Liquidation Trustee Liability What You Cant See Can Hurt You

Liquidation Trustee Liability What You Cant See Can Hurt You

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As chapter 11 filings increase, so will the number of chapter 11 liquidations. Indeed, filing chapter 11 does not equate to reorganization. A chapter 11 orderly liquidation is often the result of a failed reorganization attempt. In fact, debtors often file chapter 11 petitions intending to file and confirm a liquidating plan.

Regardless, the increase of chapter 11 liquidation plans will result in the increased use of liquidation trusts. Liquidation trusts typically allow for a larger return than a "fire sale" of the debtor's assets, which are transferred into a trust for the benefit of creditors upon confirmation of a liquidating plan. A liquidating plan usually contemplates establishing a liquidation trust, assigning assets and causes of action, and appointing a liquidation trustee.

After confirmation and appointment, the liquidation trustee then serves as the liquidation trust's representative and is responsible for complying with the trust agreement (and confirmation order), liquidating the assets and making distributions to trust beneficiaries. The liquidation trustee in essence has the duties and responsibilities of a state law trustee, including fiduciary duties to the liquidation trust. As such, candidates for liquidation trustee positions must consider the exposure potential to liabilities for acts and omissions occurring while administering the liquidation trust.

The Basis for Liquidation Trust Liability

The potential liability for a liquidation trustee takes many forms. For example, liquidation trustees not only have duties to the liquidation trust itself—and therefore its beneficiaries—they also have potential government liability, and potential liability for the expenses of administering the liquidation trust. Indeed, trustees can be exposed to personal liability for acting outside of their official capacity and for breaches of fiduciary duty. See Better Brite, 483 N.W.2d at 578-79.

The fiduciary duty standard of care, however, is not clear, and the case law is split over the applicable standard. See Dodson v. Huff (In re Smyth), 207 F.3d 758, 761 (5th Cir. 2000) (discussing willful and deliberate, gross negligence and negligence standards); Better Brite, 483 N.W.2d at 579 (discussing both willful and negligent breaches); Compton v. Powers (In re Powers), 112 B.R. 178, 181 (Bankr. S.D. Tex. 1989) ("Trustees of an estate in bankruptcy are subject to personal liability for willful violations of fiduciary duties."). This necessitates a liability policy and/or an indemnity agreement to protect the liquidation trustee from errors and omissions.

Liability for such errors and omissions is not necessarily limited to such insurance proceeds. Other penalties may be imposed, such as reducing the liquidation trustee's compensation or imposing a surcharge on the liquidation trustee. See 4 Norton Bankr. L. & Prac. 2d §79.21 (2001). To avoid such personal liability, trustees must take the utmost care in their duties, particularly considering the differing causes of action that could accrue.

Potential Causes of Action

As a "trustee," a liquidation trustee has potential exposure for numerous liabilities. For example, the U.S. Supreme Court held that under the Internal Revenue Code, a liquidation trustee must "pay the tax due on the income attributable to the corporate debtors' property because [26 U.S.C.] §6012(b)(3) requires him to make a return as the 'assignee' of the 'property...of a corporation.'" Holywell Corp. v. Smith, 503 U.S. 47, 52 (1992). Therefore, "[a]s the assignee of 'all' or 'substantially all' of the property of the corporate debtors, the trustee must file the returns that the corporate debtors would have filed had the plan not assigned their property to the trustee." Id. at 54.

While 11 U.S.C. §1146(c) provides that "The issuance, transfer or exchange of a security, or the making or delivery of an instrument of transfer under a plan confirmed under §1129 of this title, may not be taxed under any law imposing a stamp tax or similar tax," failing to pay other taxes could create personal liability for the liquidation trustee if the liquidation trust's assets are depleted. United States v. Hemmen, 51 F.3d 883 (9th Cir. 1995).

In Hemmen, the Ninth Circuit held a chapter 7 trustee personally liable for failing to honor an IRS notice of levy against the allowed administrative expense claim of a corporate debtor's president. The trustee received notice of the levy and then paid the debtor's president's allowed administrative claim from the liquidation funds of the estate. The court held the trustee personally liable under 26 U.S.C. §6332 for failing to honor the levy, even though the trustee notified the government that he was going to disburse the funds and the IRS raised no objection at that time.

Although the trustee in Hemmen was not held personally liable for taxes, it is an example of the caution a liquidation trustee must exercise in administering the liquidation trust.

Additional liability may result from the requirement to pay quarterly fees to the U.S. Trustee "until the case is converted or dismissed." 28 U.S.C. §1930(a)(6). A liquidation trustee is generally required to pay post-confirmation quarterly fees out of the funds of the trust. In re CSC Indus. Inc., 226 B.R. 402, 404 (Bankr. N.D. Ohio 1998); see, also, In re Hudson Oil Co., 200 B.R. 52 (Bankr. D. Kan. 1996) (dicta indicating that the liquidation trust would have been liable if amendments to 28 U.S.C. §1930(a)(6) had occurred before plan confirmation). One court addressing this issue held that because "Congress intend[ed] such fees be paid by chapter 11 debtors prior to conversion or dismissal...," and because the trust has "essentially stepped into the shoes of the original debtor," then the trust is "liable for any such fees which may be imposed." In re CSC Indus. Inc., 226 B.R. at 404. Considering quarterly fees to be an "administrative expense for which the liquidation trust was responsible," the court found that "imposing post-confirmation quarterly fees upon the liquidation trust [was] neither an attempt to modify the plan nor a violation of separation of powers...." Id. at 407.

Although liquidation trustees have not generally been held personally liable for environmental damage, the potential exists under federal and state law. See 6 Collier on Bankruptcy ¶721.05[3] (15th ed. rev. 1996). Specifically, if a liquidation trustee engages in activities that could constitute managing or operating of trust property under 28 U.S.C. §959(b), then environmental liability could arise. The Fifth Circuit has held that a bankruptcy trustee, although not personally liable, was obligated to plug wells in Texas and that failing to do so created an administrative expense priority claim. See State v. Lowe (In re H.L.S. Energy Co.), 151 F.3d 434, 437 (5th Cir. 1998).

Furthermore, the U.S. Supreme Court, in a case dealing with whether a trustee could abandon estate property under 11 U.S.C. §554(a), held that "a trustee may not abandon property in contravention of a state statute or regulation that is reasonably designed to protect the public health or safety from identified hazards." Midlantic Nat'l. Bank v. New Jersey Dep't. of Envtl. Prot., 474 U.S. 494, 507 (1986). The relevance of this decision to a liquidation trustee operating under a confirmation order and trust agreement is questionable, yet it could be a basis for making such assertions.


The potential liabilities that a liquidation trustee could face are limitless. Although only a few reported cases detail the basis for a liquidation trustee's liability, there are a number of causes of action to consider and protect against, e.g., distributing all assets prior to resolving all claims objections, the costs of administering the liquidation estate and general malpractice actions, just to name a few.

Nonetheless, liquidation trustee position can be lucrative. For those considering the position, however, the potential for personal liability is an issue to consider and safeguard against.

Journal Date: 
Friday, February 1, 2002