The Bankruptcy Code provides that, in chapter 11 cases where the court does not find "cause" for the appointment of a trustee, the court "shall" appoint an examiner, upon a request from the Office of the U.S. Trustee (the "UST") or any party-in-interest prior to confirmation of a chapter 11 plan. The examiner's role is to investigate the debtor's affairs or allegations of management misconduct, if either: (i) the court determines that the appointment would be in the best interests of stakeholders and the estate; or (ii) the debtor has qualifying unsecured debt exceeding $5 million. It is well recognized that a bankruptcy court has the discretion to determine whether the appointment of an examiner is in the best interests of stakeholders and the estate. However, courts sometimes disagree over whether the appointment of an examiner is mandatory if the debtor meets the statutory debt threshold.
The U.S. Court of Appeals for the Third Circuit addressed this issue as a matter of first impression in In re FTX Trading Ltd., 91 F.4th 148 (3d Cir. 2024). The Third Circuit reversed a bankruptcy court order denying a motion by the UST to appoint an examiner in a cryptocurrency chapter 11 case to investigate allegations of pre-bankruptcy manager misconduct even though the debtor's unsecured debt far exceeded the $5 million threshold. In so ruling, the Third Circuit joined the Sixth Circuit in concluding that the appointment of an examiner is such cases is mandatory when requested by the UST or a party-in-interest, and that the bankruptcy court's discretion is limited to defining the scope of the examiner's investigation.
Appointment of a Trustee or Examiner in Chapter 11
Ordinarily, a chapter 11 debtor's pre-bankruptcy management continues to direct the debtor's affairs and control its assets as a debtor-in-possession ("DIP"). However, if management's misconduct or incompetence indicates that it should no longer be entrusted with that role, the Bankruptcy Code provides that the DIP can be supplanted with a chapter 11 trustee.
Specifically, section 1104(a) of the Bankruptcy Code provides that during the pendency of a chapter 11 case prior to confirmation of a plan, the court, upon the request of a party in interest or the UST, and after notice and a hearing, "shall" order the appointment of a trustee either "for cause" or "if such appointment is in the interests of creditors, any equity security holders, and other interests of the estate" (but excluding the number of the debtor's security holders or the amount of its assets or liabilities). "Cause" is defined non-exclusively to include "fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management," either before or after the bankruptcy petition date. 11 U.S.C. § 1104(a)(1).
The Bankruptcy Code also contemplates a less drastic alternative—the appointment of an examiner—in cases where "cause" to appoint a trustee is absent, but where the input of an independent third party is deemed necessary to investigate the debtor's financial affairs or management's conduct. Section 1104(c) provides as follows:
If the court does not order the appointment of a trustee under [section 1104(a)], then at any time before the confirmation of a plan, on request of a party in interest or the [UST], 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 security holders, 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 $5,000,000.
11 U.S.C. § 1104(c) (emphasis added).
Thus, under section 1104(c), the bankruptcy court "shall" appoint an examiner if a chapter 11 trustee has not been appointed, a plan has not been confirmed and either: (a) the court determines that the appointment is in the best interests of creditors, interest holders or the estate; or (b) the debtor's qualifying unsecured debt exceeds $5 million.
Unlike a chapter 11 trustee, an examiner does not replace the DIP and generally assumes no management authority over the debtor or the estate. Rather, the examiner's role is to investigate and report on matters of the type described in section 1104(c) within the investigative scope established by the bankruptcy court.
Specifically, an examiner appointed under section 1104(c) has the following duties: (i) unless the court orders otherwise, a duty to "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"; (ii) a duty to file with the court as soon as practicable a report detailing the examiner's findings regarding these issues and any appropriate remedies available to the estate, and to submit the report to any official committee, indenture trustee, or other entity designated by the court; and (iii) a duty to perform "any other duties of the trustee that the court orders the [DIP] not to perform." See 11 U.S.C. § 1106(b), (a)(3), and (a)(4).
