Two Round Holes and One Square Peg The Employment of Turnaround Consultants Under 327 and 363

Two Round Holes and One Square Peg The Employment of Turnaround Consultants Under 327 and 363

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In the winter 2002 issue of the ABI Law Review, Kurt F. Gwynne penned an article on the problems facing turnaround firms and the professionals employed in bankruptcy cases.2 In that article, Mr. Gwynne recognized some of the problems created when workout, restructuring or turnaround firms3 seek to be employed as such in bankruptcy cases and designate individuals from their ranks to hold officer positions within a debtor's organization. He noted the weaknesses inherent in the partial solution offered by the "protocol" made applicable in such situations by the U.S. Trustee for Region 3,4 and suggested disengaging the retention of the turnaround firm from the hiring of individual consultants as officers as a possible resolution of the problem created by the fact that neither §327 nor §363 provides a proper statutory basis upon which to approve their employment.5

The last three years have witnessed several applications of the Region 3 protocol (as well as the largest revision of the Bankruptcy Code since 1978), yet the problem remains unresolved. By permitting the employment of turnaround firms, which then provide senior officers in the form of chief restructuring officers (CRO), interim chief financial officers (CFO) or interim chief executive officers (CEO), the courts, U.S. Trustees and turnaround professionals have created a loophole of sorts between §§327(a) and 363 of the Code.6 Stretched too far, though, that loophole may ultimately snap shut with potentially devastating consequences for both debtor and professional.

The Round Holes

Sections 327 and 363 are perhaps as well-committed to memory by bankruptcy professionals as any contained in the Code. Nevertheless, certain of their relevant parts may bear repeating for easy reference. Section 327(a) authorizes the trustee or debtor-in-possession (DIP) to employ "one or more attorneys, accountants, appraisers, auctioneers or other professional persons, that do not hold or represent an interest adverse to the estate and that are disinterested persons, to represent or assist the trustee in carrying out the trustee's duties under this title" (more on "disinterestedness" later).7 Section 327(b), which has occasionally (and in the author's view, incorrectly) been used to authorize employment of a management professional,8 states that "if the debtor has regularly employed attorneys, accountants or other professional persons on salary, the trustee may retain or replace such professional persons if necessary in the operation of such business."9 By comparison, §§363(b)(1) and (c)(1) seemingly have nothing to do with the employment of professionals of any stripe or status. Section 363 simply authorizes the DIP to use, sell or lease property of the estate (automatically for transactions occurring in the ordinary course; after notice and a hearing for all others). Yet a consistent body of case law recognizes that §363 provides a statutory basis for the approval of employment contracts, too—specifically, agreements to employ senior managers like CEOs and CFOs.10

The first key distinction in the analysis between approval of employment under §327(a) and §363 is the person's status as a "professional person." This phrase lies at the heart of the problem turnaround firms face in seeking employment in bankruptcy cases.

Courts adopting a qualitative analysis limit the concept of professionals to those who play a central role in administering the debtor's case.11 For those courts adopting a more quantitative analysis, a person is a professional if that person is "given discretion or autonomy in some part of the administration of the debtor's estate," regardless of the size or significance of the person's role.12 Still other cases have provided a laundry list of factors that may be considered in evaluating whether a given person is a professional whose employment must be subject to §327.13 For purposes of this article, it is perhaps sufficient to note the general principle identified by one bankruptcy court: Financial advisors and turnaround consultants are professional persons who can be employed only under §327; officers and other employees, who are generally not professional persons, are not subject to the requirements of §327.14

The second key distinction—relating directly to the first—is the requirement under §327(a) that the professional to be retained be a "disinterested person."15 Section 101(14) provides a fairly precise definition of a "disinterested person." Among other criteria, a disinterested person is a person who "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." For the turnaround professional who seeks to be retained as an interim officer or served in such capacity on a pre-petition basis, the plain text of §101(14) requires no elucidation. Such persons are by definition not "disinterested" for purposes of §101(14), and therefore cannot be employed under §327(a). By excluding officers of a company from the universe of "disinterested persons," §101(14) prohibits their employment by the DIP under §327(a). Yet, because it does not implicate §101(14), §363 may provide a statutory basis for a debtor to employ senior managers, including restructuring officers, on an individual basis because it does not require compliance with §101(14).

