September 15, 2021

New Working Paper Raises Significant Concerns Regarding “Bankruptcy Directors” in Chapter 11 Cases

Bankruptcy practitioners have been anecdotally aware of the increased presence of so-called “bankruptcy directors” in Chapter 11 cases over the last decade. Three academics, however, recently released a seminal working paper containing the first empirical study on the effect such directors have in Chapter 11 cases.

Bankruptcy practitioners have been anecdotally aware of the increased presence of so-called “bankruptcy directors” in Chapter 11 cases over the last decade. Three academics, however, recently released a seminal working paper containing the first empirical study on the effect such directors have in Chapter 11 cases.

In June 2021, Jared A. Ellias, Ehud Kamar, and Kobi Kastiel circulated The Rise of Bankruptcy Directors as part of the European Corporate Governance Institute (ECGI) Working Paper Series in Law. Their study analyzed a sample of all Chapter 11 filings for large firms (more than $250 million in assets or liabilities on their bankruptcy petition) between January 1, 2004, and December 31, 2019, in which the identities of each of the firm’s directors were disclosed to the bankruptcy court. Overall, the findings showed that the percentage of firms in Chapter 11 cases with bankruptcy directors increased from just 3.7% in 2004 to 48.3% in 2019. Furthermore, “over 60% of the firms that appointed bankruptcy directors had a controlling shareholder and about half were under the control of private-equity funds.”

While bankruptcy directors are supposed to be “neutral experts that act to maximize value for the benefit of creditors,” the authors’ study and research findings cast serious doubt on the independence of directors and provide evidence that the increased use of directors is correlated with significantly decreased recoveries by creditors.

Who Are Bankruptcy Directors?

In short, bankruptcy directors are individuals with special bankruptcy experience and expertise appointed to the boards of directors for distressed companies in preparation of, or shortly after, a Chapter 11 filing, and who receive board power “to make core bankruptcy decisions” in connection with the proceedings, including financing negotiations. Of the bankruptcy cases in the study’s sample with information on director join dates available, “the average bankruptcy director joined the board seven months prior to the petition date.” This trend has dramatically escalated in recent years:

Increasingly, large firms prepare to file for Chapter 11 by adding to the board one or two former bankruptcy lawyers, investment bankers, or distressed debt traders. The new directors receive the board’s power to make important Chapter 11 decisions and claim in court to be neutral experts that make decisions to benefit the firm and its creditors.

The supposed neutrality of bankruptcy directors and their expertise may heavily influence a bankruptcy judge to accept and trust their findings and recommendations, akin to the decisions of a court-appointed Chapter 11 Trustee or examiner. This is no doubt one of the intended purposes of the increased use of bankruptcy directors in Chapter 11 cases: “The creation of the new role of bankruptcy directors in the past decade is the work of entrepreneurial bankruptcy lawyers and restructuring professionals. They have cleverly blended corporate law’s deference to independent directors with bankruptcy law’s faith in neutral trustees.”

What Powers Do Bankruptcy Directors Possess?

Besides financing negotiations, one the most significant powers granted to bankruptcy directors includes the investigation of potential claims by creditors, including those of self-dealing, against a firm and its private-equity sponsors. These types of claims can be a main source of recovery for unsecured creditors. In fact, bankruptcy directors investigated claims against insiders in roughly half of all cases. Nevertheless, the authors found that “the presence of bankruptcy directors is associated with 21% lower recoveries for unsecured creditors.” More shockingly, in cases in which bankruptcy directors investigated claims against firm insiders, “unsecured creditors fare[d] on average as much as 43% worse than in other firms.”

While the authors cautioned that they were not alleging causation between the presence of bankruptcy directors and lower recoveries for creditors, they claimed that such findings were “concerning because it raises the possibility that bankruptcy directors make decisions that are not value-maximizing” and “at least shifts the burden of proof to those claiming that bankruptcy directors improve the governance of distressed companies.” 

Are Bankruptcy Directors Neutral?

There are certainly several reasons to doubt the neutrality of bankruptcy directors and suspect that they might be biased in favor of debtor firms and their shareholders or private-equity sponsors. Some of the systemic problems in the use of bankruptcy directors have to do with the public nature of bankruptcy cases and the small community of experts from which these directors are drawn.

First off, these positions can be quite lucrative, with compensation starting at flat fees of between $200,000 to a few hundred thousand per annum, plus $500 to $1,000 per hour for time, all for jobs that might last six months or less. If a bankruptcy director can quickly and successfully navigate a large firm out of Chapter 11 with good results, he or she is likely to get noticed by the bankruptcy community and receive offers of employment on the boards of other distressed firms.

Second, there are a relatively small number of law firms that can “exert significant influence” over the hiring process of bankruptcy directors by distressed companies. For example, the law firms of Kirkland and Weil, “two preeminent law firms specializing in the representation of distressed companies,” accounted for a huge share of cases in the study’s sample. These same two firms were also strongly tied to a small number of bankruptcy directors who had served on the boards of dozens of firms in Chapter 11 cases.

These incentives and the prospect of future employment can lead a bankruptcy director to favor the wishes of the board of directors over those of creditors as a form of “audition bias”:

[B]ankruptcy directors are not neutral experts. Shareholders appoint them on the advice of their lawyers. They are naturally predisposed to favor those who chose them for this lucrative engagement. Moreover, a bankruptcy directorship is a short-term engagement that creates incentives to treat it as an audition for the next engagements. The dependence on future engagements strengthens bankruptcy directors’ desire to be helpful to shareholders and their lawyers. A bias in favor of shareholders can result in cheap settlements of claims against shareholders and in restructurings that let shareholders retain more equity. A bias in favor of lawyers can result in quick settlements to make the lawyers look good at the expense of creditors. In short, shareholders’ control of the appointment of bankruptcy directors undermines their independence.

