ABA MODEL CODE PROJECT DRAFT WHITE PAPER IN SUPPORT OF PROPOSED AMENDMENTS TO 11 U.S.C. 327(a) AND BANKRUPTCY RULE 2014

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1 ABA MODEL CODE PROJECT DRAFT WHITE PAPER IN SUPPORT OF PROPOSED AMENDMENTS TO 11 U.S.C. 327(a) AND BANKRUPTCY RULE 2014 TO: Members of Model Code Project (Legislation Committee, ABA Business Bankruptcy Committee) FROM: Brian K. Gart, Berger Singerman, LLP (co-chair) (with assistance from Ashley Dillman Bruce and Alisa Paige Mason) DATE: September 2, 2014 RE: Proposed amendments to 327(a) and 101 of the Bankruptcy Code and Rule 2014 of the Federal Rules of Bankruptcy Procedure regarding the post-petition retention of an existing CRO I. Summary The proposed amendments seek to clarify and/or streamline certain procedures applicable to the post-petition retention of a Chief Restructuring Officer ( CRO ) and a CRO s turnaround management firm (collectively, the CRO ). The White Paper utilizes historical knowledge, case law, and scholarly articles, together with contributions from current participants in all facets of the typical CRO retention, to support proposed revisions which will, if enacted, leave the intent of the Statute fully intact while modifying certain procedures to better accommodate current practices and conditions. The Task Force Members are in general agreement that 11 U.S.C. 327(a) should be amended to include reference to a CRO as a professional person and that 11 U.S.C. 101 should be amended to include the definition of a CRO. The Committee further recommends that Congress recognize that a CRO s pre-petition retention should not automatically disqualify the CRO as a professional post-petition, either in legislative notes or in Bankruptcy Rule of Procedure II. Background 1

2 The retention of a CRO is intended to help restructure a distressed company s balance sheet and allow for recommendations that will define a company s business going forward. A CRO focuses on the reorganization process so that a distressed company s, and later a debtor in possession s ( DIP ), officers are able to focus their attention on implementing the CRO s recommended new business model and running day-to-day operations. Today, most large companies will employ a CRO before filing for bankruptcy and often seek to retain the CRO after the bankruptcy filing. Retaining a CRO in a chapter 11 case raises a host of issues. As a preliminary matter, the Bankruptcy Code does not define, much less reference, CROs or turnaround managers or provide procedural guidelines for their retention. DIPs have relied on and argued both 327 and 363 of the Code authorize the retention of a CRO. While at first blush the existence of more than one statutory basis for the post-petition retention of a CRO appears to provide some flexibility to DIPs, the ultimate result has been confusion, diverging case law, and the fallback on a protocol with overly stringent requirements. Under 327(a), a DIP, subject to court approval, may employ one or more attorneys, accountants, appraisers, auctioneers or other professional persons, that do not hold or represent an interest adverse to the estate, and that are disinterested persons, to represent or assist the trustee in carrying out the trustee s duties under this title. 11 U.S.C In other words, in order to retain a CRO under 327(a), he or she must (1) be a professional person, (2) not hold or represent an interest adverse to the estate and (3) be a disinterested person as defined in 101(10). Section 101(14) defines a disinterested person as, inter alia, someone who is not a creditor of the debtor, and someone who is not, and was not, within two years before the petition 2

