In this installment of the Bankruptcy Blog’s series on the ABI Commission to Study the Reform of Chapter 11, we turn our attention to the recommendations and findings on the trustee’s avoiding powers (section V.C.), the standard for reviewing settlements and compromises (section V.G.), and the in pari delicto doctrine (section V.H.).

Avoiding Powers

The ABI Commission focused on two aspects of the trustee’s powers of avoidance under the Bankruptcy Code: the trustee’s ability to pursue preference claims under section 547 and to recover property involved in any avoided transfers (or the value of such property) under section 550.

A preference is a transfer of property to or for the benefit of a creditor, made within 90 days of the filing of the bankruptcy petition by an insolvent debtor on account of a preexisting debt, which allows the transferee to receive more than it would have received in a chapter 7 liquidation. A preference defendant can rebut the showing of a prima facie preference by establishing certain defenses.

The Commission noted “strong frustrations with preference law” expressed during the various public hearings and the perception that preference law no longer equalizes distribution among creditors nor does it maximize estate value. Preference recoveries also often no longer go to benefit unsecured creditors, as secured creditors are frequently granted liens upon chapter 5 avoidance proceeds or the recoveries pay administrative creditors of administratively insolvent estates.

The Commission suggested codifying a standard requiring the trustee to “perform reasonable due diligence” and “make good faith efforts to evaluate the merits of the preference claim” before pursuing it. Moreover, the Commission recommended that the trustee be required to “plead with particularity factual allegations in the complaint that establish a plausible claim for relief” under the section in accordance with U.S. Supreme Court precedent. These recommendations sought to curb perceived abuses by trustees who pursue preference actions without the necessary diligence or who pursue the action merely to extract settlement payments. On the other hand, the Commission rejected certain proposed reforms that would have made it more difficult for a trustee to pursue preference claims, such as having a presumption in favor of the creditor that the prepetition transfer was made in the ordinary course of business, which a trustee would then have to rebut.

To recover property subject of an avoided transfer, section 550 requires the trustee to file an avoidance action prior to filing a recovery action, a process criticized as “cumbersome.” To remedy this defect, the Commission recommended amending the section so that the trustee is allowed to name an alleged subsequent transferee as a defendant in the original complaint of the underlying action. If the alleged subsequent transferee is not named, then the trustee should sue the subsequent transferee in the recovery action under section 550, with the subsequent transferee having the ability to raise defenses, including those relating to the original avoidance action.

The Commission next tackled the extra-territorial application of section 550 and agreed that, although foreign subsequent transferees could be subject to the trustee’s avoidance powers, such powers must be balanced against principles of comity and whether the extra-territorial application is “reasonably necessary to protect the interests of the estate.” In arriving at this recommendation, the Commissioners acknowledged the need for a “delicate balance,” considering that foreign transferees may be unaware of any links to the debtor and may reasonably expect to be governed by the laws of their respective jurisdictions.

Finally, on the issue whether the phrase “for the benefit of the estate” in section 550(a) should be interpreted broadly to include administrative claimants and equity holders, the Commission declined to limit the phrase to general unsecured creditors. Instead, the Commission “voted to endorse a broad interpretation of the term . . . to mean all parties with claims against, or interests in, the estate, including administrative claimants and old equity but not including claims of postpetition secured creditors.”

Settlements and Compromises

Rule 9019 of the Federal Rules of Bankruptcy Procedure allows the court to approve a compromise or settlement upon motion and after notice and a hearing, but the rule lacks any criteria for approving the same. Responding to the absence of a standard in evaluating proposed settlements and compromises in both the Bankruptcy Code and the Bankruptcy Rules, as well as the silence on the timing of such compromises and settlements, the Commission acknowledged the need to codify the settlement approval process and the appropriate standard for review. After reviewing a range of approaches, the Commission opted for a “hybrid standard” requiring the settlement or compromise to be “reasonable and in the best interests of the estate.”

In Pari Delicto

The in pari delicto doctrine bars the cause of action of a plaintiff who acts in concert with the defendants or is otherwise involved in the wrongful conduct asserted. Under existing case law, the in pari delicto defense is available against a trustee or a debtor in possession. The Commission explored the implications of eliminating the in pari delicto defense in bankruptcy, with some Commissioners viewing the enforcement of the doctrine “as penalizing the debtor’s innocent creditors.” After considering both the practical implications and policy issues raised by the proposal (including the scenario in which the very same individuals who participated in the wrongdoing subsequently may be retained by the debtor in possession), the Commission recommended eliminating the in pari delicto defense against a trustee appointed under section 1104 of the Bankruptcy Code but could not reach a consensus on eliminating the defense with respect to other estate fiduciaries.

Observations

The recommendations of the Commission in this area are not particularly controversial and attempt to bridge gaps existing in the statute (in the case of settlements and compromises) or as a result of the evolution of bankruptcy practice (in the case of preferential transfers). Given the global nature of most large businesses, however, it will be interesting to see whether courts will adopt the standard enunciated by the Commission in connection with the extra-territorial application of section 550. Moreover, how courts will tackle the in pari delicto defense in light of the Commission’s recommendations will be another development worth noting.