fiduciary duties for court appointed, court approved, code created or other mythical creatures in...

8/12/2019 FIDUCIARY DUTIES FOR COURT APPOINTED, COURT APPROVED, CODE CREATED OR OTHER MYTHICAL CREATURES IN BANKRUPTCY

http://slidepdf.com/reader/full/fiduciary-duties-for-court-appointed-court-approved-code-created-or-other 1/39



Fiduciary Duties For Court Appointed, Court Approved,Code Created or Other Mythical Creatures in Bankruptcy i

FIDUCIARY DUTIES FOR COURT APPOINTED, COURT APPROVED,CODE CREATED OR OTHER MYTHICAL CREATURES IN

BANKRUPTCY

Charles A. Beckham, Jr., Haynes and Boone, LLP, HoustonJohn P. Melko, Gardere Wynne Sewell LLP, Houston

Abigail Ottmers, Haynes and Boone, LLP, San Antonio

TABLE OF CONTENTS

I. INTRODUCTION .................. .................. .................. .................. .................. .................. ............... 1II. WHO OR WHAT: PARTIES IN BANKRUPTCY.................. .................. .................. .................. . 1

A. Debtors and Debtors-in-Possession................. .................. .................. .................. .................. .. 1B. Appointed Trustees...................... .................. .................. .................. .................. .................. .... 2C. Examiners in Chapter 11 Cases................ .................. .................. .................. .................. ......... 3D. Committees................................................................................................................................3E. Court Approved Counsel and Other Professionals for Trustees, Examiners and Committees..4

III. FIDUCIARY....................................................................................................................................5A. What is a Fiduciary..................... .................. .................. .................. .................. ................... .... 5

1. State ....................................................................................................................................62. Bankruptcy..........................................................................................................................6

IV. FIDUCIARY DUTIES.................... .................. .................. .................. ................. ................... ....... 7A. DEBTORS.................................................................................................................................7

1. Fiduciary Duties Of Officers And Directors............ .................. ................... .................. .... 72. Basic Principles...................... .................. .................. .................. .................. ................. .... 7

a. Duties Owed in a Solvent Corporation..................... .................. .................. ................ 7 b. Business Judgment Rule........ ................... .................. ................... .................. ............. 9

3. No Fiduciary Duty to Creditors in a Solvent Corporation................. .................. ............... 94. Fiduciary Duties Upon Insolvency ................. ................... .................. ................... .......... 10

a. The Narrow View (Prohibition Against Self-Dealing and Insider Preferences) ........ 11 b. Intermediate Views (Duty To Minimize Loss Upon Insolvency) .................. ............ 11c. Expansive View (Duty To Maximize Long-Term Wealth Creating Capacity).......... 15

5. Does the Fiduciary Duty Shift to Creditors, to the Exclusion of Shareholder Interests?.. 176. When is the Fiduciary Duty to Creditors Triggered?............ .................. .................. ........ 187. Fiduciary Duties Owed in Bankruptcy .................. .................. .................. .................. ..... 20

B. TRUSTEE .................. .................. .................. .................. .................. .................. ................. .. 21C. EXAMINERS..........................................................................................................................22D. COMMITTEES.......................................................................................................................23

1. Rights and Duties of a Committee ................. .................. .................. .................. ............. 242. Duties to Investigate the Debtor’s Business and Plan of Reorganization..... ................... . 263. Objections to Applications of Professionals ................. .................. .................. ................ 264. Duty to Request Appointment of a Trustee or Examiner.................... .................. ............ 265. Standing Of Creditors’ Committees To Sue On Behalf of Debtors’ Estate............. ......... 276. Deference to Creditor Interest........... ................... .................. ................... .................. ...... 287. Fiduciary Duty ................. ................. .................. ................. .................. .................. ......... 298. Committee’s and Committee Members’ Liability ................. .................. .................. ....... 31

E. STANDARD OF REVIEW................. .................. ................. .................. ................. .............. 32



Fiduciary Duties For Court Appointed, Court Approved,Code Created or Other Mythical Creatures in Bankruptcy ii

F. COURT APPROVED COUNSEL AND OTHER PROFESSIONALS FOR DEBTORS,TRUSTEES, EXAMINERS, AND COMMITTEES ................. ................... .................. ........ 34

V. POTENTIAL USE OF SPECIAL CONFLICTS COUNSEL................... .................. ................... 36



Fiduciary Duties For Court Appointed, Court Approved,Code Created or Other Mythical Creatures in Bankruptcy 2

permits the bankruptcy court to require officers and directors to perform certain acts under theBankruptcy Rules, but does not make the officers and directors the DIP. A DIP has sometimes beenconsidered as a separate entity from the pre-petition debtor. 8 At other times the debtor and DIP have beenregarded as the same entity. 9 The DIP is required to “perform all the functions and duties...of atrustee,” 10 and functions essentially in the role of a trustee. The DIP owes a fiduciary duty to all partiesthat have an interest in the DIP’s bankruptcy estate. It is critical for the DIP to adhere to its fiduciaryduties to all parties in interest.

B. Appointed Trustees

Under Chapter 7, a trustee is appointed to perform various functions. 11 At the filing of a Chapter7 bankruptcy proceeding, a disinterested Chapter 7 trustee is appointed to oversee the debtor’s estate. 12 AChapter 7 trustee is obligated to perform nine enumerated tasks, including but not limited to collectingmonies, accounting for all property received, ensuring the debtor performs all necessary tasks,investigating the debtor’s financial affairs, examining proofs of claim, and making reports to the court andthe United States Trustee. 13 A Chapter 7 trustee, has a fiduciary duty to all creditors. 14

The appointment of a trustee in a Chapter 11 case is governed by Section 1104 of the BankruptcyCode. Any party in interest or the United States Trustee may request for the appointment of a Chapter 11trustee. 15 A party may request the appointment of a Chapter 11 trustee any time before plan confirmationin a reorganization bankruptcy. 16 The court may appoint a Chapter 11 trustee if a party in interest canshow cause for the removal of the DIP or that the appointment of a Chapter 11 trustee would be in the

best interest of the creditors. 17 The Bankruptcy Code prefers a debtor to remain in possession of thecompany while in bankruptcy, therefore, Chapter 11 trustees are typically appointed only upon a strongshowing of cause. “Cause” is statutorily defined to include fraud, dishonesty, incompetence, and grossmismanagement of the DIP’s business affairs. 18

If a Chapter 11 trustee is appointed, the Bankruptcy Code defines the Chapter 11 trustee’s dutiesto include protecting the assets of the estate, making financial reports to the court, and operating thedebtor’s business. 19 The Chapter 11 trustee is also charged with investigating the debtor, the debtor’s

business practices and the feasibility of continuing the debtor’s operations. 20 The Chapter 11 trustee is

8 See In re Chapel Gate Apartments, Ltd. , 64 B.R. 569, 576 (Bankr. N.D. Tex. 1986).9 See NLRB v. Bildisco and Bildisco , 465 U.S. 513, 528 (1984) (viewing the DIP “as the same entity which existed

before the filing of the bankruptcy petition” but vested with certain powers and obligations by Bankruptcy Code).10 11 U.S.C. § 1107(a)11 11 U.S.C. §§ 701 and 704.12 11 U.S.C. § 701.13

11 U.S.C. § 704(1)-(9).14 United Pacific Ins. Co. v. McClelland (In re Troy Dodson Construction Co., Inc.) , 993 F.2d 1211, 1216 (5th Cir.1993).15 11 U.S.C. § 1104(a).16 11 U.S.C. § 1104(a).17 11 U.S.C. § 1104(a)(1)-(2).18 11 U.S.C. § 1104(a).19 11 U.S.C. § 1106(a)(1) (stating that the trustee must perform the duties of a Chapter 7 trustee as specified insections 704(2), 704(5), 704(7), 704(8), and 704(9)); 11 U.S.C. § 704(2), 704(8).20 11 U.S.C. § 1106(a)(3).




also responsible with filing a plan of reorganization. 21 The Chapter 11 trustee owes fiduciary duties likethat of a common law trustee and will be discussed more fully below. 22

C. Examiners in Chapter 11 Cases

An examiner, like a court-approved trustee, owes fiduciary duties to the bankruptcy estate. Whena trustee has not been appointed, the Bankruptcy Court may appoint an examiner. 23 The BankruptcyCode provides that “the court shall order” the appointment of an examiner if “(1) such appointment is inthe interests of creditors . . .; or (2) the debtor’s fixed, liquidated, unsecured debts other than debts forgoods, services or taxes, or owing to an insider, exceed $5,000,000.00.” 24

Courts have construed the language of section 1104(c) to mean the appointment of an examiner ismandatory when the statutory requirements are present. 25 When the statutory requirements are not met, acourt has discretion to appoint an examiner when the equity security holders interest would be betterserved and when the costs of the examiner is not “disproportionately high.” An examiner may performany of the “duties of a trustee that the court orders the debtor in possession to perform.” 26 More often, anexaminer is appointed for the limited purpose of investigating the debtor under Section 1104(b). 27 Examiners are also appointed to perform special tasks. 28 Examiners are often appointed in the context ofa compromise of a motion seeking the appointment of a Chapter 11 trustee.

D. Committees

Creditors’ and equity security holders’ committees are authorized under Section 1102 of theBankruptcy Code. 29 Shortly after the filing of a bankruptcy petition, the United States Trustee mayappoint a committee of unsecured creditors. 30 The court may order the United States Trustee to appointadditional committees of creditors or equity security holders. 31

Section 1103 of the Bankruptcy Code describes the “powers and duties” of duly appointedcreditors’ and equity security holders’ committees. Section 1103(c) states that a committee may:

(1) consult with the trustee or debtor in possession concerning theadministration of the case;

(2) investigate the acts, conduct, assets, liabilities, and financial condition ofthe debtor, the operation of the debtor’s business and the desirability of

21 11 U.S.C. § 1106(a)(5).22 Willoughby v. Howard , 302 U.S. 445, 451-52 (1983).23 11 U.S.C. § 1104(b).24 11 U.S.C. § 1104(c).25 See In re Revco D.S., Inc . 898 F.2d 498, 501 (6th Cir. 1990) (appointment is mandatory under section

1104(c)(2)); In re 1243 20th Street, Inc. , 6 B.R. 683, 685, n. 3 (Bankr. D.D.C. 1989) (same); In re Lenihan , 4 B.R.209, 211 (Bankr. D.R.I. 1989) (same); see also L. King, 7 C OLLIER ON BANKRUPTCY § 1104.03 (15th ed. rev. 2000).26 11 U.S.C. § 1106(b).27 11 U.S.C. § 1104(b).28 See, e.g., In re Fox , 232 B.R. 229 (Bankr. D. Kan. 1999) (examiner appointed for the limited purpose of preparinga report for court to use at the disclosure statement hearing); In re Imperial Corp. of America , 181 B.R. 501 (Bankr.S.D. Cal 1995) (examiner appointed to determine the amount available to disgorge).29 11 U.S.C. § 1102.30 11 U.S.C. § 1102(a)(1).31 11 U.S.C. § 1102(a)(2).




to “investigate the acts, conduct, assets, liabilities and financial condition of the debtor, the operation ofthe debtor’s business and the desirability of the continuance of such business, and any other matterrelevant to the case or to the formulation of a plan.” 37 Any committee is also entitled to request theappointment of a trustee or examiner under Section 1104 of the Bankruptcy Code. 38 The Fifth Circuitstated “[a] ‘creditors committee not only has, with the court’s approval, the power to employ attorneys,accountants, and other agents to represent or perform services for the committee, it has the duty todetermine what assistance it requires in order to perform such duties, when such assistance is required,and to select those best qualified to render such assistance.’” 39 The Fifth Circuit further stated that the“committee has the duty to use any tool available under Section 1103.” 40

Counsel and advisors for a committee have the same fiduciary duty to the committee’sconstituency as the committee itself does. 41 Committee counsel has an independent duty to all unsecuredcreditors and yet, is faced with taking instructions from either an unreasonably conservative or anunreasonably aggressive committee majority. No bright-line rules exist in these circumstances andcounsel must be ever vigilant to assure that self-interested agendas of certain committee members do notunreasonably put the committee and its counsel at risk. Further, neither the committee nor its counselhave duties to any specific creditor.

