Official Committee Members: Fiduciary Duty Liability

Scenario 2: The claims of the debtor's secured lenders are undersecured. Certain committee members are bondholders with claims that are contractually subordinated to those of the secured lenders such that any dividend which the bondholder committee members would otherwise receive must be remitted to the secured lenders. Is it proper for the committee to allow the subordination issue affecting some of its members to shape its strategy to enhance recovery for unsecured creditors, even when unsecured creditors generally have no subordination restrictions?

These conflict-of-interest questions can cause concern for committee members, most of whom are typically relatively senior employees of the debtor's institutional or trade creditors. The committee member serves on the committee not as a public service, but because the member's employer has a very large claim against the debtor on account of which the service of the employee on the committee is advantageous to the employer. Committee members are justifiably concerned about being exposed to liability on account of the conflict between their obligation to advance their employer's interests and their fiduciary duty to unsecured creditors generally not clearly defined by the Bankruptcy Code. A committee member might reasonably fear that self-interest is not allowed at all, an expectation that would be nearly impossible to meet as a practical matter. However, if self-interest is allowed, is there a threshold at which it is no longer permissible and, if so, where is that threshold?

This article suggests that the inherent conflicts faced by committee members are best addressed by the committee's adoption and thoughtful use of procedures to first, clarify the scope of potential liability for committee members and, second, to use disclosure of potential conflicts to shield members from liability and to resolve conflict of interest issues as they arise.

Scope of Liability

Unfortunately, the decided cases often fail to clearly define the scope of committee member fiduciary duties. Where the conflict issue reaches the stage of actual litigation leading to a published decision, the court often has been dealing with fairly flagrant misconduct on the part of a committee member and the court, not burdened by a close question of fact, may contrast the quite obvious misconduct with the exalted standard for the conduct of a fiduciary set out in the grand words of Justice Cardozo:

“Many [11] forms of conduct permissible in a workaday world for those acting at arm's length, are forbidden by those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the 'disintegrating erosion' of particular exceptions. Only thus has the level of conduct for fiduciaries been kept [at] a level higher than that trodden by the crowd.”

See In re Mesta Machine Co., 67 B.R. 151, 157 (Bankr. W.D. Pa.1986) (finding a breach of fiduciary duty where members of a special committee engaged in rampant self-dealing and resisted requests for an accounting; quoting Justice Cardozo in Meinhard v. Salmon, 164 N.E. 545, 546 (N.Y. 1928)). This elegant prose, however, is of little help in delineating fiduciary duty standards for application to the common conflicts that can arise in the committee setting and fails to provide a basis for committee counsel's advice to a member trying to act responsibly in an inherently contradictory role.

There is some decisional law that provides protection to committee members who have acted in good faith despite the shadow of potential conflicts of interest. For example, members of official committees have a qualified immunity from suit with respect to their conduct as committee members. The exact formulation of this qualified immunity may somewhat depend on the jurisdiction; in the Third Circuit and in the Southern District of New York, committee members are generally immune from suit except for willful misconduct or ultra vires acts. See In re PWS Holding Corp., 228 F.3d 224, 246 (3rd Cir. 2000) (approving exculpatory language in a plan because committee members' liability is limited to willful misconduct and ulta vires acts); Pan Am Corp. v. Delta Airlines, Inc., 175 B.R. 438, 514 (S.D.N.Y. 1994) (judgment in favor of members where plaintiff failed to establish activities of committee in opposing a plan amounted to willful misconduct or ultra vires acts). In the words of the Pan Am court, ultra vires acts require a showing that the alleged impermissible conduct was engaged in “without any authority whatever … Willful misconduct requires a showing of either the intentional performance of an act with knowledge that the performance of that act will probably result in injury or the intentional performance of an act in such a manner as to imply reckless disregard of the probable consequences.” Id. at 514 n.66. Accordingly, advocacy within the committee deliberative process or casting a vote for a particular plan or committee strategy should not be an ultra vires act, even if self-interested, because such activity is precisely what committee members are expected to do regardless of motivation. (By contrast, trading in the debtor's securities using material, non-public information gained by committee membership is an ultra vires act and is the classic example of a prohibited activity.)

