Confusion and solution: Chapter 11 bankruptcy trustee's standard of care for personal liability.

• Author: Primack, David P.

In Chapter 11 of the Bankruptcy Code, (1) a debtor is given a chance to reorganize his troubled estate rather than to liquidate it outright. Normally, the debtor remains in possession of the assets of the estate and continues to operate the business. (2) In extraordinary situations, however, the court must appoint a trustee to take over the duties of the debtor and run the estate. (3) The trustee is guided by the duties enumerated in the Code, but, unfortunately, one duty was not specifically spelled out: the personal liability standard for trustees.

The National Bankruptcy Review Commission (NBRC) (4) recently recommended that the Code define this standard of care. This particular recommendation has been influential. As Brady Williamson stated:

Perhaps the most tangible jurisprudential effect of the [National Bankruptcy Review] Commission's work to date has come in cases involving the liability of trustees. The Bankruptcy Code ... does not provide a personal liability standard, and a long line of court decisions has led to varying conclusions--requiring a standard of care ranging from simple negligence to virtual immunity. The Commission recommended a "gross negligence" standard that balanced too little protection (and the resulting disincentive to serve) with too much protection (and the resulting disincentive to care). [In May 2000], the U.S. Court of Appeals for the Fifth Circuit expressly adopted the Commission's recommendations.... (5) Mr. Williamson, former chairman of the NBRC, was referring to the recent case of Dodson v. Huff (In re Smyth) (6) where the Fifth Circuit Court of Appeals held that a Chapter 11 bankruptcy trustee should not be subjected to personal liability for damages to the bankruptcy estate unless the trustee acted grossly negligent in performance of their duties. (7) What is most curious about the above quotation, particularly because it was delivered by the former chairman of the NBRC, is that the court in Dodson did not explicitly follow the Commission's recommendations. In fact, Huff was appointed as a Chapter 11 trustee, (8) and according to the proposal adopted by the NRBC, a Chapter 11 trustee ought to be personally liable for damages to the bankruptcy estate if they breach "the standard of care applicable to officers and directors of a corporation in the state in which the Chapter 11 case is pending." (9) As will be shown later in this Note, the Fifth Circuit clearly rejected the recommendation of the NBRC in relation to Chapter 11 trustees, and decided that the standard of gross negligence that the NRBC suggested for Chapter 7 trustees will suffice.

Confusion has always surrounded the standard of care for bankruptcy trustees. (10) This Note will attempt to explain the source of this confusion among the courts, stemming from a misreading of one Supreme Court decision, and ultimately provide a solution that differs from both the Fifth Circuit and the NBRC recommendations. Specifically, the first section describes the trustee duties that are delineated by the Bankruptcy Code. The next section outlines the confusion of the courts, beginning with a misunderstanding of the "willful and deliberate" standard of Mosser v. Darrow (11) and leading to the "gross negligence" standard as spelled out in the recent Dodson v. Huff case. The third section analyzes and criticizes the recommendations of the NBRC. Finally, the last section proposes that Chapter 11 trustees have a national, uniform standard of care that is akin to the standard of care for corporate directors.

THE BANKRUPTCY CODE AND ENUMERATED DUTIES OF A TRUSTEE

Before delving into the Code's lack of specificity about the personal liability standard for Chapter 11 trustees, it is important to know what duties the Code actually delineates. "Section 1106(a) [of the Code] specifies six duties of a trustee in a reorganization case and incorporates by reference five duties of a trustee in a liquidation case." (12) The five duties imposed on Chapter 7 trustees, applying also to Chapter 11 trustees, are that the trustee shall: (i) be accountable for all property received; (13) (ii) examine and object to proofs of claims; (14) (iii) furnish information about the estate and its administration upon request of a party in interest; (15) (iv) file any required reports or summaries of the operations of the business to the court or governmental unit; (16) and (v) make and file a final report and account of the estate with the court. (17) It is clear that these common duties require both Chapter 7 and Chapter 11 trustees to examine the estate with which they are entrusted and to disclose information about it to the appropriate entities.

