Breaking the Chapter 11 Logjam: Court's Sua Sponte Appointment of Chapter 11 Trustee Not Abuse of Discretion January/February 2005 Thomas A. Wilson The reorganization of a business under the aegis of chapter 11 of the Bankruptcy Code embodies a Congressional determination that the continued operation of a salvageable concern produces a net societal benefit. To promote that benefit, the Bankruptcy Code recognizes that the people most familiar with a debtor's business, i.e. , a debtor's current officers and managers, are those best suited to pursue the goal of reorganization efficiently, and, therefore, authorizes them to direct the debtor's ordinary course affairs with a minimum of interference by the bankruptcy court. The default option of allowing a debtor to remain in possession of its assets, however, does not always result in the maximization of the value of those assets. Occasionally, failures of honesty or competence on the part of a debtor's managers, among other things, lead to the conclusion that the interest of all parties affected by a debtor's attempt to reorganize are best served by the appointment of a disinterested person, or trustee, to assume stewardship of the reorganization. A recent decision of the Third Circuit Court of Appeals, In re U.S. Mineral Products Co. , examines both the legal standard for appointment of a chapter 11 trustee and the statutory mechanism pursuant to which such an appointment may be ordered. Appointment of a Trustee in Chapter 11 Section 1104(a) of the Bankruptcy Code provides that, prior to confirmation of a plan of reorganization, "on request of a party in interest or the United States trustee, and after notice and a hearing, the court shall order the appointment of a trustee — (1) for cause . . . or (2) if such appointment is in the interests of creditors, any equity security holders, and other interests of the NYI-2182018v1
estate." Section 1104 allows for either the identification and appointment of a trustee by the United States trustee upon order of the court or, if requested by any interested party, the election of a trustee by the creditors of the debtor. "Cause" is defined in section 1104(a)(1) of the Bankruptcy Code to include "fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management … or similar cause." These non-exclusive examples of "cause," each describing egregious conduct on the part of a debtor's management, serve to underscore a central theme of the relevant caselaw addressing the question of a trustee's appointment: namely, that such an appointment is an extraordinary remedy. This theme is further underscored by section 1104(a)(2)'s use of the conjunctive in offering courts an alternative basis upon which to order a trustee's appointment. Although section 1104(a)(2) would appear on its face to present courts with a less stringent standard for appointment than section 1104(a)(1), the requirement that all interests in a debtor's estate be best served by the removal of current management (including the debtor's interests) strictly limits those occasions upon which section 1104(a)(2) might serve to facilitate a trustee's appointment. Indeed, the appointment of a trustee for "cause" is a far more common occurrence than an appointment under the "interests" test of section 1104(a)(2). In the same way that section 1104's substantive requirements counsel judicial restraint on replacing management with a trustee, the statute's procedural elements purport to limit the circumstances under which a court will have occasion to make such a determination in the first instance. As noted above, section 1104(a) provides that a court will determine whether the appointment of a trustee is required only "on request of a party in interest or the United States NYI-2182018v1
trustee, and after notice and a hearing." Despite these procedural impediments, however, some courts, relying on the broad grant of judicial power embodied in section 105 of the Bankruptcy Code, have taken the step of appointing a trustee on their own initiative. Section 105 was amended in 1986 in response to a circuit court ruling that a bankruptcy court is powerless to act on its own if a provision of the Bankruptcy Code expressly requires a request for action by a party-in-interest. It now states that "[n]o provision of this title providing for the raising of an issue by a party in interest shall be construed to preclude the court from, sua sponte [that is, "on its own"], taking any action or making any determination necessary or appropriate to enforce or implement court orders or rules, or to prevent an abuse of process." Trustee appointments sua sponte almost invariably occur in the presence of "cause" that had theretofore gone unaddressed by the parties. In In re U.S. Mineral Products Co. , however, the Third Circuit Court of Appeals upheld a bankruptcy court's sua sponte decision to appoint a trustee under the "interests" standard in section 1104(a)(2). The Third Circuit's Ruling in U.S. Mineral Products The facts underlying U.S. Mineral Products were, as the Third Circuit itself put it, "anything but pristine." The debtor was a manufacturer of fire-resistant material, insulation and acoustical products that filed for bankruptcy in 2001 to resolve asbestos-related liabilities. Although the debtor had submitted several plans to the asbestos claimants, the parties had been unable to work out a consensual plan more than two years after the filing, with the debtor's asbestos claimants seeking the opportunity to file their own competing plan. At a hearing held in July of 2003, the bankruptcy court expressed its misgivings as to whether the parties would ever be able to work out a consensual resolution. Accordingly, the court informed them of its intention, should the NYI-2182018v1
parties fail to come to terms by the end of August, to appoint a chapter 11 trustee "who can sell the company and prepare a plan and file and go forward with it." The United States trustee overseeing the case subsequently filed a statement with the Court noting that "in the absence of reason to believe that this pattern will change, it may be in the best interests of creditors and the estate to appoint a disinterested trustee." When the parties were still at loggerheads at the expiration of the allotted time, the court ordered the appointment of a trustee pursuant to section 1104(a)(2). The bankruptcy court based its decision on the acrimonious relationship between the debtor and the asbestos claimants, the need to construct a plan acceptable to creditors, the debtor's failure to have listed all creditors on its schedules submitted to the court and its finding that "such appointment is in the interests of creditors." The debtor appealed to the district court, which affirmed. Taking its appeal to the Third Circuit, the debtor argued that, given the procedural requirements of section 1104(a), the bankruptcy court lacked the power to appoint a trustee of its own volition. The Third Circuit, affirming the decision below in an unpublished opinion, firmly rejected the debtor's argument. Following the Ninth Circuit Court of Appeals' decision in In re Bibo, Inc. , the Court held that section 105(a) of the Bankruptcy Code has essentially eliminated the relevant procedural hurdle of section 1104(a), making it impossible for an appellate court to find a lower court's sua sponte appointment of a trustee impermissible as a matter of law. The debtor further argued that the court had violated due process based upon the lack of any "notice and a hearing" preceding its action. The Court rejected this due process challenge as NYI-2182018v1
well, holding that the bankruptcy court's announcement of its intentions one month prior to the issuance of its appointment order constituted adequate notice. Finally, the Court upheld the evidentiary basis underlying appointment pursuant to section 1104(a)(2), noting a court's "broad discretion" in making such a determination and citing to its previous decision in In re Marvel Entertainment Group, Inc. for the proposition that "deep-seeded [sic] conflict and animosity" between the parties provides a court with sufficient grounds to order the appointment of a trustee. Analysis U.S. Mineral Products is noteworthy for several reasons. It may well be the first case in which a court has upheld the sua sponte appointment of a chapter 11 trustee pursuant solely to the "interests" test of section 1104(a)(2), i.e. , in the absence of a finding of "cause." However, that the court did so without any specific finding that the parties' inability to arrive at a consensual resolution rose to the level of "abuse of process" is troubling. Congress sounded a strong contrapuntal note to the policy, otherwise deeply ingrained in the Bankruptcy Code, of removing bankruptcy judges from the administration of bankruptcy cases when it amended section 105 in 1986 to empower courts to act on their own under certain conditions. Still, as amended, the provision erects a fairly high standard for assessing the propriety of such initiatives. The Third Circuit's ruling, even though it has no precedential value, indicates that unilateral court action may be appropriate even where conduct falls short of "abuse of process." Such a broad interpretation of a bankruptcy court's equitable mandate may portend increased court initiative in chapter 11 cases to break a logjam resulting from the players' reluctance or inability to make progress toward a workable exit strategy. NYI-2182018v1
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