United States: Creditor´s Committee Member Inaction: Any Liability?

Co-written by Mr John J. Voorhees Jr.

In the context of Chapter 11 cases, bankruptcy courts uniformly agree that creditor committee members owe a fiduciary duty to their constituents, but they also recognize that unfettered committee member liability would make creditors reluctant to serve on committees. The policy of promoting creditor participation on committees is embodied in Bankruptcy Code § 1103(c), which courts have held confers limited immunity upon committee members that prevents a committee member from being held liable for actions taken within the scope of its statutory authority, as long as those actions do not constitute "willful misconduct" or "ultra vires" conduct. Pan Am Corp. v. Delta Air Lines Inc., 175 B.R. 438, 514 (S.D.N.Y. 1994); Luedke v. Delta Air Lines Inc., 159 B.R. 385, 392-93 (S.D.N.Y. 1993). According to the court in Pan Am:

175 B.R. at 514 n.66 (citations omitted).

By defining the scope of a committee member’s limited immunity in terms of which affirmative actions can give rise to liability, however, courts have failed to take into account the possibility that a committee member’s inaction could also give rise to liability. Courts and commentators have observed that many committees are inactive, ineffective and add little to the reorganization process. In re Gusam Restaurant Corp., 32 B.R. 832, 834 n.1 (Bankr. E.D.N.Y. 1983) ("in too many cases where creditors’ committees are formed, the creditors’ committees exist in name only and are completely ineffectual") rev’d on other grounds, 737 F.2d 274 (2d Cir. 1984); Robert C. Aronoff, Appointing and Organizing Official Creditors’ Committees with Model By-Laws, 20 Cal. Bankr. J. 289, 290 (1992) ("studies have shown the creditors’ committees are often ineffective"). There currently appear to be no reported decisions, however, that directly hold a committee member liable for failure to perform the member’s statutory duties. Two commentators have suggested that "[p]erhaps the same apathy and sense of hopelessness which often result in inactive committees also produce creditors who fail to consider whether the committee properly represented its interests." Blain and O’Gawa, Creditors’ Committees Under Chapter 11, 73 Marq. L.R. at 615. Another problem may be that it would be difficult to prove what damages, if any, were caused by a committee’s inaction.

Two recent bankruptcy court decisions hint, however, at the prospect that not all bankruptcy courts may be so willing to tolerate inactive or ineffective committees. The question remains, however, whether courts will consider committee members’ liability as a way to hold committee members accountable for injuries caused by their inaction.

In In re Bidderman Indus. Inc., 203 B.R. 547 (Bankr. S.D.N.Y. 1997), the debtor sought court approval of a letter agreement that contemplated a leveraged buyout of its businesses that would have funded its plan of reorganization. In connection with the LBO, the debtor’s CEO, a turnaround consultant retained by the debtor prepetition, was to receive an equity stake in the debtor.

The Bidderman unsecured creditors’ committee supported the sale. Two secured creditors objected to the sale on the basis that the debtor’s CEO/turnaround consultant had a conflict of interest because he was on both sides of the sale. The debtor argued that the sale should be approved because, among other things, the committee’s support of the sale "cleansed" the deal.

The court disallowed the sale. According to the court, the only reason that the committee supported the sale was that it met the conditions of a prior agreement between the committee and certain secured note holders. The court criticized the committee, stating that "once it became apparent that the debtors were amenable to a sale of the businesses, the committee should have explored whether its constituency might fare better than it would pursuant to the agreement with the note holders." 203 B.R. at 553.

The court believed that a better deal could have been struck for the unsecured creditors because, although the LBO before the court would allow the debtor to propose a plan that would pay unsecured creditors 50 percent of their allowed claims, the debtor’s CEO had testified that the debtor was prepared to implement a plan that would pay unsecured creditors 100 percent of their allowed claims if that were necessary to obtain the noteholders’ approval of the plan.

Bidderman turned on whether the CEO/turnaround consultant’s self-dealing prevented the approval of the letter agreement. Whether the committee’s inaction in Bidderman was sufficient for the committee members to be held liable to the unsecured creditors was left unresolved by the court. Nonetheless, the court clearly felt that the committee should have taken a more active role to ensure that the best price was achieved for the debtor’s businesses once they were for sale. Presumably, if the sale had been approved, despite the debtor’s demonstrated willingness to pay unsecured claims 100 percent, unsecured creditors could have arguably asserted damages against the committee members in the amount of the difference between the distribution received under the proposed plan and a 100 percent payout.

In In re ABC Automotive Prods. Corp., 210 B.R. 437 (Bankr. E.D. Pa. 1997), the court denied counsel’s request to be retained by the unsecured creditors’ committee where the court found that counsel had orchestrated his own retention by a committee that had demonstrated an unwillingness to participate in the debtor’s bankruptcy case. Initially, there was not enough interest to form a committee in the debtor’s case. Later, however, a committee was formed and an attorney who had been contacted by a number of committee members solicited proxies from them for the purpose of voting for a chairman of the committee and retaining the attorney’s law firm as committee counsel. The attorney convened a "meeting" of the committee at which only the attorney was present. The attorney voted the proxies to appoint a chairman of the committee and to approve the retention of his firm as committee counsel.

The elected committee chairman was unwilling to sign the application to approve the retention of the attorney and his firm, so the attorney executed the application himself. The U.S. Trustee and another party objected to the committee’s retention of the attorney on the basis that his actions in soliciting and voting the proxies created a disqualifying conflict of interest. The court denied the retention of the attorney because the attorney put his own interests in employment before those of the committee, which created a disqualifying conflict.

Aside from the clear manipulation of the process engaged in by the attorney, the court was troubled by the passivity of the committee members. According to the court, the language granting committees their powers under § 1103(c) imposes a duty on committees "to ‘use any tool available under § 1103’ to accomplish its goal of acting in the best interest of creditors." 210 B.R. at 441 quoting In re Advisory Committee of Major Funding Corp., 109 F.3d 219, 224-25 (5 th Cir. 1997).

In dicta, the court recognized that this duty raised an "interesting issue" regarding the liability of inactive or ineffective committee members. Because the case was brought before the court on the motion to approve retention of counsel to the committee, however, the issue of liability of the committee members to the unsecured creditors was not before the court. Nonetheless, because the court felt that an inactive committee would likely do more harm than good, the court encouraged the committee to meet, organize, retain counsel and take an active role in the case. The implication was that if the committee failed to act, it risked exposing its members to liability.

Bidderman and ABC Automotive should serve as a potential warning to creditors that the committee members’ passivity may not provide immunity from liability for damages caused by their inaction.

What remains unanswered, however, is how the fiduciary duty standard should be applied to determine whether and when a committee member should be held liable for its inaction. Although it is easy to understand a court’s concerns, the difficulty with any standard of care applied to committee member inaction is that hindsight has a way of making it easy to second-guess decisions not to act. For instance, it is far too easy to second-guess a committee’s decision not to object to a debtor’s plan of reorganization after the plan has failed. Could the plan’s failure have been avoided if the committee had been more active, or was the failure the result of unforeseen events beyond the committee’s control? Courts should therefore approach such issues with extreme caution to avoid creating a disincentive to serving on committees and thereby undermining the important oversight role played by committees.

While this issue remains unresolved by the courts, committee members should, first and foremost, minimize their risk of liability for inaction by actively participating in the Chapter 11 case to which they are appointed. Committee members should also continue the practice of negotiating releases of their members as part of plans of reorganization. Until the law in this area develops further, such defensive measures are the best way to minimize a committee member’s risk of liability while allowing the members to participate on a committee.