Bankruptcy courts also recognize that self-interest plays a role in committee member conduct and it is not per se improper. Self-interested conduct, without more, should not give rise to liability. “Conflicting points of view … are common when committee members act to protect their individual interests. Membership on a committee does not preclude members from pursuing their own interests so long as this can be done without running afoul of their fiduciary duties to all unsecured creditors.” See In re FAS Mart Convenience Stores, Inc., 265 B.R. 427, 432 (Bankr. E.D. Va. 2001) (finding, where committee member sought to establish its secured status and immediate turnover of $4 million of trust funds and committee sought disqualification of member, U.S. Trustee's failure to remove the committee member was an abuse of discretion).

The courts also acknowledge that trade creditor committee members may properly act to preserve a customer relationship with the debtor. “[C]onflicts of interest are not unusual in reorganizations. Materialmen creditors, for example, may sometimes prefer to forego payment for past sales in hopes of preserving a customer, while lenders may prefer liquidation and prompt payment.” See In re Altair Airlines, Inc., 727 F.2d 88, 90 (3rd Cir. 1984) (arguing in a pre-Bildisco decision that collective bargaining agents should not be the only self-interested creditors to be excluded from committees). One court has even suggested that a committee member may assert its self-interest at the expense of its constituency in limited circumstances:

“Although committee members owe fiduciary duties, they are hybrids who serve more than one master. Every member of the committee is, by definition, a creditor. Thus, he is [in] competition with every other creditor for a piece of a shrinking pie. He may assert his rights as a creditor to the detriment of the creditor body as a whole without running afoul of his fiduciary obligations.”

See In re Rickel & Assoc., Inc., 272 B.R. 74, 100 (Bankr. S.D.N.Y. 2002) (refusing to dismiss breach of fiduciary duty claim against committee member that purchased assets of the debtor, but only because he had special responsibility within the committee regarding such assets and took advantage of such responsibility, including misrepresenting their value to the committee).

Disclosure

Disclosure can have a protective effect in two ways. First, it is a fundamental tenet of fiduciary law that a fiduciary may often act where he has divided loyalties provided there has been full disclosure of self-interest. “If dual interests are to be served [by a fiduciary], the disclosure to be effective must lay bare the truth, without ambiguity or reservation, in all its stark significance.” See Rickel, 272 B.R. at 100 (quoting , 154 N.E. 303, 304 (N.Y. 1926) (Cardozo, J.)).

Second, the courts often show deference to the committee as to its informed decisions regarding committee conflicts of interest. See In re Enron Corp., 2002 Bankr. LEXIS 1720 (Bankr. S.D.N.Y. 2002) (finding it significant that the committee was unconcerned about Wendt v. Fischeran alleged conflict of interest and denying creditor's request to disqualify committee counsel); In re America West Airlines, 142 B.R. 901, 903 (Bankr. D. Ariz. 1992) (denying the request of former committee member, who had become a secured creditor, to be reappointed to the committee and observing that the decision of the committee itself was a factor in determining whether a creditor could adequately represent committee's interests).

A committee member, having disclosed its self-interest, and obtained committee support for its participation in the committee action, should be doubly protected. It will have made a full disclosure of its interest pursuant to fiduciary law and participated in the action on the strength of the committee's decision that such participation did not amount to an improper conflict of interest. In such circumstances, it is unlikely that courts would find that there had been willful misconduct or an ultra vires act on the part of the committee member. Committee counsel could (and we suggest it should) provide further insulation from liability by providing the committee with its opinion on the potential conflict (which may be informal but should at least be memorialized), thereby allowing the committee member to defend itself further from attack with the additional defense of reliance on the advice of counsel.

Based on these dual principles of recognition of member self-interest and adequate disclosure, the following practical guidance is suggested for committee members and committee counsel: Committee counsel, at the outset of a Chapter 11 case, should make a presentation to the committee concerning committee members' fiduciary duties, together with a realistic assessment of where and how liability could arise for committee members. (The exhortative, “punctilio of honor” approach to fiduciary duty is not recommended here, as neither realistic nor providing practical guidance.) Thereafter, counsel should facilitate a full and frank exchange as to actual and potential areas of self-interest of the various committee members.

As the work of the committee progresses, the possibility of member self-interest should be considered by both committee members and committee counsel in connection with any significant action contemplated by the committee. If it appears that the self-interest of a committee member might materially affect its conduct in relation to the contemplated action, the committee member should consider recusing itself with respect to the action. Committee counsel should give its professional opinion regarding whe- ther the member's self-interest is so severe that it would likely prevent the member's ability to thoughtfully consider the affect of the issue on other creditors and thus should disable participation under the circumstances. If need be, the committee can vote on whether the conflict should prevent the committee member from participating with respect to the action. The minutes of the committee meeting should reflect the member's disclosure, any discussion of it, and any vote pertaining to the propriety of the committee member's participation.