Section 1104(c)(2) is a vestige of the "public company" exception that was included in the original U.S. Senate bill later enacted as the Bankruptcy Code in 1978. See S. 2266, 95th Cong. 2d Sess., §§ 1101(3), 1104(a), 1109(b), 1125(f), 1126(b)(3), 1128, 1130(a)(7), 1130(a)(8)(B), and 1130(b) (1978), reprinted in Collier on Bankruptcy ("Collier") at App. Pt. 4(e). The Senate bill would have made the appointment of a trustee mandatory in a chapter 11 cases involving a "public company," which was defined as a company with at least $5 million in unsecured debt and at least 1,000 security holders. The inclusion of section 1104(c)(2) as a ground for the mandatory appointment of an examiner was a compromise after the public company provision was removed. See 124 Cong. Rec. H11,102 (daily ed. Sept. 28, 1978), reprinted in Collier at App. Pt. 4(f)(i); S17,419 (daily ed. Oct. 6, 1978), reprinted in Collier at App. Pt. 4(f)(iii)). The $5 million threshold in section 1104(c)(2) is typically satisfied "where there is outstanding unsecured bank debt or outstanding publicly issued debentures in an aggregate sum in excess of $5,000,000." Collier at ¶ 1104.03[2].
In examining section 1104(c)(2) and its legislative history, a majority of courts, including the U.S. Court of Appeals for the Sixth Circuit and many district and bankruptcy courts, have held that the statute's plain language requires the appointment of an examiner in cases satisfying the $5 million threshold. See Morgenstern v. Revco D. S., Inc. (In re Revco, D. S., Inc.), 898 F.2d 498, 500–01 (6th Cir. 1990); Walton v. Cornerstone Ministries Invs., Inc., 398 B.R. 77, 81 (N.D. Ga. 2008); In re Dynegy Holdings, LLC, 2013 WL 12568343, at *1 (Bankr. S.D.N.Y. Jan. 18, 2013); In re Vision Dev. Grp. of Broward Cnty., LLC, 2008 WL 2676827, at *3 (Bankr. S.D. Fla. June 30, 2008); see also Loral Stockholders Protective Comm. v. Loral Space and Commc'ns, Ltd. (In re Loral Space and Commc'ns, Ltd.), 2004 WL 2979785, at *5 (S.D.N.Y. Dec. 23, 2004) (agreeing that the appointment of an examiner is mandatory if the debt threshold is satisfied and noting that "it is well-established that the bankruptcy court has considerable discretion in designing an examiner's role"); In re Erickson Retirement Communities, LLC, 2010 WL 881727, at *2 (Bankr. N.D. Tex. March 5, 2010) ("[If] the $5 million unsecured debt threshold is met, a bankruptcy court ordinarily has no discretion. The only judicial discretion that comes into play is in defining the scope of the examiner's role/duties."); In re UAL Corp., 307 B.R. 80, 84 (Bankr. N.D. Ill. 2004) ("Although the question is not free from doubt, the best reading of the statute differs from that proposed by either of the parties: appointment of an examiner is mandatory if the four conditions are met, but the court retains the discretion to determine the nature and scope of the examiner's investigation.").
However, despite the mandatory language of section 1104(c), some courts have refused to appoint an examiner even though a chapter 11 debtor's fixed, liquidated, unsecured debt— other than debt for goods, services, or taxes—or debt owing to an insider, exceeds $5 million. These courts have reasoned that the phrase "conduct such an investigation of the debtor as is appropriate" in the provision modifies the term "shall," meaning that a bankruptcy court has the discretion to refuse to appoint an examiner under section 1104(c)(2) even if the debtor satisfies the debt threshold. See, e.g., In re Residential Cap., LLC, 474 B.R. 112, 121 (Bankr. S.D.N.Y. 2012) ("While section 1104(c) expresses a Congressional preference for appointment of an independent examiner to conduct a necessary investigation, the facts and circumstances of the case may permit a bankruptcy court to deny the request for appointment of an examiner even in cases with more than $5 million in fixed debts. Accordingly, section 1104(c)(2) requires that a court order the appointment of an examiner when (1) no plan has been confirmed; (2) no trustee has been appointed; (3) the debtor has in excess of $5 million in fixed debts; and (4) the facts and circumstances of a case do not render the appointment of an examiner inappropriate."); In re Spansion, Inc., 426 B.R. 114, 126 (Bankr. D. Del. 2010) (the appointment of examiner was not warranted, even though the statutory debt threshold for appointment of examiner was met, where the record contained insufficient evidence of misconduct to make investigation of the debtors appropriate and the appointment of an examiner would cause undue cost to the estate that would be harmful to the debtors and delay administration of the debtors' chapter 11 cases); see also In re Collins & Aikman Corp., 368 B.R. 623, 626 (Bankr. E.D. Mich. 2007) (denying the UST's motion for the appointment of an examiner even though the debt threshold was met because the UST was seeking an investigation of the debtor's bankruptcy professionals rather than the debtor).
