Alternative Methods for the Retention of Estate Professionals Are Appropriate in 'Unusual Cases'

May 23, 2022

Section 327(a) of the Bankruptcy Code allows debtors to employ estate professionals. The section requires these professionals to be “disinterested persons” who “do not hold or represent an interest adverse to the bankruptcy estate.” While well-intentioned, Section 327(a) can have an unduly limiting effect on debtors seeking to retain professionals who have performed prepetition services for the debtor and who have gained beneficial institutional knowledge of the debtor’s operations. As an example, professionals often provide services to a business that ultimately files for bankruptcy protection. If these prepetition services remain unpaid as of the bankruptcy petition date, the professionals will become creditors of the debtor, and Section 327(a) renders them ineligible to be retained. Additionally, because prepetition directors and officers are excluded from the definition of “disinterested person” as insiders under Section 101(14), a prepetition chief restructuring officer may be unable to continue providing services to the debtor after the petition date.

To facilitate a debtor’s post-petition operations, many courts have resorted to Bankruptcy Code Sections 105(a) and 363(b) to approve the employment of professionals who may not otherwise satisfy the restrictive “disinterestedness” requirements of Section 327(a). Section 105(a) bestows upon the court broad equitable powers to “carry out the provisions of” the Bankruptcy Code, while Section 363(b) allows a debtor (after notice and hearing) to “use, sell or lease, other than in the ordinary course of business, property of the estate.” While Section 363(b) does not address employment on its face, courts have reasoned that this section affords the debtor significant discretion to use property of the estate (in this case, cash to hire professionals) as long as the debtor uses reasonable business judgment.

In In re Express Grain Terminals, Case No. 21-11832 (Bankr. N.D. Miss. Jan. 31, 2022), the U.S. Bankruptcy Court for the Northern District of Mississippi took things a small step further: in approving the debtor’s employment of a turnaround management firm to provide a chief restructuring officer, the court relied on Sections 105(a) and 363(b) rather than on Section 327(a), even though the debtor had employed neither the firm nor its chief restructuring officer before filing for bankruptcy protection. The court determined that it would avoid relying on Section 327(a) because some of the debtor’s creditors continued to allege certain improprieties in the turnaround management firm’s selection and hiring process, thereby potentially precluding a finding that the firm was “disinterested.”

Express Grain Terminal (Express Grain) owned and operated a grain terminal and crushing facility in the Mississippi Delta. The debtor petitioned for Chapter 11 relief on Sept. 29, 2021, and filed an emergency motion to use cash collateral on Oct. 4. The court entered an interim order the next day and set the motion for further hearing on Oct. 12. At the continued hearing, the debtor orally requested authority to employ CR3 Partners to supply a CRO and supporting personnel. Although CR3 had recently begun providing services, the parties had not yet finalized CR3’s engagement. The court entered a second interim cash collateral order that approved the retention on an interim basis “subject to a final motion and order defining the entire scope and terms of compensation.”

The order provided CR3 with a right to “reasonable compensation” as well as standing to assert a surcharge on the debtor’s encumbered assets to recover such compensation. In the absence of a formal application or engagement letter, the order also delineated the CRO’s interim powers, which included directing the operations of the debtor, overseeing any sale process, approving any material cash disbursements to preserve assets of the estate, and preparing schedules and financial reports. The order further provided that the CRO would report directly to the debtor’s board of directors.

On Oct. 27, Express Grain filed a formal application to employ CR3 under Section 363(b) and 105(a). In addition to relaxing the “disinterestedness” requirements of Section 327(a), retentions under Section 363(b) are not automatically subject to the rigid disclosure requirements of Bankruptcy Rule 2014(a) or the fee application controls of Bankruptcy Sections 330 and 331, offering the potential for flexibility or efficiency in the engagement. Despite representing that CR3 was a “disinterested person” not subject to disqualification under Section 327(a) and that the debtor had not employed CR3 prepetition, Express Grain argued that retention under Section 363(b) was the appropriate retention provision simply because CR3 would provide a CRO, citing several cases in which courts had approved CRO retentions under Section 363(b). However, the cited decisions did not address CRO retentions generally but rather involved the continued employment of a prepetition CRO who might otherwise have been deemed an insider and thus not be disinterested for the purposes of Section 327(a).

