In many bankruptcies, the creditors receive much or all of the equity in the reorganized business. The issuance of equity to creditors raises a host of corporate governance issues, namely: Who decides the size and composition of the board of directors? Who selects the directors? Who drafts the corporate charter and bylaws? What happens to current management? Who sets compensation for management in the reorganized company?

Almost invariably, these issues are negotiated and consensually resolved as part of the plan negotiations between the debtor and creditor constituencies. In the recent United Air Lines case,¹ the issues reached an unusually advanced stage. There, the company's proposed plan contemplated that the post-confirmation board would be selected almost entirely by the nominating committee of the existing board of directors. The existing board had been elected in May 2002—about seven months before the bankruptcy filing and nearly four years before the confirmation hearing—by the then-shareholders whose equity interests (to the extent they hadn't been sold) would be extinguished pursuant to the plan. The plan also proposed to set aside up to 15 percent of the reorganized company's stock for a management equity incentive program (MEIP), which would reward incumbent senior management by the issuance of restricted stock and stock options conservatively valued at $285 million.

The creditors' committee, though generally supportive of the reorganization plan, objected to the provisions for selection of directors and to the proposed MEIP. The committee argued that the plan failed to provide for any input by the creditor constituencies into the selection of officers and directors, even though the plan provided that creditors were to receive substantially all of the stock in the reorganized debtor. The committee also objected to a provision in the proposed corporate charter that would have authorized the issuance of "blank check preferred stock," which could be used for a variety of purposes including the adoption of a poison pill that would deter any hostile takeover of the company.

The dispute was resolved during the pendency of the confirmation hearing. By agreement, the committee appointed five directors and the company appointed five directors, with two other directors appointed by unions pursuant to collective bargaining agreements. The company also agreed that the corporate bylaws would prohibit the adoption of a poison pill without shareholder approval. It further agreed to limit the number of shares available for the MEIP to 8 percent, which still allowed awards of more than $150 million. The bankruptcy court overruled objections by the unions to the modified MEIP.

Because these issues usually are resolved consensually, it is not surprising that the case law addressing corporate governance issues in the plan confirmation context is sparse. Nonetheless, the negotiation of these issues does not occur in a legal vacuum, but rather takes place within the context of the requirements for proposing and confirming a plan of reorganization. This article summarizes the law and concludes with some observations on how the chapter 11 process drives the negotiating leverage of the various constituencies.

The Legal Framework: Selection of Officers and Directors

Sections 1123(a)(7) and 1129(a)(5) of the Bankruptcy Code govern the disclosure and selection of post-confirmation officers and directors. Section 1123(a)(7) provides that a reorganization plan must:

contain only provisions that are consistent with the interests of creditors and equity security-holders and with public policy with respect to the manner of selection of any officer, director or trustee under the plan and any successor to such officer, director or trustee.

A plan that fails to satisfy this provision cannot be confirmed because it does not "compl[y] with the applicable provisions" of the Code, as required by §1129(a)(1).²

Section 1129(a)(5)(A) provides that, as a condition to confirmation, the bankruptcy court must find:

(i) The proponent of the plan has disclosed the identity and affiliations of any individual proposed to serve, after confirmation of the plan, as a director, officer or voting trustee of the debtor...or a successor to the debtor under the plan; and (ii) the appointment to, or continuance in, such office of such individual, is consistent with the interests of creditors and equity security-holders and with public policy.

Taken together, these provisions impose both procedural and substantive requirements. Procedurally, the plan proponent must disclose prior to confirmation the identity and affiliations of persons who initially will serve as directors and officers of the reorganized debtor. Substantively, the court must determine that both (1) the appointment to or continuance in office of the initial officers and directors, and (2) the provisions regarding manner of selection of both the initial officers and directors and their successors, "are consistent with the interests of creditors and equity security-holders and with public policy."³

But neither Congress nor the courts have provided much guidance regarding the scope of this review. In In re Machne Menachem Inc.,⁴ the debtor was a New York-based nonprofit corporation that ran a summer camp for Hasidic youths. Under the proposed plan, the debtor's existing board would be replaced with a three-person board that included one Yaakov Spritzer, who had been removed from the board before the bankruptcy pursuant to an intracorporate dispute, and two of his supporters. The bankruptcy court explained that §1123(a)(7) derives from §216(11) of the former Bankruptcy Act,⁵ and was incorporated into the Code without comment:

