Are CROs More Powerful than Turnaround Consultants?
Creditors Drive Trend Toward New Title

(TMA International Headquarters)

Although turnaround professionals have assisted financially troubled companies in the reorganization process for decades, there has been variation in how such professionals are retained.

Turnaround professionals historically have been retained as independent consultants who report to a troubled company’s chief operating officer or directly to the company’s board of directors. Within the last several years, however, it has become quite common for turnaround professionals to be employed as chief restructuring officers (CROs) rather than as consultants. This article addresses the upsurge in the use of CROs and considers whether the recent trend toward CROs is substantively meaningful or whether it is merely a change in nomenclature.

What has driven the new trend toward appointing CROs? Not surprisingly, it has been motivated in large part by the creditor community. As part of the process by which creditors historically have required or influenced troubled companies to “voluntarily” retain turnaround professionals to assist in the restructuring process, creditors are now directing such companies to retain turnaround professionals as CROs rather than as consultants.

But why? What difference does it make to a creditor whether the turnaround consultant is retained as a CRO or an independent consultant? The theory behind it is that a CRO has greater authority to direct the reorganization process than a turnaround consultant and greater independence over existing management.

When retained as an independent consultant, a turnaround professional’s authority to act is solely derived from his or her retention agreement. Typically, a turnaround professional reports to a company’s officers or board of directors and acts at its direction. As a result, if a difference of opinion regarding the future direction of the company arises, the turnaround professional may be terminated at the discretion of the company’s officers or board of directors (although such a termination may have implications under the company’s agreements with its creditors, such as triggering an event of default under a loan agreement).

On the other hand, when a turnaround professional is employed as a CRO, there is an important perception that the person is in complete control of the reorganization process and may act outside the confines of customary corporate governance rules. This concept was recently discussed in an article by Harvey Miller and Shai Waisman in the American Bankruptcy Law Journal, “Does Chapter 11 Reorganization Remain a Viable Option for Distressed Businesses for the Twenty-First Century?” 1 In their article, Miller and Waisman provide the following summary of the authority of a CRO to direct the reorganization process:

The CRO is vested with executive decision making powers and direct access to the debtor’s governing body. Direct access to the CRO is given to the creditor constituency responsible for the CRO’s appointment. The CRO has the authority to meet privately with the creditor constituency and otherwise deal with that creditor constituency as to the administration and formulation of a reorganization plan. From the perspective of some observers, the CRO is almost a de facto trustee.

Miller and Waisman compare the modern day CRO with the “responsible officer” concept that was used by lenders soon after the enactment of the U.S. Bankruptcy Code to gain control or influence over the reorganization process. Miller and Waisman conclude that similar to a responsible officer, a CRO may “dramatically change the nature of the reorganization process.” In essence, a CRO “takes away the decision making power of the debtor in possession and transfers control of the administration of a reorganization in or out of Chapter 11 to third parties other than the debtor.”

Is the premise correct that a CRO has greater authority to act than a turnaround professional employed as an independent consultant? If so, Miller and Waisman are correct that that the appointment of a CRO may indeed dramatically change the nature of the reorganization process, and the trend toward appointing CROs may signify a shift in the balance of power toward creditors.

On the other hand, if a CRO ultimately acts at the discretion of the debtor’s governing body that may remove or replace the person, then the trend toward naming a consultant a CRO is simply a change in nomenclature, and there is no shift in the balance of power. At the end of the day, it is the difficulty or ease by which a CRO may be replaced by shareholders that determines the ability of a creditor to indirectly control or direct the reorganization process through the CRO.

Case Law

There are few reported cases regarding the appointment or retention of a CRO, whether in or outside of bankruptcy. Most of the cases are older and address the power of creditors to appoint a responsible officer during a bankruptcy. Nevertheless, these cases are instructive in considering whether the title CRO carries with it an implied authority to act outside the confines of customary corporate governance rules.

In addition, there are several important cases addressing the rights of shareholders to remove or control management during a bankruptcy proceeding that should be considered. While an exhaustive review of these cases is beyond the scope of this article, several of them are worth mentioning.

In re Gaslight Club, Inc ., 2 is the leading case involving the appointment of a responsible officer in a bankruptcy proceeding. In Gaslight , at the request of the creditors’ committee and with the consent of the debtor’s president and majority shareholder, the Bankruptcy Court designated a turnaround professional as a responsible person with the “full and exclusive power” to exercise the rights and perform the obligations of the debtor in possession.

After the turnaround professional discharged the majority shareholder from his position as president, the majority shareholder sought the appointment of a trustee or, in the alternative, to vacate the prior consent order. The Bankruptcy Court denied the motion, and the U.S. District Court and the 7th U.S. Circuit Court of Appeals affirmed. The court concluded that the Bankruptcy Court’s appointment of a responsible person was authorized by Sections 105 and 1107 of the Bankruptcy Code. It further ruled that the appointment was justified under the circumstances because all constituent parties—including the majority shareholder—had agreed to it.