The Third Circuit weighed in on this issue in FTX Trading.
FTX Trading
Global cryptocurrency exchange FTX Trading Ltd. and numerous affiliates (collectively, the "debtors") filed for chapter 11 protection in the Southern District of New York beginning on November 11, 2022. The bankruptcy filings came days after the debtors suffered a catastrophic decline in value and a severe liquidity crisis as customers withdrew billions of dollars from their accounts over the course of a few days in early November 2022. After the filings, it soon became apparent that the debtors' primary owner, Samuel Bankman-Fried, who also owned cryptocurrency hedge fund Alameda Research, had engaged in massive fraud, the misappropriation of billions of dollars in customer assets, and self-dealing that would ultimately lead to his criminal conviction for fraud in November 2023. It also emerged after preliminary investigations of the debtors' affairs that FTX Trading was grossly mismanaged without, among other things, basic corporate governance practices, observation of corporate formalities, or maintenance of books and records accurately reflecting the extent of the debtors' assets and liabilities.
Less than three weeks after FTX Trading commenced its chapter 11 cases, the UST filed a motion seeking the appointment of an examiner. According to the UST, a public report of an examiner's investigation could reveal the "wider implications" of the debtors' collapse for the cryptocurrency industryz, and the appointment of an examiner could "allow for faster a more cost-effective resolution" of the chapter 11 cases by allowing the CEO who replaced Bankman-Fried to focus on his "primary duty of stabilizing the debtors' businesses" while the examiner investigated the debtors' pre-bankruptcy collapse and management.
The UST asserted that, because the debtors' unsecured debts substantially exceeded $5 million, the appointment an examiner was mandatory under the plain language of section 1104(c)(2) of the Bankruptcy Code. The UST also argued that the appointment of an examiner would be in the best interests of the estates, creditors, and equity security holders given the grounds to suspect "actual fraud, dishonesty, or criminal conduct" in the management of the debtors.
The official unsecured creditors' committee, the debtors, and the joint liquidators of a non-U.S. affiliate opposed the UST's motion. Among other things, they argued that: (i) the phrase "as is appropriate" in section 1104(c) makes the appointment of an examiner in cases satisfying the debt threshold not mandatory, but within the bankruptcy court's discretion; and (ii) the appointment of an examiner in this case would be highly inappropriate because the investigation would be too costly for creditors, interfere with efforts to stabilize the debtors, duplicate the debtors' own investigations of mismanagement, and pose a security risk to customers' confidential information.
Based on the "as is appropriate" language in section 1104(c), certain pre-Bankruptcy Code court decisions, and legislative history, the bankruptcy court concluded that the appointment of an examiner was discretionary despite the fact that the debtors' unsecured debt far exceeded $5 million. The court reasoned that the debtors' new CEO was "completely independent" from the debtors' founders and that any remaining prior officers "have been stripped of any decision making authority." It accordingly denied the UST's motion to appoint an examiner. The Third Circuit agreed to certify a direct appeal by the UST of the bankruptcy court's order.
The Third Circuit's Ruling
A three-judge panel of the Third Circuit reversed the bankruptcy court's order and remanded the case with an instruction to appoint an examiner.
Writing for the panel, U.S. Circuit Court Judge L. Felipe Restrepo explained that the issue before the court was one of statutory interpretation, which begins with an examination of the language of the statute to determine lawmakers' intent. According to Judge Restrepo, in section 1104(c), "Congress made plain its intention to mandate the appointment of examiner by using the word 'shall,' as in the Bankruptcy Court 'shall' appoint an examiner if the terms of the statute have been met." FTX Trading, 91 F.4th at 153.
The Third Circuit held that the bankruptcy court erred as a matter of statutory construction when it read "shall" to mean "may" by grafting the "as is appropriate" modifier onto the "obligatory command to appoint an examiner, when the conditions of subsection 1104(c)(2) have been met." Id. In addition, the panel agreed with the UST's argument that section 1104(c) does not state that the court shall order the appointment of an examiner to conduct an investigation of the debtor "if appropriate," indicating that the bankruptcy court has a choice, but "as is appropriate," indicating that the bankruptcy court has the discretion to determine the extent of the examiner's investigation into the specified allegations, but does not have the discretion to deny the appointment of an examiner if the statutory conditions have been satisfied. Id. at 154 (emphases added).
