Can They Do That? A Look Back At Precedent for the Bankruptcy Court’s Equitable Powers

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Contributed by Sara Coelho

Recent times have highlighted the extraordinary powers of the bankruptcy courts.  From altering property rights to giving the green light for complex transactions, the scope of the court’s discretion on weighty matters can be shocking to those uninitiated to bankruptcy.  For this Throwback Thursday we dust off American United Mutual Life Insurance Co. v. City of Avon Park, an old Supreme Court case authored by Justice Douglas in 1940 that describes the expansive equitable powers of the bankruptcy courts and demonstrates that the bankruptcy court’s wide discretion has historical roots.  Not only does the case proclaim the ample powers of the bankruptcy court to ensure a fair process, but it also has all the drama of reorganizations of the era, from scheming professionals to control of the vote by insiders.  The answers in Avon Park to these problems have a familiar ring to the modern reader too, and the case is a reminder that, in bankruptcy, what looks new is probably old.

In Avon Park a creditor of the City of Avon Park, a municipal debtor, appealed from confirmation of a plan of composition for the city.  The city had entered into a “fiscal agency agreement” with R.E. Crummer & Co. under which both parties agreed to use their best efforts to convince creditors to participate in a “refunding plan,” which appears to be premised on an exchange offer of bonds.  Crummer solicited assents to the plan and also helped put the city over the vote threshold by purchasing and voting bonds itself.  Crummer’s compensation was derived not from the city, but from assessing costs against bondholders, acquisition of interest coupons from bondholders at discounted prices, and later refund of bonds acquired at distressed prices.  Disclosure of Crummer’s interests as a creditor, its intent to vote acquired claims in favor of the plan, and the circumstances surrounding the claim acquisitions was not included in the plan.

This did not fly with Justice Douglas, who some readers may know as the author of a report when he was chairman of the SEC decrying the “emoluments of control” taken by management, bankers and lawyers who ran the reorganizations of the 1930’s and advocating reforms that remain in the law today.  In addition to objecting to the reasonableness of the compensation received by Crummer and Crummer’s representation of both the city and bondholders at the same time, Justice Douglas found that Crummer’s lack of disclosure tainted the vote.  He said, “Where it does not affirmatively appear that full and complete disclosure of the fiscal agent’s interests was made to the bondholders when their assents were solicited, it cannot be said that those assents were fairly obtained. . . . And where without such disclosure the fiscal agent’s vote was cast for acceptance of the plan, it cannot be said that such acceptance was in ‘good faith’ within the meaning of [the Bankruptcy Act].”  He went on to hold that the court’s responsibility “entails scrutiny of the circumstances surrounding the acceptances, the special or ulterior motives which may have induced them, the time of acquiring the claims so voting, the amount paid therefore, and the like.”  Justice Douglas’s holding previews the controversies today over what disclosures claims purchasers should be required to make under Bankruptcy Rule 2019 and when a court should designate the votes of claim purchasers.

In this context, Justice Douglas commented on the powers of the bankruptcy court to rectify abuses of the bankruptcy process and even to strip parties of rights they would otherwise have.  He held that where a court’s investigation of the circumstances surrounding the vote reveals “unfair dealing, a breach of fiduciary obligations, profiting from a trust, special benefits for the reorganizers, or the need for protection of investors against an inside few or of one class of investors from the encroachments of another, the court has ample power to adjust the remedy to meet the need.”  He enumerated a number of remedies, including limiting voting rights, and held that the court’s “power is ample for the exigencies of varying situations.  It is not dependent on express statutory provisions.  It inheres in the jurisdiction of a court of bankruptcy.”  He found a “necessity” for exercise of this inherent power in “the responsibility of the court before entering an order of confirmation to be satisfied that the plan in its practical incidence embodies a fair and equitable bargain openly arrived at and devoid of overreaching, however subtle.”

The current section 1129 of the Bankruptcy Code, enumerating confirmation requirements, does not contain such a broad requirement of inquiry into the “bargain arrived at” by the parties, but the bankruptcy process overseen by the bankruptcy courts is designed in myriad ways to foster a fair bargain, and Avon Park is still cited for its statement of the bankruptcy court’s broad equitable powers.  Such a power may be necessary to maintain fairness in a process with so many participants and necessarily limited process.