Chapter 11, Corporate Governance and the Role of Examiners

• Citation: Vol. 34 No. 2
• Publication year: 2018

Chapter 11, Corporate Governance and the Role of Examiners

Stefan Korch

CHAPTER 11, CORPORATE GOVERNANCE AND THE ROLE OF EXAMINERS

Stefan Korch^*

Abstract

The debtor-in-possession model causes major corporate governance problems because the debtor's management has huge incentives to favor some parties over others before or in bankruptcy, e.g., through fraudulent conveyances or preference transfers. Control mechanisms, conversely, are weak. For instance, creditors' committees are often not appointed, ineffective, or conflicted. The bankruptcy court has, however, a strong instrument to detect and undo wrongdoing: the appointment of examiners. They can help to overcome many of these problems because they can neutrally investigate all potential violations of the law. On the other side, their appointment also has downsides, e.g., fees, potential delays, and disruptions in reorganization. Hence, the critical question is how courts can assess whether or not to appoint an examiner. There is no easy answer because the courts have little insight into the debtor's circumstances. To overcome this information asymmetry problem, I propose the appointment of preliminary examiners. They should be appointed in a majority of chapter 11 bankruptcy cases. They would conduct a summary investigation to detect potential violations of the law and report their findings to the bankruptcy court. On that basis, the court could make a more informed decision on the initial question of whether to appoint an ordinary examiner and, further, on the scope of her mandate. The main advantage compared to traditional examiners would be the substantially lower costs. This reform proposal would not only help to enrich the estate in the individual case but would also deter wrongdoing in the future. It hence can be understood as a tool to improve corporate governance in financially distressed or bankrupt companies.

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Introduction.......................................................................................413

I. Challenges for Corporate Governance in Chapter 11 ... 416

A. Shareholder-Dominated Cases.............................................418
B. Creditor-Dominated Cases...................................................421
C. Possible Solutions.................................................................425

1. The 363 Sale ...................................................................425
2. Appointment of a Bankruptcy Trustee ............................427
3. Creditors' Committees and Their Advisors ....................429

D. Concluding Remarks.............................................................432

II. The Appoinment of an Examiner...........................................433

A. Legal Framework and Legal Practice..................................434
B. Examiners' Impact on Corporate Governance.....................436

1. Arguments in Favor of the Appointment of Examiners ... 436
2. Objections and Critical Discussion ................................440
3. The Discussion in a Broader Context ............................. 443
4. Conclusion ......................................................................445

C. Comparative Legal Insights..................................................445
D. The ABI Reform Proposal.....................................................448
E. How Can Courts Know That They Should Appoint an Examiner?.............................................................................449

1. Preliminary Examiners ...................................................450
2. Pre-examiners under the Bankruptcy Code .................... 453
3. Reform Proposal ............................................................. 454

Conclusion...........................................................................................458

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INTRODUCTION

Corporate governance does not have many advocates in bankruptcy proceedings. In chapter 11 actions, managers run the company and have to take many heterogeneous interests into account. However, they do not always have incentives to do so. Depending on the circumstances, management relies either on the shareholders or on the influential creditors.¹ The latter case is more common nowadays because of sophisticated creditors and activist turn-around investors such as hedge funds or private equity funds. Minor creditors and other stakeholders usually have little influence on the reorganization process. Consequently, they can be outsmarted not only through an unfavorable reorganization plan but also through actions taken by management, shareholders, and main creditors prior to or within bankruptcy. Potential discriminatory actions include fraudulent conveyances, preference transfers, and the non-enforcement of claims against management.² These claims can amount to hundreds of millions or even billions of dollars.³

Of course, many of these actions are illegal. But who should detect and correctly evaluate them? In theory, management is in the best position. However, since it was often the same management that violated the law in the first place, to favor one party over others, it will not (voluntarily) reveal and undo the action. The next potential institution is the creditors' committee. However, creditors' committees are often not even appointed ⁴ When they are appointed, they are often criticized as being inactive or ineffective.⁵ Further, they are not seldom conflicted, since some investigations might target their members.⁶ Finally, the bankruptcy court can only discover wrongdoing, such as fraudulent payments or preference transfers, if it is obvious from the materials submitted to the court by the debtor or if insiders provide some indication. Because the management and perhaps even the main creditor as well as the debtor-in-possession lender might have incentives to cover up infringing actions, the bankruptcy court oftentimes will not detect violations of the law. Under-detection and under-prosecution of such actions are thus likely and will lead to under-deterrence.

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Only two possibilities remain: the appointment of trustees or examiners. Skepticism is great as to both. This is understandable with respect to trustees because their frequent appointment would undermine the legislature's decision for the debtor-in-possession model in chapter 11.⁷ It should therefore be a last resort.⁸

For less evident reasons, bankruptcy courts, especially in Delaware,⁹ are also very reluctant to appoint examiners. For a long time, mostly the downsides, such as costs and disruptions caused during the reorganization process and for the business, were emphasized.¹⁰ The perception, however, has shifted because examiners can conduct valuable neutral investigations without replacing the management entirely.¹¹ Some scholars, such as Jonathan C. Lipson, Christopher F. Marotta, Daniel J. Bussel, and Lynn M. LoPucki, have therefore supported a more frequent use of examiners.¹² Likewise, the SABRE-Report from 2004 suggests a more flexible and more regular use of examiners.¹³ The most prominent support has come recently from the American Bankruptcy Institute (ABI) Reform Proposal.¹⁴

This Article contributes to this ongoing discussion and to the literature on corporate governance in bankruptcy generally. Unlike the ABI Reform Proposal, it also addresses the crucial question of how courts can estimate whether or not they should appoint an examiner. It takes up and develops the idea of "mini-

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examiners" by Lipson and Marotta.¹⁵ I argue that "preliminary examiners"¹⁶ should conduct a summary investigation to help the court to determine whether a more substantial investigation is warranted or not. Their short and timely report would put bankruptcy courts in the position to make more informed decisions on both questions of whether to appoint an ordinary examiner and the scope of her mandate. In contrast to Lipson's and Marotta's proposal, my concept is not experimental but focuses on the individual case to support the court in its decision-making process, and it thereby would increase payments to creditors. The main advantages of preliminary examiners as compared to ordinary examiners are substantially lower costs, a smaller disruption of the business, and fewer delays in the reorganization process. Their appointment would, at the same time, ensure the avoidance of violations of the law in the specific bankruptcy case and improve general deterrence.¹⁷ As a result, their appointment would help to overcome many corporate governance problems.

I explain in this Article how preliminary examiners can be appointed under the Bankruptcy Code (the Code); further, I propose amendments to the Code in order to change the starting point: The appointment of preliminary examiners should be the rule and non-appointment the exception. I explain in detail the situations in which preliminary examiners should not be appointed due to the absence of any net benefit for the estate and reorganization process.

The remainder of the Article is organized as follows. The challenges for corporate governance in a bankruptcy setting are described in Part I. The focus is on conflicts of interest, which exist irrespective of whether the shareholders or the main creditors dominate the case through the management. In both scenarios, management has clear incentives to favor the influential parties over (other) stakeholders. In Part I.C., I outline possible solutions such as a sale of assets, the appointment of a trustee, or the appointment of creditors' committees. I concentrate on the appointment of examiners in Part II. Advantages, especially with respect to corporate governance, and disadvantages are discussed in Subsection B. This is followed by a comparative legal analysis. In Subsection E, I focus on the crucial question: How can courts know that an examiner should be appointed? I propose the use of preliminary examiners and discuss the concept in detail.

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I. Challenges for...