How An Official Committee Member Breaches Fiduciary Duties–And Pays A Price

By: Donald L Swanson

Defendant “seriously breached her fiduciary duties” as a member of the Official Committee of Unsecured Creditors.

Naylor v. Farrell (In re Farrell), 610 B.R. 317, 323 (Bkrtcy.C.D.Cal. 2019).

Facts

Here’s what happened: Defendant failed to play by the rules.

Debtor filed a voluntary Chapter 11 bankruptcy. Debtor and and his spouse (the Defendant in the bankruptcy opinion quoted above) were in a divorce proceeding in California family law court. But the family law court had not yet divided their community property or awarded permanent spousal support to Defendant—and it still hasn’t.

Defendant applied for membership on the Official Committee of Unsecured Creditors in her husband’s case, estimating the amount of her property and support claims at $6 million. And she filed a proof of claim, asserting a first-priority domestic support obligation in an “unliquidated” amount.

The US Trustee appointed Defendant to the Committee, and Defendant signed the Committee’s By-Laws, acknowledging her “fiduciary duty” to all unsecured creditors.

Defendant served as “a very active” Committee member, providing information on (and urging liquidation of) Debtor’s assets, thereby “greatly augmenting the amount of cash” in the bankruptcy estate.

Mediation

Defendant also sought relief from stay, so she could proceed in family court to establish her property and support rights. Debtor and Committee opposed such relief.

The dispute went into mediation, which resulted in a “Binding Mediation Term Sheet” signed by Debtor and Defendant, which the Bankruptcy Court approved.

The Binding Mediation Term Sheet provides in part:

“after reservation of funds sufficient to pay community claims and any administrative claims determined by the bankruptcy court to be payable from community property, any excess property will be awarded to both Debtor and [Defendant] as their separate property.”

The Bankruptcy Court ultimately rules that the Binding Mediation Term Sheet is, truly, binding in the bankruptcy case, since the Bankruptcy Court approved it.

But, the Bankruptcy Court says, what the California family law court might do with the Term Sheet “is a matter entirely in the hands of the California family law court.”

Punking the Trustee

The Committee moved for appointment of a Chapter 11 trustee. Debtor consented, and the Court granted the motion. Whereupon, Karen Sue Naylor became appointed as Debtor’s Chapter 11 Trustee.

Trustee became concerned about the magnitude of Defendant’s claim, with its potential first-priority status. Multiple discussions thereon ensued.

Trustee repeatedly emphasized that she would not administer disputed assets solely for Defendant’s benefit, but Trustee could not get a straight answer from Defendant on the nature and scope of Defendant’s claims. Instead, Defendant used the stock phrase “it will all work out” to lure the Trustee and estate professionals into liquidating assets—for Defendant’s sole benefit.

Defendant’s efforts worked: Trustee started liquidating estate assets and incurred sizable professional fees in doing so.

Then, Defendant “finally showed her hand.” While simultaneously dodging Trustee’s inquiries and demanding aggressive liquidation action, Defendant filed an Omnibus Response to professional fee applications. In such Response, Defendant finally says:

• “It is entirely possible” that Defendant’s priority claims “will consume the property that remains in this estate”; and
• The Court cannot authorize a payment of any fees at this time because Defendant has a higher-priority claim.

Then, Defendant resigned from the Committee.

The Court granted the fee applications on an interim basis, but would not allow the Trustee to pay them.

Suing Defendant

So, the Committee filed a complaint against Defendant, commencing this adversary proceeding.

Then, Debtor’s case converted to chapter 7 with the same Trustee, who substituted-in as Plaintiff in the adversary proceeding—hence, the opinion’s caption is Naylor v. Farrell.

Trustee filed an amended complaint stating causes of action for, (i) breach of Defendant’s fiduciary duty, (ii) equitable subordination of Defendant’s claim, (iii) declaring the Binding Mediation Term Sheet to be enforceable against Defendant, and (iv) declaring that all administrative expense claims be paid from Defendant’s community property, in the “interest of justice.”

Ruling

Here’s how the Bankruptcy Court ruled.

–Breach of Fiduciary Duty

A Committee has a fiduciary duty to all unsecured creditors, including a duty of care, of loyalty and of disclosure. Such duties are strict and uncompromising.

Defendant “correctly points out” that each Committee member is a creditor in competition with other creditors for a piece of a shrinking pie. And a Committee member may assert and defend its own claims without breaching a fiduciary duty.

But, while pursuing a first-priority domestic support claim, Defendant may not actively conceal her intentions and dodge Trustee’s repeated inquiries on the subject.

Defendant’s fiduciary duties required her to disclose, from the outset, her secret intentions and argument: that bankruptcy estate professionals and general unsecured creditors “do not have a right” to payment from assets that she claims.

Dodging Trustee’s pointed inquiries, and waiting until much later to disclose her intentions, lured the estate’s professionals into furthering Defendant’s hidden agenda: to enlist Trustee and estate professionals into working for free and for Defendant’s sole benefit. This is a serious breach of fiduciary duties.

–Equitable Subordination Remedy

Equitable subordination is a remedy for Defendant’s breach of duties. It requires proof of three elements:

1. Defendant engaged in inequitable conduct;
2. the misconduct injured creditors or conferred an unfair advantage on Defendant; and
3. subordination must be consistent with the Bankruptcy Code.

Other considerations include, (i) equitable subordination is remedial, not punitive, in nature; and (ii) the extent of subordination should only be as necessary to offset the harm suffered.

Here’s how the Bankruptcy Court applied each of the three elements.

First element. It is inequitable to push for liquidation while intending to claim all the benefits of liquidation and to pay for none of it and while concealing the true intentions.

Second element. Creditors are injured and Defendant gained an unfair advantage:

• Trustee would have declined to administer the estate and incur administrative claims (e.g., professional fees), had Trustee known of Defendant’s true intentions; and
• The Court cannot yet determine the extent to which unsecured claims are harmed, because the family law court has yet to liquidate Defendant’s domestic support claims.

Third element. Subordination is consistent with the priorities established by the Bankruptcy Code because the Bankruptcy Code, itself, expressly authorizes subordination in § 510(c).

Paying a Price

Accordingly, the Bankruptcy Court equitably subordinates Defendant’s entire claim to the administrative claims of Trustee and Committee professionals that were incurred after Trustee’s appointment.

As to next steps, the Bankruptcy Court says:

• Debtor and Defendant are to return to the California family law court to liquidate Defendant’s domestic support claims and property rights;
• Concurrently, Trustee will (i) pay the Trustee and Committee professionals their allowed fees and expenses incurred after Trustee’s appointment, and (ii) create a reserve for the payment of Trsutee’s own fees; and
• If funds remain, Trustee will make a distribution to general unsecured creditors.

The Bankruptcy Court’s ruling is, of course, on appeal.

Conclusion

It’s a rare thing: judicial action against a member of an official committee for violation of fiduciary duties.

But it happens. Naylor v. Farrell is an example—and provides a lesson on the need to play by the rules.

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