The by-laws and procedures of the committee should specifically permit conflict of interest issues to be addressed in the foregoing manner. The by-laws should establish that committee members have an opportunity (but, to avoid becoming an independent source of liability, not a duty), to disclose material self-interests. The by-laws should expressly confirm that committee members have the full protection of the law with respect to carrying out their duties on the committee and that they may disclose any self-interest and vote, subject, of course, to any decision of the committee.

With these procedures in place, and referring to the self-interest problems posed at the beginning of this article, we suggest that the trade creditor committee member in Scenario 1 may support a plan option in which an advantageous business relationship would continue with the reorganized debtor, ideally after its self-interest has been fully disclosed and the committee, in its wisdom, has implicitly or explicitly (through a vote) permitted its participation. Similarly, the contractual subordination in Scenario 2 may properly shape the committee's strategy, again ideally, after the issue has been fully disclosed and subject to the informed consideration of the committee.

In summary, committee members are in an inherently contradictory position – selected because of the significance of their self-interest in the case, yet seemingly asked to put the interests of other creditors before their own. However, the qualified immunity that committee members enjoy suggests reasonable boundaries for what would otherwise appear to be excessive risk of liability that could arise from such a conflicted situation. Full disclosure of self-interest plus reliance on the committee's informed decision as to whether the self-interest amounts to a disabling conflict of interest in any given circumstance should shield the committee member from liability.

Members of official creditors' committees in Chapter 11 cases owe a fiduciary duty to the entire body of unsecured creditors. See Woods v. City National Bank , 312 U.S. 262, 268-69 (1941). As fiduciaries, committee members should have undivided loyalty to those they serve, free of any conflict of interest. Id. The imposition of such a broad duty to unsecured creditors generally might be otherwise unremarkable, except that committee members themselves obviously have significant selfish interests in the outcome of the bankruptcy case. See 11 U.S.C. ' 1102(b)(1) (committee shall ordinarily consist of the persons, willing to serve, that hold the seven largest claims against the debtor). In brief, bankruptcy law puts committee members in a contradictory position: They owe their membership on the committee to the magnitude of their self-interest in the case, yet they seem to be legally required to put the interests of others ahead of their own interests.

Accordingly, conflict of interest questions often arise in the committee setting. The following are not atypical:

Scenario 1: There are proposed competing plans of reorganization. Plan A would provide unsecured creditors with a 10% cash dividend. Plan B would provide reorganization securities to unsecured creditors, the value of which are very probably less than the 10% dividend offered by Plan A. However, an advantageous business relationship with the reorganized debtor would continue only under Plan B for a trade creditor member of the committee, but not for the bondholders whose claims constitute much of the unsecured debt in the case. May that trade creditor member vote in favor of a committee resolution to favor Plan B?

Scenario 2: The claims of the debtor's secured lenders are undersecured. Certain committee members are bondholders with claims that are contractually subordinated to those of the secured lenders such that any dividend which the bondholder committee members would otherwise receive must be remitted to the secured lenders. Is it proper for the committee to allow the subordination issue affecting some of its members to shape its strategy to enhance recovery for unsecured creditors, even when unsecured creditors generally have no subordination restrictions?

These conflict-of-interest questions can cause concern for committee members, most of whom are typically relatively senior employees of the debtor's institutional or trade creditors. The committee member serves on the committee not as a public service, but because the member's employer has a very large claim against the debtor on account of which the service of the employee on the committee is advantageous to the employer. Committee members are justifiably concerned about being exposed to liability on account of the conflict between their obligation to advance their employer's interests and their fiduciary duty to unsecured creditors generally not clearly defined by the Bankruptcy Code. A committee member might reasonably fear that self-interest is not allowed at all, an expectation that would be nearly impossible to meet as a practical matter. However, if self-interest is allowed, is there a threshold at which it is no longer permissible and, if so, where is that threshold?

This article suggests that the inherent conflicts faced by committee members are best addressed by the committee's adoption and thoughtful use of procedures to first, clarify the scope of potential liability for committee members and, second, to use disclosure of potential conflicts to shield members from liability and to resolve conflict of interest issues as they arise.

