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The Examiners Report and the Hearsay Rule Are Both Mutually Inclusive Part I

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Given the current corporate climate where the conduct and decisions of an entity's directors, officers, principals and employees are under increased scrutiny by the courts, and in light of the heightened obligations placed upon a corporation and its leaders under the Sarbanes-Oxley Act, it is hardly a far-fetched notion that bankruptcy courts in the future will be more routinely faced with motions to appoint a trustee filed by a debtor-in-possession's (DIP's) creditors when the creditors suspect fraud, dishonesty or gross mismanagement with respect to the business operations of the DIP. However, a less draconian but perhaps more economical method for investigating any alleged misconduct by the DIP's corporate management is for the court to appoint a bankruptcy examiner pursuant to §1104 of the Bankruptcy Code.1 Indeed, the appointment of an examiner is warranted whenever allegations of corporate fraud or misconduct are substantiated by credible evidence.2 As part of his or her duties in investigating the affairs of the DIP, §1106 of the Code requires an examiner to "file a statement" with respect to any investigation conducted, "including any fact ascertained pertaining to fraud, dishonesty, incompetence, misconduct, mismanagement or irregularity in the management of the affairs of the debtor."3 The examiner is required to file a copy of his or her statement with the court and transmit a copy to any creditors' committee, equity securityholders' committee, indenture trustee or any other entity as the court designates.4 Although it may not be apparent at first blush, the examiner's report creates a problematic issue for a party that wishes to introduce the report into evidence during a motion, contested matter or trial for the truth of the matters contained in the report.5 In short, the report satisfies the definition of "hearsay" contained within Federal Rule of Evidence 801 and would be otherwise inadmissible unless the moving party could demonstrate that the report fell within an exception to the hearsay rule. Indeed, Federal Rule of Evidence 802 provides that "[h]earsay is not admissible except as provided by these rules or by other rules prescribed by the Supreme Court pursuant to statutory authority or by Act of Congress."6v The Code is silent on the issue of how an examiner's report may be utilized in a bankruptcy case. More particularly, until the recent decision by the U.S. Bankruptcy Court for the District of Vermont in In re Fibermark Inc., 339 B.R. 321 (Bankr. D. Vt. 2006), no judicial decision squarely addressed the circumstances under which an examiner's report may be admitted into evidence over the objection of a party, or how a filed examiner's report "fits into the rubric created by the Federal Rules of Evidence."7 Thus, the decision rendered in Fibermark was an issue of first impression for the federal courts. This article will address the intersection between the hearsay rule and an examiner's report and offer suggestions for practitioners seeking to admit an examiner's report into evidence during a hearing or trial. The General Rule of Hearsay Federal Rule of Bankruptcy Procedure 9017 makes the Federal Rules of Evidence applicable to bankruptcy cases.8 Consequently, "hearsay" is not admissible in bankruptcy cases except as permitted by the Federal Rules of Evidence.9 Federal Rule of Evidence 801(c) defines "hearsay" as "a statement, other than one made by the declarant while testifying at the trial or hearing, offered in evidence to prove the truth of the matter asserted."10 Federal Rule of Evidence 801(b) defines a "declarant" as "a person who makes a statement."11 In turn, Federal Rule of Federal Rule of Evidence 801(a) defines a "statement" in part as "an oral or written assertion."12 At its core, hearsay testimony is presumptively unreliable under the common law because the opposing party has no opportunity to cross-examine and test the declarant's truthfulness under oath before the factfinder.13 Consequently, the hearsay rule was devised precisely because the truthfulness of an "out-of-court declarant cannot be assessed by the ordinary methods with which we determine the truth of testimonial evidence—oath, cross-examination and the factfinder's scrutiny of the witness' demeanor."14 As articulated by the Fifth Circuit Court of Appeals in Southmark Properties v. Charles House Corp., "the hearsay rule is not merely a technicality, but rests on the sound principle that the reliability of out-of-court declarations not