CLS Blue Sky Blog

What History Tells Us About the Value of Bankruptcy Directors

The proliferation of bankruptcy directors represents a controversial shift in the corporate governance landscape.  Independent directors appointed when a company experiences financial distress (known colloquially as “bankruptcy directors”) bring restructuring expertise and experience to a high-stakes situation.  Their appointment also insulates conflicted transactions and claims from the elevated scrutiny of derivative standing and entire fairness.  What would otherwise be negotiations between insiders on both sides (the board of directors, who are appointed by equity, and equity holders) is transformed into an unconflicted negotiation when the bankruptcy directors are delegated authority by the board of directors.  As a result, the bankruptcy court evaluates the bankruptcy directors’ decisions using the deferential business justification standard, and approval is usually perfunctory.

Critics, however, have questioned bankruptcy directors’ independence and cleansing effect.  Are bankruptcy directors really independent when their role includes negotiating with or investigating the same parties who appoint them?  Should their decisions be given deference when their appointments are associated with lower recoveries for creditors?

In a recent article, I apply historical and practical lessons to explain why bankruptcy courts should apply the entire fairness standard to evaluate whether bankruptcy directors have cleansing effect.  The  article’s main contribution is to examine the debate over bankruptcy directors through the lens of bankruptcy law’s historic struggles with conflicted corporate governance, informed by two recent cases that emphasize the need for a formal practice and show how my proposal could be applied.  This article’s framework for analyzing bankruptcy directors is rooted in the fact that while bankruptcy directors are new, the policy stakes here are not.  By tracing the history of case control and the treatment of conflicted transactions, the lessons gleaned from past practice can be applied within the current statutory framework while accounting for the impact of contemporary capital structures.

A bankruptcy case’s trajectory is commonly a function of who controls the case.  When the statutory framework is flexible, like the current Bankruptcy Code, market capacities and capital structures can empower parties.  Reflecting the prowess of private-equity sponsors and the ubiquitousness of financial distress at their portfolio companies,  sponsors often compete with lenders for primacy.

Case control manifests in the treatment of conflicted transactions.  The appointment of bankruptcy directors at the behest of powerful insiders like private equity sponsors is simply the most recent example.  The appointments of independent co-receivers during the equity receivership era of the early 20th century present a compelling parallel.  The corresponding reforms of the Chandler Act, namely the mandatory appointment of independent trustees, went too far.  Cases languished because creditors were impotent and trustees lacked industry experience.  Reorganizations were rare and creditor recoveries were scant.  Reflecting these lessons, the Bankruptcy Code gives creditors more options in the face of conflicted transactions. They can request a disinterested fiduciary (an examiner or trustee) or rely upon common law protections provided by the entire fairness doctrine and derivative standing.  Creditors have resoundingly chosen the latter options; examiner and trustee appointments remain rare.

The numerous proposals for evaluating bankruptcy directors’ cleansing effect highlight their salience.  None of these suggestions, however, reflect the arc of bankruptcy case control, the development of safeguards covering conflicted corporate governance in bankruptcy, and the realities of bankruptcy case administration.

Professors Ellias, Kamar, and Kastiel propose that the creditors who will be affected by the bankruptcy directors’ decisions vote on whether the bankruptcy directors will have a cleansing effect.  Although they appropriately prioritize creditors’ interests, their solution would be hard to put into effect.  The identity of the affected creditors can be uncertain because the proposed voting occurs early in the case , when valuation is a moving target and the universe of claims is indefinite.  An electoral process, including accompanying education of creditors, would add further complexity to the often-chaotic opening month of the bankruptcy case.

Senator Warren and her legislative co-sponsors would empower unsecured creditor committees as the sole party with standing to prosecute conflicted claims.  One drawback of her proposal is that it ignores the debtor’s capital structure.  It is the fulcrum creditors (the lowest priority creditors who will receive a distribution) whose recoveries are altered by conflicted transactions.  Although unsecured creditors were once the default fulcrum security, blanket liens are now commonplace, and often secured creditors are the fulcrum security holders.  Yet, Warren’s proposal would eliminate the bankruptcy judge’s oversight role in granting derivative standing, where she can consider whose money is at issue and, correspondingly, who should have standing to pursue claims. Why should the unsecured creditors committee automatically enjoy power in excess of what they have traditionally possessed, when the committee’s constituents are often out of the money?

Ellis and Yeh suggest more liberal appointment of chapter 11 trustees and examiners and note the possibility of the bankruptcy judge selecting the bankruptcy directors.  Creditors have generally shunned court-appointed fiduciaries. Stakeholders naturally prefer to control the litigation of conflicted claims and transactions.  Their views should be respected; it is their money that is on the line.

Others, including former-Judge Jones, recommend greater disclosure requirements, including identification of bankruptcy directors’ connections with insiders who engineer their appointments.  Disclosure is certainly important, but making it the sole focus does not reflect the empirical findings that bankruptcy director appointments are correlated with lower creditor recoveries.  The risks are real and a higher burden for granting them cleansing authority is appropriate.

Indeed, that is what my proposal does by requiring the debtor to satisfy the entire fairness standard to treat bankruptcy directors as independent actors.  The proposal gives effect to the fair process and fair selection required by entire fairness through (i) a standardized protocol for the disclosure of connections between bankruptcy directors and the insiders who appoint them and (ii) a heightened burden for approval reflecting the structural bias endemic to bankruptcy directors’ relationship with the insiders.  All interested parties could object or support the debtor’s motion, and the bankruptcy judge can consider whose distributions are most at risk and give those parties’ views greater weight.  Reflecting the lessons from the past while acknowledging the reality of current bankruptcy practice, the proposal is flexible, workable, and creditor-focused.

This post comes to us from Professor Robert W. Miller at the University of South Dakota’s Knudson School of Law. It is based on his recent article, “Everyone is Talking About Bankruptcy Directors,” available here.

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