In this Article, we use hand-collected data to shed light on a troubling development in bankruptcy practice: distressed companies, especially those controlled by private equity sponsors, often now prepare for a Chapter 11 filing by appointing bankruptcy experts to their boards of directors and giving them the board’s power to make key bankruptcy decisions. These directors often seek to wrest control of self-dealing claims against shareholders from creditors. We call these directors “bankruptcy directors” and conduct the first empirical study of their rise as key players in corporate bankruptcies. While these directors claim to be neutral experts that act to maximize value for the benefit of creditors, we argue that they suffer from a structural bias because they often receive their appointment from a small community of repeat private equity sponsors and law firms. Securing future directorships may require pleasing this clientele at the expense of creditors. Indeed, we find that unsecured creditors recover on average 20% less when the company appoints a bankruptcy director. While other explanations are possible, this finding shifts the burden of proof to those claiming that bankruptcy directors improve the governance of distressed companies. Our policy recommendation, however, does not require a resolution of this controversy. Rather, we propose that courts regard bankruptcy directors as independent only if an overwhelming majority of creditors whose claims are at risk supports their appointment, making them accountable to all sides of the bankruptcy dispute.
In August 2017, the board of directors of shoe retailer Nine West confronted a problem. The firm would soon file for Chapter 11 protection, and its hopes to emerge quickly from the proceeding were in danger due to the high probability of creditor litigation alleging that the firm’s controlling shareholder, private equity fund Sycamore Partners Management, had looted more than $1 billion from the firm’s creditors. The board could not investigate or settle this litigation because it had a conflict of interest.
To take control of the litigation, the board appointed two bankruptcy experts as new directors who claimed that, because they had no prior ties to Sycamore or Nine West, they were independent and could handle those claims. Once the firm filed for bankruptcy, its creditors objected. They argued that the new directors still favored Sycamore because it stood behind their appointment, so the directors would “hamstring any serious inquiry into [its] misconduct.” Nevertheless, the gambit was successful. The bankruptcy court allowed the new directors to take control of the litigation. The new directors blocked creditor attempts to file lawsuits on their own and ultimately settled the claims for about $100 million.
The Nine West story illustrates the emergence of important new players in corporate bankruptcies: bankruptcy experts who join boards of directors shortly before or after the filing of the bankruptcy petition and claim to be independent The new directors—typically former bankruptcy lawyers, investment bankers, or distressed debt traders—often receive the board’s power to make important Chapter 11 decisions or become loud voices in the boardroom shaping the company’s bankruptcy strategy. We call them “bankruptcy directors.”
The rising prominence of bankruptcy directors has made them controversial. Proponents tout their experience and ability to expedite the reorganization and thus protect the firm’s viability and its employees’ jobs. Opponents argue that they suffer from conflicts of interest that harm creditors.
This Article is the first empirical study of these directors. While a voluminous literature has considered the governance of Chapter 11 firms, this Article breaks new ground in shining a light on an important change in the way these firms make decisions in bankruptcy and resolve conflicts with creditors. It does so by analyzing a hand-collected sample of all large firms that filed for Chapter 11 between 2004 and 2019 that disclosed the identity of their directors to the bankruptcy court. To our knowledge, it is the largest sample of boards of directors of Chapter 11 firms yet studied.
We find that the percentage of firms in Chapter 11 proceedings claiming to have an independent director increased from 3.7% in 2004 to 48.3% in 2019. Over 60% of the firms that appointed bankruptcy directors had a controlling shareholder and about half were under the control of private equity funds.
After controlling for firm and bankruptcy characteristics, we find that the recovery rate for unsecured creditors, whose claims are typically most at risk in bankruptcy, is on average 20% lower in the presence of bankruptcy directors. We cannot rule out the possibility that the firms appointing bankruptcy directors are more insolvent and that this explains their negative association with creditor recoveries. Still, this finding at least shifts the burden of proof to those claiming that bankruptcy directors improve the governance of distressed companies to present evidence supporting their view in this emerging debate.
