A hobby of mine the past couple of years has been an empirical study of the use of examiners in the bankruptcy reorganizations of large, public companies (okay, I admit I have an odd definition of the word “hobby”).

“Examiners” are private individuals who may be appointed to investigate allegations of mal- or misfeasance when a company seeks protection under Chapter 11 of the U.S. Bankruptcy Code. Examiners have played important, sometimes controversial, roles in such recent, high-profile cases as Enron, Worldcom, Refco, Mirant and New Century. Their investigations have sometimes cost millions of dollars and resulted in major lawsuits or settlements.

The use of examiners presents two basic questions.

First, when will they be appointed? Bankruptcy Code section 1104(c) provides that an examiner is to be appointed either when it is “in the interests of creditors, any equity security holders, and other interests of the estate,” or when the debtor’s “fixed, liquidated, unsecured debts, other than debts for goods, services, or taxes, or owing to an insider, exceed $5,000,000.”

Case law is confused on both the grounds for, and the scope of, examiner appointments. Some, but not all, courts treat appointment as mandatory when dealing with a large debtor. These courts reason that this reflects a natural reading of the text. Others, however, say that the appointment of an examiner is discretionary, especially if a party seeks the appointment for strategic reasons. Courts have struggled to signal the rules that really do govern the appointment of examiners.

Second, once appointed, what are they supposed to do? Under Bankruptcy Code section 1104(c) examiners may “conduct such investigation of the debtor as is appropriate, including an investigation of any allegations of fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the affairs of the debtor of or by current of former management . . . .” Yet, evidence shows that examiners have been appointed to perform tasks that have little to do with an investigation of this sort. Among other things, they have been appointed: to perform or assist in valuations; to help negotiate reorganization plans; to investigate allegations of misconduct by creditors; and to sue on behalf of the estate.

In order to start to develop answers to these questions, we looked at dockets from 650 large Chapter 11 cases from Professor Lynn LoPucki’s database. These are cases in which the debtors have assets in excess of $100 million and publicly traded securities. We selected this database because, among other reasons, these cases would seem likely candidates for the appointment of an examiner. Most of them will involve debtors with assets above the statutory threshold of $5 million. More important, having publicly traded securities, they would seem to be the sort of cases Congress had in mind when it created the examiner position in the 1978 Act. Among other things, Congress created examiners to protect the “investing public”—i.e., investors in public companies that go into Chapter 11.

Our initial findings, however, suggest that the investing public does not want the remedy Congress created.

First, despite the fact that these are cases in which appointment should be mandatory if requested, and would meet Congress’ goal of protecting the investing public, we found examiners were sought in only 89 (13%) of the 650 cases. And, despite the seemingly mandatory nature of the statute, less than half (42) of these motions were granted.

Second, and even more surprising, were cases involving evidence of fraud or mismanagement—also statutory elements relevant to the appointment of an examiner. The LoPucki database identified 31 cases as involving fraud. Yet an examiner was sought in less than one-third (9) of these cases—and the motions were granted only five times. The frequency in the case of mismanagement was even lower: Of 71 cases in which the CEO was removed (admittedly an imperfect proxy for mismanagement), an examiner was sought only seven times, and those seven requests were granted only four times.

So, what’s going on here?

I’ll save my speculation for the next post. In the meantime, I’d be interested in hearing what Credit Slips readers think explains these data. Why does the investing public apparently not want the remedy that Congress created? If fraud or mismanagement in large cases is not likely to lead to a request for an examiner, when should we expect to see them? And, if they are not just examining, what should they be doing?