made under oath and not subject to cross-examination and other checks of the trial process is inherently suspect."15 Federal Rule of Evidence 801(d)(1) excludes the following types of statements from the definition of hearsay: a prior statement by a witness that is either (1) inconsistent with the declarant's testimony and was given under oath subject to the penalty of perjury at a trial, hearing or other proceeding, or in a deposition; (2) consistent with the declarant's testimony and is offered to rebut an express or implied charge against the declarant of recent fabrication or improper influence or motive; or (3) one of identification of a person made after perceiving the person.16 Moreover, Federal Rule of Evidence 801(d)(2) also excludes from the definition of hearsay a statement offered against a party and is either (1) the party's own statement, in either an individual or representative capacity; (2) a statement of which the party has manifested an adoption or belief in its truth; (3) a statement by a person authorized by the party to make a statement concerning the subject; (4) a statement by the party's agent or servant concerning a matter within the scope of the agency or employment, made during the existence of the relationship; or (5) a statement by a co-conspirator of a party during the course and in furtherance of the conspiracy.17 An examiner's report, without more, would not fall under the ambit of a statement that is "not hearsay" under either Federal Rule of Evidence 801(d)(1) or (d)(2).18 Appointment of a Bankruptcy Examiner Section 1104(c) of the Code governs the appointment of an examiner in a chapter 11 case and provides as follows: If the court does not order the appointment of a trustee under this section, then at any time before the confirmation of a plan, on request of a party in interest or the U.S. Trustee, and after notice and a hearing, the court shall order the appointment of an examiner to conduct such an investigation of the debtor as is appropriate, including an investigation of any allegations of fraud, dishonesty, incompetence, misconduct, mismanagement or irregularity in the management of the affairs of the debtor of or by current or former management of the debtor, if— (1) such appointment is in the interests of creditors, any equity securityholders, and other interests of the estate; or (2) the debtor's fixed, liquidated, unsecured debts, other than debts for goods, services or taxes, or owing to an insider, exceed $5 million.19 Thus, based on the language contained in §1104(c), the appointment of an examiner has four requirements: (1) the debtor must still be in possession of the estate—that is, a trustee must not have been previously appointed; (2) a reorganization plan must not yet have been confirmed by the court; (3) a party in interest must request the appointment of an examiner; and (4) either the appointment of an examiner is in the best interests of the estate or the debtor's liquidated unsecured debts exceed $5 million.20 As a corollary to §1104(c), §1104(d) provides that if the court orders the appointment of an examiner, then the U.S. Trustee, after consultation with the parties in interest, shall appoint one "disinterested" person to serve as examiner in the bankruptcy case.21 A court-appointed bankruptcy examiner typically investigates the debtor's business and handles other duties specifically assigned by the bankruptcy court within the context of the chapter 11 case, but unlike a trustee, an examiner does not replace the DIP or "divest the debtor of control over the progress of the case or the operation of the business."22 More specifically, §§1106(b) and 1106(a)(3) of the Code, taken together, provide that a bankruptcy examiner shall, except to the extent the court orders otherwise, "investigate the acts, conduct, assets, liabilities and financial condition of the debtor, the operation of the debtor's business and the desirability of the continuance of such business, and any other matter relevant to the case or to the formulation of a plan."23 The investigation of a bankruptcy examiner ordinarily focuses on alleged fraud, dishonesty, incompetence, misconduct, mismanagement or other irregularities surrounding the business operations of the debtor; nonetheless, a bankruptcy court "retains broad discretion to direct the examiner's investigation, including its nature, extent and duration."24 The investigation of the examiner is conducted pursuant to Federal Rule of Bankruptcy Procedure 2004 and is broader than the scope of civil discovery.25 In fact, the parameters of a Rule 2004 examination have been likened to a "fishing expedition," and is supposed to be "as