Two Cases Emphasize Distinct Approaches to Trustee Discretion

Trustees, like debtors-in-possession, owe a fiduciary duty to their constituents, but are protected by the business judgment rule.   Two recent cases illustrate how a trustee’s discretion can be exercised depending upon which rule is given primacy.    In  In re Tres-Ark,Inc., No. 09-12589 (Bankr. W.D. Tex. 11/21/12), which can be found here, the Bankruptcy Court denied Debtor’s Motion to Remove Trustee finding that the Trustee properly exercised his business judgment. On the other hand, In In re CNC Payroll, Inc., No. 12-33012 (Bankr. S.D. Tex. 3/4/13), the Court sua sponte issued an Order to Show Cause Why Trustee Should Not Be Removed Pursuant to 11 U.S.C. §324 based upon concerns over breach of fiduciary duty in employing the trustee’s firm as counsel.  The order can be found here (PACER registration required).

Tres-Ark and the Business Judgment Standard

In the Tres-Ark case, a chapter 7 debtor listed a counterclaim against a creditor and a possible legal malpractice claim against its former counsel in its schedules.   The only parties to file claims were Horiba, the same party against whom the debtor was asserting the counterclaim, and the Debtor’s president and his wife.    

John Patrick Lowe, the trustee, requested court permission to dismiss the counterclaim against Horriba to allow him to pursue the legal malpractice claim.   Subsequently, he sought permission to compromise the malpractice claim for $1,550,000.    Rather than being thrilled with this substantial recovery, the insiders sued the trustee for negligence and gross negligence and then filed a Motion to Remove Trustee.    

The Court noted that neither the Bankruptcy Code nor Fifth Circuit precedent set forth substantive standards for removing a trustee.    The Court noted that under the business judgment rule that a trustee would not be removed for “mistakes in judgment where the judgment is discretionary and reasonable under the circumstances” (quoting Collier on Bankruptcy) and that removal of a trustee “is as serious an action as a bankruptcy judge could possibly decide.”    

With respect to the Horriba counterclaim, the Debtor complained that the trustee had dismissed the counterclaim “with prejudice” when he had merely requested permission to dismiss it without specifying whether it would or would not be with prejudice and that he had undervalued the counterclaim.   The Court rejected these contentions, stating:

Put simply, this boils down to a difference of opinion in how Trustee should proceed with the administration of the estate.   Such scenarios do not place a trustee’s status as a disinterested person in jeopardy.  The fact that Debtor, or some of the estate’s creditors, want the Trustee to take different action is not cause for removal.

 Opinion at 10.

The Debtor also sought to remove the trustee on the ground that the trustee’s relationship with the Debtor had grown acrimonious, minimizing the likelihood for cooperation.   In the typical case, it is common for the Debtor and the trustee to have a testy relationship since the trustee may often pursue avenues the Debtor would prefer to leave unexamined.   However, in this case, the Debtor’s insiders were also some of the principal creditors.   The Court noted that the case cited by the Debtor did not appear to support a “continuing animosity” standard for removal, but noted that the Debtor had failed to establish this ground as a factual matter.

Finally, the Debtor argued that the trustee was no longer disinterested because the Debtor had commenced an adversary proceeding against him and because he had retained counsel to defend himself.   The Court dismissed each of these concerns, stating that:

If filing an adversary proceeding constituted cause, any creditor unhappy with the administration of the estate would simply file an adversary proceeding against Trustee and then come to the court seeking the trustee’s removal.  

 ***

 Debtor should have reasonably understood that its decision to file a claim against Trustee, whether to preserve the statute of limitations or otherwise, would require Trustee to seek legal counsel to defend himself.

 Opinion, pp. 12, 13.

CNC Payroll and the Fiduciary Duty Standard

Less comforting to the Trustee was the Court’s Order to Show Cause Why Trustee Should Not Be Removed in CNC Payroll.   That case involved W. Steve Smith, “a chapter 7 panel trustee in this District with a long history of commendable service.”   Order, p. 1.    Trustee Smith sought to employ his own firm as general counsel in the case.    The application disclosed that the estate was holding cash of $219,523, but stated that only the trustee’s firm or other firms used to representing trustees would be “willing or able to perform services ‘betting on the come,’ even with a significant contingent fee factor.”    

Although no party objected, the Court required the Trustee to supplement his application to “detail the efforts undertaken by the Trustee to find alternative counsel.”    As the Court subsequently stated in its Order to Show Cause:

(T)rustees must demonstrate more than the competence of their own firms.   Trustees must demonstrate that retention of their own firm is better than any available alternative.

Order to Show Cause, p. 2.

On December 18, 2012, the Trustee sent letters to 31 firms offering to let them be considered for employment.   The letter requested a response by December 31, 2012.  The letter requested that firms applying for employment provide extensive information as to their experience and plans for proceeding with the case.    The letter also contained disclosures as to the unpleasantness of representing a trustee, including that payment of fees would be subject to court approval and that the Court “mandates that counsel provide an ‘identifiable, tangible and material benefit’ to the estate in order to be compensated.”     No firm timely responded to the trustee’s solicitation.

