Appointment of a Chapter 11 Trustee in a Business Bankruptcy Case

Business Continues OperationsThe Debtor in Possession

Business bankruptcy cases under Chapter 11 of the United States Bankruptcy Code generally give rise to a new entity known as a “debtor in possession.”  Under section 1108 of the Bankruptcy Code, the debtor in possession continues to operate the business.  While there are constraints upon how the debtor in possession must operate the business while remains in a Chapter 11 bankruptcy case, the norm is the business keeps its leadership intact to guide it through the reorganization process.  The policy of allowing the debtor in possession to continue the day to day operations of the business is usually very sound.  The management of the business typically understands the company better than any outsider does and, very often, has a strong incentive to restore the enterprise to profitability (if only to retain employment).

However, if the case is converted to a case under Chapter 7 of the Bankruptcy Code, the debtor in possession ceases to exist and a Chapter 7 trustee is appointed to oversee the liquidation of the business.  Sometimes an independent trustee is appointed to oversee the business affairs of a debtor with a strong prospect of reorganization.

Appointment of a Chapter 11 Trustee

For Cause Appointment of a Chapter 11 Trustee

Section 1104(a) of the United States Bankruptcy Code provides that any time between the filing of the bankruptcy case and before confirmation of a Chapter 11 plan, a court is empowered to appoint a Chapter 11 trustee.  The United States Trustee or a party in interest may request the appointment of a Chapter 11 trustee for cause.  Cause includes “fraud, dishonesty, incompetence or gross mismanagement of the affairs of the debtor by current management.”  The “for cause” appointment of a Chapter 11 trustee makes sense for the  same reason that it makes sense to retain existing management:  to maximize the debtor’s opportunity to effectively reorganize.  If the debtor’s management has demonstrated that it is not competent the manage the affairs of the debtor, than that debtor and its creditors are better served by replacing that management.

Nevertheless, the cases are clear that the appointment of a Chapter 11 trustee is an exception.  The debtor’s existing management is entitled to deference.  Furthermore, even if the appointment of a trustee would put the debtor in better hands, that might not mean that it would make the debtor better off.  If a court orders, a Chapter 11 trustee may be elected during a meeting of the debtor’s creditors.  The new trustee must learn enough about the business of the debtor to oversee its operations.  Also, the Chapter 11 trustee will typically be compensated from the debtor’s estate.

Appointment of a Chapter 11 Trustee Based on the Best Interests of Creditors or Interest Holders

The Bankruptcy Code also permits the appointment of a Chapter 11 trustee when that appointment is in the best interests of the creditors, equity security holders or other interests of the debtor’s estate.  This “best interests” appointment of a Chapter 11 trustee does not require a finding of negligence or wrongdoing on the part of the debtor’s existing management.  Whether a court appoints a Chapter 11 trustee under this test turns only on an analysis of the interests of those creditors.  However, because a business is typically best served by its experienced, pre-bankruptcy management, it is not typically in the best interests of interest holders to appoint a Chapter 11 trustee.

Appointment of a Chapter 11 Trustee When Grounds Exist to Convert or Dismiss the Bankruptcy Case

Additionally, a court can appoint a Chapter 11 Trustee when there are grounds to convert or dismiss a bankruptcy case but, conversion or dismissal of the case is not in the best interests of the creditors or the estate.  A case may be converted to a case under Chapter 7 or dismissed for a number of reasons including but not limited to failure to pay certain fees, failure to attend a meeting of creditors, failure to timely provide information to the United States Trustee or failure to comply with an Order of Court.  After finding that cause exists to convert the case to a case under Chapter 7, pursuant to section 1112 of the Bankruptcy Code, a court could decide to appoint a trustee instead of converting the case.

Limitations on Right to Appeal Appointment of a Chapter 11 Trustee

Recent case law suggests that the rights of an ousted debtor in possession has limited ability to appeal the Order appointing a Chapter 11 trustee.  Once a Chapter 11 trustee is appointed, it manages the affairs of the debtor and exercises its rights and responsibilities as a debtor.  Thus, the right to appeal an Order appointing a Chapter 11 trustee belongs to the Chapter 11 trustee.  Nevertheless, an ousted debtor in possession has some recourse to appeal the adverse decision of a bankruptcy court.  However, it must timely appeal and move to stay the Order appointing the Chapter 11 Trustee pending appeal.

The appointment of a Chapter 11 trustee is strong medicine.  Whether you are a creditor who would like to see the management of a debtor displaced or a debtor in possession seeking to maintain control of your business, you should talk to your bankruptcy attorney regarding the appointment of a Chapter 11 trustee.

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