3 date, a director, officer, or employee of the debtor. 101(14)(A), (D). Since a CRO was likely retained within the two years leading up to the petition date, may have been appointed to the Board, and might not qualify for the de minimus exception, CROs immediately face a roadblock to retention. Another statutory alternative is to retain a CRO under 363(b)(1), which statute permits a DIP to conduct transactions and use property of the estate outside the ordinary course of business, subject to court approval only after notice and a hearing. Section 363(b)(1) was first used to authorize the retention of a CRO pursuant to a settlement reached between the Office of the United States Trustee ( UST ) for Region 3 and Jay Alix & Associates ( Jay Alix ), a turnaround firm now operating as AlixPartners. The dispute initially arose when the UST objected to the retention of Jay Alix in bankruptcy cases in Delaware. 1 The UST opposed the engagement of Jay Alix and sought to disqualify Jay Alix and to obtain disgorgement and prospective disallowance of fees and expenses based upon Jay Alix s alleged failure to satisfy the disinterested requirement of 327 and 101(14). Jay Alix had been seeking employment in a number of cases in which Jay Alix s principals served as officers or directors of the debtor. Ultimately, the parties agreed on a cumbersome protocol (the Jay Alix Protocol ) which provided terms for future retentions as a CRO in other cases. Although the Jay Alix Protocol arose from a settlement agreement in Region 3, many courts have since approved its use when retaining a CRO. 2 Despite the growing acceptance of 1 In re Safety-Kleen Corp., Case No (PJW) (Bankr. D. Del. Aug. 27, 2001). 2 See, e.g., In re Revstone Indus., LLC, No BLS (Bankr. D. Del. Mar. 21, 2013); In re Harry & David Holdings, Inc., No (MFW) (Bankr. D. Del. Apr. 27, 2011); In re Archbrook Laguna Holdings LLC, No (S CC) (Bankr. S.D.N.Y. Aug. 3, 2011); In re Calpine Corp., No (BRL) (Bankr. S.D.N.Y. Jan. 17, 2007); In re Dana Corp., No (BRL) (Bankr. S.D.N.Y. Mar. 3

4 approving the post-petition retention of CROs under 363 who comply with the Jay Alix Protocol, the Protocol still requires that a CRO fulfil certain rigorous requirements regarding retention and fee compensation. First, under the Alix Protocol, a CRO must wear only one hat. That hat can either be as a financial adviser under 327(a) or, alternatively, a crisis manager under 363(b). Second, CROs are required to identify those individuals who will serve as executives and identify the functions of any staff that will be employed. The CRO must submit monthly expense reports to the UST and each of any official committees. These reports can be significantly more time consuming for the CRO than a typical fee application under 330 and 331, thereby taking away time that could be devoted to the DIP and the administration of the bankruptcy case. Third, an independent board of directors must approve the retention of the CRO. Fourth, notwithstanding the reliance on 363(b)(1), the CRO must still make all the same disclosures that he would have had he or she been retained under 327(a). Finally, a CRO will not be retained if any of its principals, employees, or contractors have served as a director of the DIP within the past two years. Additionally, the Jay Alix Protocol governs the terms of compensation, requiring a CRO and his firm to keep similarly detailed records as required for professionals of the estate. The CRO s firm must also file quarterly expense reports, which are subject to court review, and serve these reports to the UST and each official committee. Consequently, when the post-petition retention of a CRO sought under 363(b) is denied because the requirements of the Alix Protocol cannot be met, the DIP is the ultimate loser 29, 2006); In re Global Home Prods. LLC, No (Bankr. D. Del. May 4, 2006); In re Meridian Auto. Sys.-Composite Op. Inc., No (Bankr. D. Del. July 19, 2005); In re Cable & Wireless USA Inc., No (Bankr. D. Del. Jan. 16, 2004); In re WorldCom Gp., No (Bankr. S.D.N.Y. Sept. 17, 2002). 4

5 because it is forced to retain a new CRO with no history, background or institutional knowledge about the DIP. The stringent requirements, along with the absence of CROs from the definition of a professional person and the disinterestedness issues that arise with the application of both 363(b) and 327(a), have also caused some very creative, but not entirely productive, maneuvering by DIPs to ensure the post-petition retention of their pre-petition CROs. For example, some CRO s resign from their respective firms so as to ensure post-petition retention. Many CROs are technically creditors of the DIP because they likely hold a claim for the payment of fees that arose before petition date. Likewise, many CROs are retained prepetition as officers or directors of the debtor. 3 In most cases, a CRO will also have a contractual indemnification claim against the DIP to protect against claims for acts taken prepetition, other than gross negligence or willful misconduct. Under any of the foregoing scenarios, a CRO would need to properly structure his engagement agreement to navigate around these issues because under the Alix Protocol the CRO is probably not disinterested. Some of these disputes have been settled by the courts under fact-specific rulings, but results have not been consistent on a nationwide basis. As previously mentioned, some courts apply the qualitative versus quantitative test to determine whether a CRO is a professional person. Some DIPs seek to retain a CRO under 363 and some proceed under 327. Although certain of the disinterestedness issues can be avoided by structuring engagement of the CRO differently, both practitioners and the courts alike desire additional statutory guidance, uniformity and/or clarification regarding the appropriate procedures for CRO retention. 3 See, e.g., Committee v. ABC Capital Mkts. Group & Capitol Metals Co., Inc. (In re Capitol Metals Co.), 228 B.R. 724 (B.A.P. 9th Cir. 1998) (finding CRO not disinterested and ineligible for post-petition employment because CRO was hired as the company s chief financial officer). 5

