United States: South Edge: Who Can Appeal The Appointment Of A Trustee?

Is it procedurally correct, fair or even rational to appoint an outsider to run a company—over management's objections—and then permit that outsider, and only that outsider, the opportunity to challenge his or her own appointment? In South Edge, the U.S. District Court for the District of Nevada did just that. It dismissed a debtor's and its constituent equity-owners' appeals from the appointment of a chapter 11 trustee, holding that only the newly appointed trustee had authority to appeal her own appointment.¹

At first blush, this appears to impair the appellate rights of the aggrieved party in interest, present significant due-process concerns for affected debtors and apply a "through-the-looking-glass" circular logic. After all, what trustee would challenge his or her own appointment? A closer examination of the South Edge decision, however, reveals that it is grounded in longstanding principles of corporate and bankruptcy law and preserves the right to a meaningful appeal of a trustee's appointment. Ultimately, the South Edge decision presents a new twist in a familiar tale—which corporate debtors, their managers and stakeholders should consider carefully when faced with the possible appointment of a bankruptcy trustee.

South Edge: The Appointment of an Involuntary Trustee

South Edge was a Nevada limited liability company created in 2004 by several of the nation's largest homebuilders (known as "members") for the sole purpose of acquiring land south of Las Vegas and developing a master-planned 2,000-acre, 14,000-residential unit, "new urbanism" project called Inspirada. To this end, the members caused South Edge to borrow more than $500 million pursuant to syndicated multi-tiered loans, which South Edge was obligated to repay as members purchased from the acquisition entity and developed their respective allocated parcels of land. Initial development of Inspirada seemed promising, but the collapse of the U.S.—and in particular the Nevada—housing market beginning in 2006, and the ensuing mortgage market crash of 2007, set in motion a domino effect that ultimately caused South Edge to default on its loans. Following more than a year of state court litigation, the default eventually precipitated an involuntary chapter 11 case against South Edge commenced by the lenders in the Nevada bankruptcy court. The petitioning creditors also moved to appoint a chapter 11 trustee.²

After a four-day trial, the bankruptcy court granted both the creditors' involuntary petition (the "involuntary order") and the creditors' motion to appoint a trustee (the "trustee order"), thereby divesting existing management—directed by a board consisting of representatives of the individual members—from operational control of the project and disposition of the property of the estate, setting the stage for the inevitable appeals from the bankruptcy court's orders.

Two events transpired, or rather did not transpire, during the bankruptcy court trial that dramatically affected the appeals that followed. First, the members did not oppose the creditors' motion to appoint an involuntary trustee (only South Edge opposed the motion through its own, separate counsel), and second, neither the members nor South Edge moved the court to stay the orders pending appeal.³

Appeals from Trustee's Appointment

South Edge and its members each appealed the trustee order and the involuntary order to the Nevada district court. Since they had not formally opposed the motion to appoint a trustee, the members also filed a "protective" motion to intervene in South Edge's appeal.

Upon her appointment, the trustee moved to dismiss the appeals on the grounds that only the trustee (as opposed to South Edge's former management) was authorized to prosecute an appeal on South Edge's behalf and that upon conducting appropriate diligence, she had determined that the appeal was not in South Edge's best interest. The trustee further argued that the members had waived their right of appeal by failing to object to the appointment of the trustee. The trustee relied heavily on the Tenth Circuit decision in C.W. Mining Co. v. Aquila Inc.,⁴ which held that the authority to appeal on behalf of a chapter 7 corporate debtor vests with the trustee and not with the debtor's former management, which is "completely ousted" upon the trustee's appointment. The C.W. Mining court's conclusions were firmly grounded in the U.S. Supreme Court's decision 25 years earlier in Commodity Futures Trading Comm'n v. Weintraub,⁵ in which the Court held that a chapter 7 trustee of a liquidated brokerage firm had authority to waive the firm's attorney/client privilege for all communications occurring before his appointment—over the objections of the brokerage firm's former general counsel. The Court reasoned that once a trustee is appointed to represent the debtor, former management retains "virtually no management powers" other than those provided under the Bankruptcy Code (i.e., turning over corporate property and providing certain information to the trustee).⁶

In its opposition to the trustee's motion to dismiss the appeals, South Edge made several arguments in support of its right to appeal the appointment of the trustee. The most interesting was that a rule permitting a trustee to control the appeal of its own appointment would effectively insulate the bankruptcy court's decision from meaningful review:

The South Edge court firmly disagreed with this position.

