This is the next post in Plan Proponent’s series on the confirmation-related recommendations in the ABI Commission Report (and, in particular, its Exiting the Case piece). Part A of that piece is titled “General Authority of Debtor in Possession and its Board of Directors.” The second section of Part A (and this post) addresses the role of the debtor in the plan process. We addressed the first part (the debtor’s authority in the plan process) here.

Debtor v. Debtor-in-Possession in the Plan Process

The second section addresses the distinction, if any, between a debtor and a debtor-in-possession when it comes to fiduciary duties. After all, Section 1121 of the Code refers to the “debtor” having the right to file a plan–not the debtor-in-possession. Does the debtor, as plan proponent, owe fiduciary duties under the plan-related Code sections (e.g., 1121, 1127, 1129, 1141, 1142, etc.) in the same manner that the debtor-in-possession owes fiduciary duties to the estate?

The Commission points out that some courts have determined that a plan proponent does not owe fiduciary duties in the plan process. Seee.g., In re Waters Edge Ltd. P’ship, 251 B.R. 1, 7 (Bankr. D. Mass. 2000) (finding that a plan proponent’s “bargaining and cramdown rights necessarily exclude” fiduciary obligations, including any duty of loyalty to unsecured creditors). It points out that other courts find that the debtor-in-possession’s fiduciary duties continue to apply in the plan process. And, finally, other courts are not very precise on the issue either way.

Ultimately, the Commission recommends that Section 1121 should be amended to clarify that the “debtor should be separated from the debtor in possession in the plan context, and that the debtor acting as plan proponent should not be considered a fiduciary for the creditors.”

The Commission reasons that it would be difficult, if not impossible, for a plan proponent to negotiate a plan for itself and its equity security holders, on the one hand, and negotiate a plan in satisfaction of the debtor-in-possession’s fiduciary duties to creditors, on the other hand. And although the Commission considered novel proposals for choosing, clarifying, or determining a plan proponent’s fiduciary duties, the Commission fell back on the state law deference that we discussed in the previous post:  applicable state governance law should determine a plan proponent’s fiduciary duties in “negotiating, drafting, and seeking confirmation of a chapter 11 plan.”

Refresher on Fiduciary Duties In and Out of Bankruptcy

Although other resources are likely better-equipped to fully address management’s state law fiduciary duties (and the continuing evolution of the law in that area), Plan Proponent will attempt to supply  a high-level refresher.

First, most states recognize that directors and officers, or similar managers, have a duty of loyalty and a duty of care to the corporation. Under the duty of care, management must exercise ordinary care and prudence under the circumstances and act in good faith and in the best interests of the corporation and its shareholders. Under the duty of loyalty, management must refrain from self-dealing and avoid conflicts of interest and even the appearance of impropriety.

Second, under the business judgment rule, if management acts in good faith, on an informed basis, and in a manner that it reasonably and honestly believes is in the corporation’s best interests, then there is a strong presumption in favor of respecting managerial actions. Ultimately, the business judgment rule focuses more on the decision-making process than the decision itself. It provides a sort of safe harbor for duty of care questions, but not duty of loyalty questions.

[Note: Courts have struggled for the last 20 years to determine whether those duties change as a business entity approaches insolvency (the “zone of insolvency”) and/or when it becomes insolvent. The better view appears to be that approaching insolvency or becoming insolvent does not change the nature of the duties. Rather, it becomes a question of who are the beneficiaries of the duty (i.e., the community of interests served by the duties expands to include and provide standing to creditors). At bottom, it still appears that managers simply need to maximize or preserve the long-term going concern value of the entity in good faith and on an informed basis.]

Generally, these duties and the business judgment rule continue to apply in Chapter 11 even though (i) a debtor-in-possession’s management is, by definition, not disinterested and (ii) Chapter 11 presents a “turbulent rivalry of interests.”  See 7-1108 Collier on Bankruptcy P 1108.10 [5] (16th ed.) (quoting In re Curlew Valley Associates, 14 B.R. 506, 510 (Bankr. D. Utah 1981)).

Therefore, current practice and the Commission appear to agree with the following general proposition: In Chapter 11, management can (and, arguably, is expected to) continue to seek profit for shareholders, even with some risk, so long as it acts with due care, without self-dealing or bad faith, and while considering the prospects of reorganization and the need for support from one or more constituencies. All constituencies should be considered, but not all constituencies have to be in agreement.

Arguably, that rule is particularly appropriate because (i) the Code has such a preference for the continuation of interested and potentially conflicted management; (ii) the Code provides additional checks and balances via Sections 1102 and 1109 (i.e., creditor and equity committees and the general right to be heard); and (iii) the Code provides an ultimate backstop via bankruptcy court scrutiny.

As an aside, a financial advisor who we routinely engage in Chapter 11 cases often refers to the equity class in a plan as the “good news class,” the idea being that so long as bankruptcy’s priority scheme (including the absolute priority rule) is satisfied, maximizing a debtor’s profit and going concern value almost naturally guarantees that creditor constituencies are being taken care of in an optimal fashion.

[For the avoidance of any doubt, the Commissioners also determined that requiring separate professionals for the debtor, on the one hand, and the debtor-in-possession, on the other hand, would likely be duplicative and costly, with no real advantage, so long as the subject professionals were otherwise disinterested under Sections 327 or 328.]

In our next post on the ABI Commission Report, we will address “Approval of Section 363x Sales.”