We also examine a mechanism through which bankruptcy directors may reduce creditor recoveries. In about half of the cases, these directors investigate claims against insiders, negotiate a quick settlement, and argue that the court should approve it to save the company and the jobs of its employees. We supplement these statistics with two in-depth studies of cases in which bankruptcy directors defused creditor claims against controlling shareholders: Neiman Marcus and Payless Holdings.
Finally, we consider possible sources of pro-shareholder bias among bankruptcy directors. Shareholders usually appoint bankruptcy directors without consulting creditors. These directors may therefore prefer to facilitate a graceful exit for the shareholders. Moreover, bankruptcy directorships are short-term positions, and the world of corporate bankruptcy is small, with private equity sponsors and a handful of law firms generating most of the demand. Bankruptcy directors depend on this clientele for future engagements and may exhibit what we call “auditioning bias.”
In our data, we observe several individuals appointed to these directorships repeatedly. These “super-repeaters” had a median of 13 directorships and about 44% of them were in companies that went into bankruptcy when they served on the board or up to a year before their appointment. Our data also show that super-repeaters have strong ties to two leading bankruptcy law firms. Putting these pieces together, our data reveal an ecosystem of a small number of individuals who specialize in sitting on the boards of companies that are going into or emerging from bankruptcy, often with private equity controllers and the same law firms.
These findings support the claim that bankruptcy directors are a new weapon in the private equity playbook. In effect, bankruptcy directors assist with shielding self-dealing transactions from judicial intervention. Private equity sponsors know that if the portfolio firm fails, they could appoint bankruptcy directors to handle creditor claims, file for bankruptcy, and force the creditors to accept a cheap settlement. Importantly, the ease of handling self-dealing claims in the bankruptcy court may fuel more aggressive self-dealing in the future.
Our findings have important policy implications. Bankruptcy law strives to protect businesses while also protecting creditors. These goals can clash when creditors bring suits that threaten to delay the emergence from bankruptcy. While bankruptcy directors may aim for speedy resolution of these suits, their independence may be questionable because the defendants in these suits are often the ones who appoint them. Moreover, bankruptcy directors often bypass the checks and balances that Congress built into Chapter 11 when they seek to replace the role of the official committee of unsecured creditors (“UCC”) as the primary check on management’s use of the powers of a Chapter 11 debtor.
We argue that the contribution of bankruptcy directors to streamlining bankruptcies should not come at the expense of creditors. We therefore propose a new procedure that bankruptcy judges can implement without new legislation: the bankruptcy court should treat as independent only bankruptcy directors who, in an early court hearing, earn overwhelming support of the creditors whose claims are at risk, such as unsecured creditors or secured creditors whom the debtor may not be able to pay in full. Bankruptcy directors without such support should not be treated as independent and therefore should not prevent creditors from investigating and pursuing claims.
The creditors will likely need information on the bankruptcy directors to form their opinion, and bankruptcy judges can rule on what information requests are reasonable. This will create standardization and predictability. However, disclosure is no substitute for creditor support. Requiring disclosure without heeding creditors on the selection of bankruptcy directors will not cure bankruptcy directors’ structural biases.
Some might argue that our solution is impractical or otherwise lacking. We answer these claims. More importantly, our solution is the only way to ensure that bankruptcy directors are truly independent. If it cannot be made to work, bankruptcy law should revert to the way it was before the invention of bankruptcy directors, where federal bankruptcy judges were the only impartial actors in most large Chapter 11 cases. In such a scenario, debtors will be free to hire whomever they want to help them navigate financial distress, but the court will regard these bankruptcy directors as ordinary professionals retained by the debtor. The court should weigh the bankruptcy directors’ position against the creditors’, allow the creditors to conduct their own investigation and sue over the bankruptcy directors’ objections, and not approve settlements merely because the bankruptcy directors endorse them.
Our study also lends support to the bill recently introduced by Senator Elizabeth Warren to prevent debtors from prosecuting and settling claims against insiders. Like our proposal, this bill would restore the traditional checks and balances of the bankruptcy process while allowing distressed firms to appoint directors of their choice. Still, our proposal has several advantages. It does not require new legislation, it preserves greater flexibility for the bankruptcy court and, by requiring that bankruptcy directors be acceptable to creditors, it ensures that all board decisions in bankruptcy, not just decisions regarding claims against insiders, advance creditor interests.