exploratory and groping as appears proper" to the bankruptcy examiner.26 Directly relevant to the rule of hearsay is Code §106(a)(4), which provides that a trustee shall as soon as practicable (a) file a statement of any investigation conducted...including any fact ascertained pertaining to fraud, dishonesty, incompetence, misconduct, mismanagement or irregularity in the management of the affairs of the debtor, or to a cause of action available to the estate; and (b) transmit a copy or a summary of any such statement to any creditors' committee or equity securityholders' committee, to any indenture trustee, and to such other entity as the court designates.27 The Fibermark Decision In In re Fibermark Inc., when the debtors filed their bankruptcy cases, it appeared to the court that the debtors, the U.S. Trustee, the unsecured creditors' committee and the primary secured creditor "were proceeding in a remarkably collaborative fashion" towards the filing of an acceptable reorganization plan.28 However, approximately a year after the bankruptcy filing, the issue of corporate governance of the post-confirmation entity became a subject of dispute among the parties, and caused the collaboration to disintegrate.29 A stalemate ensued that derailed the confirmation process and prompted the debtors to withdraw their reorganization plan.30 As a consequence of this development, the bankruptcy court issued an order to show cause as to why an examiner should not be appointed to investigate the parties' allegations and to make recommendations on various matters, including the debtors' principals' alleged breaches of fiduciary duty.31 All of the parties supported the appointment of an examiner. The U.S. Trustee subsequently recommended, and the court ultimately appointed, Harvey R. Miller to serve as the examiner.32 A court-appointed bankruptcy examiner typically investigates the debtor's business and handles other duties specifically assigned by the bankruptcy court within the context of the chapter 11 case, but unlike a trustee, an examiner does not replace the DIP or "divest the debtor of control over the progress of the case or the operation of the business." The examiner spent 11 weeks conducting his investigation and thereafter produced a 298-page report that included 1,244 footnotes and cost the bankruptcy estate $1.75 million.33 The reorganized debtors sought to admit the examiner's report into evidence in connection with their objection to the fee application of Chanin Capital Partners LLC.34 In sum, the reorganized debtors argued that the entire examiner's report could be admitted into evidence, as an expert opinion, "on the basis that it [was] relevant to the [d]ebtors' assertion that Chanin failed the test of disinterestedness and acted with an interest adverse to that of the bankruptcy estate."35 Notably, Chanin did not oppose admission "of those portions of the [e]xaminer's report that constitute[d] the [e]xaminer's recommendations and conclusions, but characterize[d] the remainder of the report as 'rank hearsay.'"36 In arguing for the admittance into evidence of the examiner's report, the debtors relied upon "the regular practice in the bankruptcy courts for examiner's reports to be received into evidence and considered as part of the evidentiary record."37 The court, however, refused to rely upon this argument because none of the precedent offered by the debtors specifically addressed whether an examiner's report that contained hearsay statements is admissible into evidence over the objection of another party to the bankruptcy proceeding.38 Contrary to the situation where an examiner is employed to conduct an analysis of purely objective issues based on objective data from the examiner's particular field of expertise, the examiner in Fibermark was specifically appointed by the court to investigate the motives of parties involved in the bankruptcy case and whether any breaches of fiduciary duty occurred. To that end, the examiner reviewed more than 65,000 pages of documents and conducted 19 Rule 2004 examinations, which resulted in approximately 4,425 pages of testimony.39 Because the out-of-court statements upon which the examiner relied in drafting his report lacked the indices of reliability required under the Federal Rules of Evidence and "the factual portions of his report contain[ed] an abundance of statements that [were] the purest sort of hearsay," the bankruptcy court denied the request to admit the examiner's report in its entirety. Nonetheless, the bankruptcy court admitted into evidence the examiner's conclusions and opinions as an expert opinion.40 Editor's Note: Part II will appear in the February 2007 issue. Footnotes 