The CPA's role as bankruptcy examiner. (Certified Public Accountant)by Quintero, Ronald G.
HOW WE GOT WHERE WE ARE
During the 1980s approximately 20,000 businesses a year sought Chapter 11 protection, while individual bankruptcy filings exceeded 700,000 by the end of the decade. Of more significance is the recent trend of filings. Most of the 25 largest bankruptcies in U.S. history have been filed in the last three years.
Many companies languish in bankruptcy, making no apparent progress toward rehabilitation. A report issued at the end of 1989 by the Administrative Office of the Courts indicated that:
* More than one-quarter of Chapter 11 cases filed prior to 1987 were still pending in mid-1989.
*Approximately half the Chapter 11 cases filed prior to 1987 were closed in Chapter 11 without confirmation of a plan of reorganization, or were closed as no-asset Chapter 7 cases.
* Of the Chapter 11 cases whose plans were eventually confirmed, an average of 740 days elapsed from date of filing until confirmation.
* The report also indicates that only 10% to 12% of Chapter 11 cases result in a successful reorganization of the debtor's business.
The courts are becoming congested by a growing backlog of unresolved cases; and the size and complexity of many add to the problem. While existing cases remain unresolved, they ae being joined by a flood of new bankruptcy filings resulting from a different economic climate and a variety of other reasons.
The Bankruptcy Code requires debtors-in-possession to pay for professionals (including the bankruptcy examiner) approved by the court to assist the creditors, shareholders, and other parties in interest. The administrative costs can be overwhelming--and many companies continue to hemorrhage while in bankruptcy. Meanwhile, the bankrupt entities face mounting hardship as nervous customers transfer business elsewhere, suppliers require more onerous terms, or key employees leave. A significant reason for appointing an examiner is to break up the proceedings logjam that can cause companies to languish and die while in Chapter 11.
APPOINTING AN EXAMINER
Sec. 1104 of the Bankruptcy Code allows the court to appoint an examiner at the request of any party in interest or by the Trustee if:
1. Such appointment is in the interest of creditors, equity security holders, and other interests of the estate; or
2. The debotr's fixed, liquidated, unsecured debts, other than debts for goods, services, or taxes, or owning to an insider, exceed $5 million.
Parties in inte4rest are notified of the hearing to appoint an examiner. At the hearing, the parties in interest have the opportunity to challenge the need for an examiner, or to challenge the qualifications of a particular examiner selected by the court.
The U.S. Trustees select the examiners. The majority of examiners are either CPAs or attorneys. Many U.S. Trustees have identified a panel of examiners who have demonstrated relevant expertise. Examiners are selected depending on the requirements of particular cases. CPAs are selected most often for cases that involve possible financial fraud, financial investigations, or an evaluation of business issues.
SCOPE OF POTENTIAL
A court order appointing the examiner commences an engagement. Typically, court orders are silent in specifying the scope of the engagement. Such lack of specificity 1) gives the examiner sufficient flexibility to exercise judgment in determining the appropriate range of activities, 2) reflects the still evolving role of the examiner, and 3) reflects the general nature of the guidance given in the Bankruptcy Code as to the function of an examiner.
Secs. 1106(3) and 1106(4) comprise the main body of information regarding the activities of an examiner.
Sec. 1106(3). "Except to the extent that the court orders otherwise, the examiner shall investigate the acts, conduct, assets, liabilities, and financial condition of the debtor, the operation of the debtor's business and the desirability of the continuance of such business, and any other matter relevant to the case or to the formulation of a plan."
Sec. 1106(4). The examiner shall as soon as practicable, 1) file a statement of any investigation conducted under paragraph (3) of this subsection, including any fact ascertained pertaining to fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the affairs of the debotr, or to a cause of action available to the estate; and 2) transmit a copy or a summary of any such statement to any creditors' committee or equity security holders' committee, to any indentured trustee, and to such other entity as the court designates."
The examiner must be prepared to review the historical conduct of the business as well as its current operations, and to determine whether the business has a future. The examiner's findings are documented in a report that is submitted to the court, and to such other parties in interest as the court specifies. The examiner acts as an adviser to the court on behalf of all parties in interest. He or she is expected to be an objective evaluator of the facts and information at hand.
A final bit of authoritative guidance on an examiner's role is contained in Sec. 1106(b) which states that the examiner may perform "except to the extent that the court orders otherwise, any other duties of the trustee that the court orders the debtor in possession not to perform." These duties may include:
* Being accountable for property of the estate;
* Filing a list of creditors, schedules of assets and liabilities, and of current income and expenditures, and a statement of financial affairs as of the date of the bankruptcy;
* Examining creditrs' proofs of claim and objecting to improper claims;
* Filing priodic reports with the court, the U.S. Trustee, and tax authorities;
* Providing tax authorities with information pertaining to years for which no tax return has been filed;
* Filing a plan of reorganization, reporting why such a plan cannot be filed, or recommending the conversion of the case to Chapter 7, 12, or 13, or its dismissal; and
* Presenting a final report on the administration of the estate to the court and the U.S. Trustee.