III. FIDUCIARY

A. What is a Fiduciary

Fiduciary relationships are difficult to define. 42 Fiduciary relationships encompass trustee and beneficiary, attorney and client, guardian and ward, and agent and principal relationships. 43 A fiduciary isdefined as “[o]ne who owes to another the duties of good faith, trust, confidence, and candor… [or] [o]newho must exercise a high standard of care in managing another’s money or property.” 44 Justice FelixFrankfurter’s oft-cited discussion of fiduciary law in SEC v. Chenery Corp. 45 described the initial analysisto determine a fiduciary relationship: “To whom is he a fiduciary? What obligations does he owe as afiduciary? In what respect has he failed to discharge these obligations.” 46

The Restatement (Second) of Trusts defines a fiduciary relation as:

A person in a fiduciary relation to another is under a duty to act for the benefit ofthe other as to matters within the scope of the relation. A fiduciary is normally

36 11 U.S.C. § 1103.37 11 U.S.C. § 1103(c)(2).38 11 U.S.C. § 1103(c)(4).39 Advisory Committee of Major Funding Corp. v. Sommers (In re Advisory Committee of Major Funding Corp.) ,109 F.3d 219, 224 (5th Cir. 1997) (quoting Irving Sulvmeyr, For Creditors’ Committees , ¶ 13.09 (Lawrence P.King, ed., Matthew Bender 1996)) (emphasis added).40

Id. at 225.41 In re Mesta Mach. Co. , 67 B.R. at 156; Pension Benefit Guaranty Corp. , 42 B.R. at 963.42 Stanley Pietrusiak, Jr., Comment, Changing the Nature of Corporate Representation: Attorney Liability for Aidingand Abetting the Breach of Fiduciary Duty , 28 S T. MARY ’S L.J. 213, n.100 (1996).43 R ESTATEMENT (SECOND ) OF TRUSTS , § 2 cmt. b (1959); Stanley Pietrusiak, Jr., Comment, Changing the Nature ofCorporate Representation: Attorney Liability for Aiding and Abetting the Breach of Fiduciary Duty , 28 S T. MARY ’SL.J. 213, n.100 (1996).44 BLACK ’S LAW DICTIONARY 640 (7th ed. 1999).45 318 U.S. 80 (1943).46 SEC v. Chenery Corp., 318 U.S. 80, 85-86 (1943).




IV. FIDUCIARY DUTIES

A. DEBTORS 53

1. Fiduciary Duties Of Officers And Directors

The concept that the fiduciary duties of directors shift from shareholders to creditors in the eventof insolvency is not new; indeed, its origin has been traced by courts and commentators to the “trust funddoctrine” promulgated 175 years ago by Justice Story in Wood v. Dummer .54 Under this theory, uponinsolvency of the corporation, the directors become “trustees” for creditors and hold corporate assets as a“trust fund” for their benefit. 55 More recent leading decisions are Geyer v. Ingersoll Publications Co. ,56 and Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp .57 Credit Lyonnais , in

particular, contains the now famous statement imposing broadened duties when “a corporation isoperating in the vicinity of insolvency.” 58

Judicial decisions in which a breach of fiduciary duty to creditors often is found to involvediversion or disposition of assets from an insolvent or near insolvent entity for the benefit of insiders orshareholders — the type of conduct regulated by fraudulent transfer, preference, and illegal dividendstatutes. The fiduciary concept often functions to extend the reach of personal liability for such conduct,and most specifically to impose personal liability on directors for fraudulent transfers by a corporateentity. 59

2. Basic Principles

To analyze fiduciary duties that arise in the insolvency context, one must start with the base case,a solvent, non-distressed corporation.

a. Duties Owed in a Solvent Corporation

State corporation statutes generally vest responsibility for management of the corporation’s business and affairs in a board of directors. 60 The directors, in turn, owe fiduciary duties to stockholdersof a solvent corporation. It is the stockholders who own the corporation and who have entrusted the

53 Hon. Nancy Dreher, et al., Operating a Business in the Zone of Insolvency , A NNUAL MEETING OF THE AMERICANBAR ASSOCIATION (AUG 10, 2002) (with permission by author Robert Millner, Sonnenschein Nath & Rosenthal).54 30 F. Cas. 435 (C.C.D. Me. 1824) (No. 17,944); s ee In re Mortgageamerica Corp. , 714 F.2d 1266, 1268-69 (5thCir. 1983).55 In re Mortgageamerica Corp. , 714 F.2d at 1269; Clarkson Co., Ltd. v. Shaheen , 660 F.2d 506, 512 (2d Cir. 1991),cert. denied, 455 U.S. 990 (1982).56 621 A.2d 784 (Del. Ch. 1992).57

No. 12150, 1991 WL 277613 (Del. Ch. Dec. 30, 1991).58 Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp. , No. 12150, 1991 WL 277613, *34 (Del.Ch. Dec. 30, 1991).59 Official Comm. of Asbestos Claimants of G-1 Holding, Inc. v. Heyman , 277 B.R. 20, 37 (S.D.N.Y. 2002)(distribution to shareholders constituted not only fraudulent transfer but also breach of fiduciary duty to creditors bydebtor’s chairman, CEO and controlling shareholder); Hechinger Inv. Co. of Del. v. Fleet Fin. Group , 274 B.R. 71,89-91 (D. Del. 2002) (even where payments to debtor’s shareholders in connection with LBO were insulated fromavoidance as settlement payments under section 546(e), directors could still be personally liable for transfer amounts

based on breach of fiduciary duty to creditors).60 See, e.g. , DEL. CODE A NN . tit 8, § 141 (a).




directors with control and management of their property. Generally, directors and officers of acorporation do not owe fiduciary duties to creditors of the corporation. 61

The duties owed by directors are principally duties of loyalty and care. 62 The duty of loyaltyrequires that directors act in good faith and in the reasonable belief that the action taken is in the bestinterests of the corporation. This duty prohibits self-dealing-type conduct, such as, misappropriation ofcorporate opportunities, taking excessive compensation, and utilizing corporate assets or information for

personal gain. 63

The duty of care requires that directors exercise the care that an ordinarily prudent person wouldexercise under similar circumstances. 64 Delaware, however, allows corporations, by provision in thecertificate of incorporation, to eliminate personal liability of directors to the corporation or itsstockholders for failure to act with due care (but not liability for breach of duty of loyalty or intentionalmisconduct). 65 More than forty (40) other states have passed similar statutes. 66

Directors also owe the duties of courage and inquiry to the corporation and shareholders. 67 Theduty of courage requires the directors to “ask the tough questions while facilitating a positive atmosphereof pursuing the corporation’s best interest.” 68 The duty of inquiry requires directors to ask questions andinquire into financial statements, proposed business transactions and other business issues. 69 Directors arerequired to fully analyze these business issues to determine the consequences to the corporation and theshareholders. 70 Directors may hire experienced professionals to advise them on the consequences of these

business issues. 71

61 See, e.g., United States v. Jolly , 102 F.3d 46, 48 (2d Cir. 1996); Lorenz v. CSX Corp. , 1 F.3d 1406, 1414 (3d Cir.1993).62 Section 8.30(a) of the Model Business Corporation Act provides:

A director shall discharge his duties as a director . . .(1) in good faith;(2) with the care an ordinary prudent person in a like position wouldexercise under similar circumstances; and (3) in a manner he reasonably believes to be inthe best interests of the corporation.

MODEL BUS . CORP . ACT § 8.30(a) (1991).63 See Ramesh K.S. Rao et al., Fiduciary Duty a la Lyonnais: An Economic Perspective on Corporate Governancein a Financially-Distressed Firm , 22 J. CORP . L. 53, 60-61 (1996) (collecting cases to illustrate specific violations ofduty of loyalty); s ee also Pepper v. Litton , 308 U.S. 295, 306-07, 311 (1939) (“The essence of the test is whether ornot under all the circumstances the transaction carries the earmarks of an arm's length bargain.... He who is in sucha fiduciary position cannot serve himself first and his cestuis second.”)64 MODEL BUS. CORP . ACT § 8.30(a); s ee also Richard M. Cieri et al., The Fiduciary Duties of Directors ofFinancially Troubled Companies , 3 J. B ANKR . L & PRAC . 405, 406 (1994) (“The duty of care requires that directorsact in an informed and considered manner, meaning that prior to making a business decision, the directors must haveinformed themselves of ‘all material information reasonably available to them’ and, ‘[h]aving become so informed,they must then act with requisite care in the discharge of their duties.’”) (quoting Aronson v. Lewis , 473 A.2d 805,812 (Del. 1984)).65

DEL. CODE . A NN . tit. 8 § 102(b)(7).66 See Ramesh K.S. Rao et al., Fiduciary Duty a la Lyonnais: An Economic Perspective on Corporate Governancein a Financially-Distressed Firm , 22 J. CORP . L. 53, 59 (1996).67 Myron M. Sheinfeld & Judy L. Harris, Fiduciary Duties of Directors of a Corporation in the Vicinity of

Insolvency and After Initiation of a Bankruptcy Case , AMERICAN COLLEGE OF BANKRUPTCY FIFTH CIRCUITFELLOWS MEETING at 2-3 (February 7, 2004).68 Id. at 2.69 Id. at 3.70 Id. 71 Id.




b. Business Judgment Rule

Directors are also protected by the business judgment rule, which is a judicially created“presumption that in making a business decision the director of a corporation acted on an informed basis,in good faith and in the honest belief that the action taken was in the best interest of the company.” 72 The

protection of the business judgment rule will be lost upon a showing of improper director interest in atransaction (if the transaction is not approved by a majority of disinterested directors) or that the directorhas not adequately informed himself. 73 If the protection of the business judgment rule is lost, the burdenshifts to the director to prove the fairness of the challenged transaction. 74 Some courts rely on the generalfairness of a transaction rather than relying on the fairness of a transaction under the business judgmentrule. 75

3. No Fiduciary Duty to Creditors in a Solvent Corporation

Another basic rule is that directors of a solvent company do not owe fiduciary duties to creditors.A leading case, Simons v. Cogan ,76 holds that no fiduciary duties are owed to holders of a corporation’sconvertible debentures. 77 Federal decisions have upheld this principle in change of control situations,when debtholders assert (unsuccessfully) that the transaction (an LBO or other acquisition) will impairtheir ability to be paid. 78 There are limited exceptions to the general rule of course, if a solventcorporation is rendered insolvent, the decisions giving rise to the insolvency can be re-examined under theharsher light described below. 79

72 In re Healthco Int'l, Inc. , 208 B.R. at 306 (quoting Aronson , 473 A.2d at 812). The protection of the business judgment rule is modified in the takeover context, in Delaware and certain other jurisdictions, to require thatdirectors make a threshold showing of the reasonableness of their actions before receiving the protection. RichardM. Cieri et al., Breaking Up Is Hard to Do: Avoiding the Solvency-Related Pitfalls in Spinoff Transactions , 54 B US. L. 533, 544 n.37 (1999).73 In re Healthco Int'l, Inc. , 208 B.R. at 306; see Richard M. Cieri et al., Breaking Up Is Hard to Do: Avoiding theSolvency-Related Pitfalls in Spinoff Transactions , 54 B US. L. 533, 547-49 (1999) (discussing actions leading to lossof business judgment rule protection).74 See Richard M. Cieri et al., Breaking Up Is Hard to Do: Avoiding the Solvency-Related Pitfalls in SpinoffTransactions , 54 B US. L. 533, 549 n.47 (1999) (citing Weinberger v. UOP, Inc ., 457 A.2d 701, 711 (Del. 1983) for

proposition that under “entire fairness” standard of review, directors must establish that the transaction in questionwas the product of both fair dealing and a fair price). 75 Welt v. Sasson ( In re Dollar Time Group, Inc.) , 223 B.R. 247 (Bankr. S.D. Fla. 1998) (reviewing the intrinsicfairness of a transaction); Official Committee of Subordinated Bondholders v. Integrated Resources, Inc. (In re

Integrated Resources, Inc.) , 147 B.R. 650 (S.D.N.Y. 1992) (reviewing the entire fairness of a transaction, not the business judgment on one portion of the transaction).76 549 A.2d 300, 302-04 (Del. 1988).77 Accord Lorenz v. CSX Corp. , 1 F.3d 1406,1417 (3d Cir. 1993) (“Even if the debentures are convertible, thedebentureholder is merely a creditor who is owed no fiduciary duty until conversion takes place”). See generally

