There has been an explosion of bankruptcy filings that were arguably precipitated by leveraged buyouts and private-equity-backed transactions. Two recent examples are Toys R Us and Sears, both of which were saddled with billions of dollars in debt as a result of leveraged buyouts by private equity funds. Those types of transactions are frequently the target of investigations by creditors’ committees in bankruptcy cases and may be an important tool for a creditors’ committee to use to procure recoveries for general unsecured creditors.
In an effort to short-circuit the investigation process and deprive creditors’ committees of critical leverage, debtors are increasingly turning to internal investigations of their insiders conducted by nominally independent special committees of their boards of directors. In many cases, these special committee investigations are designed to pre-empt the ability of creditors’ committees to investigate or pursue insider claims.
In the face of this growing trend, creditors’ committees should act quickly after their appointment to preserve their independent ability to investigate and, if necessary, prosecute insider claims. Otherwise, they risk losing a significant bargaining chip or potential sources of recoveries for general unsecured creditors, who are last in the Bankruptcy Code’s distribution scheme.
The official committee of unsecured creditors is appointed by the United States Trustee and is composed of unsecured creditors that hold the largest unsecured claims against the debtors. Whenever possible, the U.S. Trustee attempts to appoint a committee that is representative of the various types of claims against the debtors.
Creditors’ committees have a broad mandate and play an integral role in bankruptcy cases. One of the fundamental responsibilities of a creditors’ committee is to investigate the prepetition conduct of the debtors and their insiders.1 Indeed, Section 1103 of the Bankruptcy Code empowers creditors’ committees to “investigate the acts, conduct, assets, liabilities, and financial condition of the debtor.”2 Creditors’ committees are particularly well-suited to carry out investigations of the debtors’ insiders because committee members owe fiduciary duties solely to unsecured creditors3 and are not constrained by any allegiances to the debtors.
The creditors’ committee’s investigation may uncover causes of action against the debtors and their insiders for, among other things, breach of fiduciary duty and receipt of fraudulent transfers. These claims may be particularly valuable because they are frequently covered by the debtors’ directors’ and officers’ liability insurance policies and may be unencumbered by the liens of the debtors’ prepetition lenders. The proceeds of insider claims—whether through settlement or litigation—may represent the only form of recovery to general unsecured creditors.
At the conclusion of their investigation, creditors’ committees have several options to pursue viable claims, such as by moving for standing to pursue or settle litigation prior to the effective date of a plan. Alternatively, the creditors’ committee can preserve the litigation so that it can be pursued after the effective date of a plan by a liquidating trustee or plan administrator. If there are insufficient funds to pursue insider litigation, creditors’ committees can consider other options, such as hiring counsel on a contingency fee basis or obtaining litigation funding.
The decision on when and whether to pursue insider litigation can have a profound effect on general unsecured creditor recoveries and the overall direction of the case.
For example, the bankruptcy of the West Coast department store retailer Mervyn’s was preceded by a $1.25 billion transaction whereby private equity firms purchased Mervyn’s, moved the real estate assets to a separate entity in exchange for no consideration, and leased the real property back to Mervyn’s. Upon its appointment, the creditors’ committee determined that the statute of limitations for potential insider claims was set to expire within weeks and compelled the debtors to commence an action to preserve the potentially valuable claims. The creditors’ committee later substituted in as plaintiff and prosecuted claims against the insiders for self-dealing and fraudulent transfers that were designed to extract and monetize over $1 billion of Mervyn’s valuable owned real estate for higher and better uses.
After several years of contested litigation, the insiders ultimately settled and as a result, the estate received significant sums, hundreds of millions of dollars in claims were expunged, and the estate went from administrative insolvency to solvency with a plan that provided a material return for unsecured creditors.
In an apparent response to the successful pursuit of insider litigation by creditors’ committees, debtors have utilized special committees in an attempt to control the investigation process. Although these special committees are ostensibly composed of independent directors, many debtors retain professional directors who may not be truly independent.