The Senate Report accompanying the Chandler Act stated, with respect to §216(11), that such provision "directs the scrutiny of the court to the methods by which the management of the reorganized corporation is to be chosen, so as to ensure, for example, adequate representation of those whose investments are involved in the reorganization." The provision was originally suggested by the Securities and Exchange Commission and was intended to make certain that discredited management will not be perpetuated, and that provision will be carried in the plan for the selection—at least for the mechanics or means of selecting the managements which will carry forward the reorganization in the interest of the parties.⁶

Despite the overwhelming support of creditors, the court refused to confirm the plan because the replacement of the existing board with Spritzer and his colleagues failed to comply with the New York Not-for-Profit Corporation Law (NFP). That statute, the court found, codified New York's public policy, and "the removal or selection of debtor's directors in a manner contrary to New York's public policy, as codified in its NFP, would directly violate §§1123(a)(7) and 1129(a)(1) and (2) of the Code."⁷ In construing the "public policy" requirement of §1123(a)(7), the court went on to say: "'Public policy' may also allude to a concern that this debtor should not be reorganized under the direction of an individual that was severely chastised [by a judge in prepetition litigation] for failure to abide with statutory requirements in administering the pre-petition debtor..."⁸

Similarly, in In re Mahoney,⁹ the court denied confirmation for failure to comply with §§1123(a)(7) and 1129(a)(1). In this case, the debtor, an individual, sought to confirm a chapter 11 plan pursuant to which his business assets would be transferred to a California corporation to whose board the debtor would be appointed for a five-year term. The court found that the debtor's proposed board structure violated California law and "decline[d] to confirm a plan which disregards California's public policy as embodied in [the applicable corporate law]."¹⁰

In In re Acequia Inc.,¹¹ Clinton, a 50 percent shareholder of the debtor, had been charged with concealing information and mismanaging the debtor. The plan provided that Clinton's ex-wife and her two sons would manage the reorganized debtor and sit on the board, and precluded shareholders from voting to remove or elect directors post-confirmation. Clinton argued that these provisions violated Idaho corporate law. The court of appeals disagreed and affirmed the bankruptcy court order confirming the plan.¹² Though the threshold issue was the plan's compliance with state corporate law, the court also appeared to recognize a bankruptcy court's broad discretion to review selection of the board and management: "[C]ourt[s] scrutinize any plan which...establishes management in connection with a plan of reorganization... In analyzing these provisions in plans (i.e., regarding manner of selection of officers and directors), we believe that a court should consider, inter alia, the shareholders' interests in participating in the corporation, the desire to preserve the debtor's reorganization and the overall fairness of the [plan] provisions."¹³ The court concluded that the plan provisions met that test.¹⁴

The case law also makes clear that the officers and directors of the reorganized entity must meet some minimal standard of competence and integrity. As one court put it: "Continued service by prior management may be inconsistent with the interests of creditors, equity security-holders and public policy if it directly or indirectly perpetuates incompetence, lack of discretion, inexperience or affiliations with groups inimical to the best interests of the debtor."¹⁵

Because these decisions typically have involved small corporations that were closely held or not-for-profit, and focused on the fitness of a particular person who may have engaged in misconduct to serve on the reorganized company's board, it is difficult to extrapolate how the courts will apply the statute to a reorganized debtor that will be a publicly held corporation. At one extreme, the debtor in United Air Lines argued that the bankruptcy court's review is limited to whether the proposed officers and directors meet minimal competence standards and whether the corporate charter and bylaws comply with state corporate law. It characterized the composition of the board as nothing more than a "deal point" in pre-confirmation negotiations between the company and creditor constituencies. This view seems consistent with the Collier commentary, which opines that the court should not have to make a "substantive judgment" that the post-confirmation service of officers and directors is consistent with the interest of creditors:

The identities of the individuals will be disclosed during the balloting stage. As a consequence, creditors and equity-holders will have the opportunity to factor in the character and history of the management in their vote. To give the bankruptcy court the power to second-guess the interests of such entities seems somewhat out of place in the general scheme of confirmation.¹⁶

This view, however, puts enormous stress on the creditors' vote on the plan, particularly given the limited disclosures required by §§1123 and 1129 and the fact that—contrary to the assumption in the Collier commentary—the management and board of the reorganized company often are not disclosed until after the disclosure statement has been distributed and the creditors have voted. It also requires a very narrow reading of the statutory language, which requires independent findings that the ongoing service of the officers and directors and the method of selection of officers and directors comport with the interests of creditors regardless of how the creditors vote on the plan. If Congress had intended to limit the necessary finding to compliance with state law, it could have said so.¹⁷

But if it is true that the bankruptcy court has discretion to review the board composition of the reorganized company, there is virtually no guidance as to how the court should exercise that review.¹⁸ In United, the committee argued that it, as the representative of the creditors, should be permitted to determine the size of the new board, determine its committee structure and select its members. Buttressing its argument with the testimony of a corporate governance expert, the committee argued that its input was critical because the new board would determine the compensation of management, including the terms and allocation of incentive-based equity ownership under the MEIP, and that without the committee's input the new board would be selected de facto by existing management. Further, the new board would determine whether to implement a poison pill and other provisions that could entrench management. The issue became moot when the bankruptcy court approved a settlement providing for the committee and debtor to appoint an equal number of board members.