With such a broad mandate, an examiner could spend considerable time on each case. The time spent could prove to be disproportionate to the resulting value. An examiner must understand how to achieve maximum effectiveness in order to avoid professional embarrassment, and reduce the risk of non-payment for services deemed unnecessary by the court.
A newly appointed examiner should begin by having a preliminary conversation with representatives of each of the parties in interest. The examiner should ask questions that will ultimately result in useful information in his or her report. The information the examiner may be called upon to furnish includes:
* Whether a company has reasonable prospects for being reorganized, or that it has limited prospects for reorganization, and a recommendation for liquidation or dismissal from Chapter 11 will be made;
* Evidence that management is dishonest or incompetent, and should be replaced by a trustee;
* Identification of the potential for recoveries of assets from litigation, preference payments, or fraudulent transfers;
* Identification of opportunities to raise cash, reduce cash drains, or mitigate claims;
* A comprehensive analysis of the company;
* Independent analysis of critical problems in areas where the parties in interest have divergent viewpoints; and
* Any other information that is responsive to requests by the court or the U.S. Trustee.
The information developed should be action oriented, and lead to decision making. Ideally, the efforts of the examiner should directly or indirectly fall into one of the following categories:
* Actions and information that require the examiner's objectivity;
* Actions and information that will lead to increasing the estate; and
* Actions and information that will expedite the bankruptcy proceeding.
There is no direct authoritative guidance in accounting literature on bankruptcy examiner engagements. The CPA acting as an examiner is operating in the general category of litigation consulting and as such would be subject to the AICPA Code of Professional Conduct in general, and the rules related to integrity and objectivity and the general standards in particular. A full discussion of the professional standards with respect to litigation consulting is contained in "Litigation Consulting--A Practitioner's Guide," by Raymond Sloane, appearing in the April 1990 issue of The CPA Journal.
It is not completely clear, however, as to the professional standards that apply to the reports issued by the CPA in his or her role as examiner. Preparation of reports in connection with litigation consulting engagements are generally exempt from the professional standards of reporting because such reports are usually subject to detailed analysis and challenge by each party to the dispute. The issue as to whether an examiner's report issued to the Bankruptcy Court qualifies for the exemption is not specifically discussed in the standards.
Some would say that the nature of the report is to perform agreed-upon procedures (agreed upon by the Bankruptcy Court by its acceptance of such report) and the report should follow the Statement on Standards for Attestation Engagements. Others would say that the full exemption afforded reports produced as part of a proceeding before a "trier of fact in connection with the resolution of a dispute between two or more parties" would apply.
The advice given by Raymond Sloane in the article referred to above seems appropriate: "Despite there being no authoritative guidance for written reports generated as a result of litigation services engagements, it is advisable, at a minimum in any written report, to designate it as prepared in connection with a specific action captioned at the top of each page."
Written reports are only a part of the examiner's role. Much of an examiner's work consists of interpreting information about which no written assertions are made. An examiner's role extends to evaluating people rather than just data, and assessing an entire situation based on both data and observations.
Executing an assignment as examiner is as much an art as it is a science. The examiner must:
* Set the objectives of the examination;
* Determine the information needed to attain the objectives; and
* Be prepared to shift course if information is unavailable or incomplete, if circumstances change, or if inquiries lead to new areas of investigation. A company in bankruptcy is often a moving target. Events can cause the fortunes of the company to change rapidly. Important issues can change daily. An examiner must have the experience to evaluate the information provided, ferret out what is important, and convert results into a useful format as quickly as possible.
In most cases, examiners perform their investigations under less than optimal circumstances:
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* Available information can be incomplete, disorganized, inaccurate, or nonexistent;
* The debtor is usually understaffed, and the staff available is not competent to handle the conditions; and
* Because of concern with the potential for unfavorable findings and conclusions, the debtor may be reluctant to provide certain information.
An examiner has no direct authority to compel a debtor to furnish information. He or she should attempt to make the debtor aware of the potential benefits to be gained from the work to be done. Among a debtor's motivations for cooperating with the examiner are:
* To influence the examiner's findings and conclusions;
* To avoid incurring the displeasure of the court for appearing obstructive; and
* To end any disruption, caused by the activities of the examiner, as soon as possible.
