Exploring the Role of Creditors’ Committees in Directing the Affairs of a Chapter 11 Debtor
Chapter 11 of the Bankruptcy Code allows the existing management of a debtor to remain in control of the company as a “debtor in possession” (“DIP”) while negotiating a restructuring (or liquidation) of its affairs in the form of a chapter 11 plan. Among other things, this means that the DIP is authorized to operate its business in the ordinary course without bankruptcy-court approval and that the court will generally defer to the DIP’s business judgment in doing so. One of the underlying policies of the Bankruptcy Code is that the persons in the best position to operate the debtor’s business are its current management team, rather than newly appointed outsiders with little familiarity with the debtor’s business operations.
In some instances, however, the court or parties in interest lose faith in the DIP’s ability to exercise sound business judgment. At other times, the DIP may be overly influenced or controlled by a third party. In such circumstances, the Bankruptcy Code establishes specific mechanisms to ensure that the interests of the estate and all stakeholders are protected. These include procedures for: (i) terminating the DIP’s exclusive right to propose and solicit acceptances of a chapter 11 plan; (ii) the appointment of an examiner to investigate the debtor’s affairs; or (iii) in cases of fraud, mismanagement, or other specified types of misconduct or incompetence, the appointment of a chapter 11 trustee to manage the debtor’s affairs and steward it toward confirmation of a chapter 11 plan.
Creditors and other stakeholders also play a role in acting as a watchdog over a DIP’s conduct, most notably in the form of official committees of creditors (or shareholders) appointed in a chapter 11 case that are conferred with statutory powers under section 1103 of the Bankruptcy Code. These powers include, among other things, the ability to: (i) consult with the DIP or chapter 11 trustee concerning administration of the case; (ii) investigate the DIP’s conduct and affairs to evaluate whether its business should be continued; (iii) participate in the formulation of a chapter 11 plan; (iv) request the appointment of a trustee or examiner; and (v) “perform such other services as are in the interest of those represented.” A ruling recently handed down by an Illinois bankruptcy court addresses the breadth of an official committee’s role in seeking court intervention to control a DIP’s management of its business affairs. In In re Commercial Mortgage and Finance Company, the court granted a motion by the official committee of unsecured creditors to impose liens on the assets of a chapter 11 debtor’s wholly owned nondebtor subsidiaries to secure creditors’ recoveries against the debtor-parent and to restrict the ability of the debtor and its subsidiaries to enter into loan transactions and transfer bank deposits.
CMFC had suffered operating losses throughout the decade prior to its bankruptcy filing and acknowledged that any chapter 11 plan would provide for the orderly liquidation of its assets (including the sale and liquidation of the assets of its subsidiaries) and cessation of its business. Based upon those circumstances and admissions, the official committee of CMFC’s unsecured creditors (the “Committee”) sought an order from the bankruptcy court: (i) imposing liens and encumbrances on the assets of CMFC’s nondebtor subsidiaries to secure recoveries for CMFC’s creditors; (ii) restricting the ability of CMFC and its subsidiaries to enter into new loan transactions; and (iii) directing that any proceeds from the sale of CMFC or its subsidiaries, or their respective assets, be deposited into a restricted, segregated bank account.
According to the Committee, it was the “[c]ourt’s responsibility to protect creditors’ interests from the actions of inexperienced, incapable, or foolhardy management, whether old or new.” CMFC countered that, as a DIP, it had the authority to operate the estate in the ordinary course of business and that the Committee was attempting to usurp this right.
In its decision, the bankruptcy court explained that, pursuant to section 1107(a) of the Bankruptcy Code, a DIP’s right to conduct ordinary-course business affairs is subject “to such limitations as the court may prescribe,” particularly where such limitations are imposed to protect creditors’ interests. Furthermore, the court noted, when a DIP is liquidating its business, its business decisions are not entitled to the same degree of deference as those of a reorganizing debtor.
The bankruptcy court then addressed whether it had the equitable power to impose liens on the assets of CMFC’s nondebtor subsidiaries for the benefit of CMFC’s creditors. The court acknowledged that each corporation is a separate legal entity and that, unlike a subsidiary’s stock, a subsidiary’s assets are not part of the parent company’s bankruptcy estate. Even so, the bankruptcy court concluded, “the assets of subsidiaries should be subject to the debts of creditors of the parent corporation where necessary to avoid fraud and injustice.” Moreover, the court stated, “courts may extend jurisdiction to the assets of a debtor’s subsidiaries to restrain the subsidiaries from using their assets to the detriment of the interests of the debtor’s creditors.” In fact, the court remarked, “pursuant to 11 U.S.C. § 105, courts have a duty to preserve the assets of the debtor and its subsidiaries for the benefit of creditors when a plan includes the sale and liquidation of all of the assets of the debtor and its subsidiaries.”