The Legal Framework—Management Compensation

Section 1129(a)(5)(B) of the Code requires that a plan disclose "the identity of any insider that will be employed or retained by the reorganized debtor, and the nature of any compensation for such insider."¹⁹ On its face, this provision requires the disclosure of compensation but does not address the reasonableness of compensation. Does the bankruptcy court have the power to consider whether a compensation package for ongoing management is excessive?

The implementation of management compensation plans has engendered extraordinary controversy in recent years, particularly as companies continue to use chapter 11 to renegotiate collective bargaining agreements and vendor agreements, and to extract concessions from lenders. In the course of the chapter 11, the debtor-in-possession (DIP) must seek court approval to implement such plans under §363 of the Code.²⁰ Ordinarily, this requires the debtor to show that the plan comports with reasonable business judgment, but many courts have held that, to the extent the compensation plan covers "insiders" such as senior executives, they are subject to heightened scrutiny.²¹ Further, the new amendments to the Code circumscribe a debtor's ability to implement a key employee retention program.²²

In United Air Lines, the opponents argued that §1129(a)(1) of the Code requires compliance with §363, and thus that a plan compensating insiders should be subject to the same heightened standard of review as would a compensation plan for senior management of a DIP.²³ There appears to be no authority, however, applying that standard of review to confirmation of a plan. The court in United addressed the issue orally in overruling the unions' objections to confirmation after the committee and debtor had settled their disputes. The court concluded that §363 governs the conduct of a DIP, not that of a reorganized debtor, and thus is inapplicable to whether the plan may be confirmed.²⁴ The court ruled that its review was limited to determining whether the proposed plan fell broadly within general market standards:

[I]f the debtor's compensation package is consonant with what's being done in the marketplace, then it's very difficult to have the court say that it's excessive, and if excessive, to what extent it's excessive. There's no yardstick that can be applied, other than the length of the chancellor's foot... It may well be that we have a culture in this country that overcompensates management... But United is just one enterprise that operates in that general environment, and if there is some skewing that's taking place generally, United can't stand against that tide....²⁵

The court concluded on the basis of the factual record that the MEIP was reasonable within the context of the industry.²⁶

The Negotiating Framework

A fundamental premise of chapter 11 is that the plan proponent determines the content of the plan. This means that the proponent, usually the DIP, drafts the corporate charter and bylaws, selects the directors, decides whether to keep management in place or to select new management, and decides how much to pay management.

Once the plan has been proposed, the creditors' committee essentially has two tools at its disposal. It may recommend that the unsecured creditors vote to reject the plan, and it may oppose confirmation of the plan. But these are blunt instruments, and if carried out they can be injurious to all the interested parties. Delay in confirming a plan may be, if not fatal to reorganization, strongly detrimental to creditor recoveries. Creditors may be better off with a reorganized company with overpaid management and poor corporate governance than with the risk that the company's value will deteriorate following the court's denial of confirmation.

These courses of action also have procedural limitations. Even if the class of unsecured creditors votes to reject the plan, the court may confirm the plan under the cramdown provisions of §1129(b). As a practical matter, an order denying confirmation is likely to precipitate negotiations leading to a more favorable result for creditors. But neither the committee nor the bankruptcy court has the power to modify the plan; that is something only the proponent can do.

In the context of a plan-confirmation hearing, the dynamics are likely to favor a finding that the corporate-governance provisions are consistent with the interests of creditors and equity-holders and with the public interest. Absent the most egregious circumstances, most bankruptcy judges are reluctant to risk the ongoing value of the business and the jobs of the debtor's employees by denying confirmation based on what it likely would perceive are tangential issues. Equally important, creditors opposing a plan cannot point to a bright-line test as to why particular corporate governance provisions do not satisfy the statutory standards. As shown above, the limited cases denying confirmation under §§1123(a)(7) and 1129(a)(5) typically have involved egregious misconduct by management or failure to comply with state law. The ruling in the United case by Hon. Eugene Wedoff, a thoughtful and respected judge, is instructive. He approved what under any standard is an enormously generous compensation package to existing management. Despite the facts that the package included no ongoing performance criteria and that the unions who had made billions of dollars of concessions to support the reorganization vehemently opposed it, the court concluded that the package fell within the broad contours of the market.