Our analysis also has implications for corporate law. Much of the literature on director independence in corporate law has focused on director ties to the corporation, to management, or to the controlling shareholder. We explore another powerful source of dependence: dependence on future engagements by other corporations and the lawyers advising them.
This Article proceeds as follows. Part I lays out the theoretical background to our discussion, showing how the use of independent directors has migrated from corporate law into bankruptcy law. Part II presents examples of bankruptcy director engagements from the high-profile bankruptcies of Neiman Marcus and Payless Holdings. Part III demonstrates empirically how large firms use bankruptcy directors in Chapter 11. Part IV discusses concerns that bankruptcy directors create for the integrity of the bankruptcy system and puts forward policy recommendations.
. See Notice of Motion of the 2034 Notes Trustee for Entry of an Order Granting Leave, Standing, and Authority to Commence and Prosecute a Certain Claim on Behalf of the NWHI Estate at 15, In re Nine West Holdings, Inc., No. 18-10947 (Bankr. S.D.N.Y. Jan. 31, 2019) [hereinafter Notice of Motion of the 2034 Notes Trustee]; Kenneth Ayotte & Christina Scully, J. Crew, Nine West, and the Complexities of Financial Distress, 131 Yale L.J.F. 363, 373 (2021) (describing some of the transfers in detail). For example, the private equity sponsor had allegedly purchased the assets of Kurt Geiger for $136 million in April 2014 and sold them in December 2015 for $371 million. See Notice of Motion of the 2034 Notes Trustee, supra, at 34.
. See Motion of the Official Committee of Unsecured Creditors for Entry of an Order Granting Leave, Standing, and Authority to Commence and Prosecute Certain Claims on Behalf of the NWHI Estate and Exclusive Settlement Authority in Respect of Such Claims at 17, In re Nine West Holdings, Inc., No. 18-10947 (Bankr. S.D.N.Y. Oct. 22, 2018) [hereinafter Nine West Standing Motion].
. See Transcript of Hearing at 43, In re Nine West Holdings, Inc., No. 18-10947 (Bankr. S.D.N.Y. May 7, 2018).
. See Nine West Standing Motion, supra note 2, at 34 (“[The lawyers for the independent directors] attended . . . depositions . . . but asked just a handful of questions of a single witness . . . . [And they] chose not to demand and review the Debtors’ privileged documents relating to the LBO . . . .”).
. See Nine West Standing Motion, supra note 2, at 13 (“The Debtors have barred the Committee from participating in its settlement negotiations with Sycamore . . . .”).
. Shortly after the unsecured creditors proposed to put the claims against the private equity sponsor into a trust for prosecution after bankruptcy, the independent directors unveiled their own settlement plan. See Notice of Filing of the Debtors’ Disclosure Statement for the Debtors’ First Amended Joint Plan of Reorganization Pursuant to Chapter 11 of the Bankruptcy Code at 1–3, In re Nine West Holdings, Inc., No. 18-10947 (Bankr. S.D.N.Y. Oct. 17, 2018) [hereinafter Nine West Disclosure Statement Announcing Settlement].
. See Nine West Standing Motion, supra note 2, at 11 (seeking permission to prosecute claims for “well over $1 billion”); Soma Biswas, Nine West Settles Potential Lawsuits Against Sycamore Partners, Wall St. J. (Oct. 18, 2018, 2:12 PM), https://www.wsj.com/articles/nine-west-settles-
potential-lawsuits-against-sycamore-partners-1539886331 [https://perma.cc/RLH4-M9EU] (“Nine West Holdings Inc. unveiled Wednesday an amended restructuring plan that settles potential lawsuits against private-equity owner Sycamore Partners LP for $105 million in cash, far less than the amount the unsecured creditors committee is seeking.”).