Special committee investigations typically commence shortly before the filing of the bankruptcy case and are highlighted in a debtor’s first day declaration.4 The special committee investigations continue after the petition date and may culminate in a public report concluding that litigation should not be instituted and recommending that the estate grant releases to insiders. The special committee may also negotiate and seek approval of a settlement with the insiders without consulting the creditors’ committee.
To further complicate matters, debtors tend to employ special committees in cases with rapid timetables for plan confirmation, leaving minimal time for a creditors’ committee to fully complete its own investigation. If a special committee investigation is pending, the debtors may rely upon the pendency of the investigation to object to the creditors’ committee’s motion for standing to pursue claims on the grounds that another investigation is unnecessary and duplicative.5
Accordingly, there is a significant risk that the special committee may reach a below-market settlement or discount valuable insider litigation. Because the special committee’s decision to settle litigation is governed by the generous standards of Bankruptcy Rule 9019, it is possible that a special committee could decide that, although actionable litigation exists, the costs of the litigation outweigh any benefits to the estate. While it may be rare that a special committee counsels against the pursuit of valuable insider litigation, the applicable legal standard allows a special committee to settle claims for pennies on the dollar so long as the settlement falls within the lowest range of reasonableness.6
The risk of such below-market or nominal settlements is magnified in restructuring cases, where there is a strong incentive for the debtors to settle or release insider claims rather than allow them to be pursued by the creditors’ committee or a liquidating trust. The special committee’s proposed resolution of insider claims may also lead to expensive, time-consuming satellite litigation over whether the special committee’s decision should be approved.
Two recent examples illustrate the potential for special committee investigations to potentially frustrate and thwart a creditors’ committee’s discharge of its fiduciary duties.
First, Sabine Oil, an energy company that acquired and developed onshore oil and natural gas properties, filed for bankruptcy amid a steep drop in oil prices and missed interest payments on its debt. Sabine Oil filed a restructuring plan that proposed to release insiders, including directors and officers, from claims arising from the company’s prepetition merger with another company that saddled the debtors with substantial debt.
The creditors’ committee and the debtors’ special committee both conducted their own investigations into wrongdoing by the insiders and arrived at opposite conclusions over whether colorable claims existed. After extensive discovery and a contested hearing that effectively amounted to a minitrial, the court agreed with the special committee’s conclusions and denied the creditors’ committee standing to pursue insider claims.7
Sabine Oil illustrates the potential for disputes between special committees and creditors’ committees to lead to the imposition of significant administrative expenses on the debtors’ estate. The pendency of the special committee investigation may have hampered the parties’ ability to settle claims before engaging in time-consuming and expensive litigation over whether any actionable claims existed.
Second, in the bankruptcy of women’s discount retailer Rue21, the company filed within four years of completing a leveraged buyout that transferred all of the equity in the company to a private equity sponsor. The company filed a plan of reorganization and sought to grant releases to the private equity sponsor without receiving any significant consideration in exchange. In support of those releases, the debtors relied upon a special committee investigation and report that concluded there were no actionable claims.8
The creditors’ committee objected to the plan on the grounds that the releases were premature and that the debtors failed to demonstrate that the private equity sponsor made a “substantial contribution” to the debtors’ reorganization that was sufficient to justify the releases. After a contested plan confirmation hearing, the court approved the releases, relying heavily on the special committee investigation and the factual and legal conclusions contained in its report.9
Rue21 highlights the risk that a compressed time frame for plan confirmation may create a premature adjudication of whether viable claims exist, leading the court to adopt the special committee’s conclusions without providing a creditors’ committee with sufficient time to complete its own investigation.
There are no signs that the growing trend of special committee investigations is slowing. To the contrary, debtors appear to be more aggressively relying upon special committees to protect their insiders from potential litigation. This presents a serious risk for creditors’ committees, given the special committee’s rights under Bankruptcy Rule 9019 to settle even actionable litigation so long as the settlement falls above the lowest range of reasonableness.
Creditors’ committees must closely monitor special committee investigations to ensure they do not threaten the creditors’ committee’s statutory duties to investigate the debtors and their insiders. Otherwise, special committees may supplant the role of creditors’ committees as the primary investigative body in bankruptcy cases, resulting in less leverage and reduced recoveries for general unsecured creditors.