In adopting this interpretation, the Third Circuit panel agreed with the Sixth Circuit's conclusion in Revco that the contrast between subsections 1104(c)(1) and 1104(c)(2) "could not be more striking," and that there is no "weighing of interests in subsection 1104(c)(2)." Id. (citing Revco, 898 F.2d at 501). Rather, Judge Restrepo noted that the court is allowed to determine only whether the debt threshold in subsection 1104(c)(2) has been satisfied. Interpreting the provision to give the court discretion by ignoring the differences between the plain text of subsections 1104(c)(1) and 1104(c)(2), he wrote, "would defy 'the usual rules of statutory interpretation' by assuming that 'Congress adopt[ed] two separate clauses in the same law to perform the same work.'" Id. (citations omitted).
Moreover, Judge Restrepo emphasized, based upon floor statements made by congressional sponsors of the Bankruptcy Code indicating that section 1104(c)(2) was enacted to protect the public interest in larger bankruptcy cases, "refusal to give effect to the mandatory language" concerning the appointment of an examiner would fail "to give effect to the legislative intention." Id. (quoting Collier at ¶ 1104.03[2][b] (internal quotation marks omitted) and citing 124 Cong. Rec. 33990 (1978)).
The Third Circuit panel rejected as unsupported by evidence the debtors' argument that granting every party-in-interest the right to seek the appointment of an examiner in cases where the debt threshold is met is illogical and encourages abuse. Id. at 155 and n.7. In addition, Judge Restrepo explained: (i) the bankruptcy court can set the parameters of the examiner's investigation, thereby ensuring no duplication of effort or unnecessary disruption of the reorganization process; and (ii) even if the mandatory nature of subsection 1104(c)(2) encourages a party-in-interest to "invoke an investigation to tactically delay proceedings," the bankruptcy court retains the discretion to continue with the chapter 11 plan confirmation process without considering the examiner's findings. Id. at *6 (citing Collier at ¶ 1104.03[2][b]).
Finally, the Third Circuit panel faulted the bankruptcy court's rationale that an examiner was unnecessary because old management had been supplanted by independent managers untainted by allegations of fraud or mismanagement. According to Judge Restrepo, the existence of independent management is irrelevant because the appointment of an examiner is mandatory under section 1104(c)(2).
The court also rejected the argument that an examiner's investigation would be duplicative and wasteful given the ongoing efforts of the debtors and the committee to uncover the extent of pre-bankruptcy mismanagement. Lawmakers, Judge Restrepo explained, "guaranteed that an investigation under subsection 1104(c)(2) would differ from those [conducted by the debtors and the committee] in several significant ways." Specifically, an examiner, unlike a DIP or an official committee, must: (i) be "disinterested" and "nonadversarial," and "answer[] solely to the Court"; and (ii) make his or her findings public, thereby "further[ing] Congress' intent to protect the public's interest as well as those creditors and creditors directly impacted by the bankruptcy." Id. at 157 (citations omitted).
Outlook
The language of section 1104(c) of the Bankruptcy Code on its face requires that a bankruptcy court, upon the request of a party-in-interest or the UST, appoint an examiner to investigate past or ongoing managerial misconduct or incompetence in a chapter 11 case if the debtor has more than $5 million in qualifying unsecured debt. Courts, however, have sometimes refused to do so, reasoning that the appointment of an examiner is discretionary or simply unwarranted under the circumstances. With FTX Trading, two circuit courts of appeals have now ruled that the appointment of an examiner under section 1104(c)(2) is mandatory, and that the court's discretion is limited to defining the scope of the investigation. In so ruling, the Third Circuit bolstered the majority view on this question based upon the plain language of the provision and its legislative history.
Under the reasoning adopted by those circuits, it would appear that the UST or any party-in-interest (including creditors and equity interest holders) can secure the appointment of an examiner in chapter 11 cases that satisfy the debt threshold. In FTX Trading, the Third Circuit was unconvinced that the automatic appointment of an examiner in such cases would lead to needless expense, delay, and gamesmanship in chapter 11 cases, principally because the Third Circuit concluded that the appointing court has the right to define the scope of the examiner's investigation and need not defer the plan confirmation process pending the issuance of the examiner's report.
Nevertheless, if this approach is followed by other courts, the impact could be significant. Bankruptcy filings data indicate that approximately 270 cases were filed in the last two years that would satisfy the $5 million unsecured debt threshold.
On January 23, 2024, the debtors in FTX Trading informed the Third Circuit that they would not seek U.S. Supreme Court review of its decision.
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