After an in-depth three-year study process, the ABI Commission to Study the Reform of Chapter 11 (the “Commission”) released its Final Report and Recommendations in December 2014. Insolvency and restructuring practitioners have varying opinions about the need for reform and the Commission’s recommendations. We asked three leading bankruptcy attorneys to provide different perspectives about Chapter 11 rehabilitation and the Commission’s recommendations for appointing a trustee, examiner, or estate neutral.
Maria Ellena Chavez-Ruark, partner at Saul Ewing LLP, has a diverse debtor-creditor practice and represents parties in interest in bankruptcy cases of all sizes. Ms. Chavez-Ruark has been recognized with many honors, including being named in The Best Lawyers in America under Bankruptcy and Creditor-Debtor Rights Law/Insolvency and Reorganization Law annually since 2013.
Elizabeth Guffy, senior counsel at Locke Lord LLP, has more than 25 years of experience in all areas of bankruptcy and finance law representing both creditors and debtors, and she frequently serves as an appointed trustee in Chapter 11 cases.
Bruce J. Ruzinsky, partner at Jackson Walker LLP, has more than 30 years of experience and primarily focuses his practice on representing financial institutions, corporations, and other business entities in workout/restructure efforts, chapter bankruptcy proceedings, and litigation. Mr. Ruzinsky has been recognized with many honors, including being named in The Best Lawyers in America under Bankruptcy and Creditor-Debtor Rights Law/Insolvency and Reorganization Law annually since 2008.
Stout: Chapter 11 was enacted to foster economic growth by giving companies a second chance, allowing them to reorganize while still operating, benefiting the companies and their employees and creditors. Today, America is very different from 1978, when the Bankruptcy Code was enacted. Many believe that distressed companies are relying on alternative solutions rather than filing for Chapter 11 protection because they think it’s too expensive or just doesn’t work, which has created a need for reform. Others believe Chapter 11 reform could negatively impact credit markets or that reform isn’t necessary because the system works. What changes, if any, do you believe are needed to rehabilitate Chapter 11?
Maria Ellena Chavez-Ruark (MCR): In recent years, distressed companies have used Chapter 11 less and have sought relief through receiverships, assignments for the benefit of creditors and other judicial and non-judicial alternatives to bankruptcy. Some speculate that this is because bankruptcy has become too expensive or debt structures have become too complex, among a number of other possible explanations. While the reasons are not entirely clear, the inescapable conclusion is that Chapter 11 needs reform if it is going to be considered a viable means of reorganization or liquidation. Interestingly, efforts to review and assess business reorganization laws have been undertaken approximately every 40 years — in 1898, 1938, and most recently in 1978 when the Bankruptcy Code was enacted. Perhaps it is because economic cycles are not as different as one may think, or maybe it is just coincidence. Regardless, it is time. The Chapter 11 process works. It rehabilitates companies, preserves jobs, stabilizes the economy, protects the rights of creditors, and incentivizes ownership. But it can provide these benefits only if it is used. Filings are down, and they have been for some time, because something about the process is not working. The Commission made recommendations seeking to (i) reduce barriers to entry by providing debtors more flexibility; (ii) facilitate more timely and efficient diligence, investigation and resolution of disputed matters; (iii) enhance the debtor’s restructuring options by eliminating the need for an accepting impaired claim in a cram down plan and formalizing a process to permit the sale of the debtor’s assets outside of a plan; (iv) incorporate checks and balances on the rights and remedies of the debtor and other parties in interest; and (v) create an alternative restructuring scheme for small and medium-sized enterprises that would enable them to utilize Chapter 11 more efficiently. These are exactly the changes that are needed to rehabilitate Chapter 11. The Commission did an outstanding job of considering the problem areas for Chapter 11 cases, exploring potential improvements and recommending changes that may make Chapter 11 a workable solution for any distressed company.
Elizabeth Guffy (EG): Developments in Chapter 11 practice over the years since the Bankruptcy Code was enacted have made it more difficult for debtors to reorganize. All too frequently, mid-market companies find an effective reorganization out of reach financially, resulting in a trend toward liquidation for these companies. The primary problem lies with the increasing inability of small or mid-market debtors with existing secured debt to obtain debtor-in-possession (“DIP”) financing from anyone other than their existing secured lender. This creates an imbalance in power that the Code, as it currently exists, does little to correct. As a result, the prepetition lender who morphs into the DIP lender can essentially dictate the entire course of the Chapter 11 case. Typically, lenders will insist on a roll-up of their prepetition debt, converting it into a superpriority administrative claim, something that’s not contemplated by the Code. They also impose a wide range of fees, frequently including a hefty “success fee” if the debtor makes it to confirmation, even though no other group of creditors would consider the case a “success.” They also increasingly impose unrealistic “milestones,” requiring the debtor to file a plan or sell all of its assets in a very tight time frame, which prevents the debtor’s estate from being able to either fully explore a potential reorganization or properly market its assets.