. See, e.g., Notice of Appearance—Lisa Donahue, AlixPartners, Petition (Feb. 19, 2020), https://www.petition11.com/news/2020/2/19/notice-of-appearance-lisa-donahue-alixpartners [https://
perma.cc/NA6H-69AT] (noting that “[independent directors in bankruptcy have] . . . become the latest cottage industry in the restructuring space”).
. See Regina Stango Kelbon, Michael DeBaecke & Jonathan K. Cooper, Appointment of Independent Directors on the Eve of Bankruptcy: Why The Growing Trend? 17 (2014) (“Employing an outside director to exercise independent judgment as to corporate transactions in bankruptcy may not only provide additional guidance to a suffering business, but can make the decision-making process seem right in the eyes of stakeholders and ultimately, the court.”).
. See Robert Gayda & Catherine LoTempio, Independent Director Investigations Can Benefit Creditors, Law360 (July 24, 2019, 3:55 PM), https://www.law360.com/articles/1174248/independent-director-investigations-can-benefit-creditors [https://web.archive.org/web/20220401015757/https://
http://www.law360.com/articles/1174248/independent-director-investigations-can-benefit-creditors%5D (noting that independent directors are helpful in bankruptcy where “speed to exit is paramount”).
. See, e.g., “Independent” Directors Under Attack, Petition (May 16, 2018), https://petition.substack.com/p/independent-directors-under-attack [https://perma.cc/G9RY-U9D4]; Lisa Abramowicz, Private Equity Examines Its Distressed Navel, Bloomberg (May 26, 2017), https://www.bloomberg.com/opinion/articles/2017-05-26/payless-shoesource-private-equity-examines-its-distressed-navel [https://perma.cc/NC4H-DK9M]; Mark Vandevelde & Sujeet Indap, Neiman Marcus Director Lambasted by Bankruptcy Judge, Fin. Times (June 1, 2020), https://www.ft.com/content/
0166cb87-ea50-40ce-9ea3-b829de95f676 [https://perma.cc/5VY4-VQA8]; American Bankruptcy Institute, RDW 12 21 2018, Youtube (Dec. 20, 2018), https://www.youtube.com/watch?v=
Ah8RkXYdraI&ab_channel=AmericanBankruptcyInstitute [https://perma.cc/KG37-TJUC]; The “Weil Bankruptcy Blog Index,” Petition (Jan. 10, 2021), https://petition.substack.com/p/weilbankruptcy
blogindex [https://perma.cc/L356-TFPY] (calling the Nine West case a “standard episode of ‘independent director’ nonsense”).
. See, e.g., Douglas G. Baird & Robert K. Rasmussen, Antibankruptcy, 119 Yale L.J. 648, 651 (2010) (considering creditor conflict); Douglas G. Baird & Robert K. Rasmussen, The End of Bankruptcy, 55 Stan. L. Rev. 751, 784 (2002); David A. Skeel Jr., Creditors’ Ball: The “New” New Corporate Governance in Chapter 11, 152 U. Pa. L. Rev. 917, 919 (2003) (considering the role of secured creditors); Michelle M. Harner & Jamie Marincic, Committee Capture? An Empirical Analysis of the Role of Creditors’ Committees in Business Reorganizations, 64 Vand L. Rev. 749, 754–56 (2011) (considering the role of unsecured creditors). For other articles that, like this Article, criticize recent changes in Chapter 11 practice, see generally Adam J. Levitin, Purdue’s Poison Pill: The Breakdown of Chapter 11’s Checks and Balances, 100 Tex. L. Rev. 1079 (2022); Lynn M. LoPucki, Chapter 11’s Descent into Lawlessness, 96 Am. Bankr. L.J. 247 (2022).
. Our full dataset consists of the boards of directors of 528 firms and the 2,895 individuals who collectively hold 3,038 directorships at these firms. While all Chapter 11 firms are required to provide information on their board to the bankruptcy court, not all comply with the law. For more on our sample, see infra Part III.
. See infra note 152 and accompanying text.
