Debtor v. UST: The Battleground Over Retention of a Chief Restructuring Officer

After extensive fact-finding, Judge Chapman overruled the UST's objection, called the UST's position the elevation of "form over function," and concluded that A&M had, in fact, complied with the J. Alix Protocol. Noting that A&M's retention was supported by "creditors and/or creditor groups representing virtually all levels of the Debtors' capital structure," the judge criticized the UST for failing to cite even once to the J. Alix Protocol and for baldly asserting that "[a] debtor cannot use Section 363(b) to employ a professional person."

Another example of the UST's bright line position on CRO roles recently occurred in the Reagor-Dykes Auto Group cases (lead case No. 18-50214-rlj11, pending in the United States Bankruptcy Court for the Northern District of Texas).

In August 2018, the debtors filed a motion to retain a CRO to replace certain former officers and investigate the activities of some of those same officers. The UST objected, contending that the Bankruptcy Court could not grant the CRO the power to investigate, as that was a function under the Bankruptcy Code "normally reserved to debtors-in-possession or Chapter 11 trustees." In other words, since the Bankruptcy Code granted debtors/trustees and examiners the power to investigate, no other parties could be granted this power.

That strict constructionist approach may be debated, but there is a more fundamental flaw in the UST's argument: A CRO retained as an officer of the debtor is, in fact, acting on behalf of the debtor in possession, which the UST conceded was a party with a power to investigate. The judge overruled the objection and authorized the retention of the CRO with certain general investigatory powers.

The Nine West and Reagor-Dykes cases are consistent with the premise that the UST will now oppose a proposed CRO retention that strays even slightly beyond the J. Alix Protocol's chalk lines, regardless of creditor support or effect on the estate if the retention is not approved. One of those chalk lines requires that the debtor have an independent board to which the CRO can report. An effort to retain a CRO under 11 U.S.C. §363(b) for a corporation without an independent board will inevitably draw an objection from the local UST.

Our Experience

The authors experienced this first-hand in the GEM Hospitality, LLC affiliated cases currently pending in the United States Bankruptcy Court for the Central District of Illinois (lead case No. 18-80361). GEM and affiliates operated two contiguous hotels in downtown Peoria, IL, including the historic Pere Marquette Hotel. The debtors were formed, owned, and operated by two local developers. There was no independent board for any of the debtors.

The debtors retained CBIZ Corporate Recovery Services shortly before the petition date to provide CRO and supporting financial services, and executed resolutions appointing Jeffrey T. Varsalone of CBIZ to the role of CRO with the power to oversee the debtors' operations and financial management. An application to retain CBIZ and Varsalone under 11 U.S.C §363(b) faced an objection from the UST and an informal objection from one secured lender. Adding fuel to the issue, the same lender had already lodged a motion to appoint a Chapter 11 trustee, based on allegations of prepetition malfeasance by the debtors' principals.

In response to the concerns about existing management raised in the pending Chapter 11 trustee motion, the debtors passed additional corporate resolutions substantially expanding the CRO's role, granting the CRO plenary authority over the debtors' businesses, including naming Mr. Varsalone the manager of each of the debtors, and granting him proxies to vote the members' interests. These changes satisfied the lender, but did not assuage the concerns of the UST, who contended that the lack of an independent board meant that the CRO reported to no one, and, furthermore, that the resolutions granting the CRO voting powers violated Illinois law.

The Court eventually approved the debtors' application to employ CBIZ/Varsalone under 11 U.S.C §363(b) over the UST's objection. As had Judge Chapman in Nine West, Judge Thomas Perkins took a more practical view of the issue in GEM Hospitality. At argument on the matter at a hearing early in the case, the judge expressed his reservations about the argument that, by completely supplanting management and without an independent board, the CRO would be operating without authority and in a vacuum.

Judge Perkins noted that the CRO would be operating under his jurisdiction and subject to the debtors' reporting obligations. Regarding the Illinois state law issue raised by the UST, Judge Perkins stated that the resolutions and the powers granted by them were a matter of state law and he did not have the authority to ignore them.

The EOUST Chapter 11 Trustee Initiative and Its Potential Effect on UST Reaction to CRO Retentions

Is the EOUST walking away from the J. Alix Protocol, as Judge Chapman concluded in Nine West? The EOUST executive director, Clifford White, III, insists not. (See, e.g., C. White, III, et al., "Future of USTP's CRO Protocol," ABI Journal, September 2018). However, as a matter of policy, the EOUST is now pushing back against the presumption that a company is entitled to chart its own course through Chapter 11. The EOUST has launched an initiative to see more Chapter 11 trustees appointed in Chapter 11 cases, arguing that "too few Chapter 11 trustees are appointed in the modern bankruptcy system." (See, C. White, III, "Agenda on Chapter 11 Corporate Reorganization Issues" presented at a June 2017 AIRA conference in Dallas, TX). The EOUST contends that the "cause" standard for appointment is too stringent and the movant's burden of proof should be eased.

It should not be surprising that an initiative to push for appointment of more Chapter 11 trustees exists side by side with an increasingly skeptical view of CRO retentions under 11 U.S.C.§363(b). Regardless, the Chapter 11 trustee initiative is facing a heavy lift. Over the past forty years (since the Bankruptcy Code became law) a consensus of case law has set a high bar for appointing a Chapter 11 trustee over the objection of a debtor.