If Chapter 11 is to meet its avowed purpose — to foster economic growth by giving companies a second chance, allowing them to reorganize while still operating, benefiting the companies and their employees and creditors — the Bankruptcy Code must be amended to give Chapter 11 debtors some protection in such circumstances. Some lenders will protest, asserting that what I’ve described is simply the market at work and that no lenders, even the prepetition secured lenders, will be willing to make DIP loans if their ability to extract these kinds of terms is limited. I respectfully disagree. The current state of play simply allows lenders to use Chapter 11 for their own benefit, liquidating their collateral under more favorable terms than foreclosure while extracting substantial additional fees and obtaining releases from the debtor. If the Code were amended to give the debtor some ability to push back, perhaps by limiting the conditions under which a roll-up can be approved, limiting fees for DIP loans, and ensuring that there was sufficient opportunity to market assets or formulate a restricting, the balance of power in a Chapter 11 case would be better calibrated to achieve the purpose intended for Chapter 11.
Bruce J. Ruzinsky (BJR): I would suggest the following six changes to the Bankruptcy Code to help rehabilitate Chapter 11.
First, Section 362(d)(2)(A) should be revised to substitute a minimum equity cushion amount for the current “no equity” requirement. A secured creditor should not have to wait until there is absolutely no equity before (d)(2)(A) is satisfied, especially if property values are declining.
Second, Section 362(d)(1) should give examples of “lack of adequate protection.” For example, a lack of adequate insurance coverage on estate property that is the subject of a lift stay motion should be per se a lack of adequate protection.
Third, the cram-down interest rate in Section 1129(b)(2)(A)(II) should be truly market based.
Fourth, the equitable subordination remedy in Section 510 should be modified to provide that it is only available in truly extreme/very egregious circumstances.
Fifth, Section 506(b) should be revised to provide (i) for an oversecured creditor’s entitlement to non-usurious default-rate interest so long as there is enough collateral value, and (ii) that the procedure for an oversecured creditor to seek attorney’s fees/related expenses is more relaxed and less prohibitive than the process required of estate-retained professionals.
Sixth, Section 505(b)(2) should be revised to specifically permit a secured creditor to request a determination of any unpaid estate liability for any tax incurred during the administration of the estate on estate property that collateralizes the secured creditor’s claim.
Stout: The Commission recommended that parties in interest should be allowed to object to the trustee appointed by the U.S. Trustee if the party in interest can provide clear and convincing evidence that (1) the U.S. Trustee did not properly consult with the parties in interest; (2) the trustee selected is not eligible or has not qualified to serve under Section 321; (3) the trustee selected is not disinterested; or (4) the selected trustee has a disqualifying conflict of interest. Do you believe that parties of interest should be allowed to object, and, if so, do you agree with the objection criteria developed by the Commission?
BJR: I do believe that parties in interest should be allowed to object to a Chapter 11 trustee appointed by the U.S. Trustee. I agree with the objection criteria developed by the Commission, provided that with respect to the first objection criterion (“the U.S. Trustee did not properly consult with the parties in interest”), the statute should specify objective criteria for the U.S. Trustee to satisfy its obligation to “properly consult.”
MCR: All parties in interest should have the ability to object to any matter affecting the administration of a bankruptcy case including, but not limited to, the selection of the individual appointed to serve as trustee. Section 1109(b) of the Bankruptcy Code provides that a party in interest “may raise and may appear and be heard on any issue in a case under this chapter.” This broad right to be heard is an essential aspect of administration of a bankruptcy case.