6 III. Proposed Amendments The Bankruptcy Code does not define the term professional person utilized in 327(a) and 327(a) offers only the examples of attorneys, accountants, appraisers, [and] auctioneers. The Task Force believes that amending 327(a) to include a CRO as a professional person would provide more uniformity to an ever growing need for distressed companies retention of CROs. Amending 327(a) alone to include CROs, would do little. A comprehensive definition of CRO must be added to 101. We would propose using a definition that sheds light on the CRO s role as the person responsible for restructuring a company s business, making key decisions in a time of financial turmoil, and shaping the direction of a company going forward. Including a CRO as a specifically enumerated example in 327(a) does not drastically change the Code. Case law has found that the term is limited to persons in those occupations which play a central role in the administration of the debtor proceeding, which fits the role of a CRO. See, e.g., In re First Merchants Acceptance Corp., No JJF, 1997 WL , at *3 (D. Del. Dec. 15, 1997); In re Bartley Lindsay, 120 B.R. 507, 512 (Bankr. D. Minn. 1990); In re Fretheim, 102 B.R. 298, 299 (Bankr. D. Conn. 1989); In re Seatrain Lines Inc., 13 B.R. 980, 981 (Bankr. S.D.N.Y. 1981). In addition to the foregoing, which is oft-described by courts as the quantitative test, most CROs would also meet the qualitative test applied by some courts. This test provides that a person is a professional person if they have discretion or autonomy in the administration of the DIP s estate. Finally, other professionals who were employed by the DIP pre-petition have been retained for a special purpose such as special counsel under 327(e). 6

7 A further amendment to 101(14) is also needed to exclude an independently hired CRO from being deemed officer, director, or employee or person in control of the debtor. As recognized above, CROs are often hired pre-petition to evaluate the appropriateness of restructuring an already distressed company. Prohibiting a DIP for proactively seeking to employ a CRO pre-petition would only serve to penalize rather than enable an effective reorganization. Rule 2014 should also be amended to explicitly include a CRO in sections (a) and (b). Right now, Rule 2014(a) simply provides that [a]n order approving the employment of attorneys, accountants, appraisers, auctioneers, agents, or other professional persons pursuant to 327, 1103, or 1114 of the Code shall be made only on application of the trustee or committee. Section (b) provides that other accountants or attorneys at a firm or corporation (whether the firm, corporation or named attorney or accountant at a particular firm or corporation) may act as the employed person without further order, but makes no such allowance for the turnaround management firm of a CRO. A. Proposed Changes (Redlined) 1. Proposed Amendments to 11 U.S.C. 101 a. Add Definition of CRO (4B) The term chief restructuring officer means a person employed as an officer for the purpose of overseeing the reorganization of the debtor. The duties of a chief restructuring officer may include any activities in support of what can be included in a plan under 11 U.S.C

8 b. Amend 101(14) The term disinterested person means a person that (A)is not a creditor, an equity security holder, or an insider; (B) is not and was not, within 2 years before the date of the filing of the petition, a director, officer, or employee of the debtor; (C) does not have an interest materially adverse to the interest of the estate or of any class of creditors or equity security holders, by reason of any direct or indirect relationship to, connection with, or interest in, the debtor, or for any other reason; and [FOR DISCUSSION PURPOSES] (D)is a chief restructuring officer unless a. it holds an asserted pre-petition indemnification claim against the debtor; or b. within 2 years before the date of the filing of the petition, i. it served as a member of the debtor s board of directors or other governing body; ii. was an officer, director, or member of the debtor; iii. was in control of the debtor; or iv. was an insider. c. Notwithstanding subsections a. and b., after notice to the court and all creditors, a chief restructuring officer may still be deemed a disinterested person if it provides adequate disclosures and representations and interested parties are given an opportunity to object and be heard as to issues surrounding the chief restructuring officer s disqualification. 2. Proposed Amendments to 11 U.S.C Employment of professional persons 8

