Good afternoon. I am grateful for the opportunity to speak with you today about the mission of the United States Trustee Program (USTP or Program) as it relates to the corporate restructuring community. I very much respect the contributions of the Association of Insolvency and Restructuring Advisors (AIRA) and all of you to promoting the national economy by helping businesses reorganize inside and outside the bankruptcy system. You possess important skills that have a positive impact on our fellow citizens who rely upon an expanding economy where businesses can flourish and companies in financial distress may be rehabilitated or their assets deployed to more efficient uses. Your work saves and creates new jobs, and it fosters economic prosperity.
The great economist Joseph Schumpeter wrote about the importance of economic dynamism and the entrepreneurial spirit. He knew the personal sting of bankruptcy, but remained convinced that change and the “wild spirits” of entrepreneurs were the key to economic growth. An effective bankruptcy system is an essential element of every developed national economy. It encourages entrepreneurship by accounting for failure. Bankruptcy provides individual debtors with a “fresh start” and business debtors with a “breathing spell” during which the business can be reorganized or sold. Importantly, bankruptcy also provides a mechanism for the efficient distribution of assets in the event of business failure.
Role of the United States Trustee in Chapter 11 Cases
The role of the United States Trustee Program is to act as the “watchdog” of the bankruptcy system. Our mission is to promote the integrity and efficiency of the bankruptcy system for the benefit all stakeholders. To accomplish this, we carry out a wide variety of administrative, regulatory, and enforcement responsibilities. Regardless of whether a case is consumer or business, liquidation or reorganization, our core responsibility is to help ensure that all participants in the bankruptcy system – consumers, business executives, creditors, and professionals – comply with the Bankruptcy Code.
The Limits of Discretion in a Code-Based Bankruptcy System
In the Bankruptcy Code, Congress established the rules and the public policies that bind all participants in the system. Neither judges exercising their discretion, nor the parties in a case reaching an agreement, can contravene the law or substitute their preferences for those of the Congress as expressed in statute.
One of the best examples of the limits of this arose in Czyzewski v. Jevic Holding Corporation, which was decided in March by the United States Supreme Court. The essential facts in the case were that the debtor laid off employees on the eve of bankruptcy and later sought approval of a settlement to dismiss the case that provided for a final distribution of available assets. The problem was that the distribution excluded the WARN Act claims of the laid off truck drivers, even though those claims were entitled to payment priority under the Code. The proposed settlement favored lower priority creditors who would be paid in return for the creditors’ committees dropping a fraudulent conveyance lawsuit against the creditors who bought the company in a leveraged buy-out. Fortunately and appropriately, the Supreme Court said “no.”
The United States Trustee sided with the truck drivers in objecting to the settlement in bankruptcy court. We lost. We then unsuccessfully argued for reversal in the United States Court of Appeals for the Third Circuit. Ultimately, we were signatories on the Solicitor General’s brief in the Supreme Court where we prevailed. The Supreme Court made clear that the bankruptcy court does not possess discretion to approve a final distribution through a structured dismissal that violates the priority of creditors carefully set forth by the Congress in the Bankruptcy Code – at least not without the affirmative consent of the harmed stakeholders.
The rationale of the Jevic decision may have major implications, not only in protecting the chapter 11 plan confirmation and priority of distribution process, but also in many other contexts where parties seek to circumvent statutory mandates.
Significant USTP Actions in Chapter 11 Cases
In carrying out our responsibilities, the USTP takes positions that sometimes are adverse to those of debtors and major creditors. This tension is consistent with the adversarial nature of any legal process and is particularly present in bankruptcy where there is a multiplicity of interests. To monied players in a case, bankruptcy is a framework for deal making driven by the motivation to obtain the best possible economic outcome. For the USTP, bankruptcy is a judicially supervised process that is not just guided, but defined, by a statute written by Congress. Our different perspectives are natural and contemplated by the Congressional draftsmen.