If the debtor refuses to cooperate, the examiner can report this intransigence to the court. The court response can range from compelling the debtor to produce documents, imposing a trustee, dismissing the case from Chapter 11, or ordering that the bankruptcy be converted to Chapter 7. A capable examiner will seldom, if ever, need to rely on the court to compel the debtor to cooperate. Generally, the examiner's best ally, if the debtor is unreasonable, is the debtor's attorney. The attorney will normally counsel his or her client vigorously against any actions likely to prejudice the court.
Exhibit 1 illustrates an example of an examiner's document review list. The examiner can reduce waiting time for documents by providing the debtor with a list of the required information prior to commencing field work. In order to expedite an examiner's requirements, there has to have been some conversation, among judges and trustees, about including an information list, tailored to each case, in a court order to produce docuents. Care must be exercised, however, if there is a risk that advance notification could cause the debtor to alter or destroy documents. Prompt responses by the debtor to information requests, as well as appropriate and complete answers to questions can expedite the process and create an atmosphere of cooperation that will benefit the debtor in the long run.
An examiner's responsibility is not the same as an auditor's. The auditor is examining financial statements for purposes of rendering an opinion on the financial statement, taken as a whole. Examiners must resist the temptation to execute assignments as if they are audits of financial statements. The tests, analyses, and procedures performed must be tailored to the specific objectives that have been established. Exhibit 2 lists examples of issues for an examiner to evaluate.
Examiners would be remiss in their responsibilities if they confined their tasks to analyzing documents. Much of the information to be evaluated is soft rather than hard data. Impressions from conversations with management, employees, customers, suppliers, and professionals representing the various parties in interest provide important feedback in weighing issues such as management competence, honesty, business viability, and the will to reorganize.
THE EXAMINER'S REPORT
The Bankruptcy Code specifies that the examiner must file his or her report with the court "as soon as practicable." A long turnaround time may limit the usefulness of the report; conditions may change, and new issues may surface daily.
The examiner's report documents his or her findings and conclusions. It can vary in length from a couple of pages on a small project, an interim report or a narrow scope engagement, to several hundred pages on a large or complex engagement. In preparing a report, the examiner must carefully judge the appropriate level of detail for each situation. Usefulness and timeliness may take precedence over a finely polished product.
As discussed earlier, the professional standards that apply to this type of report are not clearly established. The CPA may want to consider the Standards of Reporting related to Attestation Standards and the guidelines for reporting on Agreed Upon Procedures. The Standards of Reporting for attest engagements require that:
1. The report shall identify the assertion being reported on and state the character of the engagement.
2. The report shall state the practitioner's conclusion about whether the assertion is presented in conformity with the established or stated criteria against which it was measured.
3. The report shall state all of the practitioner's significant reservation about the engagement and the presentation of the assertion.
4. The report on an engagement to evaluate an assertion that has been prepared in conformity with agreed-upon criteria or on an engagement to apply agreed-upon procedures should contain a statement limiting its use to the parties who have agreed upon such criteria or procedures.
In interpreting the standard of reporting as it relates to performing agreed-upon procedures, the auditor believes that the examiner should consider acceptance of the report by the court and the U.S. Trustee as acceptance that the agreed-upon procedures were appropriate. And clearly the report should be marked and restricted as to its purpose and use, notwithstanding that as a practical matter, the examiner's report is usually a public document.
The objective of the examiner's report is to inform, rather than mechanically report the results of various procedures. The findings, conclusions, and recommendations represent the significant information. How you got there is the date. The report contents should be geared to the specific actions the readers must consider.
There is no standard format for an examiner's report. Reports vary in format, content, length, and style based on the attributes of the case, the examiner, and the role of the examiner. The information that should appear in any examiner's report includes:
* Scope of the work or agreed-upon procedures performed;
* Sources of information;
* Findings and conclusions;
* Reservations and qualifications;
* Exhibits and appendices;
* A statement of the examiner's independence and qualifications; and
* The signature of the examiner.
The examiner's report should be organized in a manner that enhances its usefulness. I find it effective to provide a simmary at the beginning of the report, followed by the detailed text, exhibits, and appendices. An examiner should be realistic and understand that all parties will not read the entire report nor necessarily absorb it. The summary should furnish the
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reader with the significant information contained in the report, including methodologies used and significant qualifications. The remainder of the report may be divided into sections such as topic, issues before the court, or analytical techniques used.
Often, the author finds it helpful to circulate a report in draft form or share significant findings and conclusions with parties in interest prior to finalizing the report. This provides them an opportunity to challenge any disputed facts or conclusions, and reduces the likelihood of material deficiencies in the report. If the parties in interest accept the qualifications of the examiner, his or her methodologies, and the facts relied upon, it is more difficult to dispute the examiner's conclusions. When employing this technique, it is important to limit the review time, because the report must be submitted in a timely fashion.