. We identified bankruptcy directors using information from each firm’s disclosure statement. We then searched those disclosure statements and identified 78 cases in which the debtor represented that its board was “independent” or “disinterested.” See infra Section III.C.1. Independent directors are not new to bankruptcy. WorldCom, for example, used independent directors as part of its strategy to get through the bankruptcy process in its 2003 Chapter 11 filing. See Kelbon, supra note 9, at 20. The change is that a practice that was once relatively uncommon has become ubiquitous and a central and standard part of the process of preparing for a Chapter 11 bankruptcy filing, leading to the growth of an industry of professional bankruptcy directors who fill this new demand for bankruptcy experts on the board of distressed firms. See infra Section III.C.1
. See infra Table 2.
. In many cases, a debtor-in-possession contract that requires the firm to leave bankruptcy quickly heightens the debtor’s urgency. See, e.g., Frederick Tung, Financing Failure: Bankruptcy Lending, Credit Market Conditions, and the Financial Crisis, 37 Yale J. on Regul. 651, 672 (2020).
. See infra Section III.C.4.
. See infra Section III.C.5.
. See Telephonic/Video Disclosure Statement and KEIP Motion Hearing at 34, In re Neiman Marcus Grp. Ltd. LLC, No. 20-32519 (Bankr. S.D. Tex. July 30, 2020) [hereinafter Neiman Marcus Settlement Transcript] (arguing that independent directors are changing incentives for private equity sponsors, who will be “encouraged to asset strip”).
. As Sujeet Indap and Max Frumes write, a leading bankruptcy law firm that advises debtors “developed a reputation for keeping a stable of ‘independent’ board of director candidates who could parachute in to bless controversial deal making.” Sujeet Indap & Max Frumes, The Caesars Palace Coup: How a Billionaire Brawl Over the Famous Casino Exposed the Power and Greed of Wall Street 419 (2021).
. See Alexander Saeedy, Elizabeth Warren Floats Expanded Powers for Bankruptcy Creditors Against Private Equity, Wall St. J. (Oct. 20, 2021, 1:17 PM), https://www.wsj.com/articles/elizabeth-warren-floats-expanded-powers-for-bankruptcy-creditors-against-private-equity-11634750237 [https://
. See generally Lucian A. Bebchuk & Assaf Hamdani, Independent Directors and Controlling Shareholders, 165 U. Pa. L. Rev. 1271 (2017); Da Lin, Beyond Beholden, 44 J. Corp. L. 515 (2019).
* Professor of Law, Harvard Law School.
† Professor of Law, Tel Aviv University, Faculty of Law.
‡ Associate Professor, Tel Aviv University, Faculty of Law; Lecturer on Law, Harvard Law School. We thank Kenneth Ayotte, Lucian Bebchuk, Vincent Buccola, Anthony Casey, Alma Cohen, Elisabeth de Fontenay, Jesse Fried, Lynn LoPucki, Tobias Keller, Michael Klausner, Michael Ohlrogge, Adam Levitin, Robert Rasmussen, Adriana Robertson, Mark Roe, Daniel Sokol, Robert Stark, Roberto Tallarita, Robert Tennenbaum, and seminar and conference audiences at the Annual Meeting of the American Law and Economics Association, Bay Area Corporate Law Scholars Workshop, the Bar Ilan University Law Faculty Seminar, the Corporate Law Academic Webinar Series (CLAWS), the Duke Faculty Workshop, Florida–Michigan–Virginia Virtual Law and Economics Seminar, the Harvard Law School Empirical Law and Economics Seminar, the Harvard Law School Faculty Workshop, Harvard Law School Law and Economics Workshop, Tel Aviv University Faculty of Law Workshop, the Turnaround Management Association, the University of Toronto Seminar in Law and Economics, and the University of California, Berkeley Law, Economics, and Accounting Workshop for helpful comments. We also thank Noy Abramov, Jacob Barrera, Jade Henry Kang, Spencer Kau, Victor Mungary, Julia Staudinger, Or Sternberg, Jonathan Tzuriel, and Sara Zoakei for excellent research assistance. This research was supported by The Israel Science Foundation (Grant No. 2138/19).