9 (a) Except as otherwise provided in this section, the trustee, with the court's approval, may employ one or more attorneys, accountants, appraisers, auctioneers, chief restructuring officers, or other professional persons, that do not hold or represent an interest adverse to the estate, and that are disinterested persons, to represent or assist the trustee in carrying out the trustee's duties under this title. (b) If the trustee is authorized to operate the business of the debtor under section 721, 1202, or 1108 of this title, and if the debtor has regularly employed attorneys, accountants, chief restructuring officers, or other professional persons on salary, the trustee may retain or replace such professional persons if necessary in the operation of such business. (c) In a case under chapter 7, 12, or 11 of this title, a person is not disqualified for employment under this section solely because of such person's employment by or representation of a creditor, unless there is objection by another creditor or the United States trustee, in which case the court shall disapprove such employment if there is an actual conflict of interest. (d) The court may authorize the trustee to act as attorney or accountant for the estate if such authorization is in the best interest of the estate. (e) The trustee, with the court's approval, may employ, for a specified special purpose, other than to represent the trustee in conducting the case, an attorney that has represented the debtor, if in the best interest of the estate, and if such attorney does not represent or hold any interest adverse to the debtor or to the estate with respect to the matter on which such attorney is to be employed. (f) The trustee may not employ a person that has served as an examiner in the case. a. Proposed Amendments to Legislative Notes 3. Proposed Amendments to Federal Rule of Bankruptcy Procedure

10 Rule Employment of Professional Persons (a) Application for an order of employment An order approving the employment of attorneys, accountants, appraisers, auctioneers, agents, chief restructuring officers, or other professionals pursuant to 327, 1103, or 1114 of the Code shall be made only on application of the trustee or committee. The application shall be filed and, unless the case is a chapter 9 municipality case, a copy of the application shall be transmitted by the applicant to the United States trustee. The application shall state the specific facts showing the necessity for the employment, the name of the person to be employed, the reasons for the selection, the professional services to be rendered, any proposed arrangement for compensation, and, to the best of the applicant's knowledge, all of the person's connections with the debtor, creditors, any other party in interest, their respective attorneys and accountants, the United States trustee, or any person employed in the office of the United States trustee. The application shall be accompanied by a verified statement of the person to be employed setting forth the person's connections with the debtor, creditors, any other party in interest, their respective attorneys and accountants, the United States trustee, or any person employed in the office of the United States trustee. (b) Services rendered by member or associate of firm of attorneys or accountants If, under the Code and this rule, a law partnership or corporation is employed as an attorney, an accounting partnership or corporation is employed as an accountant, or a turnaround management firm is employed as a chief restructuring officer, or if a named attorney, accountant or chief restructuring officer is employed, any partner, member, or regular associate of the partnership, corporation or individual may act as attorney or accountant so employed, without further order of the court. Table of Additional Authorities 1. Brink, Timothy & Irving, James, Emerging Trends and Lingering Criticisms: a CRO Retention Update, 32 Am. Bankr. Inst. J. 18 (Sept. 2013) 10

11 2. Baum, Kevin, The Basics for Retaining a CRO, 30 Am. Bankr. Inst. J. 50 (Oct. 2011) 3. Wikel, Dan & Lane, Elaine, Moral and Ethical Considerations for Turnaround Professionals, 31 Am. Bankr. Inst. J. 36 (Aug. 2012). 4. Gwynne, Kurt, Employment of Turnaround Management Companies, Disinterestedness Issues Under the Bankruptcy Code, and Issues Under Delaware General Corporation Law, 10 Am. Bankr. Inst. L. Rev. 673 (Winter 2012). 5. Young, Curt, Crossing the Line: Continuing to Represent Clients After a Chapter 11 Filing (Part II), 28 Am. Bankr. Inst. J. 50 (May 2009). 6. Chelsey, Richard, Bankruptcy Retention and Compensation Issues for Financial Advisors and Investment Bankers, 1 Professional Compensation Committee Newsletter 3 (Oct. 2004). 7. Financial Advisory Issues in Chapter 11: A Case Study - Overview of the Jay Alix Protocol, American Bankruptcy Institute Workshop (Aug. 5, 2010) 11