WEIL , GOTSHAL & MANGES , R EORGANIZING FAILING BUSINESSES , ch. 16, 5-9 (1998) (also noting several casesfinding that directors do not owe duties to creditors).78 C-T of Virginia, Inc. v. Barrett , 124 B.R. 689, 692-93 (W.D. Va. 1990); Metropolitan Sec. v. OccidentalPetroleum Corp. , 705 F. Supp. 134, 141 (S.D.N.Y. 1989); Metropolitan Life Ins. Co. v. RJR Nabisco, Inc. , 716 F.Supp. 1504, 1525 (S.D.N.Y. 1989).79 Directors of banking institutions owe fiduciary duties to depositors, and directors of non-banking corporations thathold funds in trust owe fiduciary to the owners of the funds held in trust. See WEIL , GOTSHAL & MANGES , R EORGANIZING FAILING BUSINESSES , ch. 16, p.9 (1998). An exception also arises out of “constituency statutes,”enacted in the mid 1980s largely in response to takeover activities. See Richard M. Cieri et al., Breaking Up Is Hardto Do: Avoiding the Solvency-Related Pitfalls in Spinoff Transactions , 54 B US. L. 533, 540 n. 31 (1999) (collecting




affected by the business decisions of managers. At the same time, theclaims of the shareholders are (at least temporarily) worthless. As a resultit is the creditors who now occupy the position of residual owners. 87

In short, in an insolvency situation, the directors are playing with the creditors’ money. “Since theliability of shareholders is limited to their investments, anything the managers do to increase or decreaseshareholder equity is primarily to the benefit or detriment of the creditors, rather than the shareholders,until the corporation regains solvency.” 88 When there is no equity in the company (and assuming thatsecured claims are covered), the unsecured creditors actually “own” the entity.

a. Scope of the Duty

There is no single formulation, or set of clearly articulated competing formulations, defining thefiduciary duty (or duties) owed creditors upon insolvency. Courts tend, simply, to invoke undefined trustduties. 89 To obtain an understanding of how courts have actually understood the fiduciary duty tocreditors, one must look closely at specific cases.

b. The Narrow View (Prohibition Against Self-Dealing and InsiderPreferences)

In St. James Capital Corp. v. Pallet Recycling Assoc. of North America, Inc. ,90 the court ruled thatdirectors and officers owe no duty of care to the creditors of an insolvent corporation, and that theirfiduciary duty does not extend beyond a prohibition against self-dealing and insider preferences. 91

c. Intermediate Views (Duty To Minimize Loss Upon Insolvency)

New York Credit Men’s Adjustment Bureau v. Weiss ,92 articulates a duty to obtain the best resultsfor creditors in a non-bankruptcy liquidation. New York Credit was an action by a bankruptcy trusteeagainst the directors (and owners) of a corporation, a wholesaler of electrical supplies, that had liquidatedits assets through public auction sale. There was no allegation of self-dealing or insider preference, andthe auction proceeds were turned over to the bankruptcy trustee upon an involuntary filing shortly afterthe auction.

The complaint against the directors was that they had failed to supervise personally theliquidation sale. They had instead put the liquidation in the hands of a licensed auctioneer. Thecornerstone of plaintiff’s case was that the sale proceeds were too little ($23,262.33), given that the book

87 225 B.R. at 653 (footnote omitted). 88 In re Ben Franklin Retail Stores, Inc. , 225 B.R. at 653 n. 13.89 The typical state-court case involves a closely-held corporation in which the directors are also significantshareholders. The alleged breaches of duty generally involve self-dealing. Cases in which fiduciary liability to

creditors has been found are collected and catalogued by commentators. See Bruce A. Markell, The Folly of Representing Insolvent Corporations: Examining Lawyer Liability and Ethical Issues Involved in ExtendingFiduciary Duties to Creditors , 6 J. BANKR . L. & PRAC . 403, 413-14 (1997); Laura Lin, Shift of Fiduciary Duty UponCorporate Insolvency: Proper Scope of Directors’ Duty to Creditors, 46 V AND . L. R EV. 1485, 1513-22 (1993); s eealso Bovay v. H.M. Byllesby & Co. , 38 A.2d 808 (Del. 1944). 90 589 N.W.2d 511 (Minn. App. 1999).91 Accord Helm Fin. Corp. v. MNVA RR., Inc. , 212 F.3d 1076, 1082 (8th Cir. 2000) (Under Minnesota law, spinoffof subsidiary to shareholders is not actionable as breach of fiduciary duty to creditors because defendant debtorswere not creditors of debtors and hence did not receive insider preferences.).92 New York Credit Men's Adjustment Bureau v. Weiss , 110 N.E.2d 397 (N.Y. 1953).




value of the assets was $73,492.21, and their cost was $60,000. The trustee specifically contended that alarger return could have been obtained in a “proper sale or orderly liquidation.” 93 Yet, there was noallegation of irregularity in the auction or that the sale constituted a fraudulent transfer (or any otherfraud).

The court closely scrutinized the directors’ conduct and focused, in particular, on the fact thatcreditors were not given notice of the sale. The court rejected any notice requirement. “[D]espite the factthat the creditors were primarily concerned with defendant’s [sic] activities in this respect, defendantswere under no obligation to give notice to each creditor of their intention to convert the assets intocash.” 94 Nevertheless, the court put the burden on defendants to prove that they had obtained “full valueunder the circumstances.” The court did not define what it meant by “full value under thecircumstances.” The court remanded for a new trial to afford defendants “an opportunity to account fortheir handling of the res in the matter of the sale and to show that full value was realized for the assetsupon the sale.” 95

In re Ben Franklin Retail Stores, Inc .,96 is difficult to categorize. The bankruptcy court decision,which dismisses a fiduciary claim based on fraudulent misrepresentation to creditors, endorses a narrowview of the fiduciary duty to creditors. Yet, core dicta in the case (perhaps reflecting the impact of Credit

Lyonnais ) shows that the court would impose liability for conduct other than transfers resembling insider preferences and fraudulent transfers.

Ben Franklin involved a failed chapter 11 of a holding company and subsidiaries that comprised awholesale and retail variety store business. Upon conversion, the chapter 7 trustee brought suit for breachof fiduciary duty against the debtors’ officers and directors. The charge was that the defendants hadwrongfully prolonged the debtors’ lives through fraudulent valuation of receivables:

They are accused of wrongfully prolonging the Debtors’ corporate lives beyond the point of insolvency by misrepresenting the true value of theDebtors’ accounts receivable. Specifically, they “refreshed” or redatedthe due dates of millions of dollars of receivables to make it appear thatthey were current when, in fact, they were seriously past due. As a result,receivables that should have been written down were recorded at fullvalue. Based on that overvaluation, the Defendants induced creditors tolend money and supply inventory and other value to the Debtors, evenafter the Debtors were insolvent. Creditors were harmed because theDebtors sank deeper into insolvency as their liabilities grew. 97

As the court recognized, the trustee had made a tactical decision to dress fraud claims, based onindividual reliance of specific creditors, as a breach of fiduciary duty (undoubtedly to enhance the

93 Id. at 399.94 Id. at 398.95 Id. at 400.96 225 B.R. 646 (Bankr. N.D. Ill. 1998), aff’d in part and rev’d in part , 2000 WL 28266 (N.D. Ill. 2000).97 In re Ben Franklin Retail Stores, Inc ., 225 B.R. 646, 649 (Bankr. N.D. Ill. 1998), aff’d in part and rev’d in part ,2000 WL 28266 (N.D. Ill. 2000).




prospect of insurance recovery). 98 Indeed, in order to assure the trustee’s standing and ability to provedamages based on creditor losses, the creditors expressly assigned their claims to the trustee. 99

The bankruptcy court in Ben Franklin focused on the theory of law advanced by the trustee andcarefully analyzed whether the conduct alleged constituted a breach of the duty of care, as the trusteecontended. The court dismissed the complaint, stating that the trustee “has attempted to allege a breach offiduciary duty. He has failed to do so.” 100

The principal basis for the bankruptcy court’s ruling in Ben Franklin is the view that fiduciaryduties to creditors should be limited to something like a prohibition on directors denuding the entity ofassets for the benefit of insiders and shareholders:

On this theory, creditors have a right to expect that directors will notdivert, dissipate or unduly risk assets necessary to satisfy their claims.That is the appropriate scope of a duty that exists only to protect thecontractual and priority rights of creditors. 101

The concept of “unduly risk[ing]” assets in the above quotation is significant. Although dictum(because not necessary to this decision), the articulation of the concept is a part of an attempt by the

bankruptcy court to distill a coherent theory based on the case law and academic writing to date. Thecourt continued:

This is not to say that the duty could not be violated by causing thecorporation to incur unnecessary debt to or for the benefit ofshareholders. Subjecting assets to unwarranted claims is a way ofdiverting them from legitimate corporate uses. In an appropriate case,therefore, directors who cause their corporation to incur debt may be in

breach of duties enforceable by creditors. This is not such a case. 102

Moreover, the bankruptcy court viewed the duty of care as very much operative in the area offiduciary duty to creditors. As authorized by Delaware law, the debtor’s certificate of incorporationeliminated liability for failure to act with due care. 103 The directors urged, and the court rejected, thecertificate as a defense:

It is also true, however, that shareholders’ elect directors; creditors donot. Creditors should not be bound by limitations on the scope of theduties of fiduciaries they had no part in selecting because, unlikeshareholders, they cannot protect themselves by being careful in theirselection of managers.

More broadly, shareholders’ investments in corporations are subject tothe rights and limitations of the certificate of corporation. Creditors’“investments” are not; they are subject to specific contracts. The

98 Id. at 656.99 Id. at 649.100 Id. at 656.101 Id. at 655.102 Id. at 656 (footnote omitted).103 Id. at 652.




Defendants’ duties to creditors arose, if at all, to protect the value ofthose contract claims from diminution by reason of improper conduct.Those duties cannot be reduced by a provision in a certificate that formsno part of the creditors’ contracts or the inducement for their“investments.” Indeed, the provision itself is limited to “the Corporationor its stockholders.” It makes no mention of creditors. 104

All in all, the bankruptcy court’s decision in Ben Franklin is one of the most thoughtfulexpositions to date of fiduciary duty to creditors. The lasting significance of the case may be its warningthat ill-planned turnaround efforts, based on unrealistic or excessive new debt obligations, will exposedirectors to fiduciary liability.

d. Deepening Insolvency

In Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., Inc. ,105 the court recognizeda cause of action for “deepening insolvency” under Pennsylvania law. Lafferty involved a Ponzi scheme

by two related and closely-held corporate debtors. Allegedly, the debtors’ principal and related insidersorchestrated a scheme with two outside professionals, Lafferty (accountant) and Cogan (underwriter)whereby the debtors issued and marketed debt securities while insolvent. The action was brought by acreditors’ committee on behalf of the debtors’ estates. The claims against the principal and insiders werenot at issue, having been upheld by the district court on a motion to dismiss and not being subject to theappeal. The appeal dealt exclusively with the claims against the outside professionals (Lafferty andCogan), who were in essence aiders and abettors.

Although the Third Circuit decision affirmed dismissal of the claims against the professionals on pari delicto grounds, the decision is explicit in recognizing a “deepening insolvency” tort akin to breachof fiduciary duty. The court made clear, in upholding the committee’s standing on behalf of the estate,that expansion of corporate debt out of all proportion to ability to pay, and consequent prolongation acorporate life, constitutes a tortious injury to the corporate entity itself, not merely an injury to creditors(for which a bankruptcy trustee could not sue). 106 The harm includes forcing an entity into bankruptcy,“thus inflicting legal and administrative costs,” as well as interference with customers and operations. 107

The dismissal of Lafferty on in pari delicto grounds arises because the wrongdoing of the entity’s principals is imputed to the corporate debtors, and therefore to the bankruptcy trustee which “stands in theshoes of the Debtors.” 108 While it is possible that the conduct of directors adverse to the corporate entitywould not be imputed, when the insider wrongdoers are the sole representatives of the corporate entity,the imputation may be made. The result of this analysis is that the trustee can sue the principals anddirectors, while third party participants in the fraud or breach of duty must be sued by creditors -- a resultsimilarly reached in In re Mediators, Inc. ,109 and prior Second Circuit cases.

104 Id. (footnote omitted); a ccord Pereina v. Cogan , 2001 WL 243537, at *9-10 (S.D.N.Y.) (directors liable forfailure to exercise due care to prevent principal from taking large loans from corporation and excessivecompensation while corporation insolvent); c f. In re Healthco Int'l, Inc. , 208 B.R. at 308-09 (such provisions areeffective as to directors but grant "no protection to third parties who aid and abet directors" in their breach of duty).105 267 F.3d 340 (3d Cir. 2001).106 Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., Inc. , 267 F.3d 340, 347-48 (3d Cir. 2001).107 Id. at 349-50.108 Id. at 355.109 105 F.3d 822 (2d Cir. 1997).