After conducting a hearing on February 11, 2013, the Court issued its Show Cause Order.  It was concerned that the Trustee did not seek other counsel prior to the Court’s December 14 letter and that the December 18 letter effectively gave interested attorneys only three business days in which to reply.     The Court also expressed concern that the Trustee did not directly contact attorneys he knew because he did not wish to be accused of “cronyism” and did not respond to late requests from other firms because he did not personally know the attorneys.    As stated by the Court:

In essence, Smith would not directly contact people he knew and refused to consider people he did not know.   These decisions appear calculated to preordain the selection of Smith’s law firm, in which he has a personal financial interest.

 Accordingly, the court requires Smith to demonstrate that the December 18, 2012 letter was not a breach of his fiduciary duty to the Estate.

Order to Show Cause, p. 5.  

Comparing the Two Decisions

Serving as a trustee is often a thankless job.    Pro se debtors sometimes accuse trustees of participating in elaborate conspiracies while disgruntled creditors may write letters of complaint to the U.S. Trustee.    Trustees must sift through hundreds for no-asset cases for the princely sum of $60.00 per case while looking for a case that can result in a distribution to creditors.  Because trustees have such an important but undesirable job, Courts typically give them the benefit of the doubt, as illustrated by the Tres-Ark case.  

The fiduciary duty standard articulated by CNC Payroll, Inc., and the prior decision that it relied, upon, In re Interamericas, Ltd., 321 B.R. 830 (Bankr. S.D. Tex. 2005), give short shrift to the trustee’s exercise of business judgment.   It seems inconsistent to this author to say that trustees should ordinarily be allowed to make a decision within the range of reasonable choices in all matters except for employment of counsel, in which the trustee must make a choice that is “better than any available alternative.”    The Court acknowledged the business judgment rule in a footnote, but overruled it as a practical matter.   If the Court had relied on a business judgment standard instead of the breach of fiduciary duty rubric it invoked, then the trustee would have been protected so long as he engaged a firm that was up to the task.

Having staked out that position, I will note two caveats:

First, Judge Isgur’s approach is in my own personal pecuniary interest.  My firm does not employ a trustee.   However, we have done a substantial amount of trustee work over the years.   A rule that trustees must ordinarily look beyond their own firms for counsel would benefit me personally.   In fact, I plan to submit my resume to Trustee Smith.

Second, Judge Isgur’s concern about trustees being too willing to engage their own firms as counsel echoes the debate in Congress while the Bankruptcy Code was being formulated about breaking up the “bankruptcy ring.”   As stated by one early case:

Throughout the entire time that the Bankruptcy Reform Act of 1978 was being debated and drafted, Congress was concerned with a phenomenon known as the "bankruptcy ring." Basically, this was a pre-Reform Act situation where the creditors could select a Trustee who, in turn, would select a counsel favorable to both the Trustee and creditors.  "Where creditors do vote for a trustee, it is frequently only because law firms solicit such votes as a means of obtaining the business which will be supplied by this trustee." Report  of the Commission on the Bankruptcy Laws of the United States (July 1973) as reported in Appendix 2 Collier on Bankruptcy 4 (15th ed.).  "Persons practicing in the bankruptcy field tended to confine their activities exclusively to that area . . . .  Therefore, a relatively small group of lawyers controlled the bankruptcy field.  Those not within this group tended to regard them with suspicion and distrust." Id. at 93.  "The creditors' attorneys exact their influence to elect friendly trustees or committees in order to pluck the plum of counsel to the trustee or counsel for the committee . . . This creates the so-called bankruptcy ring with all the implications that might fall from that connotation." H.R. Debates (Oct. 27, 1977) as reported in Appendix 3 Collier on Bankruptcy IV-18 (15th ed.).

 In re Allard, 20 B.R. 902, 905 (Bankr. E.D. Mich. 1982), rev’d, 23 B.R. 517 (E.D. Mich. 1982).

In the Allard case, the Bankruptcy Court’s solution was for the Court to appoint counsel for the trustee.   That ruling was promptly reversed by the District Court.    Similarly, in this case, while Judge Isgur’s concern about a modern-day bankruptcy ring (my words) may have some validity, the solution is not for the Court to micromanage employment of counsel by the trustee.    

Debtors-in-Possession, as well as Committees sometimes (often?) do not employ the best-qualified attorney.    However, the Court does not step in to ensure that they engaged in a public solicitation process.    Section 327(a) states that:

(T)he trustee, with the court’s approval,  may employ one or more . . . professional persons that do not hold or represent an interest adverse to the estate, and that are disinterested persons . . . .

 While the statute requires the Court’s approval, the only stated standards for employment of professionals are: 1)  that they not hold or represent an interest adverse to the estate and 2) that they are disinterested persons.    While some minimum standard is probably implied (for example, the trustee should not be allowed to engage a disbarred attorney currently residing in the penitentiary), the statute does not expressly require any Code-created fiduciary to employ the best qualified professional.   By the same token, I  don’t believe that there is anything other than the Court’s self-interest which requires it to hire the best qualified law clerk (although I am willing to be proven wrong on this point).   

On the other hand, section 330 does allow the Court to consider the abilities of counsel when awarding fees.    

When Congress adopted the present structure of the Bankruptcy Code, it reduced the Court’s role in the administration of Bankruptcy cases.    For example, Bankruptcy Judges no longer preside over creditor’s meetings and the U.S. Trustee appoints trustees and examiners.   The Order to Show Cause in CNC Payroll, Inc. appears to reflect a desire by the Court to take a more active role in the day to day administration of cases.   While there may be benefits from such an approach, it raises concerns as well.