The Square Peg

Turning from the conceptual to the practical, the problem arises when a turnaround firm seeks to be retained as crisis manager or turnaround consultant and designates a member of the firm as a CRO, or other interim officer. In these situations, the appointment of a member of the turnaround firm as an officer of the debtor renders the rest of the firm unable to satisfy the "disinterestedness" standard of §101(14) and, by extension, ineligible for employment under §327(a). Section 363 is not an option, either. Under either a qualitative or quantitative analysis, a turnaround firm seeking to provide more generalized restructuring advice is undeniably a "professional person" for the purposes of §327(a).

Moreover, although at least one case (and some commentators) supports the proposition that §327(b) provides the authority for a DIP to employ turnaround professionals in interim officer roles (e.g., CRO, CFO) so long as they were employed by the debtor in their individual capacity pre-petition, the history of §327(b) and the preponderance of courts applying it reach a different conclusion. The more common reading of §327(b) is that the purpose of the statute is to distinguish between ordinary costs incurred in connection with the operation of a debtor's business and those costs incurred to comply with the Code and navigate the bankruptcy process from petition to emergence.16 Indeed, the exclusion of turnaround professionals from §327(b) finds additional support when their role in a bankruptcy case is considered in light of the qualitative and quantitative analyses mentioned above. Under either analysis, a turnaround professional—whether designated as an officer of the debtor or not—is likely to occupy a central role in the administration of the case and exercise significant autonomy over the debtor's estate. So, while a turnaround professional retained by a soon-to-be debtor as interim CFO may sustain the argument that his work relates to the ordinary business activities of the company, a turnaround professional retained as a restructuring officer for the express purpose of guiding the company through the bankruptcy process faces an uphill battle to distinguish his services from those of a professional person whose employment may only be approved under §327(a).17

To summarize the predicament, therefore, the turnaround firm seeking to be employed to provide interim officers cannot be retained under §327(a) (because it is not disinterested) or §327(b) (because it is neither salaried nor a person). For the same reason, the individual consultant cannot be retained under §327(a), and is unlikely to qualify under §327(b). Although §363(b)(1) has come to provide the "statute of choice" for the employment of turnaround firms and professionals, it fails to reconcile the problem that such firms and individuals are generally considered "professional persons" whose employment can only be authorized under §327(a). In short, they couldn't do it right if they wanted to.

This is no idle problem. Turnaround professionals face the very real danger of putting themselves at risk of losing some or all of their fees if they bet wrong and are employed by a DIP without the proper authority.18 For such professionals who find themselves employed without the proper court authorization, a bankruptcy court may not only disallow further compensation, but order disgorgement of any fees collected by the professional to date as unauthorized post-petition transfers pursuant to §549(a). While a professional cast into such circumstances could undoubtedly seek reimbursement from the estate under §503(b)(1)(A) for the reasonable value of such services, the amount of an award, if any, is unlikely to bear any resemblance to the fees typically earned by such professional.

One Solution: The Region 3 Protocol

In September 2001, the U.S. Trustee for Region 3 negotiated a settlement with Jay Alix & Associates (JA&A) after the U.S. Trustee objected to JA&A's employment and sought the disqualification of, and disgorgement of fees by, JA&A in the Safety-Kleen and Harnischfeger cases, respectively.19 As a term of the settlement, the parties agreed to the terms of a protocol designed to govern the employment of JA&A in future cases in Region 3. Among other terms and provisions, the protocol permits JA&A and its affiliates to seek employment in a case either as a financial advisor pursuant to §327 or as a crisis manager pursuant to §363, but not both. It further states that JA&A is not permitted to switch to a different role (e.g., from crisis manager to financial advisor) in the same case.

Also of particular note is the fact that, according to the protocol, JA&A provided "turnaround and crisis management services, financial advisory services, management consulting services, information systems services and claims management services."20 By contrast, "crisis management" engagements, or engagements involving the furnishing of interim executive officers, whether pre-petition or post-petition, were to be provided by its affiliate, JA&A Services LLC (n/k/a AP Services LLC, or APS).

Formulated as a negotiated resolution to a particular dispute, the protocol fails to resolve the underlying catch-22 between the desire to engage interim officers under §363 and the obligation to comply with §§327(a) and 101(14). As a notable example, the protocol expressly states that "service as a pre-petition officer will not per se cause disqualification."21 Since this directly conflicts with §101(14), under which a pre-petition officer per se cannot be disinterested, it highlights the fact that the Region 3 protocol is merely a negotiated resolution that fails to answer the ultimate dilemma.22 The protocol also blurs the precise nature of APS's role in a bankruptcy case by providing for APS (rather than the individual consultant) to be retained to provide the services of an interim officer and stating that the compensation in such engagements is paid to APS (rather than the individual consultant). Therefore, while the protocol may have represented an acceptable compromise between the precise requirements of the Code and the practical difficulties associated with the employment of restructuring officers, it cannot be said to have solved the problem entirely.