1 See In re 1243 20th St. Inc., 6 B.R. 683, 685-86 (Bankr. D.C. 1980) (holding that "an examiner will entail less administrative expense than the appointment of an independent trustee, and, in view of the examiner's limited role, will not result in any untoward disruption of the debtor's business"). See also In re Gilman Servs. Inc., 46 B.R. 322, 328 (Bankr. D. Mass. 1985) ("the appointment of an examiner is a cautious, intermediate procedure which is more economical than the appointment of a trustee") (citation omitted); In re Texasoil Enters. Inc., 296 B.R. 431, 436 (Bankr. N.D. Tex. 2003) ("an examiner, too, can be expensive, though the cost is perhaps more easily controlled by the court than in the case of a trustee"). 2 Id. at 686. 3 See 11 U.S.C.A. §1106(a)(4) (West 2006). 4 See 11 U.S.C.A. §1106(a)(4)(B) (West 2006). 5 Admittedly, this might be a rare occasion, but its significance cannot be diminished. 6 Fed. R. Evid. 801 (2006). 7 In re Fibermark Inc., 339 B.R. 321, 324 (D. Vt. 2006). 8 Federal Rule of Bankruptcy Procedure 9017 provides as follows: "The Federal Rules of Evidence and Rules 43, 44 and 44.1 F.R.Civ.P. apply in cases under the Code." See Fed. R. Bankr. P. 9017 (2006). 9 See In re Rigby, 47 B.R. 614, 618 (Bankr. N.D. Ala. 1985). 10 Fed. R. Evid. 801(c) (2006). Federal Rule of Evidence 801(d)(1) excludes the following types of statements from the definition of hearsay: a prior statement by a witness that is either (i) inconsistent with the declarant's testimony, and was given under oath subject to the penalty of perjury at a trial, hearing or other proceeding, or in a deposition; (ii) consistent with the declarant's testimony and is offered to rebut an express or implied charge against the declarant of recent fabrication or improper influence or motive; or (iii) one of identification of a person made after perceiving the person. See Fed. R. Evid. 801(d)(1) (2006). Moreover, Federal Rule of Evidence 801(d)(2) also excludes from the definition of hearsay a statement offered against a party and is either (i) the party's own statement, in either an individual or representative capacity; (ii) a statement of which the party has manifested an adoption or belief in its truth; (iii) a statement by a person authorized by the party to make a statement concerning the subject; (iv) a statement by the party's agent or servant concerning a matter within the scope of the agency or employment, made during the existence of the relationship; or (v) a statement by a co-conspirator of a party during the course and in furtherance of the conspiracy. See Fed. R. Evid. 801(d)(2) (2006). 11 Fed. R. Evid. 801(b) (2006). 12 Federal Rule of Evidence 801(a) provides in full that a "statement" is "(1) an oral or written assertion or (2) nonverbal conduct of a person, if it is intended by the person as an assertion." See Fed. R. Evid. 801(a) (2006). 13 United States v. Shukri, 207 F.3d 412, 417 (7th Cir. 2000) (citation omitted). 14 Saltzburg, Stephen A. et al., 4 Federal Rules of Evidence Manual §801.02[1][a] (9th ed. 2006). 15 742 F.2d 862, 875 (5th Cir. 1984). 16 See Fed. R. Evid. 801(d)(1) (2006). 17 See Fed. R. Evid. 801(d)(2) (2006). 18 Because a bankruptcy examiner is appointed by the court, and not retained by one of the constituents in a bankruptcy case, the examiner's report does not satisfy Federal Rule of Evidence 801(d)(2)(C) or (D), namely, "a statement by a person authorized by the party to make a statement concerning the subject" or "a statement by the party's agent or servant concerning a matter within the scope of the agency or employment, made during the existence of the relationship." See Fed. R. Evid. 801(d)(2)(C) and (D) (2006) (emphases added). Interestingly, however, some cases hold that an expert retained by a party to a litigation can be considered that party's agent under Federal Rule of Evidence 801(d)(2)(C) and, consequently, the expert's report and deposition testimony were deemed admissible. See, e.g., Collins v. Wayne Corp., 621 F.2d 777, 780-82 (5th Cir. 1980). But see Kirk v. Raymark Indus. Inc., 61 F.3d 147, 164 (3d Cir. 1995) (rejecting the holding in Collins, concluding that "[s]ince an expert witness is not subject to the control of the party opponent with respect to consultation and testimony he or she is hired to give, [an] expert witness cannot be deemed an agent." In theory, "despite the fact that one party retained and paid for the services of an expert witness, expert witnesses are supposed to testify impartially in the sphere of their expertise"). 19 11 U.S.C.A. §1104(c) (West 2006). In addition, a bankruptcy court has the authority to appoint an examiner sua sponte. See In re Pub. Serv. Co. of New Hampshire, 99 B.R. 177, 182 (Bankr. D. N.H. 1989). 