A number of individuals who served as bankruptcy directors in the cases studied were dubbed “super-repeaters” because they had been “appointed to these directorships repeatedly, pointing to a growing professionalization of their role.” The director at the very top of the “super-repeaters” list had “served on the boards of at least 96 companies, 31 of which were positions on the board of Chapter 11 debtors on the petition date or within a year thereafter.”

However, even if an individual has no prior connection to the debtor firm or its attorneys, he or she “will not want to disappoint them and jeopardize future engagements.” Also, even if bankruptcy directors make concerted attempts to remain neutral, they might have an “unconscious bias” in favor of the board of directors “because they view them as part of their group.” Finally, since creditors have no influence over the appointment of bankruptcy directors, directors inherently “lack incentives to advance creditors’ interests.”

Other Issues of Concern:

Furthermore, many Chapter 11 cases have debtor-in-possession financing agreements that require debtor firms to emerge from bankruptcy within a short period of time, sometimes in as few as 90 to 120 days. As such, bankruptcy directors can allegedly be of great assistance in situations where “speed to exit is paramount.” After the petition is filed, bankruptcy directors “typically negotiate a quick settlement and argue that the court should approve it to save employee jobs.”

However, such short time frames do not permit Unsecured Creditor Committees (UCCs) and their counsel much leeway in their own investigations of potential claims against a firm and its private-equity sponsors where a non-neutral bankruptcy director is at the wheel. In this manner, biased bankruptcy directors may “diffus[e] creditor claims against private-equity sponsors that controlled the bankrupt firms,” particularly by claiming that a separate investigation by the UCC would be “duplicative” and a waste of judicial time and resources. Ultimately, such a result frustrates Congressional intent as to the role UCCs are supposed to play in the bankruptcy system: “Bankruptcy law amplifies creditor voice by allowing the appointment of a committee of unsecured creditors that acts as a check on the board.”

As an example, the authors cite to the bankruptcy case of retailer Nine West in 2017. The company’s controlling shareholder, Sycamore Partners Management, had allegedly “looted more than $1 billion from the firm’s creditors.” The board appointed two bankruptcy directors who were both objected to by creditors. The directors, who controlled the litigation, eventually “blocked creditor attempts to file lawsuits on their own and ultimately settled the claims for about $100 million,” far less than the amount sought by the UCC.

Results like the foregoing one in the Nine West case can actually incentivize firms to asset-strip before filing for Chapter 11, knowing that their bankruptcy directors can exert tremendous influence on creditors to accept much smaller settlements:

[B]ankruptcy directors are a new weapon in the private-equity playbook. They allow sponsors to extract value from portfolio firms in self-dealing transactions and, if a firm fails, appoint bankruptcy directors to handle creditor claims, file for bankruptcy, and force creditors to accept a cheap settlement. If this claim is correct, the ease of handling self-dealing claims in the bankruptcy court ex post can fuel more aggressive self-dealing ex ante.

In general, while bankruptcy directors are supposed to provide the benefits of “adding expertise to the boardroom, streamlining the bankruptcy proceedings, and blocking frivolous litigation,” the authors’ study found absolutely no evidence to support these alleged three advantages.

A Simple Proposal to Improve the System:

At bottom, the authors argue that “the contribution of bankruptcy directors to streamlining the bankruptcy process should not come the expense of creditors.” In order to combat the systemic problems inherent with bankruptcy directors in the bankruptcy process, they propose a simple and elegant solution for consideration and adoption by the courts ⸻ namely, that judges consider bankruptcy directors to be independent only if all unsecured creditors approve of their appointment, preferably at the very beginning of bankruptcy proceedings (or even before the filing of the petition). Furthermore, the authors assert that “judges should defer to the business judgment of bankruptcy directors only after verifying their neutrality.” Such a policy would give creditors an early voice in the process and make bankruptcy directors “accountable to all sides of bankruptcy disputes.”

Permitting unsecured creditors and their counsel to have more input at the very beginning of proceedings or even before a petition is filed will likely result in a smoother and shorter litigation process: “Creditors in Chapter 11 proceedings are usually sophisticated investors with expert lawyers. There is no reason to let shareholders’ appointees prevent creditors from representing themselves in matters on which creditors and shareholders disagree. Doing so sidesteps the checks and balances built into Chapter 11.” This could easily be accomplished by bankruptcy judges adopting a standard practice of holding an early hearing in the process “in which the debtor firm will present any bankruptcy directors it appointed or plans to appoint.” If the creditors agree with the appointment, the judge may regard the bankruptcy director as neutral; otherwise, if there are any objections, the “court will regard the bankruptcy director as partisan in areas of creditor disagreement” and the director’s positions on behalf of the debtor firm should be weighed against the positions of the creditors.

While some bankruptcy practitioners may raise concerns that unsecured creditors might waive or forfeit some of their rights should they concede to the appointment of a neutral bankruptcy director, Ellias believes that the development of strong safeguards by the courts will actually lead judges to prefer even more widespread use of truly independent and neutral bankruptcy directors in Chapter 11 cases:

[B]ankruptcy judges, on average, once you build guardrails, will probably come to love it, because these folks are just going to be great witnesses in court, so much better than somebody’s CFO taking the stand who’s never been in a bankruptcy courtroom before, and it stands to reason they can be allies to the bankruptcy judge in running a professional bankruptcy case.

Only time will tell how the courts will respond to the authors’ research findings. However, bankruptcy practitioners have already begun to suggest ways to implement such safeguards into the system.