Restructuring

Contributed by Lee Jason Goldberg
A fundamental tenet of chapter 11 is that current management continues to operate the company as the debtor in possession.  The debtor in possession owes fiduciary duties to the estate and its creditors.  Where the debtor in possession is conducting a sale under section 363(b) of the Bankruptcy Code, the debtor in possession’s managers may feel tension between their desire for continued employment at the purchaser and their fiduciary duties to the estate and its creditors.  The managers’ role as fiduciaries is paramount, though, and managers may not abrogate their duties to make decisions in the interest of the estate and its creditors for their own personal benefit.  As memorably articulated by Benjamin Cardozo, then-Chief Justice of the New York Court of Appeals, the standard of behavior for fiduciaries is “[n]ot honor alone, but the punctilio of an honor the most sensitive.”  Meinhard v. Salmon, 249 N.Y. 458, 464 (N.Y. 1928).
When companies file for bankruptcy, they are often said to seek the “protection” of the bankruptcy court.  While protection generally refers to the debtor being protected from its creditors by the automatic stay, protection also entails the bankruptcy court’s oversight of the debtor in possession for the benefit of the estate and its creditors.  In overseeing the debtor in possession, the bankruptcy court ensures that the debtor in possession performs its fiduciary duties.  Should the bankruptcy court become convinced that the debtor in possession is not performing its fiduciary duties, section 1104(a) of the Bankruptcy Code requires the bankruptcy court to appoint a chapter 11 trustee to operate the debtor’s business and manage its affairs.
Appointment of a chapter 11 trustee in commercial cases, however, is relatively rare.  Often, even in cases in which creditors express distrust of management or raise allegations of fraud or dishonesty, the creditors reach an accommodation with the debtor to address their concerns.  It is, therefore, all the more interesting when, as occurred in the recent case in the United States Bankruptcy Court for the Southern District of New York, In re GSC Group, Inc., et al., Ch. 11 Case No. 10-14653 (AJG), the bankruptcy court exercises its power to appoint a chapter 11 trustee.  What made GSC Group different?
GSC Group is a closely held corporation with investment advisory and collateral management businesses.  Its board had two members:  Alfred Eckert, the CEO, chairman, and a substantial shareholder, and Peter Frank, the president.  In the event of tie between Eckert and Frank on a board vote, Eckert’s vote would break the tie, making him the de facto sole person in charge of the debtors.  Eckert and Frank also held significant unsecured claims against the debtors’ estates.
The debtors’ prepetition funding was provided through a secured credit facility.  Black Diamond Capital Management, L.L.C. held the majority of the secured debt, and a Black Diamond affiliate served as administrative and collateral agent for the secured debt.  After the debtors entered bankruptcy, the secured lenders won an auction for the debtors’ assets when the Black Diamond agent, on behalf of the secured lenders, credit bid the full amount of the prepetition secured debt for some assets and bid cash for others.  In total, Black Diamond’s bid exceeded the next-highest bid by approximately $40 million.  Certain hard-to-value assets were excluded from the auction.
After the auction, it emerged that the excluded assets had been wildly undervalued; because Black Diamond had credit bid the full amount of the secured debt, however, the value of these assets, which were part of the lenders’ collateral package, would be available for distribution to unsecured creditors and equity holders rather than the secured lenders.  Black Diamond did not seek to invalidate the sale transaction in light of these new facts, and the debtors moved forward with a hearing before the bankruptcy court to approve the sale.
Shortly before the sale approval hearing, however, the other secured lenders questioned the parties’ motives for proceeding with the sale transaction, as well as the conduct of Eckert and Frank, and moved for the appointment of a chapter 11 trustee.  The other lenders alleged that Eckert and Frank, as holders of substantial unsecured claims and equity interests, stood to receive a windfall from sharing in the value of the excluded assets.  They also alleged that after Black Diamond expressed “outrage” at Eckert and Frank’s potential windfall, Eckert sought to assuage Black Diamond by agreeing to sell Black Diamond an option to buy Eckert’s unsecured claim and certain equity interests for a future cash payment.  Against the advice of debtors’ counsel and their financial advisor, Eckert entered into this option agreement.
The other secured lenders further alleged that Eckert and Frank had a host of conflicts of interest regarding Black Diamond because they had negotiated “sale-contingent” employment and consulting agreements with Black Diamond before the debtors filed for bankruptcy protection.   Most importantly, perhaps, the lenders argued that, through the option agreement and related transactions, Eckert had essentially become the “conduit” through which Black Diamond would be able to recoup value it otherwise would not have been able to recover as a secured lender from the excluded assets.  Because, upon exercise of its option, Black Diamond alone would own Eckert’s unsecured claim and certain equity interests, the other secured lenders would not share in any value distributed to unsecured creditors and equity interest holders on account of the excluded assets.
The debtors and, initially, Black Diamond opposed the appointment of a chapter 11 trustee, arguing that Eckert’s claim and equity interests were his own property, and he was free to transfer them to any party.  As a technical matter, they argued, the other secured creditors could not point to any provision of the Bankruptcy Code that the debtors or their management had violated.  Moreover, they argued that appointment of a chapter 11 trustee would destroy the value of the debtors’ business because investors could terminate the debtors’ revenue-generating investment adviser/collateral management agreements upon a change in control of those businesses.
Subsequently, in its opposition to the debtors’ motion for appointment of a chief restructuring officer, Black Diamond changed its position and supported the appointment of a chapter 11 trustee, citing its own loss of confidence in the debtors’ management and belief that an independent trustee would be more beneficial to the sale process than a chief restructuring officer selected by the debtors’ management.  Following Black Diamond’s change in position, therefore, all of the debtors’ secured creditors supported the appointment of a chapter 11 trustee, and only the debtors remained opposed to such an appointment.
In a bench ruling on January 5, 2011, Chief Judge Arthur Gonzalez held that appointment of a trustee was warranted under section 1104(a)(2), which requires the appointment of a chapter 11 trustee “in the interests of creditors, any equity security holders, and other interests of the estate.”  Chief Judge Gonzalez stated that Eckert’s pre- and postpetition actions regarding the sale process, including his relationship with Black Diamond, raised “numerous concerns about the process and a fulfillment of his fiduciary duties regarding that process.”  Chief Judge Gonzalez found that “Mr. Eckert continuously placed himself by his own actions in positions where it compromised the integrity of the process such that the Court lacks any confidence in his ability to preside over the sale process and make a determination on behalf of the estate regarding the sale.”
While the bankruptcy court’s bench decision does not point to any particular determinative fact that tipped the balance in GSC Group to appointment of a chapter 11 trustee, it is not unusual for a purchaser to negotiate management and consulting agreements with existing management to ensure that they remain in place after a sale transaction.  However, the lack of transparency as to the option agreement may have caused the bankruptcy court to revisit all the dealings between the debtors’ management and Black Diamond and view them with a level of skepticism.  As such, GSC Group may be seen as highlighting the importance of transparency, credibility, and integrity in the chapter 11 process, particularly on the part of the debtors’ management, and the serious consequences that may result from their absence.

DISCLOSURE:  The author served as a law clerk for then-Judge Gonzalez in 2008-2009.