In our chapter 11 practice, the Program’s responsibility to uphold the Bankruptcy Code is reflected in our day-to-day practice of reviewing and, where necessary, objecting to proposed actions that we believe do not meet statutory standards. For example:
- We rigorously review applications to employ professionals to ensure the adequate disclosure of connections and the absence of disqualifying conflicts of interest. Over just the past year, we have been involved in numerous widely reported cases in this regard. In one recent case, we objected to a large advisory firm’s skeletal disclosures. Importantly, we worked out a reasonable scope of disclosure in light of the firm’s exceptionally wide-ranging client base and expansive professional services in areas remote from the terms of the engagement in the extant case. The judge agreed with the USTP’s position and the firm appears to have conformed subsequent applications to that position. In another case, the USTP objected to fees after it was revealed that there was a strong personal connection between principals in a law firm and the financial firm that was engaged to review the work performed by the law firm. Even though some expressed the view that the USTP should excuse the failure to disclose with minimal penalty, ultimately the court directed the disgorgement and denial of all fees.
- The United States Trustee is almost always alone in objecting to executive and insider bonuses that fail to meet the rigorous standards enacted by Congress in 2005 in section 503(c) of the Code. Over time, parties have become a bit more sophisticated in what can only be called evasion tactics. Instead of merely saying the money is required to retain insider executives, applicants dress up impermissible retention bonuses as incentive payments. We continue to see applications for bonuses that require unexceptional efforts by insiders, such as realizing a sales price which already has been offered by a stalking horse bidder. We also see motions seeking to assume pre-petition employment agreements that contain buried retention bonus provisions, even though section 503(c) clearly applies to agreements made pre-petition. Although in most cases we succeed in obtaining at least a modification of the initial bonus plan, it is disappointing that we have not succeeded more in improving compliance with the bonus restrictions that Congress has imposed.
- Similarly, the USTP is often the lone voice objecting to non-consensual, non-debtor third party releases. Here is a common scenario: the debtor and large creditors who seek to control the post-confirmation entity place a provision in the plan releasing non-bankruptcy claims of non-debtors against other non-debtors without the consent of the releasing parties. They say key parties will withdraw from the deal without a release. It is important to note that a creditor’s vote in favor of the plan does not in and of itself constitute consent to the release of that creditor’s right to sue on its non-bankruptcy claims against non-debtors. And even in Circuits that are more lenient in approving non-debtor releases, the scope of proposed releases is often beyond the pale. We object, but seldom do other parties. The proponent’s justification often boils down to two arguments having little to do with the merits: (1) the USTP has no financial interest in the case, so our objection should be disregarded; and (2) without the agreement, the whole deal will fall part. The court, understandably trying to bring the case to a conclusion, sometimes expresses skepticism about the objection as well. Lost in the argument, though, are the facts that: (1) the USTP was created as a neutral watchdog precisely so it would have the freedom to enforce the law as Congress has written it and to protect the rights of small creditors who cannot afford to participate actively in the case; and (2) often there is scant evidence that the benefitting parties will withdraw from the deal underlying the plan absent the releases. Not to make too fine a point, but frankly it seems that the proliferation of impermissible third party releases is due to one major factor – parties think they can get away with them. More often than not, we prevail, at a minimum, in obtaining substantial modifications to the proposed terms of the releases. But there is little doubt that, in many cases, the rights of non-consenting creditors would be unprotected but for the watchful eye of the USTP.
Instead of describing numerous other issues that often cause us to object in a chapter 11 case, let me move on to describe two initiatives underway that may be of special interest to this gathering of insolvency and restructuring professionals: professional fees and employment terms for chief restructuring officers. We will need your input on both. You are experts and we cannot possibly devise a workable framework without hearing from you individually and as an organization. We look forward to working with you on these in the weeks and months ahead.
Professional Fees of Financial Advisors and Investment Bankers
In 2013, the USTP issued new Guidelines for Attorney Fees in Large Chapter 11 Cases. We are now hard at work considering guidelines pertaining to financial advisors and investment bankers.
Large Case Attorney Fee Guidelines
The 2013 large case attorney fee Guidelines focused in significant part on seeking disclosures that would enable the court, United States Trustees, and parties to evaluate whether the law firm satisfied its burden to justify fees under statutory standards. Among other things, we focused on ensuring that fees reflected market rates rather than impermissible bankruptcy premium rates; that professionals submitted budgets to foster better cost controls; and that debtors considered cost-saving efforts, such as hiring lower-cost efficiency counsel to perform claims review and other “commoditized” tasks. We also urged that, in appropriate cases, courts approve the retention of experienced practitioners to serve as independent fee examiners to review the reasonableness of the fees in light of the work necessary to be performed in a case.