The typical statutory basis, and well-established threshold, for appointment of a Chapter 11 trustee is "cause" — malfeasance (or gross incompetence) by the debtor's principals during the case, though a showing of prepetition malfeasance or gross incompetence can also be grounds for appointment. 11 U.S.C. §1104(a)(1).

The other, far less visited, basis is that an appointment "is in the best interests of creditors, any equity security holders, and other interests of the estate." 11 U.S.C. §1104(a)(2). If the EOUST successfully pushes courts toward a presumption that the typical closely held company — run by founders and friends, without an independent board — cannot hold its own reins in Chapter 11 because that is never in the "best interests" of stakeholders, the "restructuring" element of bankruptcy will be closed to such a company. This turns Chapter 11 for smaller, closely held corporate entities into de facto Chapter 7 liquidations even if the company has the assets and/or cash flow, and stakeholder support, to survive and reorganize through Chapter 11.

Is this the intent of the EOUST's Chapter 11 trustee initiative? Unknown. But a recent experience of one of the authors suggests that the initiative may have a welcome audience at the local level. The author was involved in another middle market Chapter 11 case filed by a privately held company in the Midwest earlier this year. The debtor expressed a desire to reorganize. The UST was openly skeptical, less so of the principals' motives than the principals' chance of success. During a recess at an early status hearing, the UST discussed the possibility of appointing a Chapter 11 trustee to liquidate the estate. The author (who did not represent the debtor) asked the UST if he preferred something like the German model of bankruptcy, where liquidation was the default, for these smaller middle market cases, and the answer was "why not?" In other words, there are certainly some UST line officers who believe that Chapter 11 gives middle market, closely-held companies too much rope.

For now, we remain in a system where the debtor remains presumptively in possession, Chapter 11 trustee appointments are rare, and a small or middle market closely-held company should be able to retain a CRO, including a CRO with expanded powers, even in the face of a UST objection. Furthermore, if small and middle market closely-held companies entering Chapter 11 are going to face routine attempts by USTs to supplant owners with trustees, retaining a CRO with expanded powers at the outset of the case (or before filing) should be an effective tool to maintaining control of the case.

Retaining a CRO with Expanded Powers: The 'When' and the 'Why'

The first issue for a debtor's insiders, of course, is coming to the decision to cede responsibility to an outside professional. A board — even an independent board — may be reluctant to agree to expanded CRO powers absent a pending motion to dismiss/convert/appoint a Chapter 11 trustee. Given the UST's Chapter 11 trustee initiative, we anticipate that debtors will increasingly face these motions, even in the absence of a suspicion of insider malfeasance, and should consider the CRO option up front rather than waiting to be confronted with a Chapter 11 trustee motion.

Entering a bankruptcy case with a CRO firmly in control of a closely-held company should lower the risk of facing an early Chapter 11 trustee motion or a motion to convert the case to Chapter 7, and simultaneously provides a defense to those motions. In addition, granting the CRO complete control can maximize value to creditors by streamlining decision making. Subject to its duties to stakeholders, the CRO controls the exit strategy and timeline. Insider infighting over these issues is eliminated.

Principal insiders may not relish relinquishing control of a debtor. However, released from their prior responsibilities, principals can focus their time and energy on other matters, including (where applicable) trying to put together financing for a bid to retain the debtor either through a plan of reorganization or a Section 363 sale process.

They will also have the protection afforded them by the ability to undertake arms-length negotiations with an independent estate fiduciary. In sum, insiders are free to act in their own best interests while the CRO represents the estate. This was the case in the GEM matter, where Mr. Varsalone assessed restructuring alternatives and determined that a Section 363 asset sale was the best option to maximize the value of the Debtors' assets. While Mr. Varsalone implemented a going concern sale strategy, the Debtors' principals were able to focus on pursuing their own efforts to structure a bid for the Debtors' assets, without the associated skepticism ordinarily attached to insider bids.

Why should stakeholders support it? If stakeholders trust that the CRO is making decisions that are in the best interests of the estate and creditors, then they are less likely to engage in motion practice and litigation, saving all sides from the cost and delay such activity can cause. Stakeholders will also benefit from a professional CRO that is safeguarding the estate's assets and producing reliable financial information.

In addition, for a smaller or middle market case, a CRO firmly in control of the debtor should decrease administrative costs, facilitate a faster case timeline, and increase chances for better recoveries for stakeholders. By contrast, Chapter 11 trustees come with a commission structure and may retain counsel and financial advisors who do not necessarily supplant those retained by the estate.

Finally, if the stakeholders believe that a restructuring option should be explored, they should also support it. A Chapter 11 trustee may not have the liquidation mandate of a Chapter 7 trustee, but a Chapter 11 trustee is more likely to pursue a straightforward liquidation strategy — and less likely to search under rocks for a restructuring solution — than a debtor in possession.

*****

Mark S. Melickian is a partner and Jack O'Connor is a senior associate at Sugar Felsenthal Grais & Helsinger, LLP in Chicago. Melickian, a member of this newsletter's Board of Editors, is the head of the firm's corporate restructuring group. They may be reached at [email protected] and [email protected], respectively.