A group of farmer constituents objected to CR3’s retention and filed a motion to appoint a chapter 11 trustee instead, asserting that the debtor was “burning through corn and soybeans to pay the administrative expenses of this case” to the detriment of local farmers. Certain crop production lenders with liens on grain stored at the debtor’s facility also objected on the basis that Express Grain must seek approval under Section 327(a) rather than Section 363(b) because: a recent decision from the U.S. Bankruptcy Court for the Southern District of Texas, In re McDermott International, 614 B.R. 244 (Bankr. S.D. Tex. 2020), had largely rejected the propriety of Section 363(b) retentions; even if Section 363(b) were available, it should only be used to continue the employment of a prepetition advisory firm and/or CRO; and Section 363(b) retentions lacked transparency and limited creditors’ ability to challenge fees and services. In an attempt to address some of the objecting parties’ challenges, the debtor amended CR3’s retention application to provide that: the CRO would have absolute decision-making authority in connection with the debtor’s operations, but the debtor’s board of directors would continue to advise and consult with the CRO and would be permitted to call major disagreements to the court’s attention; and the retention application would be based on the provisions of Section 327(a) rather than Section 363(b).
The farmer constituents and production lenders again objected, this time joined by the U.S. trustee, arguing that only a Chapter 11 trustee could operate independently of the debtor’s management. Additional farmer constituencies further alleged that UMB Bank, N.A., the debtor’s primary secured lender, had forced the debtor to retain CR3 and appoint the CRO as a condition of using UMB’s cash collateral, which meant that CR3 could not be a “disinterested person.” They questioned whether the CRO was acting for “the sole purpose of readying UMB Bank’s collateral as a turn-key prospect via a Section 363 sale motion” rather than for the benefit of all creditors and the estate, arguing that the CRO would be the “captive appointee” of the senior secured creditor if a Chapter 11 trustee were not appointed.

The court observed that “[t]he basis for allowing professionals to be employed under §363(b) is that a debtor-in-possession has broad discretion to use estate property when such use represents a reasonable business judgment on the part of the debtor.” It acknowledged that “Sections 105(a) and 363(b) are commonly used when the disinterestedness requirement of Section 327(a) may prohibit employment of professionals who were employed prepetition in an advisory capacity or as an officer of a debtor,” noting that the cases the debtor had cited as authority in its original application appeared to involve this scenario. However, the court explained that mandating the retention under Section 327(a) “failed to consider the arguments and allegations made by the various farmers and farming entities that the hiring process involved some prepetition collusion with the debtor’s secured creditors, the debtor, and possibly CR3,” which must be weighed against the CRO’s testimony that the process had been fair.

The court reviewed McDermott, a case in which the Texas bankruptcy court considered an application under Section 327(a) to retain AlixPartners as financial adviser, and a separate application under Section 363(b) to retain an AlixPartners affiliate, AP Services to provide a CRO. Because the debtor had retained AP Services to provide a “chief transformation officer” before its bankruptcy filing, and the same individual was now being proposed as CRO, the U.S. trustee argued that the CRO was an “insider” under Section 101(14) and that his lack of disinterestedness meant that the retentions of both AlixPartners and AP Services must proceed under Section 363(b). The court disagreed, holding that no “per se rule” required the court to impute the individual’s alleged disinterestedness to both firms and declining to decide whether the individual’s prepetition role as chief transformation officer actually rendered him an insider. In reserving its discretion to approve a future retention under Section 363(b) in “the inevitable unusual case,” the court approved the retentions of both AlixPartners and AP Services under Section 327(a) and appointed the individual—who was employed by AP Services rather than the debtor—as CRO.

The Express Grains court stated that although it “may agree with most of the findings in McDermott, … this case may very well fall into the ‘unusual’ category.” While imputed disinterestedness was not at issue because the debtor had employed neither CR3 nor the CRO prepetition, the court held that “out of precaution, … employment under Sections 105(a) and 363(b) is more appropriate” in light of the impropriety in the hiring process that had been alleged by certain of the debtor’s creditors. Notably, the court neither made any finding on whether such impropriety had occurred nor opined whether the allegations, if true, would have negated CR3’s disinterestedness.

The court stressed that it based its decision in part on the debtor’s agreement to follow any required protocols of the U.S. trustee, to comply with the disclosure requirements of Bankruptcy Rule 2014(a), and to submit fee applications under Bankruptcy Code Sections 330 and 331, which normally govern only Section 327(a) professionals. It also found that it had identified no authority that would prevent a CRO from exercising “ultimate operational and managerial authority” without reporting to the board. However, the court cautioned that notwithstanding its decision to approve CR3’s retention under Sections 105(a) and 363(b), “the court would prefer in the future for movants to request employment under Section 327(a), unless there is a significant issue with disinterestedness of a professional, which may prohibit employment of a professional under Section 327(a).”

The Express Grains decision highlights two important points. First, notwithstanding substantial precedent authorizing the continued employment of prepetition advisory firms and their designated CROs under Sections 105(a) and 363(b), debtors proposing such retentions on the basis of imputed disinterestedness should carefully consider whether Section 327(a) would better serve them in light of McDermott and its progeny. Second, although Sections 105(a) and 363(b) retentions may no longer be necessary or appropriate in their traditional context, they are a versatile tool that can help debtors overcome a broader range of disinterestedness disputes.

Rudolph J. Di Massa Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors’ rights.

George W. Fitting, an associate with the firm, practices in the areas of commercial bankruptcy, financial restructuring, and creditors’ rights.

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