The second part of the question is less a matter of whether the criteria are appropriate and more a matter of whether the standard of proof is appropriate. The Commission recommends that the preponderance of the evidence standard apply to a motion to appoint a trustee while the higher, more difficult to satisfy clear and convincing evidence standard apply to an objection to the appointment of a particular individual as trustee. In one important respect, this is potentially concerning. Three of the four grounds for a court to deny approval of the individual selected — the trustee is not eligible or qualified, the trustee is not disinterested, and the trustee has a disqualifying conflict of interest — should disqualify an individual from serving as trustee regardless of the standard applied. It is important that a trustee serve without a cloud of controversy that causes parties in interest to question the authenticity or fairness of the process. Disqualification on these three grounds should not require a higher standard of proof. Regardless of the standard, either the person is eligible to serve, disinterested and free from conflicts, or he is not. If he is not, the court should not approve his appointment. The remaining ground for a court to deny approval of the trustee, i.e., that the U.S. Trustee did not properly consult with parties in interest, is a fair ground for objection and rightfully should be held to the higher clear and convincing evidence standard. The U.S. Trustee is an independent third party with no financial stake in the case. The court should be able to assume the U.S. Trustee engaged in a fair process and consulted with parties in interest as required by Section 1104(d) (“the United States trustee, after consultation with parties in interest, shall appoint, subject to the court’s approval, one disinterested person … to serve as trustee”). That assumption should be rebutted only if there is strong evidence — clear and convincing evidence – to the contrary.
EG: I was personally somewhat surprised by the Commission’s concern that courts may be discouraging the appointment of Chapter 11 trustees by imposing a higher evidentiary burden on parties seeking appointment of a trustee. Bankruptcy judges are very attuned to the factors and circumstances that call for the appointment of a trustee and, when those factors and circumstances are present, they tend to facilitate the appointment rather than raise additional barriers. The Commission notes that the evidence it relies upon is anecdotal, so it is possible that many of the instances where a court appeared to disfavor appointment of a trustee were reported by practitioners who had unsuccessfully moved for a trustee under circumstances that were less than convincing to the court.
Regardless, I agree with the Commission that there should be an opportunity for stakeholders to object if they have valid objective concerns as to the suitability of a Chapter 11 trustee appointed by the U.S. Trustee, and the criteria suggested by the Commission reflect a common-sense and realistic approach. I would go a bit further and specify that any objection to the appointment of a Chapter 11 trustee would have to be brought at the time of the appointment, so that there is prompt certainty for both the debtor’s estate and the trustee. A Chapter 11 trustee has to hit the ground running, so to speak, immediately upon appointment. Allowing a stakeholder more than a couple of days to object to the appointment would impose a significant hardship on the trustee.
Additionally, the first of the four suggested criteria — whether the U.S. Trustee “properly” consulted with the parties in interest — seems somewhat vague and open to a subjective interpretation. It also raises the question of which parties in interest must be consulted by the U.S. Trustee, who can’t be expected to individually contact every stakeholder in the case. Thus, in order to avoid unnecessary litigation, this factor needs to be tightened up a bit by giving some definition to what constitutes “proper” consultation and how that consultation is to be carried out. If these points were also addressed, I believe the Commission’s recommendations would very much benefit the Chapter 11 process.
Stout: When no trustee has been appointed, Section 1104(c) requires an examiner to be appointed if it is in the best interest of the creditors, equity security holders or the estate or if “the debtor’s fixed, liquidated, unsecured debts, other than debts for goods, services, or taxes, or owing to an insider, exceed $5,000,000.” The Commission recommended that the Bankruptcy Code be amended to replace an “examiner” with a non-mandated “estate neutral” appointed at the request of a party in interest or the U.S. Trustee. In addition to the traditional examiner role, the estate neutral could also facilitate dispute resolution, increasing efficiencies. In your opinion, would the appointment of an estate neutral be cost-effective and offer needed flexibility to the court, or is the role of the examiner as described in Section 1104(c) effective?
BJR: In my view the appointment of an estate neutral will be cost-effective most of the time and offer additional flexibility to the court. I believe this will be an improvement to Section 1104(c) governing the appointment of an examiner. I am not a fan of Section 1104(c)(2), which requires the appointment of an examiner when the debtor’s fixed, liquidated, unsecured debts (other than debts for goods, services or taxes, or owing to an insider) exceed $5 million, regardless of whether or not such an appointment makes sense.
EG: The Commission’s recommendations to replace examiners with “estate neutrals” are a much-needed correction to the existing provisions of the Bankruptcy Code. Parties too often use the provisions of Section 1112(b)(1) of the Code as leverage, moving for the mandatory appointment of an examiner merely to gain a tactical advantage rather than to address a legitimate concern. Some bankruptcy courts are quick to recognize this reality and contain the situation by appointing an examiner with very limited authority and responsibility. The Commission’s recommendations would eliminate this practice and, hopefully, confine requests for the appointment of the equivalent of an examiner to those cases where there is a real need for one.