While the Gaslight case supports the argument that a CRO may not be easily removed or replaced by the debtor’s governing body once it has consented to the appointment, the case is somewhat unique. In Gaslight , the turnaround professional was appointed by the Bankruptcy Court with the unanimous consent of the parties in interest. Soon thereafter, the majority shareholder sought to renege on his earlier consent and attempted to have the turnaround professional removed by requesting the court to either vacate its prior order or to appoint a trustee, rather than by exercising his corporate right to call a shareholders’ meeting and elect new directors.

As a result, the court’s decision was directed more to the issues of whether the shareholder should be allowed to renege on his consent to the court’s earlier order and whether the appointment of a trustee was in the best interest of creditors. In fact, the court really never addressed the more complicated corporate governance issues.

What if a turnaround professional is retained as a CRO prior to a Chapter 11 filing, and shareholders seek to remove the CRO during the course of the bankruptcy by exercising their state law right to convene a shareholders’ meeting and elect new directors? These were the facts confronting the court in the case of In re National Century Financial Enterprises, Inc . 3

In National Century , the debtor’s management, directors, and shareholders consented to the retention of a turnaround professional as the debtor’s president and chief executive officer in response to a state court lawsuit filed by the company’s creditors seeking the appointment of a receiver. After the turnaround professional was retained and the company filed a Chapter 11 bankruptcy, the shareholders demanded that the company convene a shareholders’ meeting to elect a new board.

In response and acting at the direction of the turnaround professional, the company filed an emergency motion seeking an order granting the turnaround professional the exclusive rights and powers of the debtor in possession. Ironically, the company did not attempt to enjoin the shareholder’s meeting from occurring. It merely sought to lessen its potential impact by seeking an order vesting exclusive control of the reorganization process in the turnaround professional.

After reviewing Gaslight and various cases recognizing the right of a debtor-in-possession’s shareholders to exercise their state law corporate governance remedies during a bankruptcy proceeding, the court in National Century concluded that the debtor and the financial consultant had not provided the court with a sufficient basis to grant their motion.

The court concluded that the turnaround professional was presently exercising the rights and powers of the debtor in possession and that the basis for the motion was speculative because it focused on what could or might happen if control of the board reverted back to previous management. Here again, the court dodged the ultimate issue of the shareholders’ right to remove a CRO retained by the company prior to the bankruptcy filing.

Perhaps the most instructive cases on the issue of the right of a CRO to remain in control of the reorganization process in the face of shareholder opposition do not involve CROs or responsible persons at all. These cases concern the generic right of shareholders to control management during a bankruptcy proceeding. 4

Although they have taken widely differing positions on the issue, courts generally have concluded that shareholders have a continuing right to compel a shareholders’ meeting to elect a new board during the pendency of a company’s bankruptcy proceedings unless they are “clearly abusing” that right. Although “clear abuse” is not precisely defined, courts have generally distinguished between cases in which the shareholders attempt to replace management to improve their bargaining leverage and those in which their attempt to replace management threatens the entire success of the reorganization. The latter is considered abuse, and the former is not.

More Than a Name Change

Whether a CRO will survive the threat of removal by shareholders will turn on the facts and circumstances of each case. Existing case law does not appear to justify the conclusion that the appointment of a CRO completely removes decision-making power from the debtor. However, it does appear that the retention of a turnaround professional has an important psychological effect on the relative rights of the parties in a turnaround scenario.

At a minimum, the retention of a turnaround professional as a CRO puts a greater distance between the turnaround professional and the debtor’s shareholders, which in turn makes it more difficult for shareholders to disrupt the turnaround professional’s efforts in the reorganization process. As such, the trend toward appointing CROs is certainly more than a change in nomenclature.

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1 78 Am. Bankr . L. J. 153 (2004).

2 782 F.2d 767 (1986).

3 282 B.R. 850 (Bankr. S.D. Ohio 2003).

4 See e.g. Manville Corporation vs. Equity Security Holders Committee (In re Johns-Manville Corporation), 801 F.2d 60 (2nd Cir. 1986) (enjoining shareholders from calling a meeting of shareholders for the purpose of installing new management on the grounds that the meeting would jeopardize a reorganization proposal that had been three years in the making and threaten liquidation of the company); Lionel Corp. v. Committee of Equity Security Holders of Lionel Corp. (In re Lionel Corp.), 30 B.R. 327 (Bankr. S.D.N.Y. 1983) (allowing equity committee to pursue a request for a shareholders meeting in Delaware Chancery Court); In re Lifeguard Industries, Inc ., 37 B.R. 3 (Bankr. S.D. Ohio 1983) (refusing to allow newly elected directors to replace existing management team).