A paper to be published soon in the University of Southern California Law Review, “The Rise of Bankruptcy Directors,” is sharply critical of the increased use of supposedly “independent directors” by distressed companies, often in anticipation of filing for bankruptcy, and the related adverse impact on creditor recoveries. Although the appointment of what the authors, Jared A. Ellias, Ehud Kamar and Kobi Kastiel, label “bankruptcy directors” has become common practice, this article appears to be the first in-depth analysis of the impact of such appointments on chapter 11 outcomes. The authors note that “the percentage of firms in Chapter 11 proceedings claiming to have an independent director increased from 3.7% in 2004 to 48.3% in 2019.” This trend has not been favorable for creditors, however. While acknowledging that other factors could account for the negative association, the authors claim that “the recovery rate for unsecured creditors . . . is on average about 20% lower in the presence of bankruptcy directors.”
Of particular concern to the authors is that such directors often seek to assume control of potential claims against corporate insiders: “bankruptcy directors often bypass the system of checks-and-balances that Congress created” by undertaking their own investigations of such claims and proposing settlements, tasks which historically in chapter 11 cases have been performed by an official creditors’ committee. The authors cite examples where litigation settlements proposed by bankruptcy directors substantially undermine the efforts of creditor committees to pursue claims against controlling shareholders.
While in theory “bankruptcy directors” should be a positive contribution to the outcome of a chapter 11 case by combining “corporate law’s deference to independent directors with bankruptcy law’s faith in neutral trustees[,]” the authors note that the independence of such directors may reasonably be questioned, given the tendency of certain individuals to be repeatedly appointed in multiple cases where the same law firms act as counsel to the debtor. Sifting through publicly available data, the authors found 15 individuals, referred to as “super-repeaters,” who were frequently appointed to directorships of distressed companies, a total of 252 appointments in all. In 44% of these appointments, the company either filed for bankruptcy while its super-repeater bankruptcy director sat on the board, or had done so a short time prior.
The article concludes with certain specific policy proposals, including that judges afford the traditional deference to bankruptcy directors as “independent” only when they have the support of a significant majority of the creditors with claims at risk. The authors also note proposed legislation that would expand the power of official creditor committees in two important ways – giving them first, the exclusive ability to pursue and settle litigation against corporate insiders, and second, the right to seek a hearing before the bankruptcy court to examine potential conflicts of interest of any director.
Chapter 11 filings are currently in a lull, but are expected to increase in the second half of this year due to waning pandemic relief and growing economic uncertainty stemming from international events, rising energy prices and interest rates. This article will be the starting point of closer scrutiny on the role of bankruptcy directors in large cases.