An examiner may prepare more than one report during the course of a case. There may be a preliminary report, or a report may be supplemented by subsequent reports on specific issues. Examiners should recognize that the legal system depends upon written information to document actions.
THE EXAMINER AS A
An examiner who limits his or her role to preparation of a report is depriving the court, the U.S. Trustee, and the parties in interest of the benefits that his or her knowledge and experience can provide. Examiners have the opportunity to act as pivotal explosives in breaking the logjam of bankruptcy cases presently burdening the bankruptcy courts.
Examiners can serve an invaluable role as advisors to the court and the U.S. Trustees. CPAs are objective and may be better able to undertake detailed reviews of debtors' operations than the court or the U.S. Trustee. An examiner's insights can be helpful to the judge or the U.S. Trustee in formulating responses to important issues. These insights may be imparted informally in conversations with the U.S. Trustee or in the judge's chambers, or even formally by providing expert testimony.
The bankruptcy process is an inherently adversarial process. Normally, the debtor, the different classes of creditors, and shareholders have divergent views on important issues. Each party in interest may present conflicting opinions based on identical data. In smaller cases, the parties in interest may quarrel about financial or business issues that even the attorneys advocating their viewpoints do not really inderstand. The expertise and objectivity of the examiner can be useful in reducing conflict, establishing alignment, and developing an equitable and reasonable basis upon which to proceed.
Examiners can play an important role in reducing the duplication of services present in many bankruptcies. Many complanies in bankruptcy are choked by administrative expenses because their activities are reviewed by multiple sets of accountants hired by secured creditors, unsecured creditors, and any other committees that have been formed. An alternative solution is for the examiner to fulfill the review function as an objective single source of professional accounting services.
The examiner can have a profound impact on a case by developing a reorganization plan or showing the parties in interest that a company is no longer a viable reorganization candidate and should therefore be dismissed or converted to Chapter 7. The examiner, however, cannot recommend that management be replaced by a trustee and then serve as the trustee. That is a clear conflict of interest and proscribed by the Bankruptcy Code.
The more proactive aspects of an examiner's role are beyond the traditional role of a CPA. An examiner must draw conclusions from imperfect data, take a stand on controversial matters, and make recommendations that can result in the life or death of a company. Many CPAs serving as examiners are uncomfortable with the new demands, or are unwilling to accept possible exposure to legal liability. Either reaction can result in all parties to a bankruptcy proceeding being deprived of insights useful to prudent decision making and the expeditious handling of the cases.
The author has recommended that the courts encourage examiners by providing them limited indemnification against liability. Under the order appointing an examiner, the parties in interest and the courts would hold an examiner exempt from any legal actions associated with his or her services, unless the examiner were proved to be grossly negligent or guilty or willful misconduct. Such indemnifications are routine in the retention of investment bankers and certain other advisers in bankruptcy proceedings. At present, the author is unaware of any cases in which an examiner has been indemnified. At the same time, litigation against examiners is rare.
Examiners must petition the court to receive payment for services rendered. The fee application must be accompanied by a detailed breakdown of work tasks, the time spent each day by each professional, hourly rates, and expenses. In some jurisdictions time must be detailed to the nearest tenth of an hour. The court, the U.S. Trustee, and the parties in interest have the right to question the relevance of work tasks performed, the amount of time spent, the level and cost of the professionals involved, and the total cost. An examiner's fees can be scaled back by the court.
Examiners' fees are paid from the assets of the estates and are considered an administrative expense. They rank in priority behind payments to secured creditors and super priority creditors, but ahead of other creditors with priority status under the bankruptcy code, unsecured creditors, and shareholders. For an examiner to be paid depends upon whether there is cash available from the debtor, and the court deems it likely that the proceeds of the estate will be sufficient to pay secured creditors and super priority creditors. There have been numerous instances in which examiners have done excellent work and were not paid. Also, an examiner could be placed in a conflict situation if a recommendation to liquidate the company will impact the payment of his or her fee.
To avoid potential conflicts and encourage examiners to take on difficult cases, some judges have awarded examiners super priority payment status, or have arranged to carve out fees for the examiner from the proceeds available to secured creditors. Because the bankruptcy courts constitute courts of equity, bankruptcy judges have a degree latitude that doesn't exist in most other courts.
CPAS MAKE GOOD
CPAs have an opportunity to provide a vital service as bankruptcy examiners. Many of the skills required of a bankruptcy examiner are more closely related to those of a CPA than to any other professional. CPAs need to move beyond their traditional roles in order to maximize their effectiveness in this area. The courts in turn can encourage CPAs by providing limited protection against liability and greater assurance of payment.
Ronald G. Quintero, CMA, CFA, CPA, is a Principal in the New York- based insolvency advisory firm R. G. Quintero & Co.
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