In re Toy King Distributors, Inc. ,110 is another recent decision of significance. The court in ToyKing , in a thorough and well researched opinion, covered the full panoply of fiduciary issues confrontinginsolvent entities. Toy King involved serial chapter 11 cases. In the second case, the creditors’ committeesued debtor’s principals (directors and officers) 111 for breach of fiduciary duty relating to fraudulenttransfer and other alleged wrongs. The corporate debtor in Toy King was insolvent at all times relevant.Among other transgressions, the insider officers and directors in Toy King authorized borrowings fromthe corporate parent at excessive interest rates and charges, which the court held to constitute a violationof the duty of care. 112 In addition, two of the directors were held to have violated the duty of loyaltyduring the first Toy King bankruptcy by acquiring a significant creditor’s claims, without advancedisclosure to the court or the committee. 113

e. Expansive View (Duty To Maximize Long-Term Wealth CreatingCapacity)

Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp .,114 presents a different,and more expansive, view of directors’ duties in insolvency situations. Credit Lyonnais involved adispute as to control of MGM-Pathe Communications Co. (“MGM”). Plaintiff, Credit Lyonnais, was amajor lender to MGM; the principal defendant, Giancarlo Parretti, was the indirect controllingshareholder of MGM. The action sought a judicial determination of the persons who constituted thelawfully elected board of MGM.

The case arose out of a leveraged buyout of MGM by a Parretti entity. Five months after theleveraged buyout, MGM’s creditors forced it into bankruptcy. Credit Lyonnais financed MGM’semergence from Chapter 11 with substantial new bank debt. As part of that transaction, Credit Lyonnaisobtained significant governance restrictions which ceded control to the lender (through an executivecommittee of the board controlled by the lender). The applicable governance contract provided that thecontrolling (98.5%) shareholder (a Parretti entity) would regain control (and the executive committee bedissolved) when the debt was paid down to a certain amount.

When MGM emerged from bankruptcy, the controlling shareholder demanded that the executivecommittee sell certain assets to pay down the loan sufficiently to restore control to Parretti. The executivecommittee rejected the demand out of concern as to adequacy of the price. “Ladd [bank nominee] and his

110 256 B.R. 1 (Bankr. M.D. Fla. 2000).111 There is an issue (not often addressed) concerning the extent that fiduciary duties extend to officers. The courtmade clear in Toy King that at least under Florida law the fiduciary duties extend to both directors and officers.

Although the statute is not specifically directed to corporate officers, the case law makes clear that both officers and directors of a corporation owe fiduciary duties to the corporation. See, e.g., SeaPines , 692 F.2d at 977; Tinwood v. Sun Banks, Inc. , 570 So.2d 955, 959 (Fla. 5th DCA 1990);

Snyder Electric , 305 N.W.2d at 869. Cf. Steinberg v. Kendig (In re Ben Franklin Retail Stores, Inc. ), 2000 WL 28266 (N.D. Ill.) [‘Although Delaware courts have found that officers owefiduciary duties to the corporation, this Court has found that the only instances where such a dutyis found are where the circumstances involved self-dealing.’].

In re Toy King Distributors, Inc., 256 B.R. 1, 165 n18 (Bankr. N.D. Fla. 2000).112 Id. at 169.113 Id. at 170-173 (relying on In re Papercraft Corp. , 187 B.R. 486, 500 (Bankr. W.D. Pa. 1995)).114 1991 WL 277613 (Del.Ch. Dec. 30, 1991).




team could reasonably suspect that he [Parretti] might be inclined to accept fire sale prices.” 115 At allrelevant times, MGM was “in the vicinity of insolvency.” 116

Each side claimed that the other had breached its contractual governance obligations and purported to remove the other’s board representatives. Parretti further alleged that the bank nominees breached their fiduciary duty to the controlling shareholder. 117 The chancellor ruled for plaintiffs and heldthat “the executive committee decisions were valid and did not represent a breach of duty.” 118 “[T]heLadd management group acted prudently with respect to these transactions from the point of view ofMGM.” 119 The court explained:

In these circumstances where the company was in bankruptcy until May28 and even thereafter the directors labored in the shadow of that

prospect, Mr. Ladd and his associates were appropriately mindful of the potential differing interests between the corporation and its 98%shareholder. At least where a corporation is operating in the vicinity ofinsolvency, a board of directors is not merely the agent of the residue risk

bearers, but owes its duty to the corporate enterprise. [FN55]….Ladd and his team could reasonably suspect that he [Parretti] might beinclined to accept fire-sale prices. But the MGM board or its executivecommittee had an obligation to the community of interest that sustainedthe corporation, to exercise judgment in an informed, good faith effort tomaximize the corporation’s long-term wealth creating capacity. 120

In footnote 55, the chancellor emphasized the need to protect creditors. “The possibility ofinsolvency can do curious things to incentives, exposing creditors to risks of opportunistic behavior, andcreating complexities for directors.” 121 In footnote 55, the chancellor posed a hypothetical in which acorporation’s sole asset is a claim against a solvent entity for $51 million, with a value (taking intoconsideration the likelihood of success) of $15.55 million; and the corporation’s debt is only $12 million.In the hypothetical, the stockholders (whose equity is worth only $3.55 million) have a 1 in 4 chance ofrealizing $39 million for themselves ($51 million less $12 million to debtholders) if the claim is notsettled, but would receive little if the claim were settled in the range of its market value, $15.55 million.The shareholders, accordingly, might well prefer to reject a fair market value settlement and gamble for awin at trial. If they lose, it is mostly all creditors’ money that will be lost, and if the stockholders win,they will get all the reward. In the chancellor’s view, the directors may incur personal liability if theytake such high risk action for the benefit stockholders. Instead, as fiduciaries to the enterprise, they shouldchoose the best settlement over $15.55 million:

If we consider the community of interests that the corporation representsit seems apparent that one should in this hypothetical accept the bestsettlement offer available providing it is greater than $15.55 million, and

115 Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp. , 1991 WL 277613, at *34 (Del.Ch. Dec.30, 1991).116 Id. 117 Id. at *33.118 Id. 119 Id. 120 Id. at *34 (emphasis supplied).121 Id. at n.55.




one below that amount should be rejected. But that result will not bereached by a director who thinks he owes duties directly to shareholdersonly. It will be reached by directors who are capable of conceiving of thecorporation as a legal and economic entity. 122

The upshot of the court’s analysis is (a) to subordinate the interests of shareholders to the interestsof creditors in an insolvency situation when they conflict and (b) to impose an open-ended duty of care to“maximize the corporation’s long-term wealth creating capacity.” 123 One might try to limit Credit

Lyonnais to situations involving potential disposition of assets for the benefit of stockholders on termsunfair to creditors, since that is what Parretti wanted to do. 124 But the reasoning of the court in Credit

Lyonnais is clearly not tied to such situations and footnote 55 has nothing to do with asset disposition andeverything to do with directors’ undertaking undue risk to achieve a return for stockholders whose equityis with little or nothing.

5. Does the Fiduciary Duty Shift to Creditors, to the Exclusion of ShareholderInterests?

The majority of cases state or contemplate that upon insolvency, fiduciary duties are owed to bothcreditors and stockholders, although certain duties to creditors may predominate under certaincircumstances (as Credit Lyonnais contemplates). 125 It has been held, however, that “when a corporation

becomes insolvent ... the officers and directors no longer represent the stockholders . . . .” 126

The majority view would appear to be the more sound. The fact of insolvency (either in a bankruptcy or an equity sense) does not preclude rehabilitation of the enterprise and restoration of positive net worth and cash flow. It has been argued persuasively that even post-petition, in a corporatechapter 11 case, until it is clear that there will be no going concern (or liquidation) value available forstockholders, the directors continue to owe fiduciary duties to stockholders. 127 The rule should be nodifferent prepetition.

122 Id. 123 Id. at *34.124 See In re Ben Franklin Retail Stores, Inc. , 225 B.R. at 655.125 See, e.g., Ed Peters Jewelry Co., Inc. v. C&J Jewelry Co., Inc. , 124 F.3d 252, 276 (1st Cir. 1997); Geyer v.

Ingersoll Publications Co. , 621 A.2d 784, 789 (Del. Ch. 1992) (“The existence of the fiduciary duties at the momentof insolvency may cause directors to choose a course of action that best serves the entire corporate enterprise ratherthan any single group interested in the corporation at a point in time when shareholders' wishes should not be thedirector's only concern.”); Pepper v. Litton , 308 U.S. 295, 307 (1939) (“For that standard of fiduciary obligation isdesigned for the protection of the entire community of interests in the corporation”).126 Fed. Deposit Ins. Corp. v. Sea Pines , 692 F.2d at 977 (citation omitted). Sea Pines ruled on duties of directors ofa South Carolina corporation, although no South Carolina cases are cited. 692 F.2d at 977; see also In re Hoffman

Assoc., Inc., 194 B.R. 943, 964 (Bankr. S.C. 1995) (“[W]hen the Debtor became insolvent, the fiduciary duty owed by [the defendant] as a director of the Debtor, shifted from the stockholders to all of the creditors of the Debtor”);

First Options v. Polonitza , 1990 WL 114740, at *4 (N.D. Ill. July 31, 1990) (applying California law and upholdingverdict based on instruction that “[a]n officer and director of an insolvent corporation has a duty to the corporation'screditors to be loyal, to act solely for the financial benefit of the creditors in all matters, and to enhance the financialinterest of the insolvent corporation”).127 Harvey R. Miller, Corporate Governance in Chapter 11: The Fiduciary Relationship Between Directors andStockholders of Solvent and Insolvent Corporations , 23 S ETON HALL L. R EV . 1467, 1468, 1514-15 (1993). “It is thegray area between liquidation value and going concern value which may be realized because of a chapter 11reorganization that provides a potential interest for existing stockholders . . . . The interests of stockholders shouldnot prolong a chapter 11 case when it is patent that there is not, and there never will be, sufficient value to provideany consideration for the stockholders. However, so long as a debtor has a good faith belief that the corporation can




The practical effect of this dual (creditor/shareholder) obligation is to weaken or defeat anyargument that the directors have a duty upon insolvency to arrange an orderly sale or liquidation for the

benefit of creditors. 128 A significant part of the court’s analysis was its view that, given the existence ofduties to both creditors and shareholders, there simply was no duty (on the allegations presented) toliquidate the company:

[T]heir [directors’] duty is to serve the interests of the corporateenterprise, encompassing all its constituent groups, without preference toany. That duty, therefore, requires directors to take creditor interests intoaccount, but not necessarily to give those interests priority. In particular,it is not a duty to liquidate and pay creditors when the corporation is nearinsolvency, provided that in the directors’ informed, good faith judgmentthere is an alternative. 129

6. When is the Fiduciary Duty to Creditors Triggered?

The fiduciary duty to creditors is triggered at or about the point of insolvency. “The fact whichcreates the trust is the insolvency . . . .” 130 Insolvency, however, is a term with more than one meaning.As set forth in In re Healthco Int’l, Inc. :

Insolvency has a settled meaning under fraudulent transfer law, whetherthe relevant statute be section 548 of the Bankruptcy Code, the UniformFraudulent Transfer Act or the Uniform Fraudulent Conveyance Act. Itsstatutory definition is, in essence, an excess of liabilities over the valueof assets. This is sometimes referred to as insolvency in the bankruptcysense.

The Trustee’s claims against the directors are based on principles offiduciary obligations rather than fraudulent transfer law. Here anotherform of insolvency is equally relevant-insolvency in the equity sense.This is an inability to pay debts as they mature. Even though notinsolvent in the bankruptcy sense, a business is insolvent in the equitysense if the assets lack liquidity. 131

be rehabilitated and that going concern value will be preserved and enhanced, the debtor and its directors have a

duty to attempt to achieve a consensual plan of reorganization incorporating plan treatment for stockholder interestsand junior creditor claims as contemplated by the Bankruptcy Code.” Id. 128 See In re Ben Franklin Retail Stores, Inc. , 225 B.R. 646.129 225 B.R. at 655.130 Bovay , 38 A.2d at 813.131 208 B.R. at 301-02 (footnotes omitted). In Geyer v. Ingersoll , the court mixed the two concepts:

An entity is insolvent when it is unable to pay its debts as they fall due in the usual courseof business. Webster's Ninth New Collegiate Dictionary 626 (1988). That is, an entity isinsolvent when it has liabilities in excess of a reasonable market value of assets held.

