CHAPTER 1, B. Examining the Role of Reorganization Trustees in Light of the New Subchapter V Standing Trustee

• Jurisdiction: United States

B. Examining the Role of Reorganization Trustees in Light of the New Subchapter V Standing Trustee

ABI Journal

December 2019

Katherine Rea

Staff attorney to Chapter 13 Trustee Pamela Simmons-Beasley

Columbia, S.C.

On Aug. 23, 2019, the Small Business Reorganization Act of 2019 (SBRA) became law. Referred to as "sub-chapter V," it seeks to help small business debtors for whom chapter 11 is too expensive and cumbersome. One of the notable features of subchapter V is that, unlike in chapter 11 cases, a trustee is appointed in all cases and districts might decide to appoint standing trustees. The choice to require a trustee for business reorganizations is a significant departure from current and historical chapter 11 practice. In addition, although the trustee's role appears fairly straightforward, the picture becomes more complicated upon closer inspection.

Early Trustees

Trustees played a role in bankruptcy proceedings even before the country's founding. Debtors seeking relief from their debts sought the appointment of someone "who [would] not only do Justice to the Creditors but Treat my Character in a Friendly and not in an Ill natured manner."¹ An early law in Connecticut provided — after a debtor was imprisoned, of course — that the debtor could petition a court for relief to negotiate his debts, and for release from prison. If relief was granted, the debtor would submit an inventory of assets and debts and swear that he had not committed any fraud. After a hearing where creditors could object, the "estate" would be assigned to a trustee, who would liquidate assets and review creditors' claims, then distribute the proceeds.² Excepting the imprisonment aspect, this is similar to a chapter 7 trustee's role today.³

Chapter 11 Trustees

The legal birth of the chapter 11 trustee can be traced to the financial reforms of the 1930s. Prior to the passage of the first federal reorganization statute, section 77 in 1934, the state court equity receivership was the only option for reorganization.⁴ Receiverships developed thanks to creative investment lawyers representing railroad bondholders.⁵ Railroad bonds were secured by a physical portion of the railroad — collateral of little resale value if the railroad was not operating as a whole.⁶ Law firms representing the investment banks said that the bank would make more money if there was a mechanism for selling a failing railroad as a whole.⁷ Eventually, they convinced state courts to get on board with the process.⁸

These receiverships were the subject of much suspicion from financial reformers, so when the process was incorporated into federal law, the law also tasked the newly created Securities and Exchange Commission to study receiverships.⁹ This study confirmed the worst of the reformers' suspicions: The receiverships were predominantly run by a small, elite network of bankers and lawyers, primarily to line their own pockets, with little benefit to smaller creditors.¹⁰ Furthermore, due to the prior relationships among the lawyers, bankers and a debtor's management, no party pursued litigation against the debtor's managers for fraud, mismanagement or waste.¹¹

In an effort to curb this corruption, the Chandler Act, passed in 1938, required courts to appoint a "disinterested" trustee in every case where the debtor's liquidated, noncontingent debts exceeded $250,000.¹² The trustee — who could not have had any prior connection to the debtor or creditors in order to be appointed — ousted management, operated the business and proposed a bankruptcy plan.¹³ Partially due to this change, corporate reorganizations fell dramatically from approximately 570 cases in 1930 to around 100 cases in 1943.¹⁴ In the 1960s, when a sharp increase in consumer bankruptcy filings prompted Congress to re-examine existing bankruptcy laws, bankruptcy professionals used that opportunity to vociferously lobby Congress to remove the mandatory-trustee requirement.¹⁵

Chapter 11 is the result of this advocacy and presumes that the debtor remains in possession.¹⁶ Section 1104 allows for the appointment of a trustee in solely two instances — first, "for cause, including fraud, dishonesty, incompetence, or gross mismanagement,"¹⁷ which case law limits to clear, unrepentant post-petition conduct by the chapter 11 debtor in possession (DIP),¹⁸ and second, § 1104(a)(2) allows appointment "if such appointment is in the interests of creditors, any equity security holders, and other interests of the estate." Trustee appointment under this section is appropriate, for example, when there is a clear conflict of interest between a debtor's management and creditors.¹⁹

Under either standard, an appointment of a chapter 11 trustee is rare.²⁰ Once appointed, however, a chapter 11 trustee, like the pre-1978 trustee, operates the business and proposes a chapter 11 plan.²¹ Existing management is out. Although § 1105 provides for the termination of the trustee's services, and thus contemplates that the debtor could regain possession, cases where that has happened are rare to nonexistent.²²

Trustees in Chapters 12 and 13

Unlike in chapter 11, there was no debate over whether a trustee should be appointed in chapter 12 and 13 cases. Presumably, the drafters believed that an objective party would help facilitate these smaller types of reorganizations. Also likely is the presumption that these smaller, individual or mom-and-pop reorganizations needed the helping hand of a trustee.

Both trustees play a role in a bankruptcy case that is neither complete control nor solely as a collector and disburs-er of payments. The most notable limitation, as compared to chapter 11, is that in no instance is either type...