Understanding Fiduciary Duties in Bankruptcy Proceedings

A fiduciary duty arises when you have been assigned to act on another person or party’s behalf. The person who owes this duty is often referred to as the “fiduciary.” In bankruptcy, fiduciary duties arise in the context of a business that has filed for bankruptcy, whether it is Chapter 7 or Chapter 11 bankruptcy. However, the term is most often associated with business owners’ and directors’ actions while going through a Chapter 11 proceeding.

Individual Duties in Bankruptcy

Individuals have an obligation to be honest in their bankruptcy proceeding. Failing to be forthcoming with the bankruptcy court can have serious consequences, including criminal charges. However, individual debtors generally do not have any fiduciary duties that they must fulfill in the bankruptcy context. While people must continue to be honest with the court and their creditors, they are acting on their own behalf in bankruptcy, so, generally speaking, no fiduciary duty arises.

Business Debtors and Fiduciary Duties

When a company files for bankruptcy, a “bankruptcy estate” is created. In Chapter 11, this usually means that the owner of the business (often just one individual) will become the “debtor in possession” or “DIP.” The DIP must still continue to run the business, but he or she also has a new role in this position as well. The DIP must act in the best interests of the estate because he or she now stands in a fiduciary role.

The DIP, and even the corporate officers and directors, are now considered trustees or “quasi-trustees” for the insolvent company’s creditors. This dual-role is often confusing, but the main function is that the DIP cannot take any action on behalf of the company that would harm or devalue the estate because that would be detrimental to the creditors. Duties of good faith, prudent investing, and loyalty also often come into play.

Forcing this role upon the DIP helps avoid situations where the DIP squanders estate assets or takes actions that may be in their best personal interest, but not to the benefit of the company as a whole. Where the DIP cannot carry out these roles due to fraud or dishonesty, the court can place a third-party trustee in this position to prevent problems with wasting assets. However, many courts try to avoid this practice because the DIP often knows the business and industry better than a third-party who does not have experience with the company. Nonetheless, appointing a trustee is necessary in some circumstances.

Trustees and Fiduciary Duties

The U.S. Trustee and anyone working on behalf of the U.S. Trustee will keep a close eye on the status of the bankruptcy so that the debtor does not squander assets or act in an unethical manner. This “watchdog” is also often characterized has having a fiduciary duty to the creditors, although the relationship is not as direct as the DIP or someone who serves in place of the DIP.

The most important thing to remember as you go through bankruptcy, whether you are an individual or business, is that honesty is the best policy. Depleting assets for your personal gain is not only unethical; it can be illegal.