Geyer , 621 A.2d at 789.




Insolvency under either definition should trigger the duty. If a corporation is insolvent in either the bankruptcy or equity sense, creditors are at risk of nonpayment and the value of their debt claims isdependent on the business decisions of the corporation’s managers.

The practical problem here is that it is hard to determine when, exactly, a corporation becomesinsolvent. The court in Geyer rejected the position that the trigger should be a bright line test,specifically, the institution of bankruptcy or other statutory insolvency proceedings:

While it is true, as Mr. Ingersoll argues, that defining the exception asarising when statutory proceedings have begun would give directors aclear and objective indication as to when their duties to creditors arise,there are other policy concerns which suggest that I interpret theinsolvency exception to arise when insolvency exists in fact. That is, it isefficient and fair to cause the insolvency exception to arise at themoment of insolvency in fact rather than waiting for the institution ofstatutory proceedings. [Citations omitted.] The existence of thefiduciary duties at the moment of insolvency may cause directors tochoose a course of action that best serves the entire corporate enterpriserather than any single group interested in the corporation at a point intime when shareholders' wishes should not be the directors only concern.Furthermore, the existence of the duties at the moment of insolvencyrather than the institution of statutory proceedings prevents creditorsfrom having to prophesy when directors are entering into transactionsthat would render the entity insolvent and improperly prejudice creditors'interests. 132

Compounding the difficulty is the dictum from Credit Lyonnais which would trigger a fiduciaryduty to creditors in the “vicinity of insolvency.” 133 There is no test or definition for “vicinity ofinsolvency.” 134 In a similar vein, the court in Healthco suggests that fiduciary duties are triggered when atransaction leaves the company with “unreasonably small capital” (a fraudulent transfer concept), which“connotes a condition of financial debility short of insolvency (in either the bankruptcy or equity sense)

but which makes insolvency reasonably foreseeable.” 135

The upshot of all this is a great deal of uncertainty. Directors, and those assisting them, mustexercise great care to demonstrate (and document) that creditor interests are being taken into accountwhenever they believe the company is in financial difficulty.

132 Id. at 789; see Fagan v. La Gloria Oil & Gas Co. , 494 S.W.2d 624, 628-29 (Tex. Civ. App.—Houston [14thDist.] 1973, no writ) (under Texas law, fiduciary duty to creditors is triggered only when a corporation is insolventand has ceased doing business altogether or without reasonable prospect of success).133 1991 WL 277613 at 34; accord In re Buckhead America Corp ., 178 B.R. 956, 968 (D. Del. 1994).134 Given that the court’s footnote hypothetical involves a balance sheet solvent entity and risk to creditors ofnonpayment through dissipation of an asset, it would seem that "vicinity of insolvency" refers to risk ofnonpayment. See Credit Lyonnais , 1991 WL 277613 at *34 n.55. 135 In re Healthco , 208 B.R. at 302.




the DIP had some business reasons for making the sale (the price was based on an independent appraisal)and that the transaction met the general standard of inherent fairness because the sale was made in goodfaith and met all the earmarks of an arms’ length transaction.

In appealing the decision, the plaintiff suggested that the debtor should be held to the higherstandard of duty of a trustee under common law. The Seventh Circuit held that the corporate fiduciarystandard was appropriate, stating that the protections afforded creditors under that standard “are sufficientwithout engrafting as well the duties of care and loyalty reserved by the common law for trustees.” 143 Afinding that the common law trustee standards of duty applied rather than the more traditional corporatelaw fiduciary duties would result in a more rigorous standard for evaluating the discharge of a DIP’sactions.

The United States Supreme Court has also indicated that the DIP also owes a fiduciary duty tostockholders. 144 The implications of this fiduciary duty are unclear since the DIP at the same time owes afiduciary duty to creditors, and the interest of creditors and stockholders often conflict. Consequently, itis difficult to define exactly how the DIP can properly act as a fiduciary for both the stockholders and thecreditors.

B. TRUSTEE

A bankruptcy trustee has a fiduciary duty to exercise care and diligence as an ordinary prudent person would exercise in similar circumstances. 145 A bankruptcy trustee has the fiduciary duty to“conserve assets of the estate and to maximize distribution to creditors.” 146 Chapters 7, 11 and 13trustees have a fiduciary duty to all creditors. 147 A trustee is liable for intentional and negligent violationsof fiduciary duties. 148 In In re Ridgen , the majority of the Ninth Circuit held that the “reasonable duediligence standard is the one by which we judge the conduct of the trustee, regardless of whether thedebtor is an individual or a corporation.” 149

The Fifth Circuit stated that the bankruptcy trustee is “charged with the duty to ‘collect andreduce to money the property of the estate for which such trustee serves, and close such estate asexpeditiously as is compatible with the best interests of parties in interest.’” 150 The Fifth Circuit alsostated that bankruptcy trustees are required to comply with state law, as ordered by federal statute. 151 Regarding a trustee’s potential liability, the Supreme Court has held that a trustee should be held

personally liable for willfully and deliberately breaching his/her fiduciary duty of loyalty. 152 The Fifth

143 Id . at 516.144 Commodity Futures Trading Comm’n v. Weintraub , 471 U.S. 343, 355, 105 S. Ct. 1986, 85 L. Ed. 2d. 372(1985).145

In re Cochise College Park, Inc. , 703 F.2d 1339, 1357 (9th Cir. 1983).146 United States v. Aldrich (In re Rigden) , 795 F.2d 727, 730 (9th Cir. 1986).147 See 11 U.S.C. §§ 704, 1106, 1302; s ee, e.g. , United Pacific Ins. Co. v. McClelland (In re Troy DodsonConstruction Co., Inc.) , 993 F.2d 1211, 1216 (5th Cir. 1993); Hildebrand v. Hays Imports (In re Johnson) , 279 B.R.218, 225 (Bankr. M.D. Tenn. 2002).148 United States v. Aldrich (In re Rigden) , 795 F.2d at 730.149 Id. at 731 n.1.150 Dodson v. Huff (In re Smyth) , 207 F.3d 758, 761 (5th Cir. 2000) (quoting 11 U.S.C. § 704(1) (1994)).151 Texas v. Lowe (In re H.L.S. Energy Co., Inc.) , 151 F.3d 434, 438 (5th Cir. 1998) (citing 28 U.S.C. § 959(b)).152 In re Smyth , 207 F.3d at 761.




conferences, consult with counsel, hear matters, and advise the court.” 155 Eventually, several partiesquestioned the propriety of the use of the advisors. The Third Circuit required Judge Wolin to recusehimself from four of the cases. The recusal was required not on a finding of unethical or biased conduct,

but rather the Third Circuit found that the district judge’s conduct carried an air of impropriety.

To avoid the air of impropriety for trustees with limited powers, examiners with expanded powersand other special creatures, the parties in a bankruptcy should play a more active role in defining anexaminer’s or advisor’s scope of engagement and participation in a bankruptcy case.

E. COMMITTEES

Committee members are deemed to have a fiduciary relationship with those whom the committeemembers represent. 156 As a result of its fiduciary relationship, committee members may not use their rolesolely for their own personal advantage. 157 Fiduciary duties are also owed by counsel to the committeethat the committee represents. 158

Committee members must act in good faith and exercise reasonable care in their decisions andrecommendations. For example, In re Tucker Freight Lines, Inc. ,159 the creditors committee was found tohave violated its fiduciary duties by issuing a letter recommending against a proposed reorganization planand asserting reasons the committee knew to be false. The court held that the committee may be entitledto limited immunity, pursuant to Bankruptcy Code Section 1103(c) but this limited immunity did notshield the creditors’ committee from dishonest or reckless acts.

However, implied in this grant of authority must also be a concurrentfiduciary duty to all unsecured creditors. At a minimum, this fiduciaryduty requires that the committee’s determination must be honestlyarrived at, and, to the greatest degree possible, also accurate and correct.For a Creditors’ Committee to urge rejection of a plan for reasons theyknew, or would have known but for the recklessness, to be false wouldviolate this duty and deprive them of any limited immunity they mightotherwise hold under § 1103(c)(3). 160

In Krafsur v. UOP (In re El Paso Refinery, L.P.) , a Western District of Texas bankruptcy courtfound that a committee member is not expected to subordinate its own interest to the interest of thecreditors’ committee. 161 In In re El Paso Refinery , the trustee brought suit against a committee member

155 Advisors, ex parte meetings led to questions of impartiality , W EEKLY NEWS , BANKRUPTCY COURT DECISION , Vol. 42, Issue 26 at 5 (June 1, 2004).156 In re Mid-Island Hosp., Inc., 276 F.3d 123 (2d. Cir. 2002); In re Caldor, Inc. , 193 B.R. 165 (Bankr. S.D.N.Y.1996); Pan Am Corp. v. Delta Airlines, Inc. , 175 B.R. 438 (S.D.N.Y. 1994) (committee held fiduciary duty to

creditors, but not to debtor or other parties); Locks v. United States Trustee , 157 B.R. 89 (W.D. Pa. 1993); Pension Benefit Guar. Corp. v. Pincus, Verlin, Hahn, Reich & Goldstein Professional Corp. , 42 B.R. 960 (E.D. Pa 1984).157 In re Nat’l Equip. & Mold Corp. , 33 B.R. 574 (Bankr. N.D. Ohio 1983) (a committee member may not actthrough the committee where the only benefit would be to place the committee member in a more favorable light tocreditors).158 In re Mesta Mach. Co. , 67 B.R. 151 (Bankr. W.D. Pa. 1986); s ee also In re J.F.D. Enter., Inc. , 223 B.R. 610(Bankr. D. Mass. 1998) (held that counsel to creditors' committee was not fiduciary of debtor or estate generally).159 62 B.R. 213 (Bankr. W.D. Mich. 1986).160 In re Tucker Freight Lines, Inc., 62 B.R. 213, 216 (Bankr. W.D. Mich. 1986) (citations omitted).161 Krafsur v. UOP (In re El Paso Refinery, L.P.) , 196 B.R. 58, 74 (Bankr. W.D. Tex. 1996).




both objecting to its proof of claim and alleging breach of fiduciary duties to the committee. 162 The bankruptcy court reasoned that while a committee member has the responsibility to deal fairly with theother committee members, the individual committee members were entitled to look out for their owninterest. 163 The court ruled that a committee member that had a “conflict” with the committee did not

breach its fiduciary duties to the committee when the member acted out of its own legitimate businessinterests. 164

[The committee member] thus experienced the “conflict” thataccompanies a creditor’s both continuing to do business and serving on acreditor’s committee. This it was (and must be) permitted to do, else theliability associated with committee membership would effectively chill

participation on such committees. Liability ought not attach wheneverthere is a conflict. Nor should courts decree that, whenever there is sucha conflict, the duty to the committee ought always prevail. Such a rule issimply too harsh and unrealistic, and would only lead to a mass exodusfrom committee participation. 165

1. Rights and Duties of a Committee

Section 1103 empowers and vests the creditors’ committee with substantial power and an equallysubstantial responsibility. On the one hand, a committee is empowered to do virtually anything that has a

prospect for furthering the interests of its constituency. This mandate could include everything frominvestigation of litigation against the debtor’s management to negotiation of a transaction for the sale ofthe debtor’s assets. The broad powers of the committee, coupled with the committee’s fiduciary duties,undivided loyalty and due care to the unsecured creditor constituency, seemingly impose on thecommittee not just the power but also the duty to “leave no stone unturned” in the pursuit of creditorinterests.

