William G. Schwab and Associates
811 Blakeslee Blvd. Dr. East (PA Route 443) PO Box 56 Lehighton, PA 18235
Tel 610-377-5200 Fax 610-377-5209
Bankruptcy September 28, 2016
Personal Injury
Criminal Law
Elder Law
Estate Planning/Probate
Real Estate

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Fraud or Mismanagement by the Chapter 11 Debtor Leads to Appointment of Trustee

In order to facilitate effective business reorganizations, Chapter 11 bankruptcy is designed to grant a failing business the opportunity to restructure its assets and debts.  With this goal in mind, the debtor in a Chapter 11 bankruptcy case generally remains in control of daily business operations.  The debtor also possesses broad discretion when it comes to entering into transactions that fall within the ordinary course of business. 
In fact, the Bankruptcy Code provides that "a debtor in possession shall have all the rights...of a trustee serving in a case."  This means that, for all purposes, a Chapter 11 debtor will usually exercise the powers otherwise reserved for a bankruptcy trustee.
Grounds for the Appointment of a Trustee
However, two situations call for the Bankruptcy Court to order appointment of a trustee to assume control of the debtor's business:
  1. For cause, if the debtor has engaged in fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the business by current management, either before or after the start of the bankruptcy case
  2. If appointment of a trustee is in the interests of creditors, equity security holders, and other interests of the estate
In these cases, the court will only order appointment of a trustee if the need for one has been established by clear and convincing evidence.
Eligibility to Serve as Trustee
In order to serve as a trustee in a Chapter 11 case, a candidate must meet the following criteria:
  1. Competent to serve
  2. Has not served as an examiner in the case
  3. Disinterested
  4. Has filed a bond with the court in favor of the United States and conditioned on the faithful performance of official duties
A "for cause" determination that the debtor has committed an act of dishonesty that requires the appointment of a trustee is within the total discretion of the court.  For example, in one case on point, the debtor violated a court order not to pay pre-petition debts without prior court approval, and the Creditors' Committee sought the appointment of a trustee.  However, the court held that the debtor's violation of a court order did not rise to the level of dishonesty required for the appointment of a trustee.
In the Interests of Creditors
Even if the court does not find cause to order appointment of a trustee due to debtor dishonesty, the court may still order the appointment of a trustee if it would serve the interests of creditors.  For example, the U.S. Bankruptcy Court has ordered the appointment of a trustee in a case where, even though the existing management had not acted fraudulently or dishonestly, the creditors lacked confidence in the existing management because the existing management had failed to take the steps necessary to prevent serious financial difficulties.

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