A Cautionary Tale: In re Mirant Corp.


The hypothetical has become a reality during the course of one of the largest bankruptcies in U.S. history and provides an excellent real-world example of the predicament that can befall a debtor and turnaround professional who attempt to wedge themselves into the narrow crevice that exists between §§327 and 363. The problem presented in this case was resolved through an informally negotiated agreement, but the circumstances nevertheless provide an excellent example of how the use of §363 to employ a turnaround firm can have potentially dire consequences for the firm or the debtor.

The case involved the hiring of APS by Mirant Corp. and its debtor-subsidiaries (collectively, "Mirant").24 As part of its first-day motions, Mirant sought authority to employ APS as crisis managers for the debtors and for APS then to designate one of its managing directors as CRO of Mirant. Uncharacteristic of such applications, however, the scope of APS's employment (as defined in their application) included both the duties of a CRO or crisis manager to:

  • assist in the development of strategic and business plans and exit strategies,
  • assist in the development of a plan and disclosure statement, and
  • assist efforts to obtain post-petition and exit financing, as well as the duties of a financial advisor:
  • analyzing the divestiture of noncore assets and
  • managing claims and the claims-reconciliation process.

The application was granted, and Mirant was authorized pursuant to §363 to employ APS as crisis manager. In turn, APS then designated one of its managing directors as CRO of Mirant.25

Less than a year later, however, in August 2004, Mirant's CFO (who was not related to APS or any other restructuring firm) assumed the duties of CRO, relieving APS's designee of that position. APS continued to provide a variety of services to Mirant, including the analysis of intercompany and third-party claims, but no longer provided Mirant with its CRO and, as a practical matter, ceased to serve as crisis manager.

Thus, APS (and Mirant, who continued to rely on APS to provide advice on a variety of matters) suddenly found itself in the awkward position of no longer providing all of the services upon which it originally justified its employment under §363 in the first place. APS had been employed under §363 ostensibly based on its role as the provider of the CRO. When APS (through its designee) ceased to perform that function, however, the procedural sufficiency (if any) of §363 evaporated. In its remaining capacity, APS became undeniably a "professional person": employed by Mirant, yet no longer possessing the proper statutory authorization for that employment. To make matters worse, the fact that an APS consultant had previously served as an officer of Mirant rendered APS thereafter incapable of satisfying the "disinterestedness" requirement of §101(14) and qualifying for retention under §327. Therefore, APS was not only not eligible for employment under §363 (having reverted overnight to its underlying status as a "professional person"), it was ineligible for employment by Mirant under §327(a) on account of its former status as an officer of Mirant.

Setting aside the protocol (the application of which in the Mirant case, in any event, is only theoretical), APS and Mirant were presented with little in the way of viable options to extricate themselves from the situation. APS could not easily file an application for re-employment as financial advisor to Mirant pursuant to §327(a) without running afoul of §101(14), nor would it have been in Mirant's best interests for APS to be forced to withdraw from the case (which the protocol might technically require).

Interestingly, the application of the protocol would have made matters even worse. In addition to its provisions enforcing a "one-hat" policy, whereby JA&A and its affiliates could act in only one capacity (i.e., crisis manager, claims agent/administrator, financial advisor or investor) in a given bankruptcy case, the protocol prohibited JA&A and its affiliates from accepting another engagement in another capacity in the same case. Thus, were APS's employment in the Mirant case governed by the protocol (which it is not), then having been retained as crisis manager under §363 and subsequently relieved of that position, APS would have been forced to withdraw from the case. Over a year into the bankruptcy case, APS's withdrawal could have been very disruptive to Mirant. Moreover, because APS was not retained under §327(a), it suddenly found itself in the precarious situation of being compensated by the Mirant estate without the proper court authorization. Based on the outcome in other cases, the stage was set for APS to lose potentially all its fees, subject to whatever it might recover by way of a quantum meruit claim under §503(b)(1)(A).

Conceivably, if APS's fees and expenses were otherwise being reviewed and made subject to the traditional procedures under §§330 and 331 for the compensation of professionals, one might determine to treat the situation as an anomaly warranting no additional consideration (save for armchair contemplation of a hard lesson learned). However, as was standard practice for APS and many other turnaround firms in these engagements, APS neither filed regular fee applications nor was subject to §§330 and 331. Instead, consistent with its general practice, APS filed only a brief notice of fees and expenses earned during the preceding month, and was otherwise paid in the ordinary course of business.