The Fifth Circuit explored the tension between committee powers and duties in AdvisoryCommittee of Major Funding Corp. v. Sommers (In re Advisory Committee of Major Funding Corp.) .166 In Major Funding , a confirmed liquidating plan of reorganization provided for the formation of anadvisory committee that was to “carry out duties under 11 U.S.C. § 1103 . . . .” 167 The expenses incurred

by the advisory committee in carrying out its duties under the plan were to be reimbursed on anadministrative priority basis. The advisory committee moved to retain counsel to investigate questionable

behavior on the part of the liquidating trustee. The liquidating trustee objected, arguing that the advisorycommittee was not authorized under the plan of reorganization to retain counsel. According to theliquidating trustee, the plan of reorganization charged the advisory committee with the statutory dutiesimposed on official creditors’ committees under Section 1103, but did not confer on the advisorycommittee the powers granted to official committees under Section 1103. The liquidating trustee arguedthat the use of “may” rather than “shall” with reference to the activities listed under Section 1103(c)

162 Id. at 63, 73.163 Id. at 74.164 Id. at 75.165 Id. 166 109 F.3d 219 (5th Cir. 1997).167 Advisory Committee of Major Funding Corp. v. Sommers (In re Advisory Committee of Major Funding Corp.) ,109 F.3d 219, 221 (5th Cir. 1997).




indicates that those activities constitute powers rather than duties of creditors’ committees and that the plan of reorganization did not confer those powers on the advisory committee. 168

The Fifth Circuit held that the plan of reorganization did authorize the advisory committee toretain counsel, determining that Section 1103(c) describes both powers and duties of creditors’committees and that the two are inexorably intertwined. 169 A creditors’ committee has one overridingduty: “to act in the best interest of the creditors it represents.” 170 “When a power granted under Section1103 is needed for the committee to fulfill its overriding duty of protecting the creditors’ interest, thecommittee is obliged to employ that power.” 171 When the advisory committee learned of the liquidatingtrustee’s questionable behavior, it had the duty under Section 1103(c)(5) to “perform such other servicesas in the interest of those represented.” 172 Since Section 1103(a) and (b) empower committees to retaincounsel, the advisory committee was “required” to use this tool, if such retention would further theinterests of creditors. Thus, by conferring on the advisory committee the duties imposed under Section1103, the plan of reorganization authorized the advisory committee to retain counsel in order to carry outits duties.

In the Sommers opinion, the Fifth Circuit depicted the powers and duties of creditors’ committeesin the broadest possible terms. A creditors’ committee is obligated to use any of its statutory powers tofurther the interest of the creditors. Sommers can be read as a mandate to committees to pursue everylead, to turn over every rock, and to fully prepare for every contingency on pain of being second-guessed

by their creditor constituency, and potentially being exposed to liability for a breach of their duties ofdiligence and due care. In reality, few bankruptcy cases can financially support a creditors’ committee toact on such a broad front which would involve much duplication of effort and, ultimately, unnecessarycost to the estate. Committees and their members have a qualified immunity and if it and they arereasonably diligent and honest, the business judgment rule should apply to their acts or failures to act. 173

The tension between powers and duties runs squarely into considerations of waste of estate assets.On the one hand, the committee must be diligent and zealous in pursuit of creditor interests while, on theother, the committee has a duty to preserve estate assets. On the other hand, Section 1103 is not a licensefor excess and inefficiency. If anything, there seems to be a bias against creditors’ committees pursuingaggressive due diligence and contingency planning. A leading treatise suggests:

[E]fforts should be directed toward facilitating discussions and resolutions of plan issuesinstead of preparing numerous committee draft plans and objections to debtor plans anddisclosures. Generally, the committee’s professional should not involve themselves inevery minute aspect of the DIP’s business, incurring excessive fees that inappropriatelydrain the estate, nor should they act as mere spectators, however, contributing nothing tothe benefit of the creditors while reaping the estate’s cash for their fees. 174

168 Id. at 223 .169 Id. at 224-25.170 Id. at 224.171 Id. 172 Id. at 225.173 See, e.g., In re Tucker Freight Lines, Inc. , 62 B.R. 213.174 NORTON BANKRUPTCY LAW & PRACTICE 2d, § 27:20 at 27-52 (1994).




2. Duties to Investigate the Debtor’s Business and Plan of Reorganization

A creditors’ committee has investigative duties regarding a plan of reorganization. In In reWestern Management, Inc. ,175 the court, in denying confirmation of the Debtor’s proposed plan ofreorganization, chastised the creditors’ committee for failing to fulfill its investigative duties, stating:

There is no indication in the record that the unsecured creditors committee has met,investigated, monitored or in any other manner attempted to fulfill its statutoryresponsibility. It was envisioned by the drafters, when they removed the bankruptcy

judge as overseer of a Chapter 11 case, that the committee would fill the void. Withoutthe recommendations and findings of the creditors’ committee, the court, in a ruling on a

plan of reorganization, is confronted with a difficult, if not impossible, task in fulfillingits statutorily prescribed duties. It is vitally important that the Court be fully andaccurately informed by independent, reliable evidence. Neither the Court, nor thecreditors should be required to rely entirely on the evidence produced by the proponentsof the plan. 176

Dismay over ineffectual creditors’ committee has come from other courts. 177 A committee should takeits responsibility very seriously.

A committee is also given broad powers to oversee and investigate the business of the debtor.The Bankruptcy Code authorizes the committee to investigate the business and financial condition of thedebtor and gives the committee the power to examine any entity as a party in interest upon filing arule 2004 motion with the court. 178

3. Objections to Applications of Professionals

Creditors’ committees should also object to a debtor’s application to hire professionals if thecommittee believes that a conflict of interest exists, 179 and to the fees of professionals, if not necessaryand reasonable. As articulated by the court in In re Western Management, Inc. ,180 a committee mustexercise its powers wisely to prevent the imposition of liability for failing to fulfill its statutoryobligations. An additional duty for an objection that should be raised by a creditors’ committee is whenthe committee or its counsel become aware that another professional in the case has developed a conflictafter the approval of the initial retention pleadings.

4. Duty to Request Appointment of a Trustee or Examiner

Frequently in chapter 11 cases, there will be allegations of mismanagement, insider dealings and perhaps fraud. The creditors in such cases very properly would be skeptical of existing management andmay seek to oust existing management. Creditors’ committees have the authority to request appointmentof a trustee, examiner, or retention of a chief restructuring officer. By virtue of its broad investigative

175 6 B.R. 438 (Bankr. W.D. Ky. 1980).176 In re Western Mgmt., Inc. , 6 B.R. 438, 440 (Bankr. W.D. Ky. 1980).177 In re B&W Tractor Co. , 38 B.R. 613, 615 (Bankr. E.D. N.C. 1984) (“most creditors’ committees are totallyinactive and ineffective”).178 See FED. R. BANKR . P. 2004.179 S ee In re Sharon Steel Corp., 19 F.3d 138 (3d Cir. 1994) (accountants with pre-petition claim disqualified fromrepresenting debtor-in-possession).180 In re Western Mgmt., Inc. , 6 B.R. 438.




authority, a creditors’ committee may be in the best position to assess the need for a trustee or anexaminer and bring such need to the attention of the court.

5. Standing Of Creditors’ Committees To Sue On Behalf of Debtors’ Estate

It widely acknowledged that, under Sections 1103(c)(3),(5) and 1109(b), a committee hasstanding to bring an action to recover preferences, fraudulent transfers or otherwise, when the DIP ortrustee unjustifiably fails to initiate the action and when the claims are shown to be colorable. 181 Thestatutory authority for this power is inferred from Section 1103(c)(2) relating to investigation of thedebtor.

The Fifth Circuit has ruled that a creditors’ committee has the authority to bring a colorableaction on behalf of the debtor-corporation. 182 In Louisiana World Exposition v. Federal Insurance Co. ,the Fifth Circuit found that because a claim was property of the estate, the DIP was bound to assert theclaim against the debtors’ board and officers for gross negligence, mismanagement and breach offiduciary duty. 183 The debtors’ board, however, citing a conflict of interest, did not pursue the claim;therefore the creditors’ committee sought court approval to institute the suit on the debtors’ behalf. 184 TheFifth Circuit held that while the Bankruptcy Code did not explicitly authorize a creditors’ committee to

bring suit on behalf of the debtors, the fact that the DIP unjustifiably refused to pursue the claim, thisaction entitled the creditors’ committee to bring the derivative lawsuit. 185 The Fifth Circuit stated that“[w]here the debtor-in-possession is unable or unwilling to fulfill its obligation [to bring a derivativesuit]—due, for instance, to a conflict of interest—the Committee may assert the cause of action on behalfand in the name of [debtor] if authorized to do so by the bankruptcy court.” 186

In recent years, other courts have further analyzed the authority of a creditors’ committee to bringan adversary proceeding on behalf of the bankruptcy estate. In 2002, the Third Circuit in Official Comm.of Unsecured Creditors of Cybergenics Corp. v. Chinery , found that the creditors’ committee did not havethe authority to bring an adversary proceeding on behalf of the bankruptcy estate. 187 The bankruptcycourt found the debtor’s refusal to bring a derivative claim unreasonable and authorized the creditors’committee to proceed with the derivative claim. The district court dismissed the committee’s derivativesuits finding that under Section 544 of the Bankruptcy Code, the committee could not bring suit. A ThirdCircuit panel upheld the district court’s ruling finding that the committee could not bring suit underSection 544 of the Bankruptcy Code. 188 Upon rehearing, the Third Circuit sitting en banc found thatalone, Sections 503(b)(3)(B), 544, 1103(c)(5) and 1109(b) of the Bankruptcy Code did not authorize thecourt to empower a creditors’ committee with derivative standing. The en banc Third Circuit, however,

181 See, e.g., Canadian Pacific Forest Products Ltd. v. J.D. Irving, Ltd. (In re The Gibson Group, Inc.) , 66 F.3d 1436(6th Cir. 1995) (stating that alternative basis for committee standing may be judicially-created derivative standing);

Louisiana World Exposition v. Fed. Ins. Co. , 858 F.2d 233 (5th Cir. 1988); In re STN Enterprises , 779 F.2d 901

(2d Cir. 1985).182 Louisiana World Exposition v. Fed. Ins. Co. , 858 F.2d 233 (5th Cir. 1988).183 Id. at 235, 246.184 Id. at 235.185 Id. at 247.186 Id. at 252.187 Official Comm. of Unsecured Creditors of Cybergenics Corp. v. Chinery , 304 F.3d 316 (3d Cir. 2002). Theinitial Third Circuit opinion was vacated when the Third Circuit granted the Committee’s motion for rehearing enbanc . Official Comm. of Unsecured Creditors of Cybergenics Corp. v. Chinery , 330 F.3d 548 (3d Cir. 2003).188 Official Comm. of Unsecured Creditors of Cybergenics Corp. v. Chinery , 330 F.3d 548 .




compromise settlement as a “factor bearing on the wisdom of the compromise” as a wayto show deference to the reasonable views of creditors. 200

7. Fiduciary Duty

The members of a committee assume a fiduciary relationship to those creditors or interest holderswhom they represent. These duties are fundamentally the same duties a director of a solvent corporationholds to the shareholder, i.e. , the duty of loyalty and the duty of due care. 201 In In re Johns-Manville , thecourt opined on the importance of these fiduciary duties in a chapter 11 case as follows:

In the case of reorganization committees, these fiduciary duties are crucial because of theimportance of committees. Reorganization committees are the primary negotiating

bodies for the plan of reorganization. They represent those classes of creditors fromwhich they are selected. They also provide supervision of the debtor and execute anoversight function in protecting their constituent’s interests.. . . .Accordingly, the individuals constituting a committee should be honest, loyal,trustworthy and without conflicting interests, and with undivided loyalty and allegianceto their constituents. 202

The members must put aside their own personal, parochial and economic self-interest andevaluate the debtor and its prospects in light of the interests of the collectivity of unsecured creditors.Thus, for instance, a committee member may not act through the committee to seek an order of the court“correcting” a statement issued by the debtor to its creditors, which statement suggested that legal actionstaken by the committee member had precipitated the chapter 11 case, when the only benefit to be gained

by “correction” would be to place the committee member in a more favorable light to other creditors. 203 Committee members’ dealings with the debtor will be scrutinized, as, for instance, when a group to whichthe member belongs speculates in securities of the debtor. 204 If a committee member violates its fiduciaryduties to creditors, a court may remove the creditor from a committee. 205 Committee members are notimmune to personal liability for breach of fiduciary duty.

In In re Seaescape Cruises, Ltd , it was not a breach of fiduciary duty, however, when members ofthe creditors’ committee sought relief from the automatic stay to enforce their liens and moved to convert

200 Id. at 918.201 See, e.g., Woods v. City Nat’l Bank , 312 U.S. 262 (1941); Bohack Corp. v. Gulf & Western Indust. (In re BohackCorp.) , 607 F.2d 258, 262 n.4 (2d Cir. 1979); In re Mountain States Power Co. , 118 F.2d 405 (3d Cir. 1941);Pension Benefit Guaranty Corp. v. Pincus, Verlin. , 42 B.R. 960 (E.D. Pa. 1984) (committee owes undivided loyaltyand allegiance to group it represents); In re Realty Assoc. Sec. Corp., 56 F. Supp. 1007 (E.D.N.Y. 1944); In reQuality Beverage Co., Inc., 181 B.R. 887 (Bankr. S.D. Tex. 1995); In re County of Orange , 179 B.R. 195 (Bankr.