20 See In re UAL Corp., 307 B.R. 80, 84 (Bankr. N.D. Ill. 2004). 21 Section 1104(d) provides as follows: "If the court orders the appointment of a trustee or an examiner, if a trustee or an examiner dies or resigns during the case or is removed under §324 of this title, or if a trustee fails to qualify under §322 of this title, then the U.S. Trustee, after consultation with parties in interest, shall appoint, subject to the court's approval, one disinterested person other than the U.S. Trustee to serve as trustee or examiner, as the case may be, in the case." 11 U.S.C.A. §1104(d) (West 2006). In turn, §101(14) of the Code defines a "disinterested person" as a person that "(A) is not a creditor, an equity securityholder, or an insider; (B) is not and was not, within two years before the date of the filing of the petition, a director, officer or employee of the debtor; and (C) does not have an interest materially adverse to the interest of the estate or of any class of creditors or equity securityholders, by reason of any direct or indirect relationship to, connection with, or interest in, the debtor, or for any other reason." 11 U.S.C.A. §101(14) (West 2006). 22 7 Collier on Bankruptcy ¶1104.01 (15th ed. rev. 2006). See also In re Gliatech Inc., 305 B.R. 832, 835 (Bankr. N.D. Ohio 2004) ("an examiner 'typically investigates the debtor's business and handles other duties specifically assigned by the bankruptcy court, but does not replace the DIP in handling the day-to-day affairs of the business'") (quoting United States v. Schilling (In re Big River Elec. Corp.), 355 F.3d 415, 422 (6th Cir. 2004)); In re Am. Bulk Transp. Co., 8 B.R. 337, 341 (Bankr. D. Kan. 1980) ("the examiner's primary duty is to investigate and report on the financial position of the debtor, the operation of the debtor's business and the desirability of the continuance of the business"). 23 See 11 U.S.C.A. §1106(a)(3) (West 2006); see also 11 U.S.C.A. §1106(b) (West 2006). 24 Morgenstern v. Revco D.S. Inc. (In re Revco D.S. Inc.), 898 F.2d 498, 501 (6th Cir. 1990). 25 Air Line Pilots Ass'n. v. Am. Nat'l. Bank & Trust Co. of Chicago (In re Ionosphere Clubs Inc.), 156 B.R. 414, 432 (S.D.N.Y. 1993) ("Bankruptcy Rule 2004 likewise gives the examiner scope to investigate which is broader than that of civil discovery under Rule 26") (citation omitted), aff'd, 17 F.3d 600 (2d Cir. 1994); In re Fibermark Inc., 339 B.R. at 324. Specifically, Federal Rule of Bankruptcy Procedure 2004(b) provides as follows: "The examination of an entity under this rule...may relate only to the acts, conduct or property or to the liabilities and financial condition of the debtor, or to any matter which may affect the administration of the debtor's estate, or to the debtor's right to a discharge. In a family farmer's debt adjustment case under chapter 12, an individual's debt adjustment case under chapter 13, or a reorganization case under chapter 11 of the Code...the examination may also relate to the operation of any business and the desirability of its continuance, the source of any money or property acquired or to be acquired by the debtor for purposes of consummating a plan and the consideration given or offered therefor, and any other matter relevant to the case or to the formulation of a plan." Fed. R. Bankr. P. 2004(b) (2006). 26 In re French, 145 B.R. 991, 992 (Bankr. D. S.D. 1992) ("Bankruptcy Rule 2004 is designed to be a quick 'fishing expedition' into general matters and issues regarding the administration of the bankruptcy case and, as such, does not offer the procedural safeguards available under Rule 26 of the Federal Rules of Civil Procedure") (citation omitted); In re Valley Forge Plaza Assocs., 109 B.R. 669, 674 (Bankr. E.D. Pa. 1990) ("R[ule] 2004 permits a party invoking it to undertake a broad inquiry of the examiner, in the nature of a 'fishing expedition'") (citations omitted); Air Line Pilots Ass'n. v. Am. Nat'l. Bank & Trust Co. of Chicago (In re Ionosphere Clubs Inc.), 156 B.R. 414, 432 (S.D.N.Y. 1993); Air Line Pilots Ass'n. v. Am. Nat'l. Bank & Trust Co. of Chicago (In re Ionosphere Clubs Inc.), aff'd, 17 F.3d 600 (2d Cir. 1994). 27 11 U.S.C.A. §1106(a)(4) (West 2006). 28 In re Fibermark Inc., 339 B.R. at 322. 29 Id. 30 Id. 31 Id. 32 Id. at 323. 33 Id. at 324. 34 Id. at 322. The decision does not state which constituency employed Chanin Capital Partners LLC. 35 Id. 36 Id. (citation omitted). 37 339 B.R. at 325. 38 Id. 39 Id. at 326. 40 Id. at 327.
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Friday, December 1, 2006

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