United States: Court Faulted For Deference to Trustee in Approving Settlement

Given the absence of sufficient assets to satisfy the claims of all of a bankrupt debtor’s creditors in the great majority of cases, bankruptcy is of necessity a process founded upon negotiation and compromise. Without the ability to settle disputes between and among the debtor, its creditors and equity holders, the administration of a bankruptcy estate would be vastly more difficult, costly and prolonged. Such disputes can range from the amount or priority of a creditor’s claim to causes of action belonging to the estate for the avoidance of fraudulent or preferential transfers. Bankruptcy courts are specifically authorized to approve compromises or settlements reached during the course of a bankruptcy case. The criteria that a court should apply in assessing whether to do so was the subject of a decision recently handed down by the Second Circuit Court of Appeals in Kayo v. Fitzgerald.

Rule 9019 of the federal rules of bankruptcy procedure provides that the court, after notice and a hearing, "may approve a compromise or settlement." The purpose of the rule "is to allow the trustee and the creditors to avoid the expenses and burdens associated with litigating sharply contested and dubious claims." It also protects the interests of others who are not parties to the agreement and whose rights may be affected. Rule 9019 is silent, however, on what standard the court should apply in determining whether to grant its approval.

This was left to the courts, which devised a number of different tests designed to gauge the reasonableness and fairness of settlements proffered by a bankruptcy trustee or chapter 11 debtor-in-possession. Uncertainty among the lower courts concerning the proper criteria for approving a settlement led the U.S. Supreme Court in 1968 to address the issue. In Protective Committee for Independent Stockholders of TMT Trailer Ferry, Inc. v. Anderson, the Court stated that a Anderson bankruptcy court, in determining whether to approve a settlement, should "apprise [itself] of all facts necessary for an intelligent and objective opinion of the probabilities of ultimate success should the claim be litigated." After having done so, the Court observed, "the judge should form an educated estimate of the complexity, expense, and likely duration of such litigation, the possible difficulties in collecting on any judgment which might be obtained, and all other factors relevant to a full and fair assessment of the wisdom of the proposed compromise."

Guided by TMT Trailer Ferry, bankruptcy courts gener- Ferry ally consider the following factors in determining whether to approve a settlement:

Satisfaction of these factors generally ensures that a settlement is fair, equitable and in keeping with the best interests of the bankruptcy estate. The court need not conduct an evidentiary hearing before approving a settlement. Still, the judge must make enough evidentiary findings so that the reviewing court knows that the proper factors were considered and an informed judgment made. A settlement approved by the bankruptcy court will be reversed only if it "fall[s] below the lowest point in the range of reasonableness." The Second Circuit was called upon to review the propriety of a court-approved settlement in Kayo v. Fitzgerald.

The chapter 7 trustee of William J. Kayo’s bankruptcy estate sued Albany Equipment Management Associates ("AEMA") and Frank Fitzgerald, Kayo’s former partner in AEMA, claiming unjust enrichment, misrepresentation, fraudulent conveyance, and breach of oral contract in connection with the pre-bankruptcy transfer of Kayo’s interest in AEMA to Fitzgerald. An appraiser hired by the trustee originally valued Kayo’s interest in AEMA to be in excess of $850,000. After the bankruptcy court concluded that because Kayo had managed AEMA, the trustee could not "assume, assign, or in any way succeed to the value of" the management component of his partnership interest, the trustee asserted that the value of Kayo’s claims diminished to about $300,000. The trustee then settled the claims for $150,000. The bankruptcy court approved the settlement and the district court affirmed. Kayo appealed to the Second Circuit.

The Court of Appeals, in an unpublished opinion, emphasized that even if the bankruptcy court’s determination that the estate could not prevail on a fraudulent conveyance claim was correct, it was unclear why the ruling would substantially diminish the monetary damages recoverable on the estate’s other claims. More importantly, the Court noted, the bankruptcy court failed to assess independently the value of the estate’s claims and merely focused on the adequacy of the trustee’s investigation. According to the Second Circuit, although the basis for the trustee’s acceptance of a settlement is relevant, the bankruptcy court should not simply defer to the trustee’s judgment on that issue. Instead, the Court observed, it is obligated to "independently exercise[] its discretion in evaluating the reasonableness of the $150,000 settlement." The Court accordingly vacated the judgment and remanded the base below for additional findings and clarification of the bankruptcy court’s reason for approving the settlement.

Kayo reaffirms the importance of settling controversies in bankruptcy. Still, it highlights two important principles that underpin the efficacy of settlements as a means of expediting the administration of a bankruptcy and generating value for the estate. First, a trustee or chapter 11 debtor-in-possession is not given carte blanche in deciding whether to settle and on what terms and conditions. The best interests of creditors and other parties-in-interest must figure into the calculus. Secondly, the court cannot blindly rely on the judgment of a settlement’s proponent. Rather, to reach the "lowest point in the range of reasonableness" benchmark, the bankruptcy court must go beyond assessing the adequacy of the proponent’s investigation of the claims and issues involved to evaluate independently the merit of the claims in keeping with the factors derived from TMT Trailer Ferry.

Kayo v. Fitzgerald, 2004 WL 206323 (2d Cir. Feb. 3, 2004).

Protective Comm. for Indep. Stockholders of TMT Trailer Ferry, Inc. v. Anderson, 390 U.S. 414 (1968). Anderson

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