Given the plan proponent's enormous leverage, the creditors' position is significantly enhanced if they have the power to submit a competing plan. In other words, the extension of exclusivity plays a significant role in the debtor's ability to dictate post-reorganization corporate governance. Once exclusivity is terminated, the committee and other parties in interest can propose their own plans with provisions less likely to favor incumbent management.²⁷ Often, governance issues have been incorporated into negotiations only as the debtor is about to file its plan or after the plan has been proposed. From the creditors' perspective, the preferred course may be to raise those issues earlier in the process, and incorporate them into negotiations for any extension of exclusivity.

Footnotes

1 In re UAL Corp. et al., No. 02-B-42191 (Bankr. N.D. Ill.).

2 See, e.g., Mabey v. SW Elec. Power Co. (In re Cajun Elec. Power Coop. Inc.), 150 F.3d 503, 513 n.

3 (5th Cir. 1998), cert. denied, 526 U.S. 1144 (1999). 3 11 U.S.C. §§1123(a)(7), 1129(a)(5)(A)(ii).

4 304 B.R. 140 (Bankr. M.D. Pa. 2003).

5 11 U.S.C. §616(11) (repealed 1978).

6 304 B.R. at 142-43 (quoting Collier on Bankruptcy §1123(a)(7) (15th ed. rev. 2003) (citing S. Rep. No. 1916, 75th Cong., 3d Sess. 35 (1938) and Hearings on H.R. 6439, 75th Cong., 1st Sess. 143 (1937)).

7 Id. at 143.

8 Id.

9 80 B.R. 197 (Bankr. S.D. Cal. 1987).

10 Id. at 201.

11 787 F.2d 1352 (9th Cir. 1986).

12 Id. at 1360 (emphasis in original).

13 Id. at 1361-62 (citing S. Rep. No. 1917, 75th Cong., 3d Sess. 7, 35 (1938)).

14 Id.

15 In re Beyond.com Corp., 289 B.R. 138, 145 (Bankr. N.D. Cal. 2003) (finding §1129(a)(5) not satisfied where there had been insufficient disclosure to permit an "intelligent analysis" of whether continuance of management was consistent with interests of creditors, equity-holders and public policy); see, also, e.g., In re Rusty Jones Inc., 110 B.R. 362, 375 (Bankr. N.D. Ill. 1990) (finding continuation in office of the officers and directors was not consistent with the interests of creditors because debtors continued to operate in red as a result of their expenditures and governance).

16 Collier on Bankruptcy |1129.03[5][b] (A. Resnick et al. eds., 15th ed. rev. 2006).

17 Compare, e.g., 11 U.S.C. §1129(a)(6), which requires that any rates of the debtor have been approved by any governmental regulatory authority with jurisdiction, or that any prospective rate change is conditioned on such approval.

18 In In re Washington Group Int'l. Inc., the bankruptcy court findings in support of its confirmation order included: "Because the Steering Committee for the Lenders and the Creditors' Committee will be entitled to designate a majority of the board of reorganized WGI...the manner of selection of the initial directors and officers of the reorganized debtors and the manner of selection of successor directors and officers of the reorganized debtors...are consistent with the interests of the holders of claims and interests and public policy." 2001 Bankr. LEXIS 2150, at * 24-25 (Bankr. D. Nev. 2001). The issue in that case, however, was not contested.

19 11 U.S.C. §1129(a)(5)(B).

20 11 U.S.C. §363(b).

21 See, e.g., In re Regensteiner Printing Co., 122 B.R. 323 (N.D. Ill. 1990) (reversing approval of employment agreements with senior executives for failure to scrutinize the insider transactions to ensure that the proposed transactions were fair); In re US Airways Inc., 329 B.R. 793, 801 (Bankr. E.D. Va. 2005); In re America West Airlines Inc., 171 B.R. 674, 678 (Bankr. D. Ariz. 1994).

22 11 U.S.C. §503(c), as amended by Bankruptcy Abuse Prevention and Consumer Protection Act, Pub. L. No. 109-8, §331 (2005).

23 Opponents also argued that because the MEIP was excessive the plan was not filed in good faith. 11 U.S.C. §1129(a)(3).

24 In re United Air Lines, No. 03-B-48191 (Bankr. N.D. Ill.), Transcript of Hearing Jan. 18, 2006, at 41.

25 Id. at 61-62.

26 Id. at 63-64.

27 The Code now limits the debtor's exclusive period to 18 months to file a plan and 20 months to have a plan accepted. 11 U.S.C. §1121(d)(2).