The U.S. Court of Appeals for the Eighth Circuit recently held that insiders who control the operations of a debtor owe a duty, as fiduciaries, to refrain from self-dealing. In re Brook Valley VII, Joint Venture (Lange v. Schropp), 496 F.3d 892 (8th Cir. 2007). The controlling insiders of two Chapter 11 debtors had thus breached their fiduciary duties to the debtors when they caused the debtors to consent to a foreclosure sale of estate properties and then secretly purchased the properties for themselves at the sale. Because the properties had substantial equity and had been operating profitably even after the bankruptcy filing, the insiders “should have been making efforts to obtain financing on behalf of the Debtors to salvage the properties,” rather than consenting to a foreclosure and searching for financing for their own purchase of the assets. Id. at 901. The court upheld the lower court’s imposition of a constructive trust in favor of the estate on the net proceeds of the foreclosure sale and awarded the bankruptcy trustee all profits that the insiders had earned from operating the properties after the foreclosure sale.

Insider Self-Dealing

Two individuals (the “Insiders”) operated the Chapter 11 debtors as partners. Each debtor owned a single property. A bank (the “Bank”) held a mortgage on each property. Within 17 days after the debtors filed Chapter 11 petitions because of a dispute with another partner, the Insiders, acting on behalf of the debtors’ estates, consented to the Bank’s foreclosure sale of the two properties. The winning bidder at the foreclosure sale was an entity (the “Buyer”) controlled by the Insiders. At the time of the sale, the Bank appraised the properties and found the combined value to exceed the purchase price paid by the Buyer. After the sale, the Insiders operated the properties at a profit. Id. at 897, 899.

The Trustee’s Attack

Following the sale, the court converted the Chapter 11 cases to Chapter 7 liquidations and a trustee was appointed. The trustee discovered that the Insiders had been on both sides of the sale transaction, and sued the Insiders for breach of fiduciary duty. Id. at 898. The Insiders and the trustee agreed to re-sell the properties and retain the proceeds subject to the outcome of the trial. The trial court held for the trustee and imposed a constructive trust on the net sale proceeds. Id. The Eighth Circuit affirmed, and also awarded the trustee the profits that the Insiders had earned from operating the properties after the foreclosure sale. Id. at 903–04.

Analysis: Breach of Loyalty and Failure to Obtain DIP Financing

The Eighth Circuit stressed that “[d]ebtors in possession and those who control them owe fiduciary duties to the bankruptcy estate.” Id. at 900. The fiduciary obligations consist of a duty of care (the duty to make reasonable, good-faith decisions) and the duty of loyalty (the duty to refrain from self-dealing, to avoid conflicts of interest and to maximize the value of the estate). Id. at 901. Though the court refrained from adopting a blanket rule barring insiders from ever bidding on estate property, it found that the Insiders here had violated their duty of loyalty in several ways.

First, the appraisals of the properties revealed substantial equity. Id. at 901. Second, the Insiders, who had consented to the foreclosure, were able to operate the properties profitably after the foreclosure sale. Id. Third, the Insiders secretly bid at the foreclosure sale using the Buyer as their front. Id. Finally, “rather than searching for financing to make their own purchase of the properties, [the Insiders] ‘should have been making efforts to obtain financing on behalf of the Debtors to salvage the properties.’” Id.

Lessons for Fiduciaries

As a result of the constructive trust imposed on the net sale proceeds from the resale of the properties and the forced disgorgement of post-foreclosure profits, the Insiders were required to compensate the estate for its losses and the Insiders’ ill-gotten gains. In discussing the appropriateness of this remedy, the court detailed the Insiders’ obligations as Chapter 11 fiduciaries. Because foreclosure was not inevitable, the debtors had alternatives under Chapter 11 for maximizing value to creditors. “[Indeed], Chapter 11 is there to allow companies whose assets have equity to attempt to preserve such equity for the benefit of their creditors . . . . Rather than consenting to the foreclosure sale and then purchasing the property through another entity, [the Insiders] could have continued to operate the buildings to preserve equity for the bankruptcy estates and creditors.” Id. at 902. The court’s message, of course, is that debtors, once they have sought Chapter 11 protection, are required, as part of their fiduciary duty, to explore all available alternatives to preserve and maximize value for creditors.