Ending the inevitable battle over whether the estate should assert claims: The case for independent fiduciary investigations

The COVID-19 pandemic, mandatory closure of non-essential businesses, and stay-at-home orders are having a devastating impact on the economy and businesses across virtually all industries. We already are seeing the beginnings of what most experts anticipate will be an unprecedented wave of business bankruptcy filings over the next 18 months. These cases will likely involve the assertion of claims by creditors of insider wrongdoing of various sorts, including claims for breach of fiduciary duty, breach of contract, fraudulent transfers, and preference actions. As the creditors seek bankruptcy court authority to pursue these claims against insiders, the debtor’s attempt to reorganize, most likely involving these same targets, could be derailed or at the very least delayed.

This alert is the first in our two-part series examining strategies for allowing the investigation of these potential claims and defenses of the board of directors’ decision on whether or not to pursue the claims while minimizing impact on the restructuring process. Oftentimes, a debtor’s creditors will seek to stand in the shoes of the debtor and pursue these claims, arguing that the debtor’s board is so hopelessly conflicted that it cannot reasonably assess the viability of the claims in question.  The creditors’ committee also has its own disabilities in making an independent decision on the merits of pursuing a claim.  The debtor still has a duty as an estate fiduciary to assess the claims, but the appearance of conflicts may discredit any board decision. 

We have found that credibility can be brought to the process while serving restructuring aims if the court allows an investigation by independent fiduciaries, either newly appointed or as a subset of the existing board, to investigate and report to the court before any decision on standing is made. At times, this may require the retention of special counsel to the independent fiduciaries to investigate the claims and determine whether they are colorable and likely to result in a benefit to the debtor’s bankruptcy estate.  In this alert, we review the background and common issues associated with these independent third-party investigations.

Independent investigations of estate claims

Chapter 11 debtors generally have exclusive standing to prosecute claims that seek to recover assets for the benefit of the debtor’s bankruptcy estate. However, in certain circumstances a bankruptcy court may authorize trustees, creditors, or other entities to bring these claims on behalf of the debtor’s estate. The standard for authorizing non-debtors to bring claims on behalf of the estate was established by the Second Circuit in In re STN Enterprises, 779 F.2d 901 (2d Cir. 1985) and its progeny. In STN, the court determined that before a non-debtor movant may bring claims on behalf of the debtor’s bankruptcy estate, the movant must show that: (1) the claims are colorable; (2) there will likely be a net benefit to the estate from prosecuting these claims; and (3) the debtor unjustifiably failed¹ to prosecute these claims. Only when all of these factors are met should a court permit the claims to be brought by a non-debtor.

Recent independent investigations and practical issues

In many bankruptcy proceedings, the creditors allege various claims of fraudulent and inequitable conduct by the debtor, seeking to stand in the shoes of the debtor and bring claims to enhance the value of the estate. Meanwhile, the debtor’s board will vigorously oppose these claims.  Yet, a debtor’s board is often conflicted and cannot conduct an independent investigation into the creditors’ allegations. In turn, bankruptcy courts have recently started to appoint independent law firms as third-party investigators, acting as special counsel to a debtor’s independent fiduciaries, to conduct an expedited litigation claims analysis under the STN standard. Appointing an independent third party to conduct the investigation ensures its independence, reliability, and efficiency in the resolution of these claims. 

The independent investigation generally culminates in a report provided to the court, the debtor, creditors, and other interested parties, assessing the merits of bringing the claim. Often, barring any deficiency in the report or additional worthy considerations raised by third parties, the court will rely on the independent report to determine whether to allow the non-debtor to pursue claims on behalf of the debtor’s estate. These independent investigations are growing in popularity and have been commissioned by bankruptcy judges in numerous jurisdictions. See, eg, In re PHI, Inc., No. 19-30923 (N.D. Tex. 2019); In re New Cotai Holdings, LLC, et al., No. 19-22911 (S.D.N.Y. 2019); In re Alta Mesa Resources, Inc. et al., No. 19-35133 (S.D. Tex. 2019); In re 4 West Holdings, Inc., No. 18-30777 (N.D. Tex. 2018).