C.D. Cal. 1995) (an indenture trustee serving on a committee must act in the best interest of all creditors represented by the committee while working on the creditors’ committee); In re Nat’l Liquidators, Inc. , 171 B.R. 819 (Bankr.S.D. Ohio 1994) (committees do not act in best interest of the individual members, but serve to protect all creditors),aff’d in part, rev’d in part, 182 B.R. 186 (S.D. Ohio 1985); In re Mesta Machine Co ., 67 B.R. 151(Bankr. W.D. Pa. 1986); In re Johns-Manville Corp. , 26 B.R. 919 (Bankr. S.D.N.Y. 1983).202 In re Johns-Manville Corp. , 26 B.R. at 925.203 In re Nat’l Equip. & Mold Corp. , 33 B.R. 574 (Bankr. N.D. Ohio 1983).204 See, e..g., In re Mountain States Power Co. , 118 F.2d at 407; In re Standard Commercial Tobacco Co. , 34 F.Supp. 304, 310 (S.D.N.Y. 1940); In re Philadelphia & W. Ry. Co., 64 F. Supp. 738 (E.D. Pa. 1946).205 In re Haskell-Dawes, Inc. , 188 B.R. 515, 522 (Bankr. E.D. PA. 1995).




the case to chapter 7. 206 The court held these acts indicated the committee was not breaching its duty, but playing a productive role as a “watchdog” in the case.

Committees and their members do not owe a duty to constituencies either above or below them inthe debtor’s capital structure. Manville Corp. v. Committee of Equity Security Holders (In re Johns-

Manville Corp.). 207 Committee members have no responsibility to push the value envelope of the estateso that the equity security holders can receive a recovery. The bankruptcy system presumes that equitysecurity holders will zealously advocate their own interest if, in fact, there is a realistic opportunity forvalue to be recovered at that level. Similarly, a creditors’ committee has no duty to creditors with rightsor priorities senior to the committee’s unsecured constituency.

Even though the committee can aggressively and zealously promote its interests even at the riskof jeopardizing the interest of those not in its constituency, numerous circumstances can arise in thecourse of the committee’s operations which create perplexing problems for the committee members andtheir counsel. Frequently committees are composed of both trade creditors and unsecured creditors whohave contractually subordinated their claims either to another group of unsecured creditors or to someform of senior debt. The potential for conflicts and casualties even within the creditors’ committeeconstituency may not be readily apparent. On the one hand, senior unsecured creditors have the potentialfor voting the interests, not only of their senior debt, but also the interests of the junior debt. In most ofthe larger cases, the combined funded debt of senior and junior subordinated debt will constitute the vastmajority (frequently 90+%) of the total unsecured debt in the case. The senior debtholders, takingadvantage of their subordination rights, may elect to pursue a quick conservative resolution of the caseeven though that result may pose little or no recovery to the subordinated debt and a diminished recoveryto the trade. By the same token, typically committees are initially organized by holders of subordinateddebt who recognize early that most impairment will occur at their level. By early aggressive action, thesubordinated debtholders are frequently able to get control of a pre-petition unofficial committee andtranslate that control into control of an official committee. In many cases, the subordinated debt ends upselecting counsel and financial advisors and becoming chairman of the committee. The approach to thecase of a committee controlled in this fashion will be a virtual mirror image of the approach taken in acase in which senior debt controls. Under these circumstances, when the sub-debt essentially is playingwith senior constituency’s money, the committee may adopt an extremely aggressive, very high riskstrategy involving such things as attempts to subordinate senior debt, assertion of speculative lenderliability claims against secured creditors and pursuit of litigation strategies of questionable pedigreeagainst third-parties. Again, trade creditors are frequently caught in the middle and their opportunity torealize a meaningful dividend may be put into play by the adoption of an aggressive “roll-the-dice”strategy by a sub-debt dominated committee.

The fiduciary duties of members of a committee in a reorganization case have generally not beenconsidered to extend to the estate or any other interested party, other than constituents. As the courtrecognized in Johns-Manville ,:

No doubt, a committee and its members are fiduciaries for each of the parties that itrepresents . . . but neither a committee nor its members has any underlying duty to thedebtor or to the estate. Rather, a committee’s only duty is to pursue the interests of itsmembers. That pursuit, together with the representation of other committees, collectivelyfurthers the reorganization process. 208

206 In re Seaescape Cruises, Ltd. , 131 B.R. 241 (Bankr. S.D. Fla. 1991).207 60 B.R. 842, 853-54 n.22 (S.D.N.Y. 1986), rev’d on other grounds , 801 F.2d 60 (2d Cir. 1986).208 In re Johns-Manville Corp. ,60 B.R. at 853-54 n.22.




Not surprisingly, it has been held that a creditors’ committee cannot cram down a plan ofreorganization on its own constituency. 209 The court stated that to do so “would be to not only allow, butalso to encourage the committee to neglect its fiduciary duties.” 210

Committee members have a duty to fully inform their constituency of proceedings in the caseimpacting the financial interest of the committee members and their counsel. In In re Mesta MachineCo. ,211 the court held that failure of the members of a subclass of unsecured creditors (who had formed acommittee) to give notice of a proposed plan modification which would reduce distributions to the classand benefit committee members, was a breach of fiduciary duty. 212

8. Committee’s and Committee Members’ Liability

Because creditors’ committees have fiduciary duties to the creditors they represent, they can alsoincur liability for actions breaching those duties in a bankruptcy case. There is no specific grant ofimmunity from liability for committee members in the Bankruptcy Code except for Section 1125(e),which protects a committee member from violation of the securities laws for good faith solicitations ofacceptances or rejections of a plan in a chapter 11 bankruptcy case.

One of the first and most far-reaching cases interpreting the fiduciary duties of a creditors’committee is In re Tucker Freight Lines, Inc .213 In Tucker Freight , the plaintiff, sole shareholder andunsecured creditor of the debtor, sued certain of the members of the official unsecured creditors’committee, alleging that the defendants unlawfully and intentionally or recklessly committed tortious actswhich resulted in denial of confirmation of the debtor’s chapter 11 plan and the conversion of debtor’scase to a case under chapter 7. 214 Specifically, the committee, by permission of the court, included in the

ballot package a letter giving the committee’s recommendations. The letter, which had not been reviewed by the court, recommended rejection of the plan of reorganization. The letter also made statementsconcerning the debtors’ good faith, the debtor’s multi-employer pension plan withdrawal liability, and

purported tax benefits to the plaintiff. Subsequently, the class of unsecured creditors rejected the plan. 215

The plaintiff claimed that the committee’s letter made false and misleading statements. The plaintiff further alleged that the letter resulted from a fraudulent scheme in violation of the committee’sfiduciary duties. The defendants claimed that, as members of a statutory creditors’ committee, theyenjoyed an absolute immunity against lawsuits such as the one brought by the plaintiff. 216 The

bankruptcy court refused to read an implicit grant of absolute immunity into Section 1103 of theBankruptcy Code. Rather, the court stated that implicit in the authority vested in the committee bySection 1103 must also be a concurrent fiduciary duty to all the unsecured creditors:

At a minimum, this fiduciary duty requires that the committee’s determinations must behonestly arrived at, and, to the greatest degree possible, also accurate and correct. For acreditors’ committee to urge rejection of a plan for reasons they knew, or would have

209 In re Cara Corp. , No. 90-15397S, 1992 WL 88189 (Bankr. E.D. Pa. April 27, 1992).210 Id. at *14987211 67 B.R. 151 (Bankr. W.D. Pa. 1986).212 In re Mesta Mach. Co. , 67 B.R. 151 (Bankr. W.D. Pa. 1986)213 62 B.R. 213 (Bankr. W.D. Mich. 1983).214 In re Tucker Freight Lines, Inc. , 62 B.R. 213.215 Id. at 215.216 Id. at 215-16.




known, but for their recklessness, to be false would violate this duty and deprive them ofany limited immunity they might otherwise hold under section 1103(c)(3). 217

The court also rejected the defendants’ contention that “if the Code is to function, the members ofthe creditors’ committee must have the same absolute immunity that Trustees do.” 218 Instead, the courtrecognized that trustees do not have “absolute” immunity, but may be held liable for intentionalwrongs. 219 Furthermore, the court stated, “the assumed tortious acts are not with [sic] the scope ofauthority of a Trustee, a debtor in possession, or a creditors’ committee.” 220 In Sowerwine v. Air Canada(In re REA Holding Corp.) ,221 the court found that the trustee stated a claim for relief in alleging thatindividual committee members had breached their fiduciary duty when they diverted business to thedebtor’s competition.

Bankruptcy courts have also sanctioned committee members and committee counsel for violatingthe automatic stay and Rule 9011 by filing a suit for improper purposes. 222 A bankruptcy court initiated acivil contempt proceeding sua sponte against the committee and committee counsel. 223 After anevidentiary hearing, the court found that the committee and committee counsel were each fifty percent(50%) culpable for violating the automatic stay and Rule 9011 of the Federal Rules of BankruptcyProcedure in authorizing special counsel to the committee to file an action challenging transfers by thedebtor to another group of creditors. 224 The court held the committee members jointly and severally liablefor fifty percent (50%) of the awarded sanctions. 225

When parties pursue state court actions against committee members for actions taken in thecontext of a bankruptcy case, a bankruptcy court may have the power to enjoin those actions. 226

E. STANDARD OF REVIEW

What standard must a committee satisfy to avoid liability for breaching a fiduciary duty?Basically, the committee will have the benefit of the business judgment rule. If the committee is careful,attentive and loyal to its constituency, it should be able to avoid liability. At least one bankruptcy courthas held that committees as fiduciaries are subject to more rigorous scrutiny. 227 Mesta Machine basically

put the burden of proof on the committee to prove its non-liability. If any transactions are challenged, the

217 Id. at 216.218 Id. at 217.219 See Mosser v. Darrow , 341 U.S. 267 (1951).220 In re Tucker Freight , 62 B.R. at 217-18.221 8 B.R. 75 (Bankr. S.D.N.Y 1980)222 Official Unsecured Creditors Committee of General Homes Corp. v. American Savings & Loan Ass’n of Florida(In re General Homes Corp.) , 181 B.R. 870 (Bankr. S.D. Tex. 1994); Robert S. Blanc, Putting a Limit on UnlimitedCreditors’ Committee Liability , 13 B ANKR . DEV. J. 359 (Spring 1997).223

In re General Homes Corp. , 181 B.R. at 877.224 Id. at 876.225 Id. at 883.226 See, e.g., In re Burstein-Applebee Co. , 63 B.R. 1011 (Bankr. W.D. Mo. 1986). A bankruptcy court has

permanently enjoined a state court libel and defamation suit filed against committee members in state court forstatements made by the committee members to a trade publication. The bankruptcy court found that not only werethe members’ statements made in good faith, but may have been required to fulfill their fiduciary duties to informthe creditor’s they represented the debtor’s condition. The bankruptcy court found it not only necessary but the“inescapable duty” of the court to issue a permanent injunction. Id. at 1019-20.227 In re Mesta Mach. Co. , 67 B.R. 151, 157 (Bankr. W.D. Pa. 1986).




committee as a fiduciary must not only prove its good faith but also show that the transaction wasinherently fair.