The Guidelines do not have the force of law. They are instructions to our own lawyers about the information they should receive from applicants in deciding whether to object to fee applications. Although some courts have adopted the Guidelines as a Local Rule to simplify enforcement, most courts have not done so. That creates some inefficiency because we sometimes have to negotiate the disclosures before we can analyze the information and determine if the fees should be awarded under statutory criteria.
After four years, we have concluded that the large case attorney fee Guidelines are achieving their purpose. We are obtaining better disclosures, firms are submitting budgets, and firms have improved their internal billing practices. We still occasionally see evidence of rates that are not adequately justified and of other non-compliant practices that we seek to remedy; but now, we and other parties have more complete information and transparency to decide whether to object to fee applications. And, in an example of the “dog that didn’t bark,” we note a substantial diminution in concerns about the practicality of the Guidelines expressed by applicant law firms.
Fee Guidelines for Financial Advisors and Investment Bankers
Using the same process that we used in developing the large case attorney fee Guidelines, we now are tackling large case fees for financial advisors and investment bankers. The process generally will entail outreach to stakeholders, publication of draft guidelines, a public meeting at which stakeholders can make statements and answer questions from USTP representatives, and publication of the final guidelines. This process provides the USTP with valuable insights and information from experts on the front end, and also transparency on the back end so all can see the enforcement criteria the Program will employ in deciding whether to object to the fees of financial professionals.
This is a propitious time to develop these guidelines. The fees charged by financial advisors in bankruptcy cases today sometimes exceed legal fees, and the scope of services goes far beyond the accountancy that used to be the main service provided. Both financial advisors and investment bankers are essential actors in analyzing the core financial problems of the debtor’s business, valuing assets, devising strategies for reorganization or sale, and identifying investors and buyers. Nonetheless, standardized disclosures of services and time spent often are vague and insufficient. In the case of investment bankers especially, there needs to be more meaningful disclosures of services and metrics for evaluating success.
More frequently for financial professionals than attorneys, retention agreements provide for a fee arrangement under section 328 of the Code. Instead of using the section 330 lodestar approach of average hourly rate times reasonable time spent delivering agreed upon services, a basic sum is agreed to at the beginning of a case. Although the USTP thinks that alternative fee arrangements can provide a more efficient mechanism for charging for professional services than the lodestar, they certainly should not be used to evade basic disclosures required under the Bankruptcy Code and Bankruptcy Rule 2016.
Investment bankers, probably more than any other professionals, have used section 328 in their retention agreements. Under the so-called “Blackstone Protocol,” USTP offices concur with the section 328 term with a proviso that fees at the end of the case still can be reviewed by the United States Trustee under the more expansive factors set forth in section 330. Some say that this defeats the purpose of having a pre-approved compensation term. We understand that point of view. But these retention applications often are submitted for approval while the proverbial “ice cube” is melting and efforts are intensely focused on trying to salvage the business or arrange a sale. As a result, the applications may lack the necessary evidentiary support and the parties and the court may not be in the best position to conduct the rigorous review required of the pre-approved compensation terms.
With new guidelines, we hope the courts and all parties will have more information so that fees can be awarded with greater assurance that they were earned under the reasonableness standards set forth in the Code.
Employment Terms for Chief Restructuring Officers
Another initiative directly involving many members of this audience involves the retention of Chief Restructuring Officers (CROs). It is well established that the CRO industry has grown markedly in the bankruptcy world over the past two decades. Just as CROs play an integral role in turning around distressed enterprises outside of bankruptcy, increasingly they have navigated companies through the shoals of chapter 11 and helped manage corporate debtors back to financial health to the benefit of shareholders, creditors, and employees.
CROs Are Not a Substitute for a Chapter 11 Trustee
While CROs can play a constructive role, they cannot fill the shoes of a chapter 11 trustee when cause exists warranting the appointment of an independent fiduciary under section 1104. Sometimes businesses have engaged in pre- or post-petition activity that disqualifies current management and the board of directors from serving as the debtor-in-possession.
As all of us know, upon filing a bankruptcy petition, by operation of law management transforms into a fiduciary that is bound to act for the benefit all stakeholders, including creditors. A recent history of financial irregularities, egregious mismanagement, or indifference by the board, along with other facts, may render the company’s management unfit for service as a fiduciary. In such circumstances, the Bankruptcy Code and principles of sound corporate governance dictate that the court authorize the United States Trustee (UST) to appoint an independent chapter 11 trustee. Unsurprisingly, management usually resists. Often, they are joined in opposition to the USTs motion for a trustee by controlling creditors or the official committee.