Common issues in independent investigations

Certain issues regularly arise in these independent investigations: (1) the attorney-client and work product privileges; (2) obtaining evidence from third parties; and (3) information sharing amongst the parties. 

a.  Attorney-client and work product privileges

As special counsel to the debtor’s independent fiduciaries, the investigating firm has the right to access the debtor’s privileged information, including attorney-client communications and work product. The investigating firm is obligated to preserve those privileges unless otherwise waived, and must take care to conduct its investigation and craft a final report that does not waive any applicable privilege. 

In certain instances, the court may appoint two independent fiduciaries, one proposed by the debtor and another by the creditors. When two independent fiduciaries are appointed, preserving privilege becomes more complicated as one independent fiduciary may want to waive the privilege while the other may not. Special counsel to the independent fiduciaries should anticipate these potential conflicts by seeking guidance and authority from the court in advance to establish a procedure to resolve these conflicts.

In In re New Cotai Holdings, LLC, et al., No. 19-22911 (S.D.N.Y. 2019), the court addressed the procedure for waiving privilege. The court determined that the two independent fiduciaries could unanimously agree to waive privilege if they determined waiver would be in the best interest of the debtors’ estates.  However, if one independent fiduciary sought to waive the privilege, and the other did not agree that the waiver was in the best interest of the estate, then either independent fiduciary could seek the court’s intervention for a determination of whether the privilege should be waived. See ¶ 5 of Order Authorizing Employment and Retention of DLA Piper LLP (US) As Special Counsel to the Debtors, No. 19-22911, Docket No. 215 (S.D.N.Y. September 26, 2019).  Special counsel to the independent fiduciaries should be prepared to advise on whether it is in the best interest of the estate to waive privilege, and what the consequences of waiver may be.

b.  Third-party evidence

Frequently, the investigating firm requires information, documents, and other discovery from third parties to complete its investigation. To obtain third-party discovery, the investigating firm likely will need the court’s assistance through Bankruptcy Rule 2004, which provides that “on motion of any party in interest, the court may order the examination of any entity.” Thus, to obtain oral testimony or documentary evidence the investigation team must file a Rule 2004 motion with the court seeking leave to issue subpoenas to obtain discovery and depositions. STN investigations are often conducted on an expedited bases, so counsel should identify relevant third parties and file Rule 2004 motions for discovery and depositions as soon as possible. Similarly, due to the truncated time within which these investigations may occur, counsel should consider asking the court to authorize discovery on an expedited basis.

c.  Information sharing

Because both the debtor and the creditors will want updates throughout the investigation, it is important, at the outset of the investigation, to create a mutually-agreed upon protocol for sharing information. The investigating firm should give the parties process-based updates on a regular basis. The information sharing protocol should define: (1) who is entitled to participate in the updates provided by the investigating firm; (2) how often these updates will occur throughout the course of the investigation; and (3) what type of information will be shared (i.e., number of documents produced, witnesses interviewed, subpoenas issued, timing of the completion of the investigation, etc.). The investigating firm should not provide substantive updates about preliminary findings, as this creates the risk of waiving privilege and giving insight into the investigation with incomplete information.

Takeaways

Requesting that the bankruptcy court employ an independent law firm to act as special counsel to a debtor’s independent fiduciary is an effective mechanism for investigating whether claims should be pursued against the debtor on behalf of the bankruptcy estate. These investigations provide the court and the parties with an efficient and cost-effective independent analysis that often leads to the resolution of a bankruptcy case. To maximize the benefits and effectiveness of an independent investigation, special counsel to the independent fiduciaries should ask the Court to establish procedures to ensure that: (1) any applicable privilege is preserved; (2) the investigating firm receives all documents and information it needs to conduct the investigation in a timely manner; and (3) all interested parties are provided with pertinent information relating to the investigation.

The authors have substantial experience conducting STN investigations and serving as counsel to independent fiduciaries appointed to conduct those investigations. For more information about any of the topics discussed herein, please contact any of the authors.

_{¹ To determine whether the debtor unjustifiably failed to bring suit, courts will look to affidavits and other evidentiary submissions to determine whether the claim is likely to benefit a debtor’s estate.  In re Sabine Oil & Gas Corp., 547 B.R. 503, 516-17 (S.D.N.Y. 2016). The debtor must present evidence that there is “a substantial reason why interposition of the proposed suit would be harmful to the estate.”Id.}