CMFC argued that the imposition of liens on its assets and the assets of its nondebtor subsidiaries for the benefit of CMFC’s unsecured creditors amounted to a sub rosa chapter 11 plan that would give the Committee’s constituency priority to the detriment of administrative claimants, including real estate tax, utility, payroll, and other administrative claims. The court rejected this argument, explaining that the secured claims would be capped at the priority levels set forth in section 507 (delineating the hierarchy of priority unsecured claims), that CMFC had no secured creditors, and that CMFC would be liquidated rather than reorganized. Moreover, the bankruptcy court explained, the aim of the proposed liens was to prevent CMFC “from dissipating its assets under the guise of independent action on the part of its subsidiaries.”
Next, the court considered whether its equitable powers extended to restricting loan transactions among CMFC, its subsidiaries, and third parties. Among other things, CMFC argued that the Committee’s mandate under section 1103(c) of the Bankruptcy Code did not extend to seeking such relief from the court. Noting that official committees generally act in an advisory capacity to the trustee or DIP, the court emphasized that a committee can also properly engage in a very broad range of additional activities. In particular, the court explained, section 1103(c)(5) states that an official committee can “perform such other services as are in the interest of those represented.” Looking to prior case law, the court concluded that the general language of section 1103(c)(5) should be construed to embrace only duties similar in nature to those listed in sections 1103(c)(1)–(4). For example, an official committee cannot partake in legislative lobbying activities that are independent of the bankruptcy case.
In this instance, the bankruptcy court determined that the relief requested by the Committee fell within the scope of section 1103(c). The court concluded that “[i]n light of the unique circumstances, including Debtor’s ten consecutive years of operating losses, the imminent liquidation plan and the lack of any secured creditors,” the Committee’s motion to restrict loan transactions should be granted. For the same reasons, the court approved the Committee’s request to require that proceeds from the sale of CMFC or its subsidiaries, or their respective assets, be deposited into a separate, restricted bank account.
In some instances, however, the court or parties in interest lose faith in the DIP’s ability to exercise sound business judgment. At other times, the DIP may be overly influenced or controlled by a third party. In such circumstances, the Bankruptcy Code establishes specific mechanisms to ensure that the interests of the estate and all stakeholders are protected. These include procedures for: (i) terminating the DIP’s exclusive right to propose and solicit acceptances of a chapter 11 plan; (ii) the appointment of an examiner to investigate the debtor’s affairs; or (iii) in cases of fraud, mismanagement, or other specified types of misconduct or incompetence, the appointment of a chapter 11 trustee to manage the debtor’s affairs and steward it toward confirmation of a chapter 11 plan.
Creditors and other stakeholders also play a role in acting as a watchdog over a DIP’s conduct, most notably in the form of official committees of creditors (or shareholders) appointed in a chapter 11 case that are conferred with statutory powers under section 1103 of the Bankruptcy Code. These powers include, among other things, the ability to: (i) consult with the DIP or chapter 11 trustee concerning administration of the case; (ii) investigate the DIP’s conduct and affairs to evaluate whether its business should be continued; (iii) participate in the formulation of a chapter 11 plan; (iv) request the appointment of a trustee or examiner; and (v) “perform such other services as are in the interest of those represented.” A ruling recently handed down by an Illinois bankruptcy court addresses the breadth of an official committee’s role in seeking court intervention to control a DIP’s management of its business affairs. In In re Commercial Mortgage and Finance Company, the court granted a motion by the official committee of unsecured creditors to impose liens on the assets of a chapter 11 debtor’s wholly owned nondebtor subsidiaries to secure creditors’ recoveries against the debtor-parent and to restrict the ability of the debtor and its subsidiaries to enter into loan transactions and transfer bank deposits.
Commercial Mortgage
Commercial Mortgage and Finance Company (“CMFC”) filed for chapter 11 protection in October 2008 in Illinois. Prior to its filing, CMFC and its wholly owned subsidiaries made mortgage loans to third parties. CMFC’s creditors made unsecured loans to CMFC, which, in turn, loaned such funds to its wholly owned subsidiaries. These subsidiaries would then loan funds to third parties, oftentimes on an unsecured basis. At the time of its chapter 11 filing, CMFC had no secured creditors, and its assets included the equity in its wholly owned subsidiaries, as well as the significant debt owed by the subsidiaries to CMFC. CMFC’s subsidiaries did not file for chapter 11 protection.