Additionally, the Committee’s recommendations would give bankruptcy courts a valuable new tool in managing Chapter 11 cases. While some bankruptcy courts have taken it upon themselves to appoint what amounts to an estate neutral for limited purposes under the existing examiner provisions, the ability to expand this practice to deal with a wider variety of situations would be very useful and could be used to keep the Chapter 11 process moving forward, especially when there is a lack of trust between key parties.
At the same time, however, this power should not be unbounded. For example, if the court had the power to appoint an estate neutral sua sponte, a bankruptcy court with an interventionist tendency could use these provisions to take control of the Chapter 11 process in a way that would be well beyond the role of the court intended by the Bankruptcy Code. It would be best if an estate neutral could be appointed only on motion of a party in interest and that the scope of authority of any appointed estate neutral be limited to the relief requested.
The Commission does not address the current provisions of Section 327(f), which prohibits a person appointed as an examiner from later serving as the Chapter 11 trustee in the same case. While that may have been an appropriate restriction for examiners, it doesn’t make sense to have the same blanket prohibition for the more flexible concept of an estate neutral recommended by the Commission. Depending on the nature of the appointment, the estate neutral may well be the best candidate for appointment as a Chapter 11 trustee, and there may be a cost savings by capitalizing on the knowledge gained by the estate neutral as opposed to bringing in yet another professional who will have to start afresh.
MCR: In practice, examiners are rarely appointed, and when they are appointed, it is usually in large cases. Even if examiners are effective (which conclusion can be reached only after a case-by-case analysis), they are used in a very small percentage of cases. The recommendation of an estate neutral is an interesting one. When there is no trustee, it may prove beneficial to parties in interest to have an independent third party to conduct an independent assessment or investigation of a particular matter. If this recommendation is adopted and incorporated into Chapter 11, it will likely take some time before we can assess whether appointment of an estate neutral is an efficient and effective tool that protects the interests of creditors or is an unnecessary drain on an estate’s resources that hinders an efficient reorganization.
The Commission recommends that the estate neutral appointment process be flexible and tailored by the court to meet the needs of a particular case. Any time a court is afforded the flexibility of considering the totality of the circumstances and the unique nature of a given situation before it makes a decision, it is a positive thing. But the proposed role of the estate neutral remains unclear. Will he serve in a role limited to one particular aspect of the case, serve in a broader role active in the overall administration of the case or serve to facilitate dispute resolution? These are the roles of an examiner, a trustee and a mediator, respectively. It is unclear how an estate neutral would serve a purpose other than those served by these individuals.
Cost is an obvious downside because the estate neutral and any professionals engaged by him would be compensated by the estate and that usually means less money for unsecured creditors. There is a potential for duplication of effort by the estate neutral and other parties such as a creditors’ committee. This may be inescapable. While the estate neutral would be an independent third party who may conduct an investigation purportedly for the good of all parties, a party in interest such as the creditors’ committee should still be entitled to conduct its own investigation and advocate for a certain result for its creditor constituents.
The idea of an estate neutral is an interesting one which very well may address some of the current problems with Chapter 11, but the usefulness, cost and potential effectiveness of an estate neutral remain to be seen. If the concept is incorporated into Chapter 11, it is likely that it will take some time before we can assess the benefits and costs of an estate neutral.
Stout: Over time we will learn what, if any, effect the Commission recommendations will have on Chapter 11. Like the Commission, Ms. Chavez-Ruark, Ms. Guffy and Mr. Ruzinsky are of the opinion that Chapter 11 does need reform. Other insolvency and restructuring professionals, such as the Loan Syndications and Trading Association (“LSTA”), deem bankruptcy reform unnecessary. In October 2015, the LSTA published “The Trouble with Unneeded Bankruptcy Reform: The LSTA’s Response to the ABI Chapter 11 Commission Report.” The report outlined the “flaws” in the commission report and the LSTA’s responses to some of the Commission’s proposals. The LSTA report concludes that Chapter 11 “as it exists today is based on clear and simple principles” and adopting the Commission’s recommendations “would be a significant step backward for federal bankruptcy law and practice.” There is one certainty: the Commission and the LSTA have completely different perspectives about the future of Chapter 11.
The author would like to thank John Baumgartner, Loretta Cross, and Neil Steinkamp of Stout for their assistance with this interview.