The Rise of Bankruptcy Directors – The Harvard Law School Forum on Corporate Governance | Vette Leader

In the past decade, a major new player in corporate bankruptcy has emerged: bankruptcy professionals who join boards of directors shortly before or after filing for bankruptcy and claim to be independent. The new directors — typically former bankruptcy attorneys, investment bankers, or distressed debt dealers — are either given board power or become loud voices in the boardroom, shaping the company’s bankruptcy strategy, including investigating self-dealing against shareholders. We call them “bankruptcy directors”.

In a new article coming soon Southern California Law Review, we examine this phenomenon using a hand-picked sample of all large companies that filed for Chapter 11 and disclosed the identity of their directors to the bankruptcy court between 2004 and 2019. To our knowledge, this is the largest sample of Chapter 11 company directors studied to date.

We find that the percentage of firms in Chapter 11 cases that claim to have an independent director increased from 3.7% in 2004 to 48.3% in 2019. Over 60% of the firms that appointed bankruptcy directors had a controlling shareholder and about half were controlled by private equity funds.

The increasing importance of bankruptcy trustees has made them controversial. Proponents tout their experience and ability to expedite the reorganization, thereby protecting the company’s profitability and its employees’ jobs. Opponents argue they suffer from conflicts of interest that hurt creditors.

Our results explain why bankruptcy trustees are controversial. After examining company characteristics, we find that the recovery rate for unsecured creditors, whose claims are typically most at risk in bankruptcy, is on average about 20% lower in the presence of bankruptcy trustees. While we cannot rule out the possibility that the firms that appoint bankruptcy trustees are more deeply insolvent and that this explains their negative association with creditor recovery, this finding at least shifts the burden of proof to those who claim that bankruptcy trustees improve the governance of distressed firms.

We are also investigating a mechanism by which bankruptcy trustees can reduce creditor recoveries. In about half the cases, these directors investigate claims against insiders, negotiate a quick settlement, and argue that the court should approve them in order to save the company and its employees’ jobs. We supplement these statistics with two in-depth studies of cases where bankruptcy trustees invalidated creditors’ claims against controlling shareholders: Neiman Marcus and Payless Holdings.

Finally, we consider possible sources of pro-shareholder bias among bankruptcy trustees. Shareholders typically appoint bankruptcy trustees without consulting creditors. These directors may therefore prefer to give shareholders a graceful exit. Additionally, bankruptcy directorships are short-term positions and the corporate bankruptcy world is small, with private equity sponsors and a handful of law firms generating most of the demand. Bankruptcy directors are dependent on this clientele for future engagements and can show what we call “auditing bias”.

In our data, we observe several individuals who have been repeatedly appointed to these board mandates. These “super repeat offenders” had a median of 13 board positions, and about 44% of them were at companies that went bankrupt while on the board or up to a year before their appointment. Our data also shows that super-repeaters have close ties to two leading bankruptcy law firms. When we put these pieces together, our data reveals an ecosystem of a small number of individuals who specialize in sitting on the boards of companies that are failing or emerging from bankruptcy, often with private equity controllers and the same law firms .

These findings support the claim that bankruptcy trustees are a new weapon in the private equity playbook. In fact, bankruptcy trustees help protect self-dealing from court interference. Private equity sponsors know that if the portfolio company fails, they could appoint bankruptcy trustees to handle creditors’ claims, file for bankruptcy and force creditors to accept a cheap settlement. Importantly, the easy handling of self-dealing claims in the bankruptcy court may lead to more aggressive self-dealing in the future.

Our results have important policy implications. Bankruptcy law is designed to protect businesses while protecting creditors. These goals collide when creditors file lawsuits that threaten to delay exit from bankruptcy. While bankruptcy trustees seek expeditious resolution of these lawsuits, their independence is in question since the defendants in these lawsuits appoint them. Additionally, bankruptcy trustees often circumvent the system of checks and balances created by Congress when they purport to perform tasks normally performed by the Unsecured Creditors Committee, such as: B. Investigating claims against insiders.

We argue that the insolvency practitioners’ contribution to streamlining insolvencies should not be at the expense of creditors. The insolvency court should therefore only treat insolvency practitioners as independent – and therefore worthy of judicial attention – who, in an early court hearing, deserve overwhelming support from creditors whose claims are at risk, e.g. B. unsecured creditors or secured creditors that the debtor may not have been able to pay in full. Insolvency practitioners without such support should not prevent creditors from examining and pursuing claims.

Creditors are likely to need information about insolvency practitioners to form an opinion, and insolvency judges can decide what information request is appropriate to create standardization and predictability. However, disclosure is not a substitute for creditor support. Requiring disclosure without regard to creditors when selecting insolvency practitioners will not eliminate insolvency practitioners’ structural bias.

Some may argue that our solution is impractical or otherwise lacking. In the article we answer these claims. More importantly, our solution is the only way to ensure insolvency practitioners are truly independent. If it can’t be made to work, bankruptcy law should go back to how it was before the invention of bankruptcy trustees, when federal bankruptcy judges were the only impartial actors in most large Chapter 11 cases. In such a scenario, the debtors are free to hire anyone who wants to help them deal with financial difficulties, but the court regards these insolvency practitioners as ordinary professionals hired by the debtor: it should weigh their position against that of the creditors and the Allow creditors to conduct their own investigation and lawsuit, and not approve settlements just because the bankruptcy trustees approve them.

Beyond bankruptcy law and bankruptcy policy, our analysis also has implications for corporate law. Much of the literature on director independence in corporate law has focused on directors’ past and present ties to the company, to management, or to the controlling shareholder. We examine another powerful source of bias: the lure of future engagements and the attorneys who advise them.

Shortly after a draft of our article was published, it was featured in the Wall Street Journal, the Financial Times, and Bloomberg, among others. It also sparked heated debate among bankruptcy attorneys. In response to the controversy, Senator Elizabeth Warren proposed federal legislation that would give the Official Committee of Unsecured Creditors exclusive authority to pursue and settle claims against insiders and to request a court hearing to investigate conflicts with directors.

Senator Warren’s proposal aligns with our findings and has similar goals to our proposal, but we urge judges not to wait for Congress to act—they can easily implement our proposal with the resources they already have .

While Senator Warren’s proposal has the advantage of simplicity and, if adopted, will ensure uniform application by different judges, our proposal has two advantages. First, it allows the debtor firm to appoint experts of its choice to manage the bankruptcy process and obtain judicial approval, so long as those appointments are acceptable to creditors. Second, by requiring insolvency practitioners to be acceptable to creditors, our proposal ensures that all actions of the board in the event of insolvency, not just decisions on claims against insiders, promote creditor interests. This is important because we find that bankruptcy trustees are associated with lower creditor returns even when they are not investigating claims against insiders.

The full paper is available for download here.

Leave a Comment