Restructuring

Contributed by Cristine Pirro
What constitutes sufficient “cause” requiring the appointment of a chapter 11 trustee?  In In re Dew, the United States Bankruptcy Court for the Eastern District of North Carolina granted the motion of the creditors’ committee to appoint a chapter 11 trustee after finding that the debtors-in-possession had grossly mismanaged their records and finances, which resulted in the creditors losing faith in the ability of the debtors to continue operating their business.  Of particular interest is the fact that nearly all the creditors filed ballots rejecting the debtors’ proposed plan, an act that the bankruptcy court found indicated such a severe level of distrust between the creditors and the debtors-in-possession that the appointment of a trustee was warranted.
The debtors, Harold and Bettie Dew, sold and rented mobile homes in a mobile-home park in North Carolina.  Mr. Dew solicited investments from creditors in 2005, promising them high returns and a security interest on the mobile homes (sometimes the homes would be specifically identified as collateral on the promissory note, sometimes not).  The loans were non-amortizing, with a single balloon payment due at maturity.  Instead of making balloon payments on the loans at maturity, however, Mr. Dew rolled the loans into new promissory notes, effectively continuing his obligation to make interest payments.  Although Mr. Dew represented to creditors that their promissory notes were secured by certain of the mobile homes, Mr. Dew often failed to identify specific mobile homes as collateral on many of the notes.  Mr. Dew also testified that he could not identify the homes that supposedly secured those notes.  In addition, Mr. Dew sold certain mobile homes that were pledged as collateral under other promissory notes without seeking permission of the note holders before entering into the sales agreements and without paying the sale proceeds forward to the note holders as repayment of their debt.
Based on the aforementioned allegations of dishonesty, incompetence, and gross mismanagement of the affairs of the debtors, the creditors’ committee moved to appoint a chapter 11 trustee under section 1104(a)(1) of the Bankruptcy Code for cause and because doing so would be in the best interests of creditors.  Section 1104(a) of the Bankruptcy Code requires the court to order the appointment of a trustee (i) for cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor, or (ii) if such appointment is in the interests of creditors, any equity security holders, and other interests of the estate.
The court found, based on the evidence and testimony, that “cause” existed requiring the appointment of a chapter 11 trustee.  The court was particularly concerned with the debtors’ sale of the mobile homes that had been pledged as collateral under the promissory notes.  The sale of property subject to a lien without the lienholder’s consent (and without repaying the lienholder) could possibly be considered a “willful and malicious injury” for the purposes of section 523(a)(6) of the Bankruptcy Code.  Although the court did not determine whether the debt was non-dischargeable under section 523, the court found that, at the very least, the debtors’ sale of assets subject to a lien was consummated with a reckless disregard for the interests of the creditors and amounted to gross mismanagement.
The court held that gross mismanagement can also be found when creditors reasonably lose all confidence in the ability of management to direct the reorganization effort.  In Dew, it was clear that the creditors had no faith in the ability of the debtors to operate the park.  This was evident in the fact that nearly all creditors voted to reject the debtors’ proposed plan of reorganization.  Only one of the 20 classes – the “Small General Unsecured Claim” class – voted in favor of the plan; the remaining 19 classes, including the rest of the general unsecured creditors and creditors that had previously loaned money to the debtors, voted against it.  The majority of the creditors lacked confidence in a plan that would ask them to continue to do business with debtors they did not trust.  The court found such acrimony between the debtors and their creditors sufficient to order the appointment of a chapter 11 trustee.
The court also expressed its own lack of confidence in the debtors, specifically with respect to the debtors’ maintenance of appropriate business records.  The debtors failed to keep adequate records and were unable to generate income statements or balance sheets upon request.  They could not demonstrate how the large amount of borrowed funds were used, nor were they able to provide an explanation for discrepancies between the amount of rents allegedly collected and the rents deposited into the debtors’ account.  The debtors’ failure to keep books and records was also evident from the debtors’ omission of certain real property held and certain transfers listed on their schedules of assets and liabilities.  The lack of record keeping was especially problematic because Mr. Dew was unable to (i) recall how many mobile homes he owned, (ii) distinguish which mobile homes were owned by the debtors and which were owned by others (e.g., the debtors’ son), and (iii) identify the mobile homes that secured each promissory note (even though the debtors had allegedly driven certain creditors around the park, pointing out specific mobile homes that were to serve as collateral for the notes).
Because the debtors lacked managerial credibility to continue the park, the court found it necessary to appoint an independent third party to oversee the business affairs of the debtors.  With the appointment of a chapter 11 trustee, the creditors were given an opportunity to regain faith in the debtors’ reorganization.  The appointment of a chapter 11 trustee was thus not only warranted for “cause,” but also because it was in the best interests of the estate and its creditors.
Dew serves as a reminder that a debtor should not expect to get away with misrepresentations and improper record-keeping while still remaining in possession.  Perhaps more relevant to most debtors-in-possession is the lesson that a debtor-in-possession should be sure to have the support and confidence of at least some creditors during the reorganization process, especially when proposing a plan of reorganization.