past governance failures. But ongoing impartiality and a robust investigative process are essential.

An internal investigation prior to a Chapter 11 filing serves several strategic purposes by:

• Preserving control by demonstrating the board and management can address wrongdoing internally
• Mitigating external interference by reducing the risk of investigation by a creditors’ committee, examiner, or trustee
• Preparing for scrutiny by offering a credible narrative to courts and stakeholders

When done correctly, such investigations can help streamline the reorganization process. However, if the investigation lacks thoroughness or impartiality, it can undermine the debtor’s credibility and invite further scrutiny.

Case Study

The case of Silvergate Capital Corp., a company winding down in Chapter 11 bankruptcy, underscores that the mere appearance of independence is insufficient.

It involved Stephanie Wickouski, who was appointed as an examiner to evaluate the independence of Ivona Smith, who conducted a pre-petition investigation as the sole member of Silvergate’s special investigations committee.

Smith’s investigation relied on the debtor’s Delaware counsel and documentation from its long-standing New York law firm. She ultimately recommended not pursuing estate claims against current and former directors and officers and issuing releases in their favor.

While Smith met the criteria for independence at the time of her appointment, the examiner found that her use of the debtor’s counsel created an unavoidable conflict. The examiner also concluded that the investigation was incomplete and lacked adequate factual and legal analysis.

Notably, the report’s conclusion that estate claims weren’t “credible” conflicted with the existence of pre-petition derivative suits.

External Investigation Risks

Under Section 1103(c)(2) of the Bankruptcy Code, a creditors’ committee may investigate “the acts, conduct, assets, liabilities, and financial condition of the debtor.” If the debtor’s internal investigation is perceived as biased, the committee is likely to undertake its own.

If the committee fails to uncover actionable misconduct, it risks having its fees challenged—creating a built-in incentive to find fault. If the committee believes the debtor’s internal investigation is biased, it likely will conduct its own.

But if properly conducted, an internal investigation can help avoid the appointment of both a bankruptcy case trustee and an examiner.

Under Section 1104(a)(1), the bankruptcy court may appoint a trustee “for cause.” A Chapter 11 trustee doesn’t report to the debtor’s board but to the court and is selected by the US trustee—part of the Department of Justice. The appointment of a bankruptcy case trustee represents a complete loss of control by existing management.

An examiner may be appointed to investigate allegations of fraud, dishonesty, incompetence, misconduct, or mismanagement. The examiner, like a trustee, is court-appointed and selected by the US trustee. Though examiners have limited powers compared with trustees, their reports often shape case outcomes and influence judicial decisions.

As shown in Silvergate, independence at the time of appointment doesn’t guarantee independence throughout the investigation. True independence requires vigilance against internal pressure, external influence, and conflicts of interest.

Challenging the Investigation

Courts examine whether directors conducting an internal investigation were truly independent and disinterested, and whether the process was free of domination by interested parties. In Auerbach v. Bennett, the New York Court of Appeals held that independence isn’t automatically lost by virtue of nomination by a controlling shareholder.

Courts have recognized that a director or officer may lose their independence if they are dominated or controlled by an individual or entity interested in the transaction at issue. For example, in Higgins v. N.Y. Stock Exchange, Inc., the court found that a director is considered to have lost independence at the moment they become dominated or otherwise controlled by an interested party

Ultimately, the burden falls on the party challenging the investigation to demonstrate these facts.

A credible and independent internal investigation can help a debtor maintain control during Chapter 11, avoid third-party oversight, and demonstrate good faith to creditors and the court.

If the investigation lacks rigor or impartiality, it may backfire—undermining trust, empowering adversaries, and prolonging reorganization.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Kenneth Rosen practices debtor and creditors’ rights law and advises companies on practical strategies for resolution of financial distress.

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