To resolve the problem in this case, APS agreed to subject itself to the same interim compensation procedures applicable to all other professionals employed in the Mirant case pursuant to §§327 and 1103, including the requirements to submit detailed monthly statements, quarterly summaries and a final fee application at the conclusion of the case. The agreement received the approval of the U.S. Trustee and the court-appointed examiner, and has apparently resolved the problem in this case (though it leaves the underlying issue still unresolved). However, no order filed in the case reflects this agreement, and it remains to be seen whether or how the bankruptcy court will ultimately address the issue.


The mere fact that the reorganization of a debtor (or family of debtors) requires the services of a number of professionals—legal, financial or otherwise—cannot permit the abrogation of the express provisions of the Code for the sake of mere expediency. At the same time, the effectiveness and resources of individual consultants could be severely curtailed if they are forced to dissociate themselves from turnaround firms in order to be retained as CROs or other interim officers.26 Too often, these things are simply addressed in off-the-record understandings. Mirant is such a case, where the current resolution is based on a consent order that has never been approved by the court, doesn't comply with §§327 and 101(14) and would fail to comply with the protocol anyway. It seems the only safe way for a debtor to employ a CRO is as an independent contractor, unattached to any turnaround firm that the debtor might also want or need to employ.27

The problem lies in the fact that a solution has not yet been devised to integrate fully the concept of the CRO who, as a professional person, must adhere to the requirements of §§327(a) and 101(14) and, as an officer of the DIP, must fail to do so. So long as Congress fails to recognize and cure this deficiency, the statutory basis for the employment of crisis firms and CROs will continue to subsist in the twilight between §§327 and 363. Until then, however, proposed engagements should be tailored carefully to fit the Code, not the other way around, or restructuring professionals will continue to face the very real risk of ending up as providers of pro bono services as the penalty for their status as a square peg in a statutory world of round holes.


1 The opinions set forth in this article are the opinions of the author alone and do not necessarily reflect the opinions, beliefs or positions of Gardere Wynne Sewell LLP or its clients. Return to article

2 Gwynne, Kurt F., "Employment of Turnaround Management Companies, Disinterestedness Issues under the Bankruptcy Code, and Issues under Delaware General Corporation Law," 10 ABI Law Review 673 (Winter 2002) (hereinafter "Gwynne"). Return to article

3 For convenience, such firms are referred to herein as turnaround firms. Return to article

4 Region 3 covers the bankruptcy courts resident in Pennsylvania, Delaware and New Jersey. Return to article

5 Gwynne, supra at 709. Return to article

6 Except as otherwise noted, all statutory references contained herein are found in Title 11 of the U.S. Code (the Code). Return to article

7 11 U.S.C. §327(a) (emphasis added). Perhaps only half in jest, the author wonders whether the limitation of professionals to the four enumerated was specifically engineered by Congress or merely the product of a healthy appreciation for the alliterative. Return to article

8 See, e.g., In re Phoenix Steel Corp., 110 B.R. 141 (Bankr. D. Del. 1989). Return to article

9 11 U.S.C. §327(b). Return to article

10 At least one published opinion disagrees with this trend and finds no relationship between the use of the estate's assets and the employment of senior managers. See, e.g., In re Bicoastal Corp., 149 B.R. 216, 219 (Bankr. M.D. Fla. 1993) (rejecting the notion that §363(c)(1) was intended to apply to the approval of an agreement to employ a certified public accountant to provide pension plan asset-management services). However, this represents a clear minority view. The better reading of the phrase "use, sale or lease" of an estate's property surely includes the use of an estate's cash and, on that reading, should guide the efforts of a DIP effort to enter into employment contracts with senior managers. See, e.g., In re Adelphia Communications Corp., et al., 2003 WL 22316543, *29 (Bankr. S.D.N.Y. 2003) (applying §363(b) to evaluate the proposed employment of a new CEO and CFO). Return to article

11 In re Seatrain Lines Inc., 13 B.R. 980, 981 (Bankr. S.D.N.Y. 1981); In re Bicoastal Corp., 149 B.R. at 218. Return to article

12 In re Fretheim, 102 B.R. 298, 299 (Bankr. D. Conn. 1989); In re Semenza, 121 56, 57 (Bankr. D. Mont. 1990). Return to article

