Will Congress Finally Act?

This is the third in a series of Alerts regarding the proposals made by the American Bankruptcy Institute’s Commission to Reform Chapter 11 Business Bankruptcies. It covers the Commission’s recommendations about the fiduciary obligations of a Chapter 11 debtor’s directors and officers and proposed changes to typical defenses asserted to state causes of action. 

Director and Officer Fiduciary Duties in Chapter 11

Management typically wants to control the restructuring effort. Except in unusual circumstances, a Chapter 11 debtor’s prepetition officers and directors continue to run the company, making the company a debtor-in-possession or “DIP.” This creates a potential conflict. Outside of bankruptcy, management’s fiduciary duties are prescribed by state law. Management owes fiduciary duties to the equity holders. But a bankruptcy case creates an estate for the benefit of creditors. Who gets fiduciary protection then?

Management’s Fiduciary Duties

The Bankruptcy Code does not discuss whether additional duties should be imposed once the company files bankruptcy. Most courts have determined that traditional state law duties of care and loyalty continue to govern management’s conduct. Basically, this means that so long as management does not self-deal or act in bad faith, it will have fulfilled its duties. In addition, the bankruptcy court must approve most extraordinary transactions, providing additional protection.

Some courts and commentators, however, have advocated for a federal fiduciary standard under which management would have the “heightened” fiduciary duties of a trustee under the Code. They reason that, in bankruptcy, the company’s management acts as a true fiduciary for the estate. Indeed, the Bankruptcy Code says management has the duties of a trustee.

The Commission has rejected this reasoning and instead recommends that state law alone govern the fiduciary duties of directors and officers in bankruptcy. The Commission concluded that competing federal and state standards would create unnecessary confusion and uncertainty among directors and officers, reasoning that existing state law fiduciary principles are well-understood and effective. As a practical matter, if state law fiduciary obligations govern a DIP’s fiduciaries, that should encourage more filings in Delaware and New York, where fiduciary duties are historically interpreted in ways that are friendly toward management.

The Plan or the Sale of the Business

The issue of management’s loyalties becomes focused when it comes time for the company to propose a plan. Creditors become concerned that management is protecting its own interests and those of the equity, rather than the interests of unsecured claimants. The Commission has resolved this concern by proposing to protect management during the plan process, so long as it acts in good faith. Officers and directors would be treated as fiduciaries for the debtor during the plan process. They would not be considered fiduciaries for creditors.

Equity holders have in the past used the potential conflicting fiduciary obligations to hold up major bankruptcy case events, arguing that a sale of all assets or a plan cannot be confirmed without shareholder consent. State law requires that consent. The Code puts the authority to proceed in the hands of the board, subject to court approval. A series of Delaware Chancery Court decisions in the 1980s, in high-profile bankruptcy cases, supported shareholder rights.

The Commission has proposed to reverse that trend. It recommends amending Section 1107 of the Bankruptcy Code to make clear that directors can take actions on behalf of the DIP that would normally require equity approval – such as selling substantially all of the company’s assets – without seeking shareholder approval. Court approval, on extensive notice, should give every interested party an opportunity to be heard.

The Heated Debate Surrounding In Pari Delicto

A debtor in bankruptcy can pursue any lawsuit that it could have pursued before the bankruptcy. Defendants may raise the same defenses that a defendant could have asserted against the debtor outside of bankruptcy. In management malfeasance cases, a troublesome issue arises when defendants assert the in pari delicto defense. This bars a plaintiff from suing when the plaintiff was also involved in the underlying wrongful conduct. The nonmanagement defendants raise the in pari delicto defense, arguing that they are not liable because management also acted wrongly.

In a bankruptcy case, the use of this defense hurts unsecured creditors, who were not involved in any wrongdoing. Dismissing the lawsuit blocks a recovery for the bankruptcy estate. These recoveries would otherwise go to creditors. While receivers in state insolvency proceedings generally are exempt from this defense, bankruptcy estate representatives (such as the DIP or a trustee) generally are not.

After extensive deliberation, the Commission recommends the elimination of the in pari delicto defense solely with respect to an officially appointed Chapter 11 trustee. This limited modification would provide a Chapter 11 trustee with rights similar to those already possessed by receivers appointed under state and federal law, while also eliminating claims brought by an entity controlled or influenced by wrongdoers. The Commission could not reach a consensus as to whether the in pari delicto defense should also be eliminated in actions brought by the DIP, the unsecured creditors’ committee or other estate representatives. The Commission’s inability to reach consensus shows just how fierce the debate is surrounding the in pari delicto defense’s application in bankruptcy cases.

Confronting Wall Street: The Section 546(e) “Safe Harbor”

The Chapter 11 debtor is responsible for bringing bankruptcy avoidance (preference, fraudulent transfer, etc.) claims that belong to the estate. A Bankruptcy Code defense originally created to handle the bankruptcy of a Wall Street “clearinghouse,” Section 546(e), has “morphed” into a bankruptcy safe harbor for lenders and Wall Street. The Commission assessed this defense and was able to reach only a limited consensus on a proposed resolution.

Sections 547 and 548 of the Bankruptcy Code allow avoidance of prepetition preferences and fraudulent transfers. Section 546 gives defendants several exemptions, or “safe harbors.” Section 546(e) precludes avoidance of a transfer that is a margin or settlement payment made by, to, or for the benefit of a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency. Similar protections apply to transfers made by, to, or for the benefit of any of these parties in connection with a securities contract.

Recent decisions have interpreted Section 546(e) to insulate transactions that arguably have only a tenuous impact on the securities transfer system, including transfers to the sellers of a privately held company through a leveraged buyout. These decisions extend the protections of Section 546(e) beyond the public securities markets to insiders of the debtor who orchestrated a private transaction involving private securities that ultimately caused the debtor’s collapse.

Balancing the need for stability in the financial markets with the estate’s need to recover avoidable transfers, the Commission recommended that the Section 546(e) safe harbor not be available to transfers to the beneficial owner of privately issued securities. The Commission considered further limiting Section 546(e)’s safe harbor to exclude transfers to beneficial holders of publicly issued securities if the transferee received the transfers in good faith, but the Commission ultimately concluded that administering such a standard would create too much uncertainly in the market.

Lastly, the Commission recommended amending Section 546(e) to clarify that the safe harbor does not preclude “actual” fraudulent transfer claims brought under state law. As written, Section 546(e) is not a defense to actual fraudulent transfer claims brought under the Bankruptcy Code, but may provide a defense to actual fraudulent transfer claims under state law. This distinction can have a significant impact, because the statute of limitations for state law fraudulent transfer claims is typically longer than the two-year period provided in bankruptcy. The policy of discouraging fraud applies equally in both situations. Thus, the Commission recommends amending Section 546(e) so that it is not a defense to actual fraudulent transfer claims brought under either federal law or state law.

The Commission’s recommendation regarding fiduciary duties reflects the reality that prepetition management usually controls the reorganization effort and is typically in the best position to make that effort successful. The Commission felt that subjecting management to new or different fiduciary duties in Chapter 11 would cause confusion and hamper restructuring. The Commission’s debates regarding Section 546(e)’s safe harbor and the in pari delicto defense were contentious and reflect the broader need to balance the power of secured lenders with the needs of a debtor trying to reorganize.