In addition to these five trustee duties common between Chapter 7 and 11, the Chapter 11 trustee must meet six duties specific to Chapter 11. The trustee must further disclose a list of creditors, a schedule of assets and liabilities, a schedule of income and expenditures, and a statement of the financial affairs of the debtor. (18) Unless the court orders otherwise, the trustee must investigate all of the operations of the debtor and the debtor's business. (19) As soon as practicable after this examination of the debtor, the trustee must disclose and file, with the court and appropriate creditors, any findings of "fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the affairs of the debtor." (20) Thus, the Code forces not only disclosure from the trustee, but also an affirmative duty of investigation of the debtor's activities. In line with the purpose of Chapter 11, a plan for reorganization or recommendations for conversion to another Code chapter should be made by the trustee "as soon as practicable." (21) Finally, the trustee is given limited immunity ("without personal liability") to provide information, if there is any available, to the appropriate governmental agency for missing tax information that the estate failed to file. (22)

There are other important Code duties that apply to this trustee. He is the representative of the estate, and as such, has the "capacity to sue and be sued." (23) Taxes must be appropriately filed. (24) In addition to his own disinterested (25) fiduciary duties, he must employ only disinterested professionals to help him in administration of the estate. (26) Finally, in the duty most important to the Chapter 11 trustee, "the trustee may operate the debtor's business." (27) The Code does not delineate the standard of care, but court decisions have applied the duties of corporate directors to this situation. (28)

The duties enumerated by the Code "support the notion of a trustee as an independent third party whose role is to represent the estate for the benefit of the various parties in interest." (29) The result of this is that the trustee is under a duty to investigate and disclose the affairs of the estate so that the parties in interest will be able to protect their interests in the estate. (30) Although the Code never defines the standard for when the Chapter 11 trustee will become personally liable for breaching these fiduciary duties, the duties delineated by the Code echo much the same duties as corporate directors: duty of care, duty of loyalty, and duty of disclosure. (31) Whereas the duties of loyalty and disclosure are well spelled out by the Code as shown above, it is the duty of care, and the standard that goes along with it, that has caused the most problems for the courts.

MOSSER'S "WILLFUL AND DELIBERATE" STANDARD

The first and only Supreme Court case to address the issue of the standard of care for a reorganization trustee is Mosser v. Darrow. (32) Because this case was decided in 1951, the original Bankruptcy Act of 1898, not the current Code, governed its decision. Hence, Darrow was referred to as a"reorganization" trustee rather than a Chapter 11 trustee. The facts of the case are as follows: in 1935, Paul Darrow was appointed as reorganization trustee for two common law trusts that functioned as holding companies, with their principle assets being securities of twenty-seven companies. (33) These two trusts and subsidiary companies had been promoted by Jacob Kulp and Myrtle Johnson and, given the financial woes of these business entities, Darrow thought it necessary to employ them to assist in the trusteeship. (34) Kulp and Johnson were employed with the express agreement that they could continue to trade in securities of the debtors' subsidiaries. (35) These two assistants traded extensively in the bonds of the subsidiary companies, on occasion acquired bonds for themselves, and then sold them to Darrow at a profit for themselves. (36) Substantial profits were made unbeknownst to Darrow. (37) In the eight years of the trusteeship, Darrow filed only one account for one of the debtor-corporations and none for the other. (38) At this point, the Securities and Exchange Commission intervened, and a special master was appointed who, after much investigation, recommended to surcharge Darrow. (39) Upon this recommendation, the District Court surcharged the trustee, but on appeal, the Court of Appeals reversed the decision saying that a trustee could not be surcharged unless guilty of supine negligence. (40) The Supreme Court reversed the Court of Appeals decision finding that Darrow should be held personally liable for the indiscrete actions of Kulp and Johnson. (41)

Writing for the majority, Justice Jackson provided what seemed to be a clear and narrow ruling. Justice Jackson first noted that the issue was not that Darrow knowingly allowed Kulp and Johnson to make a profit by buying and selling securities, because to do so would definitely result in personal liability for violation of his fiduciary duties to the estate. Rather, the extent of Darrow's responsibility for profits gained unawares was the true issue in the case. (42) The Court explained:

Equity tolerates in bankruptcy trustees no interest...