In Mesta Machine the committee was a special unsecured creditors’ committee representing thehourly employees of the debtor. The committee members took actions, pursuant to a plan modification,that was not served on the committee’s constituents which, for the benefit of the members and committeecounsel, lowered the amount the class members would receive under the plan. The bankruptcy courtfound that this was a breach of the fiduciary duties the committee owed to their class. 228 For the

breaching of their fiduciary duties, the court ordered that all money received by both the committeemembers and counsel were to be repaid to the bankruptcy court clerk. Further, the court found them

jointly and severally liable when they acted together in a breach of their duties. 229

Other courts have set a somewhat higher threshold of willful misconduct, which must be proven before a committee can be held liable for its actions. Several courts that have considered the issue haveapplied the willful misconduct standard before the court will find the committee’s qualified or limitedimmunity should be set aside for the actions it took. 230

Misconduct allegations were raised against the creditors’ committee in the Pan Am bankruptcy.In Pan Am I , Delta Airlines (“Delta”) had asserted a claim for relief against the Pan Am creditors’committee. 231 Delta asserted that the committee and its members were principal wrongdoers contributingto the failure of the Pan Am plan of reorganization. In particular, Delta alleged that the committee acted

beyond the scope of its statutory duties by de facto becoming a joint proponent of the plan ofreorganization and then by manipulating the reorganization process without regard to the viability of thereorganized Pan Am or the feasibility of a proposed plan of reorganization solely to improve, at any cost,their potential recovery. The committee asserted entitlement to qualified immunity from suit becausetheir actions were committed within the scope of their statutory authority under Section 1103. The courtacknowledged the existence of qualified immunity for creditor committee members’ conduct. Relyingupon the Drexel Burnham case, Pan Am court adopted a standard granting fairly broad immunity:

Based upon this case law concerning the qualified immunity of creditors’ committees andtheir members, any such immunity must be limited to actions taken within the scope ofthe committees’ authority as conferred by statute or the court and may not extend to“willful misconduct” of the committee or its members. 232

Pan Am II is the court’s decision on the merits of Delta’s claim against the creditors’committee. 233 The court found that Delta could not prove that any of its damages were a consequence ofthe admittedly obstructive and disruptive conduct of the committee as it related to Delta’s attempts tofund certain aspects of the Pan Am reorganization. The Pan Am II court initially observed that thecommittee had a substantial responsibility to assure that unsecured creditors’ views are heard and theirinterests promoted and protected. The court went on to observe that no duty ran from the committee toanyone other than its constituency, not Delta and not the debtor. The committee, therefore, enjoyed a

228 Id. at 159-60.229 Id. at 166.230 In re Drexel Burnham Lambert Group, Inc. 138 B.R. 717 (Bankr. S.D.N.Y. 1992), aff’d , 140 B.R. 347(S.D.N.Y. 1992); see Pan Am Corp. v. Delta Airlines Inc. , 175 B.R. 438 (S.D.N.Y. 1994) ( Pan Am II ); Luedke v.

Delta Air Lines, Inc. , 159 B.R. 385 (S.D.N.Y. 1993) ( Pan Am I ).231 Pan Am I , 159 B.R. 385.232 Pan Am I , 159 B.R. at 392-93.233 Pan Am II , 175 B.R. 438.




qualified immunity that corresponds to and is intended to further the committee’s exercise of its statutoryduties and powers. That immunity extends to conduct within the scope of the committee’s statutoryauthority. The Pan Am II court held that in order for the creditors’ committee to have liability, itsqualified immunity must be overcome by Delta and that Delta would have to prove that the committeeengaged in willful misconduct or “ ultra vires activity.” 234

The lesson of Tucker Freight , Drexel Burnham , Pan Am I and Pan Am II seems to be thatcreditors’ committees enjoy a fairly broad qualified immunity to aggressively pursue single-mindedly theinterest of unsecured creditors. So long as the committee is acting within the scope of its authority, anddoes not self-deal, it should enjoy immunity from suit.

In General Homes one Texas bankruptcy court has applied the willful conduct standard to actionsof a creditors’ committee for violations of the automatic stay. 235 The creditors’ committee filed anadversary proceeding for a cause of action belonging to the debtor without prior bankruptcy courtapproval. The committee had discussed the Louisiana World 236 case, but had concluded that LouisianaWorld did not impose an absolute requirement of prior court authorization for a committee to file anaction that was property of the estate. The bankruptcy court found that the committee had not compliedwith Louisiana World and this constituted a violation of the automatic stay, was willful misconductoutside of the committee’s limited immunity and subjected the committee members personally tosanctions. The court suggested that the debtor’s and certain secured creditor’s attorneys’ fees and costswould be the appropriate sanction against the committee members and its counsel. The committeemembers and counsel vigorously contested the bankruptcy court’s ruling and ultimately the reporteddecision was modified somewhat by an unreported decision entered in 1996.

Committee members may gain protection from liability in a confirmed plan, which they areunable to receive from the Bankruptcy Code. Often a Chapter 11 plan contains a provision releasingcommittee members from any liability for actions they took while serving on the committee. 237

F. COURT APPROVED COUNSEL AND OTHER PROFESSIONALS FORDEBTORS, TRUSTEES, EXAMINERS, AND COMMITTEES

Court approved counsel and professionals owe a fiduciary duty to their clients. DIP counsel and professionals also owe a fiduciary duty to the creditors and parties-in-interest to the bankruptcy estate.Committee counsel and professionals owe a fiduciary duty to all creditors, not merely the creditorscomprising the committee. Trustees and examiners and professionals employed by trustees andexaminers, owe a fiduciary duty to bankruptcy estate and to maximize returns for the unsecured creditors.

The trustee or DIP attorneys have a high fiduciary duty to the represented estate. 238 Thetrustee/DIP counsel owes a fiduciary duty to the bankrupt corporate estate and not the interest of the

234 Pan Am II , 175 B.R. at 514-15.235 Official Unsecured Creditors’ Committee of Gen. Homes Corp. v. Am. Savings & Loan Ass’n of Fla. (In re Gen.

Homes Corp.) , 181 B.R. 870 (Bankr. S.D. Tex. 1994).236 Louisiana World Exposition v. Fed. Ins. Co. , 858 F.2d 233 (5th Cir. 1988).237 See In re L.F. Rothschild Holdings, Inc. , 163 B.R. 45 (S.D.N.Y. 1994); In re Drexel Burnham Lambert Group,

Inc. , 138 B.R. 717.238 See, e.g., In re Evangeline Refining Co ., 890 F.2d 1312, 1323 (5th Cir. 1989); In re Consol. Bancshares , 785F.2d 1249, 1255 (5th Cir. 1986).




corporate principals. 239 The trustee/DIP counsel has a fiduciary duty to the bankruptcy estate, includingthe beneficiaries and the creditors. 240

One bankruptcy court summarized DIP or trustee’s counsel’s fiduciary duties as:

An attorney retained by the trustee, or debtor in possession, who assists with thecollection of the assets of the estate, must abide by the highest professionalstandards. ‘Not honesty alone, but the punctilio of an honor the most sensitive, ishe standard of behavior.’ 241 An attorney’s duty goes beyond not merely puttingfalse evidence before the court; the duty is greater—the lawyer has a duty to notmake misrepresentations to the court. 242

Several courts have ruled that DIP counsel does not owe a fiduciary duty to specific creditors. 243 Some courts, such as In re Sidco, Inc. and Hansen, Jones & Leta, P.C. v. Segal have found that DIPcounsel does not owe a fiduciary duty to the bankruptcy estate, its beneficiaries or its creditors. 244 In

Hansen, Jones & Leta, P.C. , the court found that DIP counsel did not owe a fiduciary duty to the beneficiaries of estate because the beneficiaries were not the clients. 245 The Sideco and Hansen, Jones & Leta, P.C. decisions relied on the fact that the Bankruptcy Code does not contain a provision imposing afiduciary duty of DIP counsel; rather, the Bankruptcy Code imposes a duty on the DIP itself.

The Southern District of Texas in ICM Notes, Ltd. v. Andrews & Kurth, L.L.P , ruled that DIPcounsel owed a general fiduciary duty to preserve the bankruptcy estate, however, this duty did not extendto a particular creditor. 246 In ICM Notes , ICM Notes purchased the debtor’s outstanding notes andelevated to the position as secured lender. 247 ICM Notes then sued the debtor’s counsel, Andrews &Kurth for breach of its fiduciary duties and tortious interference related to a foreclosure of ICM Notes’holdings. 248 The district court acknowledged that DIP counsel owed a fiduciary duty to the debtor-clientand the bankruptcy court, and recognized that many courts have employed a fiduciary duty to the

bankruptcy estate as a whole. 249 The district court ruled that the DIP counsel did not owe a fiduciary dutyto a specific creditor, ICM Notes, and reasoned: “finding that debtor’s counsel owes a particular duty toan individual creditor in a Chapter 11 bankruptcy proceeding would prevent counsel from representing hisclient in accordance with the provisions of the Bankruptcy Code.” 250 The district court noted that ICM

Notes was represented by independent legal counsel and that a ruling that DIP counsel owes a fiduciaryduty to a particular creditor “is contrary to the tenet of the Bankruptcy Code mandating that debtor’s

239 See ,e.g., In re Grabill Corp. , 113 B.R. 966, 970 (Bank. N.D. Ill. 1990).240 In re Wilde Horse Enterprises, Inc. , 136 B.R. 830, 840 (Bankr. C.D. Cal. 1991).241 Id. at 840 (quoting In re Thompson , 54 B.R. 311, 315 (Bankr. N.D. Ohio 1985) (quoting Judge Cardozo in

Meinhard v. Salmon , 249 N.Y. 458, 464 (1928)) and In re Disciplinary Action Curl , 803 F.2d 1004, 1005-06 (9thCir. 1986)).242 Id. at 840.243 See, e.g., ICM Notes, Ltd. v. Andrews & Kurth, L.L.P. , 278 B.R. 117 (S.D. Tex. 2002), aff’d, In re ICM Notes

Ltd. , 324 F.3d 768 (5th Cir. 2003); Hansen, Jones & Leta, P.C. v. Segal , 220 B.R. 434 (D. Utah 1998).244 In re Sidco, Inc. , 173 B.R. 194 (E.D. Cal. 1994); Hansen, Jones & Leta, P.C. v. Segal , 220 B.R. 434 (D. Utah1998).245 Hansen, Jones & Leta, P.C. , 220 B.R. at 457.246 ICM Notes, Ltd. v. Andrews & Kurth, L.L.P. , 278 B.R. at 123.247 Id. at 119.248 Id. 249 Id. (citing Brown v. Gerdes , 321 U.S. 178, 182, 64 S. Ct. 487 (1944) and In re JLM, Inc. , 210 B.R. 19, 25 (2d Cir.BAP 1997)).250 Id. at 126.




counsel be disinterested.” 251 The ICM Notes case was affirmed, without written opinion, by the FifthCircuit in 2003. 252

V. POTENTIAL USE OF SPECIAL CONFLICTS COUNSEL

A relatively new creature in bankruptcy is the use of special conflicts counsel. In several large bankruptcies, the courts have approved the use of special conflicts counsel to represent creditors anddebtors in bankruptcy. Often times, a party’s law firm of choice has conflicts that prevent the law firmfrom representing the party in bankruptcy. In order not to deprive a party of effective legal counsel, thecourts are approving the employment of two sets of counsel – one primary counsel and a conflicts counselto represent the party when the primary counsel has a conflict of interest. 253 In the Enron bankruptcy,

primary counsel for the creditors committee was Milbank, Tweed, Hadley & McCloy, LLP, while SquireSanders & Dempsey, LLP served as conflicts counsel. 254 Although a creditor challenged the retention ofMilbank, Tweed, Hadley & McCloy, LLP, the court ultimately employed the firm as primary counselwith the use of conflict counsel.

Although conflict counsel has been used in several large bankruptcies, questions arise as theappropriateness of special conflict counsel. The use of conflicts counsel in large bankruptcies may beappropriate for certain circumstances, however, the effectiveness of primary counsel and conflicts counselmust be monitored. The use of several law firms in one case can be expensive and duplicative.Furthermore, law firms may differ on tactics to take in a case, therefore causing internal conflict andweakening the position of the represented client. Conflict counsel has a place in bankruptcy practice;however, other remedies and solutions should be explored with more detail before the bankruptcyindustry adopts this practice as standard procedure.

251 Id. 252 ICM Notes, Ltd. v. Andrews & Kurth, L.L.P. , 278 B.R. 117 (S.D. Tex. 2002), aff’d, In re ICM Notes Ltd. , 324F.3d 768 (5th Cir. 2003).253 Mega-Case Conflict Issues: Enron Committee Counsel , 21 Sept. A M. BANKR . I NST . J. 20 (2002); David B.Young, Counsel as Preference Defendant and Conflicts Counsel: The Problems Posed by Pillowtex, Enron, andOther Cases , STATE BAR OF TEXAS 22 ND A NNUAL ADVANCED BUSINESS BANKRUPTCY COURSE , Chpt. 14.3 at 5

fiduciary duties for court appointed, court approved, code created or other mythical creatures in...

Documents