Sometimes management seeks to defeat a trustee by appointing a CRO who reports to the same board that failed to detect or remedy prior management’s malfeasance or nonfeasance. We hear predictable arguments that continuity is needed, a trustee will result in additional costs to the estate and delay in the ultimate resolution of the case, creditors will not contribute funds to a plan with unknown trustee management, or some other argument designed to thwart a trustee. As much as we may respect the integrity and qualifications of a particular CRO, we do not accept those arguments.
There are numerous cases in which the selection of a CRO by the culpable corporation has simply preserved management’s prerogatives and led to no benefit to the estate. And the lack of independence in and of itself diminishes the integrity of the process, despite the highest integrity of the individual CRO. In our view, too few chapter 11 trustees are appointed in the modern bankruptcy system. In many districts, case law sets the burden of proof at the heightened “clear and convincing” evidence standard, rather than the typical “preponderance” of the evidence standard. The fact is that it is easier to deny a discharge to a consumer debtor – known as the death penalty of bankruptcy – than it is to obtain an order ousting incumbent management in favor of an independent chapter 11 trustee. That is both unfair and contrary to the statute.
As much as we appreciate the role CROs should play in the bankruptcy system, we will persist in our position that, if grounds exist to appoint a trustee, the appointment of a CRO does not provide a substitute cure. Of course, sometimes we appoint a member of the CRO community as the trustee. When we do that, the CRO not only offers his or her deep expertise, but does so free from tainted management’s control and influence.
USTP Protocol on Scope of CRO Retention
In recognition of the important role CROs can play in many bankruptcy reorganizations, almost 20 years ago we developed a protocol governing USTP consideration of the scope of a CRO engagement. Because a CRO who worked for the company prior to filing would be disqualified under the employment provisions of section 327 of the Code, we studied the matter and developed what became known as the “J. Alix Protocol.” Under that Protocol, we state publicly that we will not object to employment of a CRO if the debtor applies for retention under section 363 pertaining to the use of estate funds out of the ordinary course of business and also agrees to other protections against conflicts that would apply to a professional employment application under section 327. For many years, this solution has properly harmonized the demands of the Bankruptcy Code with the debtor’s practical need for CRO services.
Over the two decades since the Protocol was adopted, however, there have been many changes in the CRO industry. Both the frequency of employment of CROs and the scope of services offered by CRO firms have grown dramatically. We have reached out to participants in the restructuring business and other stakeholders for information on how the Protocol should be updated to account for the facts of modern practice, while remaining faithful to the conflict of interest provisions of the Code. Among the issues to be considered are: whether the “one hat” rule limiting the CRO to a single role as either manager or financial advisor can be made more flexible; whether there should be a reduction in the post-engagement period of time during which the CRO or members of the CRO firm are prohibited from investing in the securities of the reorganized company; and whether the indemnification of the CRO should be aligned with the indemnification of officers outside of bankruptcy.
After completing our initial outreach, we plan to follow generally the same process we used for the large case attorney fee Guidelines. To ensure transparency, we will publish proposed revisions, seek public comment, hold a public meeting, and issue final guidelines that will ensure the consistent treatment of CRO applications by all USTP offices around the country.
I thank you for your time today. Over the next three days, you will hear from interesting speakers and address topics that I am certain will provide a professionally enriching experience. But in all of the material and discussion, there is one most important fact to keep in mind: the work you do can help the broader American public. You have a duty to your client, but by faithfully discharging that obligation, you are creating a more prosperous economy that should help Main Street businesses and average consumers who head off to work every day.
As Professor Schumpeter said, “economic progress, in capitalist society, means turmoil.” And bankruptcy surely displays a good bit of turmoil. But you are there to help manage that turmoil. And the USTP is there to help ensure that the reorganization process goes forward in accord with the rule of law as written by the Congress. If you do your job, and the USTP does its job, then the result at least will reflect the democratic process and hopefully result in economic growth and prosperity that benefits all of our fellow citizens.
Thank you for what you do. I look forward to working with you, and negotiating with you. And, as a last, but sometimes necessary, resort, I look forward to seeing you in court.
My respect and best wishes to each of you.