The District Court's Order Granting the Trustee's Motion to Dismiss the Appeals

The Nevada district court granted the trustee's motion to dismiss the two appeals. Following the Tenth Circuit's decision in C.W. Mining, the district court dismissed the first appeal, brought by South Edge's former managers, purportedly on the debtor's behalf, on the grounds that a corporate debtor in an involuntary chapter 11 case does not have the authority to bring an appeal through its ousted management, where a trustee has been appointed and objects to the ousted management bringing that appeal on the debtor's behalf. The district court concluded that none of the three "limits" or "exceptions" to the trustee's powers, as articulated in C.W. Mining, applied to South Edge.

First, while the South Edge managers had authority to file and did file a notice of appeal before the trustee was appointed, they failed to request or obtain a stay-pending appeal or a bond. Absent a stay, the bankruptcy court properly appointed the trustee and former management was therefore ousted. Once appointed, the authority to decide whether to continue to pursue or to dismiss any appeal on South Edge's behalf automatically transferred to the trustee. Second, the court found that while the C.W. Mining court noted a distinction between a chapter 7 and a chapter 11 trustee with respect to the scope of its fiduciary duties, a chapter 11 trustee displaces former management in precisely the same manner as a chapter 7 trustee. Third, the South Edge court agreed with the C.W. Mining court that a debtor's former managers retain the right to appeal in their own right as "persons aggrieved," but stated that this had no bearing on their right to pursue an appeal on the debtor's behalf.

The South Edge court concluded that the debtor retained a meaningful right of appeal from the order appointing the involuntary trustee. The court reasoned that a trustee is properly entrusted with the fiduciary duty to decide whether to pursue any legal action on the debtor's behalf, including an appeal from the trustee's own appointment. If former management can demonstrate that the trustee breached her fiduciary duties (which extend both to creditors and to equity—in this case, the members) when she decided not to appeal her appointment, their remedy would be to seek to have her removed and replaced or have former management reinstated, not appeal the order on behalf of the debtor:

Finally, dismissing the second appeal brought by the members, the district court held that the members waived their right to appeal as "persons aggrieved" because they did not affirmatively oppose—or even join in South Edge's opposition to—the creditors' motion to appoint the trustee in the lower court. The court concluded that by having failed to attend the evidentiary hearing on the motion to appoint a trustee, question any witnesses, make any arguments before the bankruptcy court, or otherwise object to the appointment of the trustee, the members were not "persons aggrieved."

In conclusion, the South Edge court applied established, noncontroversial principles of corporate law (a corporation acts only through its authorized agent) and bankruptcy law (once appointed, a trustee assumes the authority to pursue legal action on debtor's behalf) to a new, controversial set of facts that raises a unique question: Should a trustee be granted sole authority to appeal his or her own appointment? Finding no exemption to limit a trustee's powers in this regard, no stay-pending appeal and a waiver by former South Edge managers (in their individual capacity) of the right of appeal, the court properly answered in the affirmative and dismissed the former managers' appeals.

Practice Implications of South Edge

How, then, can a debtor's management and equityholders preserve the right to challenge a trustee's appointment in the aftermath of South Edge? When faced with the possible appointment of an involuntary trustee in a chapter 11 context, management and equityholders must take action before the bankruptcy court enters an order appointing the trustee:⁹

Oppose the appointment of a trustee in the first instance. Management (on the debtor's behalf) should contest the appointment of a trustee in the bankruptcy court in an effort to maintain control and the standing of the debtor in possession with the power of the trustee with respect to the prosecution or abandonment of any appeal by the debtor.

Seek a stay in conjunction with appealing an order appointing a trustee. If the court nevertheless orders the appointment of a trustee, management (on the debtor's behalf) must seek and obtain a stay of the order appointing the trustee if they are to preserve their standing and authority to pursue the appeal in the name of the debtor. Pursuant to Bankruptcy Rule 2005, a motion for a stay of the order or for other relief pending appeal must ordinarily be presented to the bankruptcy judge in the first instance. Alternatively, the motion may be made to the district court or the bankruptcy appellate panel, but the motion must show why the relief was not obtained from the bankruptcy judge.

