In my article Chapter 11, Corporate Governance and the Role of Examiners, I propose a possible solution to corporate governance problems caused by the debtor-in-possession model of Chapter 11 bankruptcy proceedings.

Agency and Law Enforcement Problems in Chapter 11

Corporate governance does not have many advocates in bankruptcy proceedings. In a Chapter 11 action, managers run the company and have to take many heterogeneous interests into account. However, they do not always have incentives to do so. Depending on the circumstances, management relies either on the shareholders or on the influential creditors. The latter – hedge funds, private equity funds, and other sophisticated creditors – usually hold the most sway. Minor creditors and other stakeholders usually have little influence on the reorganization process and can be outsmarted not only through an unfavorable reorganization plan, but also through actions taken by management, shareholders, and main creditors prior to or within bankruptcy. Potential discriminatory actions include illegal payments to stakeholders (fraudulent conveyances), illegitimate benefits being provided to certain influential creditors (preference transfers), and the non-enforcement of claims against management. These claims can amount to hundreds of millions or even billions of dollars. In the Caesars bankruptcy, for instance, the examiner found likely fraudulent transfers of from $3.6 billion to $5.1 billion.[1]

Weak Control Mechanisms

Of course, many of these actions are illegal. But who should detect and correctly evaluate them? It seems unlikely that management will, since it has often violated the law in favoring one party over others. The creditors’ committee might, but creditors’ committees are appointed in only about half the cases. They are also criticized as being inactive or ineffective, and their members can be targets of investigations. Finally, the bankruptcy court can only detect wrongdoing if insiders disclose it or it is obvious from the materials submitted to the court by the debtor. A further obstacle to detection is the incentive of management and perhaps other parties to cover up improprieties. Under-detection and under-prosecution are thus likely and lead to under-deterrence.

Examiners as an Alternative

Only two possibilities remain: the appointment of trustees or examiners. Trustees are problematic, though, because their frequent appointment would undermine the debtor-in-possession model of Chapter 11. It should therefore be a last resort. Bankruptcy courts, especially in Delaware,^[2] are also very reluctant to appoint examiners, in part because they were considered costly and their investigations disruptive of the reorganization process and the operation of the business. This perception, however, has shifted because examiners can conduct valuable neutral investigations without entirely replacing management. Some scholars^[3] as well as the SABRE-Report from 2004^[4] have argued for the more frequent use of examiners. The most prominent support has come recently from the American Bankruptcy Institute (ABI) Reform Proposal.^[5]

In my paper, I show that examiners can greatly benefit the bankruptcy process by investigating potential infringements and deterring wrongdoing. Given management’s incentives and the lack of control over it, examiners should be appointed more often.

The Concept of Preliminary Examiners

As examiners have advantages and disadvantages, it is not a trivial task for bankruptcy courts to decide whether they should appoint an examiner in a given case. To address this difficulty, I propose the use of “preliminary examiners,” whose sole task would be to conduct a preliminary investigation rather than a detailed or comprehensive one and to help the court determine whether a more substantial investigation is warranted. A preliminary examiner would look for any indication of unlawful actions, such as improper payments to shareholders, managers, or certain creditors prior to bankruptcy. Only if any were found would the preliminary examiner then recommend the appointment of an ordinary examiner. . This would help to reduce costs in cases in which an examiner would otherwise have been appointed (e.g. mandatorily upon request of a party in a large case) or where the scope of the mandate would have been unnecessarily broad due to the court’s lack of information. Further, after the preliminary examiner’s report, the bankruptcy court would be better positioned to evaluate which professional fees should be approved, e.g. for a creditors’ committee’s investigation.

The main advantages of preliminary examiners would be substantially lower costs, less disruption of the business, and fewer delays in the reorganization process. Their appointment would, at the same time, ensure the detection and avoidance of violations of the law in the bankruptcy case, and would lead to a higher exposure rate of violations of corporate governance and bankruptcy duties. Consequently, those violations could be corrected more often, and greater deterrence would result. Creditors, shareholders, or managers who must fear investigations would have fewer incentives to illegally favor one party over others, especially if such actions were not only reversed but also penalized, e.g., by equitable subordination, liability claims, or even criminal charges. Honest stakeholders, on the other hand, would have more reason to trust in the integrity of the bankruptcy system. Overall, a regular appointment of preliminary examiners would have a positive effect on corporate governance in bankruptcy.

Preliminary Examiners and the Bankruptcy Code

Although not explicitly mentioned, preliminary examiners can already be appointed under the Bankruptcy Code. Bankruptcy courts have vast discretion over the scope of the mandate of ordinary examiners. Preliminary examiners would simply be examiners with a very limited mandate. It is only where the initial investigation reveals the need for something more that the court would need to expand the examination.

Nonetheless, I propose amendments to the Bankruptcy Code to make the appointment of preliminary examiners routine. Exceptions would only occur for very small cases and for cases in which management could prove to the bankruptcy court the absence of any wrongdoing. Management should bear that burden of proof because it has access to all corporate books and other documents and has an incentive to prevent the appointment of a preliminary examiner. This amendment would, even if no preliminary examiner were appointed, make more information available to the bankruptcy court and lead to better decisions by bankruptcy courts in all Chapter 11 cases.

ENDNOTES

[1] See Report of Richard J. Davis, as Examiner, In re Caesars Entm’t Operating Co., Inc., No. 15-01145, 2016 Bankr. LEXIS 4529 (Bankr. N.D. Ill. May 18, 2016), https://online.wsj.com/public/resources/documents/CaesarsReport03-16-2016.pdf.

[2] See Jonathan C. Lipson & Christopher F. Marotta, Examining Success, 90 Am. Bankr. L.J. 1, 27 (2016).

[3] Jonathan C. Lipson, Understanding Failure: Examiners and the Bankruptcy Reorganization of Large Public Companies, 84 Am. Bankr. L.J. 1, 43, 59 (2010); Jonathan C. Lipson, The Shadow Bankruptcy System, 89 B.U. L. Rev. 1609, 1626-1627 (2009); Jonathan C. Lipson & Christopher F. Marotta, Examining Success, 90 Am. Bankr. L.J. 1, 50-51 (2016) (in favor of “mini-examiners”); Lynn M. LoPucki, The Debtor in Full Control – Systems Failure Under Chapter 11 of the Bankruptcy Code? Second Installment, 57 Am. Bankr. L.J. 247, 252-253 (1983).

[4] Second Report of the Select Advisory Committee on Business Reorganization, 60 Bus. Law 277, 307 (2004)

[5] See Am. Bankr. Inst., Commission to Study the Reform of Chapter 11, Final Report and Recommendations 2012‑14, 32-38, https://abiworld.app.box.com/s/vvircv5xv83aavl4dp4h.

This post comes to us from Stefan Korch, senior research fellow at the Max Planck Institute for Comparative and International Private Law in Hamburg, Germany. It is based on his forthcoming article, “Chapter 11, Corporate Governance and the Role of Examiners,” available here.