Scope of Liability

Unfortunately, the decided cases often fail to clearly define the scope of committee member fiduciary duties. Where the conflict issue reaches the stage of actual litigation leading to a published decision, the court often has been dealing with fairly flagrant misconduct on the part of a committee member and the court, not burdened by a close question of fact, may contrast the quite obvious misconduct with the exalted standard for the conduct of a fiduciary set out in the grand words of Justice Cardozo:

“Many [11] forms of conduct permissible in a workaday world for those acting at arm's length, are forbidden by those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the 'disintegrating erosion' of particular exceptions. Only thus has the level of conduct for fiduciaries been kept [at] a level higher than that trodden by the crowd.”

See In re Mesta Machine Co., 67 B.R. 151, 157 (Bankr. W.D. Pa.1986) (finding a breach of fiduciary duty where members of a special committee engaged in rampant self-dealing and resisted requests for an accounting; quoting Justice Cardozo in Meinhard v. Salmon , 164 N.E. 545, 546 (N.Y. 1928)). This elegant prose, however, is of little help in delineating fiduciary duty standards for application to the common conflicts that can arise in the committee setting and fails to provide a basis for committee counsel's advice to a member trying to act responsibly in an inherently contradictory role.

There is some decisional law that provides protection to committee members who have acted in good faith despite the shadow of potential conflicts of interest. For example, members of official committees have a qualified immunity from suit with respect to their conduct as committee members. The exact formulation of this qualified immunity may somewhat depend on the jurisdiction; in the Third Circuit and in the Southern District of New York, committee members are generally immune from suit except for willful misconduct or ultra vires acts. See In re PWS Holding Corp., 228 F.3d 224, 246 (3rd Cir. 2000) (approving exculpatory language in a plan because committee members' liability is limited to willful misconduct and ulta vires acts); Pan Am Corp. v. Delta Airlines, Inc. , 175 B.R. 438, 514 (S.D.N.Y. 1994) (judgment in favor of members where plaintiff failed to establish activities of committee in opposing a plan amounted to willful misconduct or ultra vires acts). In the words of the Pan Am court, ultra vires acts require a showing that the alleged impermissible conduct was engaged in “without any authority whatever … Willful misconduct requires a showing of either the intentional performance of an act with knowledge that the performance of that act will probably result in injury or the intentional performance of an act in such a manner as to imply reckless disregard of the probable consequences.” Id. at 514 n.66. Accordingly, advocacy within the committee deliberative process or casting a vote for a particular plan or committee strategy should not be an ultra vires act, even if self-interested, because such activity is precisely what committee members are expected to do regardless of motivation. (By contrast, trading in the debtor's securities using material, non-public information gained by committee membership is an ultra vires act and is the classic example of a prohibited activity.)

Bankruptcy courts also recognize that self-interest plays a role in committee member conduct and it is not per se improper. Self-interested conduct, without more, should not give rise to liability. “Conflicting points of view … are common when committee members act to protect their individual interests. Membership on a committee does not preclude members from pursuing their own interests so long as this can be done without running afoul of their fiduciary duties to all unsecured creditors.” See In re FAS Mart Convenience Stores, Inc., 265 B.R. 427, 432 (Bankr. E.D. Va. 2001) (finding, where committee member sought to establish its secured status and immediate turnover of $4 million of trust funds and committee sought disqualification of member, U.S. Trustee's failure to remove the committee member was an abuse of discretion).

The courts also acknowledge that trade creditor committee members may properly act to preserve a customer relationship with the debtor. “[C]onflicts of interest are not unusual in reorganizations. Materialmen creditors, for example, may sometimes prefer to forego payment for past sales in hopes of preserving a customer, while lenders may prefer liquidation and prompt payment.” See In re Altair Airlines, Inc., 727 F.2d 88, 90 (3rd Cir. 1984) (arguing in a pre-Bildisco decision that collective bargaining agents should not be the only self-interested creditors to be excluded from committees). One court has even suggested that a committee member may assert its self-interest at the expense of its constituency in limited circumstances:

“Although committee members owe fiduciary duties, they are hybrids who serve more than one master. Every member of the committee is, by definition, a creditor. Thus, he is [in] competition with every other creditor for a piece of a shrinking pie. He may assert his rights as a creditor to the detriment of the creditor body as a whole without running afoul of his fiduciary obligations.”

See In re Rickel & Assoc., Inc., 272 B.R. 74, 100 (Bankr. S.D.N.Y. 2002) (refusing to dismiss breach of fiduciary duty claim against committee member that purchased assets of the debtor, but only because he had special responsibility within the committee regarding such assets and took advantage of such responsibility, including misrepresenting their value to the committee).