Be prepared. Obtaining a stay may be an uphill battle. The bankruptcy court has discretion to require the party seeking a stay to post a bond, which may prove substantial and, in any event, beyond the reach of an insolvent debtor. In addition, in order to secure a stay, management (on the debtor's behalf) will be required to show the likelihood of success on the merits, irreparable injury, lack of substantial harm to appellee (i.e., movants for the appointment of a trustee and, by implication, creditors) and lack of harm to the public interest. Given that the trustee will have been appointed in the first instance due to "fraud, dishonesty, incompetence or gross mismanagement of the affairs of the debtor by current management," or because such an appointment was "in the interest of creditors,"¹⁰ management will be hard-pressed to convince a court that there will be no substantial harm to creditors if the current management is not removed.

Preserve an individual right of appeal by opposing the appointment of a trustee as a "person aggrieved." To the extent that they can demonstrate a personal financial injury as a direct result of the order appointing the trustee, management/equityholders should also oppose the appointment of a trustee in the bankruptcy court in their capacity as "persons aggrieved" (on their own behalf).¹¹ However, it appears that unless the estate is solvent enough that there is value to be recovered for the benefit of the estate in excess of the secured creditors' recovery on its collateral, or unless the matter involves "rights unique to [the] debtor," the debtor is not deemed a "party aggrieved."¹²

Have a contingency plan. The standard for determining whether management is "aggrieved" is not entirely clear, nor would such an appeal remove management from exposure to the bankruptcy court's imposition of a bonding requirement to maintain the status quo pending disposition of the appeal, without which the trustee still would be stepping into management's shoes in administering the case, controlling business operations and disposition of property of the estate, and potentially pursuing claims against former management.

First published in ABI Journal, Vol. XXXI, No. 8, September 2012.

Footnotes

^{1 S. Edge LLC v. JPMorgan Chase Bank NA, 2011 U.S. Dist. LEXIS 49621 (D. Nev. April 28, 2011).}

^{2 In re S. Edge LLC, BK-10-32968-BAM (Bankr. D. Nev. Dec. 9, 2010).}

^{3 Hr'g Tr., 54:23-55:17, Feb. 3, 2011 (p.m. session).}

^{4 In re C.W. Mining Co., 636 F.3d 1257 (10th Cir. 2011) (cert. denied).}

^{5 471 U.S. 343 (1985).}

^{6 Id. at 353.}

^{7 S. Edge LLC Opp. at 21.}

^{8 S. Edge LLC, 2011 U.S. Dist. LEXIS 49621 at *17-*18.}

^{9 Since the appointment of a trustee in a chapter 7 case is mandatory and effective immediately upon the U.S. Trustee's appointment of an interim trustee following entry of the order for relief, the tools available to the debtor in a chapter 11 case would not be available in an involuntary chapter 7 case. The available remedies in the latter circumstance would be an appeal from the order for relief granted on the involuntary petition and the filing of a motion to convert the chapter 7 case to one under chapter 11.}

^{10 11 U.S.C. § 1104.}

^{11 In re C.W. Mining Co., 636 F.3d at 1261-62 ("[W]e do not hold that former managers cannot appeal a bankruptcy court order in their own right. If C.W.'s managers themselves have been injured pecuniarily, they can appeal as 'persons aggrieved.'"); see also S. Edge LLC, 2011 U.S. Dist. LEXIS 49621 at *21 (declining to find that members were "persons aggrieved" because "[p]rerequisites for being a 'person aggrieved' are attendance and objection at the bankruptcy court proceedings").}

^{12 Weston v. Mann (In re Weston), 18 F.3d 860, 863-64 (10th Cir. 1994) (debtor who filed voluntary chapter 11 petition—which was converted by debtor's creditors to a chapter 7 case—lacked standing to appeal from appointment of trustee as "person aggrieved" where estate was insufficiently solvent to allow excess to go to debtor); see also Moran v. LTV Steel Co. (In re LTV Steel Co.), 560 F.3d 449, 456 (6th Cir. 2009) (former officers and directors had no standing as "persons aggrieved" to appeal bankruptcy court order authorizing creditors' committee to pursue claims against them because threat of litigation does not produce the direct and adverse pecuniary impact necessary to bestow standing).}

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