CMFC had suffered operating losses throughout the decade prior to its bankruptcy filing and acknowledged that any chapter 11 plan would provide for the orderly liquidation of its assets (including the sale and liquidation of the assets of its subsidiaries) and cessation of its business. Based upon those circumstances and admissions, the official committee of CMFC’s unsecured creditors (the “Committee”) sought an order from the bankruptcy court: (i) imposing liens and encumbrances on the assets of CMFC’s nondebtor subsidiaries to secure recoveries for CMFC’s creditors; (ii) restricting the ability of CMFC and its subsidiaries to enter into new loan transactions; and (iii) directing that any proceeds from the sale of CMFC or its subsidiaries, or their respective assets, be deposited into a restricted, segregated bank account.
According to the Committee, it was the “[c]ourt’s responsibility to protect creditors’ interests from the actions of inexperienced, incapable, or foolhardy management, whether old or new.” CMFC countered that, as a DIP, it had the authority to operate the estate in the ordinary course of business and that the Committee was attempting to usurp this right.
In its decision, the bankruptcy court explained that, pursuant to section 1107(a) of the Bankruptcy Code, a DIP’s right to conduct ordinary-course business affairs is subject “to such limitations as the court may prescribe,” particularly where such limitations are imposed to protect creditors’ interests. Furthermore, the court noted, when a DIP is liquidating its business, its business decisions are not entitled to the same degree of deference as those of a reorganizing debtor.
The bankruptcy court then addressed whether it had the equitable power to impose liens on the assets of CMFC’s nondebtor subsidiaries for the benefit of CMFC’s creditors. The court acknowledged that each corporation is a separate legal entity and that, unlike a subsidiary’s stock, a subsidiary’s assets are not part of the parent company’s bankruptcy estate. Even so, the bankruptcy court concluded, “the assets of subsidiaries should be subject to the debts of creditors of the parent corporation where necessary to avoid fraud and injustice.” Moreover, the court stated, “courts may extend jurisdiction to the assets of a debtor’s subsidiaries to restrain the subsidiaries from using their assets to the detriment of the interests of the debtor’s creditors.” In fact, the court remarked, “pursuant to 11 U.S.C. § 105, courts have a duty to preserve the assets of the debtor and its subsidiaries for the benefit of creditors when a plan includes the sale and liquidation of all of the assets of the debtor and its subsidiaries.”
CMFC argued that the imposition of liens on its assets and the assets of its nondebtor subsidiaries for the benefit of CMFC’s unsecured creditors amounted to a sub rosa chapter 11 plan that would give the Committee’s constituency priority to the detriment of administrative claimants, including real estate tax, utility, payroll, and other administrative claims. The court rejected this argument, explaining that the secured claims would be capped at the priority levels set forth in section 507 (delineating the hierarchy of priority unsecured claims), that CMFC had no secured creditors, and that CMFC would be liquidated rather than reorganized. Moreover, the bankruptcy court explained, the aim of the proposed liens was to prevent CMFC “from dissipating its assets under the guise of independent action on the part of its subsidiaries.”
Next, the court considered whether its equitable powers extended to restricting loan transactions among CMFC, its subsidiaries, and third parties. Among other things, CMFC argued that the Committee’s mandate under section 1103(c) of the Bankruptcy Code did not extend to seeking such relief from the court. Noting that official committees generally act in an advisory capacity to the trustee or DIP, the court emphasized that a committee can also properly engage in a very broad range of additional activities. In particular, the court explained, section 1103(c)(5) states that an official committee can “perform such other services as are in the interest of those represented.” Looking to prior case law, the court concluded that the general language of section 1103(c)(5) should be construed to embrace only duties similar in nature to those listed in sections 1103(c)(1)–(4). For example, an official committee cannot partake in legislative lobbying activities that are independent of the bankruptcy case.
In this instance, the bankruptcy court determined that the relief requested by the Committee fell within the scope of section 1103(c). The court concluded that “[i]n light of the unique circumstances, including Debtor’s ten consecutive years of operating losses, the imminent liquidation plan and the lack of any secured creditors,” the Committee’s motion to restrict loan transactions should be granted. For the same reasons, the court approved the Committee’s request to require that proceeds from the sale of CMFC or its subsidiaries, or their respective assets, be deposited into a separate, restricted bank account.
Outlook
Commercial Mortgage illustrates the extent to which official committees can have significant influence over the administration of chapter 11 cases. The result reached in Commercial Mortgage is unusual in terms of the scope of the relief granted to the Committee.
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In re Commercial Mortgage and Finance Co., 2009 WL 589673 (Bankr. N.D. Ill. Mar. 6, 2009).
