Chapter 4 The Basics for Retaining a CRO

• Jurisdiction: United States

4. The Basics for Retaining a CRO

Written by:

Kevin M. Baum¹

Katten Muchin Rosenman LLP; New York

During the early 1990s, a new player emerged in the business bankruptcy arena: the chief restructuring officer (CRO).² Although there are no formally defined duties,³ "the goal of a CRO is to restructure a distressed company's balance sheet and make the difficult determination of defining the company's business within a compressed timeframe."⁴ By having a CRO focus on the reorganization process, the debtor in possession's (DIP) officers are able to focus their attention on implementing a new business model and running the debtor's day-to-day operations.⁵ Today, most large companies will employ a CRO, and his or her turnaround-management firm, before filing for bankruptcy.⁶

Retaining a CRO in chapter 11, however, raises certain issues. The Bankruptcy Code does not define, or even reference, CROs or turnaround managers. Nor does the Code provide definitive guidance for retaining these turnaround specialists. As such, DIPs have successfully argued that both §§ 327 and 363 of the Code⁷ authorize the retention of a CRO.

A. Section 327(a)

Under § 327(a), a DIP, subject to court approval, "may employ one or more attorneys, accountants, appraisers, auctioneers or other professional persons, that do not hold or represent an interest adverse to the estate, and that are disinterested persons, to represent or assist the trustee in carrying out the trustee's duties under this title."⁸ Accordingly, in order to retain a CRO under § 327(a), he or she must (1) be a "professional person," (2) not hold or represent an interest adverse to the estate⁹ and (3) be a "disinterested person."

1. Are CROs "Professional Persons"?

Not all professionals are "professional persons" for the purposes of § 327(a). Rather, the section's scope is limited to those professionals who will "represent or assist the trustee in carrying out the trustee's duties."¹⁰

Since the Code does not provide a definition, courts have created multiple tests for whether a person is a "professional person." First, some courts have adopted a quantitative analysis under which a "'professional person' is limited to persons in those occupations which play a central role in the administration of the debtor proceeding."¹¹ Second, other courts have adopted a qualitative analysis under which a person is a "professional person" if that person "is to be given discretion or autonomy in some part of the administration of the debtor's estate" regardless of the size of the task.¹² Finally, other courts have adopted multifactor tests when deciding whether a person is a "professional person."¹³

Ultimately, it seems likely that CROs, and their firms, are likely "professional persons" under any standard. They are hired specifically to assist in the reorganization and are given large amounts of discretion to complete that task. Moreover, courts have generally accepted that turnaround specialists, including CROs, are "professional persons."¹⁴

2. Are CROs "Disinterested Persons"?

In order to be retained under § 327(a), the CRO must also be a "disinterested person" as defined by § 101(14). Section 101(14) provides, among other criteria, that a person is disinterested if that person "is not and was not, within [two] years before the date of the filing of the petition, a director, officer or employee of the debtor."¹⁵ This creates obvious problems for CROs who were retained pre-petition. Moreover, it may create problems for their firms because the disqualification may be imputed to the firm.¹⁶ Some courts have found that the "disinterested person" requirement does not create a total bar to retaining a CRO who was employed pre-petition. These courts have recognized a de minimus exception to the disinterested-person standard in other contexts besides the pre-petition service as a director.¹⁷ Accordingly, the brief pre-petition employment as a CRO may also be de minimus, thus, allowing the post-petition retention of that CRO.

Other courts have read § 1107(b) to qualify § 327(a). Section 1107(b) provides that "[n]otwithstanding section 327(a)...a person is not disqualified for employment under section 327...by a [DIP] solely because of such person's employment by or representation of the debtor before the commencement of the case."¹⁸ Accordingly, these courts read § 1107(b) to permit a DIP to retain a professional person who was appointed immediately prior to bankruptcy, brought turnaround management expertise, held no equitable interest in the debtors, held no claim against the debtors and did not run the debtor's day-to-day business operations.¹⁹

B. Section 327(b)

Alternatively, CROs have also been retained pursuant to § 327(b).²⁰ Under §327(b), a DIP "may retain or replace...professional persons if necessary in the operation of such business" provided that "the debtor has regularly employed [those] attorneys, accountants or other professional persons on salary."²¹ Simply put, "[s]ection 327(b) applies to the [DIPs'] continued employment of management in the ordinary course, such as its officers and directors."²² Therefore, courts have permitted a DIP to retain a CRO it hired pre-petition under § 327(b), so long as the CRO is under the DIP's board of directors' control.²³

However, § 327(b) probably cannot serve as the basis for retaining a turnaround firm because of the section's "on-salary" requirement. Specifically, by requiring that the professional be "employed 'on salary' implies that [these] professional persons...must be individuals directly employed by the [DIP]."²⁴

There is also the issue of whether a CRO can ever be hired in the ordinary course of business. Bankruptcy courts have adopted a two-part inquiry determining whether a transaction is in the ordinary course of business. First, the court will apply the "horizontal dimension" test, which examines whether the transaction is commonplace from an industry-wide standard. Next, the court will apply the "vertical dimension" test (also known as the creditor's expectation test), which, focusing on the debtor's pre-petition conduct and practices, examines whether a hypothetical creditor would reasonably expect the DIP to enter in the proposed transaction in the ordinary course of its business.²⁵ In order to be in the ordinary course of business, the proposed transaction must meet both tests,²⁶ which creates problems for characterizing employing a CRO as an ordinary-course transaction. The DIP would have to establish that it is common for companies in its industry to employ CROs and...