13 In re First Merchants Acceptance Corp., 1997 WL 873551, *3 (D. Del. 1997); In re Bartley Lindsay, 120 B.R. 507, 512 (Bankr. D. Minn. 1990). Return to article

14 See, e.g., In re Bartley Lindsay Co., 120 B.R. at 511. Return to article

15 A third distinction, of course, is presented in the requirement under §327(a) that the professional neither hold nor represent an interest adverse to the estate. However, this requirement has posed nowhere near the difficulties for turnaround professionals that the "disinterestedness" standard has. Return to article

16 See, e.g., In the Matter of Delta Petroleum (PR) Ltd., 164 B.R. 425, 428 (Bankr. D. P.R. 1994); see, also, In re Prime Foods of St. Croix Inc., 80 B.R. 758, 762 (D. V.I. 1987) (stating that §327(b) refers to professionals employed in the ordinary course of business, and holding that an attorney hired on the eve of filing bankruptcy was not employed in support of "the ordinary daily business activities of the debtor"); In re Carolina Sales Corp., 45 B.R. 750 (Bankr. E.D.N.C. 1985) (stating that §327(b) is directed to the continued employment of existing in-house employees, and holding that a management consultant is an independent contractor and therefore not allowed to take advantage of §327(b)); In the Matter of Roger J. Au & Son Inc., 65 B.R. 322, 332 (Bankr. N.D. Ohio 1984); holding that (§327(b) "cannot be read so broadly as to confer the right upon the debtor-in-possession to retain as counsel one who is nondisinterested by reason of his prior and continuing employment as an officer and director of the debtor corporation"). Return to article

17 Moreover, this assumes the workout professional is herself seeking the engagement (rather than the workout firm) and would be hired "on salary" rather than based on an hourly or daily rate. Return to article

18 See, e.g., In re Bartley Lindsay Co., 120 B.R. at 513 (ruling that all compensation paid to workout consultant post-petition was avoidable under §549(a) where consultant had been retained by debtor but not approved under §327); In re Bicoastal Corp., 149 B.R. at 218-19 (holding that, barring entitlement to compensation on a quantum meruit basis, professional person whose employment was not approved under §327(a) was not entitled to compensation). Return to article

19 In re Safety-Kleen Corp., et al., Case No. 00-2303 (Bankr. D. Del. Oct. 4. 2001); In re Harnischfeger Industries, et al., Case No. 99-2171 (Bankr. D. Del. Sept. 11, 2001). Return to article

20 Protocol at 1. Return to article

21 Protocol at 2. Return to article

22 As an example, notwithstanding the fact that it had provided the debtor with a CRO and CFO on a pre-petition basis, the affidavit supporting the employment of JA&A as restructuring consultants in In re Exide Technologies Inc. states that JA&A was a disinterested person at the time of the application. Although the pleadings do not so indicate, this affirmation was made presumably in reliance on the Region 3 protocol. Return to article

23 During the research and writing of this article, the author served as counsel for the court-appointed examiner in the Mirant case. The opinions in this article are those of the author alone and do not reflect the opinions, beliefs or official position of Mirant's examiner. Return to article

24 Mirant Corp. and 82 of its subsidiaries filed voluntary chapter 11 petitions on July 14, 2003, and dates thereafter. Listing $19.415 billion in assets, at the time it was the eleventh largest bankruptcy case in U.S. history and the largest case of 2003. Return to article

25 Interestingly, only one filed objection raised the question of whether §363 provided the necessary authority, and it submitted that §327 should apply. The objection was filed by one of the two creditors' committees. Mirant apparently sought to employ APS under §363 because the designation of the CRO as an officer of the company would otherwise prevent APS from satisfying the "disinterestedness" standard set forth in §101(14). Such an explanation, however—that APS sought employment under §363 because it could not satisfy the requirements of §327—only skirts the issue. Return to article

26 A CRO often requires support personnel experienced in turnaround situations to assist in the restructuring effort. Return to article

27 In principle, a debtor could legitimately hire Workout Firm A to provide restructuring consulting services under §327(a), but hire a single consultant from Workout Firm B under §363 to serve as chief restructuring officer (and, presumably, direct the efforts of Workout Firm A). Such an arrangement may bring its own set of difficulties by forcing a CRO from Workout Firm B to collaborate with personnel from Workout Firm A. On the other hand, by severing the relationship between the performance (and compensation) of the consulting firm and the CRO, it could provide an added layer of independence to the position of CRO. Return to article

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Thursday, September 1, 2005