United States: Examiner Who Failed to Disclose Fee Arrangement Forced to Disgorge Compensation

Bankruptcies are often zero-sum games in which every dollar recovered by one creditor amounts to a dollar lost by another creditor. In view of this reality, the Bankruptcy Code contains many safeguards that were designed to ensure that the process is not unfairly tilted in favor of one creditor (or group of creditors) over another. Two such safeguards are the disinterestedness and disclosure requirements governing the engagement and compensation of professionals and others acting as fiduciaries in the case. In In re Big Rivers Electric Corp., the Sixth Circuit Court of Appeals addressed the effect of a court appointed examiner's undisclosed agreement to link his compensation to a specific creditor's recovery. At issue in the case were the examiner's related duties of disinterest and disclosure. The court ruled that the examiner would have to disgorge all fees awarded to him during the case because he violated both his duty to remain "disinterested" and his disclosure obligations by entering into prohibited fee arrangements and failing to make appropriate disclosures.

Typically, a chapter 11 debtor remains in possession, operates the business and manages the reorganization effort. In some instances, however, such as when the debtor's management is guilty of fraud, incompetence or gross mismanagement, a bankruptcy court may order the appointment of a trustee to operate (or liquidate) the debtor’s business and devise a reorganization strategy. Less severe cases may lead the court to conclude that although circumstances do not warrant the outright removal of existing management, some kind of independent functionary — an examiner — should be appointed to conduct a thorough investigation of the debtor’s affairs. The Bankruptcy Code provides that in cases where the court does not order the appointment of a trustee, it may (and in some cases must), on the request of any party-in-interest, appoint an examiner if such relief best serves the interests of the estate, creditors and shareholders, or if the debtor’s unsecured non-trade, tax and insider obligations exceed $5 million.

Examiners have two express responsibilities. First, they are required to investigate the acts, conduct, assets, liabilities and financial condition of the debtor, the operation of the debtor's business and the desirability of the continuation of the business, and any other matter relevant to the bankruptcy case or the formulation of a chapter 11 plan. Second, each examiner must file a report, which identifies and memorializes the examiner's findings with respect to his or her investigation of fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the debtor's affairs, as well as to report on any causes of action that may be available to the debtor's estate. The court may also order an examiner to perform any other duties customarily assumed by a bankruptcy trustee that are warranted under the circumstances.

An examiner must act as a fiduciary with respect to all relevant parties in the bankruptcy. Given the nature of the examiner's responsibilities and the objectivity with which they must be performed, the Bankruptcy Code requires every examiner to be a "disinterested person." A "disinterested person" is defined in the Bankruptcy Code as someone who, among other things, does not have or represent an interest materially adverse to the interest of the estate or any class of creditors or shareholders.

As with other officers and professionals in a bankruptcy case, examiners are entitled to reasonable compensation for actual, necessary services provided to the estate. Consistent with the statutory requirement for receiving reasonable compensation and with the common law standards of fiduciary duty, examiners owe the debtor's stakeholders a duty of loyalty. Thus, they are required to forebear from all opportunities to advance self-interest. Accordingly, unlike a chapter 7 trustee, who may receive a percentage fee based on his liquidation efforts, an examiner may not be compensated based upon particular outcomes of the case.

Federal procedural rules also provide that an examiner seeking interim or final compensation from the estate must file an application for compensation which discloses any compensation that the examiner has or may receive for services rendered or to be rendered in connection with the case, as well as the source of such compensation. This disclosure is critical to the court's approval of the estate's payment of compensation to a given professional, and failure to make adequate disclosure could result in disgorgement of fees. Notably, the disclosure requirement is continuous and professionals are required to file additional disclosures as necessary. A court-appointed examiner’s failure to disclose facts that gave rise to an impermissible conflict of interest was the subject of the Sixth Circuit’s ruling in Big Rivers Electric.

Big Rivers Electric, a publicly regulated utility, filed for chapter 11 in 1996 in an effort to restructure more than $1.2 billion in debt, nearly all of which consisted of secured loans made by the Rural Utilities Service of the United States Department of Agriculture (the "Utilities Service"). Big Rivers' unsecured creditors included the Bank of New York ("BNY"), Chase Manhattan Bank ("Chase") and Mapco Equities ("Mapco"). Shortly after the case was filed, the bankruptcy court appointed J. Baxter Schilling as examiner, among other things, to work with Big Rivers and its creditors in resolving various disputes with creditors and, if feasible, to attempt to negotiate a global settlement of the disputes in the case and develop a consensual plan of reorganization. Schilling retained his own law firm, of which he was the sole member, to represent him. In an affidavit filed by Schilling in connection with his appointment, he stated that he had no connections with the debtor, creditors or other parties involved in the case.