Disclosure

Disclosure can have a protective effect in two ways. First, it is a fundamental tenet of fiduciary law that a fiduciary may often act where he has divided loyalties provided there has been full disclosure of self-interest. “If dual interests are to be served [by a fiduciary], the disclosure to be effective must lay bare the truth, without ambiguity or reservation, in all its stark significance.” See Rickel, 272 B.R. at 100 (quoting , 154 N.E. 303, 304 (N.Y. 1926) (Cardozo, J.)).

Second, the courts often show deference to the committee as to its informed decisions regarding committee conflicts of interest. See In re Enron Corp., 2002 Bankr. LEXIS 1720 (Bankr. S.D.N.Y. 2002) (finding it significant that the committee was unconcerned about Wendt v. Fischeran alleged conflict of interest and denying creditor's request to disqualify committee counsel); In re America West Airlines, 142 B.R. 901, 903 (Bankr. D. Ariz. 1992) (denying the request of former committee member, who had become a secured creditor, to be reappointed to the committee and observing that the decision of the committee itself was a factor in determining whether a creditor could adequately represent committee's interests).

A committee member, having disclosed its self-interest, and obtained committee support for its participation in the committee action, should be doubly protected. It will have made a full disclosure of its interest pursuant to fiduciary law and participated in the action on the strength of the committee's decision that such participation did not amount to an improper conflict of interest. In such circumstances, it is unlikely that courts would find that there had been willful misconduct or an ultra vires act on the part of the committee member. Committee counsel could (and we suggest it should) provide further insulation from liability by providing the committee with its opinion on the potential conflict (which may be informal but should at least be memorialized), thereby allowing the committee member to defend itself further from attack with the additional defense of reliance on the advice of counsel.

Based on these dual principles of recognition of member self-interest and adequate disclosure, the following practical guidance is suggested for committee members and committee counsel: Committee counsel, at the outset of a Chapter 11 case, should make a presentation to the committee concerning committee members' fiduciary duties, together with a realistic assessment of where and how liability could arise for committee members. (The exhortative, “punctilio of honor” approach to fiduciary duty is not recommended here, as neither realistic nor providing practical guidance.) Thereafter, counsel should facilitate a full and frank exchange as to actual and potential areas of self-interest of the various committee members.

As the work of the committee progresses, the possibility of member self-interest should be considered by both committee members and committee counsel in connection with any significant action contemplated by the committee. If it appears that the self-interest of a committee member might materially affect its conduct in relation to the contemplated action, the committee member should consider recusing itself with respect to the action. Committee counsel should give its professional opinion regarding whe- ther the member's self-interest is so severe that it would likely prevent the member's ability to thoughtfully consider the affect of the issue on other creditors and thus should disable participation under the circumstances. If need be, the committee can vote on whether the conflict should prevent the committee member from participating with respect to the action. The minutes of the committee meeting should reflect the member's disclosure, any discussion of it, and any vote pertaining to the propriety of the committee member's participation.

The by-laws and procedures of the committee should specifically permit conflict of interest issues to be addressed in the foregoing manner. The by-laws should establish that committee members have an opportunity (but, to avoid becoming an independent source of liability, not a duty), to disclose material self-interests. The by-laws should expressly confirm that committee members have the full protection of the law with respect to carrying out their duties on the committee and that they may disclose any self-interest and vote, subject, of course, to any decision of the committee.

With these procedures in place, and referring to the self-interest problems posed at the beginning of this article, we suggest that the trade creditor committee member in Scenario 1 may support a plan option in which an advantageous business relationship would continue with the reorganized debtor, ideally after its self-interest has been fully disclosed and the committee, in its wisdom, has implicitly or explicitly (through a vote) permitted its participation. Similarly, the contractual subordination in Scenario 2 may properly shape the committee's strategy, again ideally, after the issue has been fully disclosed and subject to the informed consideration of the committee.

In summary, committee members are in an inherently contradictory position – selected because of the significance of their self-interest in the case, yet seemingly asked to put the interests of other creditors before their own. However, the qualified immunity that committee members enjoy suggests reasonable boundaries for what would otherwise appear to be excessive risk of liability that could arise from such a conflicted situation. Full disclosure of self-interest plus reliance on the committee's informed decision as to whether the self-interest amounts to a disabling conflict of interest in any given circumstance should shield the committee member from liability.