Initial negotiations with creditors proved fruitless and Schilling determined that the parties would never agree on a consensual plan unless someone found a way to bring new value into the estate. He decided to undertake the task himself by performing what he called "trustee's duties, including the principal duty of a trustee to maximize the value of the debtor's estate." Resolving to take on these responsibilities, Schilling, who was regularly appointed as a bankruptcy trustee in other cases, believed that he should be compensated like one in this case (i.e. receive a fee based upon a percentage of distributions from the estate).

He accordingly convened meetings with various creditors, including BNY, Chase and Mapco, during which he stated that unless his compensation was to consist of a percentage of any increased recovery on their claims, he would refuse to perform his mediation duties. Apparently, Chase, BNY and Mapco agreed to this arrangement, subject to court approval. Subsequent correspondence among the parties alluded to an agreement to pay a "success fee" to Schilling based upon increased recoveries, but Schilling did not disclose the proposed arrangement to either the bankruptcy court or the office of the U.S. Trustee, which oversees many of the administrative aspects of a bankruptcy case, including the retention and compensation of court officers and their professionals. Moreover, the evidence indicated that Schilling and Chase may have worked together to promote Chase’s potential for recovery on its unsecured claims at the expense of the Utilities Service. During this period, Schilling and his law firm were granted interim awards of compensation from the estate. In connection with one of these awards, Schilling disclosed for the first time his plan to seek percentage-based compensation, but omitted to mention his alleged agreements with BNY, Chase and Mapco.

Big Rivers confirmed a plan of reorganization under which $147 million in new value was available for distribution to unsecured creditors, much of which was directly attributable to Schilling’s efforts. In his final fee application, Schilling sought over $4 million in compensation from the estate and various creditors, including a 3% success fee. The U.S. Trustee objected and sought an order directing Schilling to disgorge all fees because he improperly negotiated secret side agreements for his compensation. The bankruptcy court initially awarded Schilling approximately $2.6 million in fees, which covered his hourly compensation plus an enhancement of four times that amount, to be paid by Big Rivers. After reversing that determination on appeal, the district court subsequently assumed jurisdiction over the entire controversy. It ultimately ruled that Schilling was not entitled to any fees because he was not a "disinterested" examiner as required by the Bankruptcy Code. Schilling appealed to the Sixth Circuit Court of Appeals.

The Sixth Circuit affirmed, finding that Schilling's conduct as an examiner failed to meet the standards for disinterestedness and disclosure. First, the Sixth Circuit agreed that Schilling violated his duty to remain disinterested. The court held that an agreement with a single creditor that links the examiner's compensation to the creditor's recovery qualifies as an interest because it creates the risk that the examiner may favor one creditor at the expense of others.

Second, the court found that Schilling violated his disclosure obligations each time he filed an interim fee application and failed to disclose the agreements with Chase, BNY and Mapco. Notably, the court found that a court appointed fiduciary is not excused from its obligation to disclose a promise of payment based on a subsequent dispute over the existence or enforceability of the promise.

Third, the court ruled that Schilling violated his duty of loyalty by not only entering into the compensation agreements, but also by misrepresenting his actions to the court and to the parties involved in negotiations. The court reasoned that Schilling's tactics did not serve all parties in the bankruptcy in a straightforward and transparent manner as his duty as examiner dictated. Given its findings, the Court of Appeals determined that disgorgement of Schilling's fees was an appropriate, albeit harsh, remedy. It reasoned that because the Bankruptcy Code permits only reasonable compensation, and because that compensation necessarily implies loyalty and disinterested service in the interest of those for whom an examiner is supposed to act, a fiduciary may not receive compensation for services tainted by disloyalty or conflict of interest. According to the Sixth Circuit, the authority to decline all fees was inherent and should be wielded forcefully.

The lesson behind Big Rivers Electric is clear: the ends do not justify the means. It was undisputed that the examiner successfully facilitated a consensual plan of reorganization among contentious parties based on an additional $147 million in value being realized for creditors. Nevertheless, the examiner's failure to properly discharge its fiduciary duties and disclosure obligations resulted in a complete disgorgement of his fees. A growing number of courts take a very strict stance in regard to disinterestedness and disclosure requirements. Professionals must be vigilant in their efforts to provide meaningful, forthright and detailed disclosures and remain cognizant of their fiduciary duties to the relevant parties in bankruptcy.

In re Big Rivers Electric Corp., 355 F.3d 415 (6^th Cir. 2004).

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