Left to right: Andrew Kassner and Joseph Argentina of Drinker Biddle & Reath.

The trustee in bankruptcy acts as a fiduciary for all creditors to identify assets and administer the bankruptcy estate. Usually the trustee must investigate the debtor's prepetition affairs. The Federal Rules of Bankruptcy of Procedure provide a powerful tool for such activities, including the ability to obtain discovery of third parties without first filing a lawsuit. In-house counsel and nonbankruptcy practitioners are often surprised when advised the bankruptcy trustee or debtor in possession can conduct broad discovery beyond the traditional limits of nonbankruptcy civil litigation. In a 22-page opinion issued on Aug. 17 in In re Transmar Commodity Group, Case No. 16-13625-JLG, Judge James L. Garrity of the U.S. Bankruptcy Court for the Southern District of New York explored the contours of discovery powers in bankruptcy. The court's opinion provides a useful roadmap for understanding how courts determine what is, and is not permitted.

Chocolate-Flavored Bank Fraud

According to the opinion, the debtor, Transmar Commodity Group, Ltd. (debtor), was an international cocoa service trading operator and cocoa butter supplier, and borrower under a $400 million secured loan facility (loan). The debtor filed a Chapter 11 bankruptcy petition on Dec. 31, 2016. At the request of the prepetition agent for the secured lenders, the bankruptcy court converted the case to a Chapter 7 liquidation on July 26, 2017. Alan Nisselson was appointed as the Chapter 7 trustee.

Approximately two weeks after the conversion of the case, the U.S. Attorney for the Southern District of New York and the New York Office of the Federal Bureau of Investigation announced the unsealing of an indictment charging the debtor's principals with bank fraud. The indictment alleged the principals falsified borrowing base reports for at least two years prior to the bankruptcy filing to secure and maintain the Loan.

The trustee sought discovery under Rule 2004 of the Federal Rules of Bankruptcy Procedure (Rule 2004) from Amerra Capital Management LLC (Amerra), a trading partner of the debtor, and Nancy Obler, Amerra's managing director. According to the opinion, Amerra filed a claim of at least $9 million for amounts due under a subordinated note, profit participation and purchase and sale contracts. Amerra had already produced several thousand documents to the trustee, and objected to the production of all communications between Obler and any other Amerra officer, director, employee or representative concerning the debtor, or its affiliates or any related entities (the internal communications) and between Obler and any nondebtor third party concerning Cocoa Origins Africa or any African affiliates of the Debtor (the external communications), from Jan. 1, 2015 through the petition date, and with certain limitations not relevant here. Amerra also objected to the trustee's request to depose Obler.

Court Permits Examination for Possible Claims

Rule 2004 authorizes a court to order the examination of any entity, provided that the examination concerns “… the acts, conduct, or property or to the liabilities and financial condition of the debtor, or to any matter which may affect the administration of the debtor's estate, or to the debtor's right to a discharge.” The court wrote, “The purpose of a Rule 2004 examination is to assist a party in interest in determining the nature and extent of the bankruptcy estate, revealing assets, examining transactions and assessing whether wrongdoing has occurred.” Third parties may be examined “… if they possess knowledge of the debtor's acts, conduct, or financial affairs which relate to the bankruptcy proceedings.”

The decision to permit a party to conduct a Rule 2004 examination is within the discretion of the bankruptcy court, and is based upon a finding of good cause. The party seeking to conduct the exam has the burden of showing good cause. The proponent “… must demonstrate either that the proposed examination is necessary to establish the claim of the party, or that the denial of discovery would cause the party undue hardship or injustice.” If the movant meets that burden, the bankruptcy court must balance the competing interests of the parties, weighing the relevance and necessity of the information sought against the burden placed on the producing party. The opinion cites to another recent Southern District of New York decision that listed the factors to consider when balancing these interests, including, among other things, the amount in controversy, the parties' relative access to relevant information, the parties' resources, the importance of discovery in resolving the issues, and whether the burden or expense of the proposed discovery outweighs its likely benefit.

The court noted a bankruptcy trustee is an estate fiduciary, whose duty is to maximize the return to creditors, and “… is duty bound to investigate the affairs of the debtor.” As an initial matter, Amerra argued that the trustee had identified Amerra as a potential litigation target, and was attempting to use a Rule 2004 examination to circumvent the more stringent discovery standards applicable to an adversary proceeding, a separate lawsuit filed in the bankruptcy case that, like other federal actions, is governed by the federal rules of civil procedure. The court noted such circumvention is disfavored by bankruptcy courts, but in this case found the trustee had not identified Amerra as a litigation target.

The court then analyzed the trustee's request for documents related to the internal communications between Obler and other Amerra personnel regarding the debtor. The trustee argued that he should be given greater latitude because the debtor's principals had engaged in bank fraud. The court agreed; however, it noted when a debtor engages in wrongdoing, the trustee must still show the information being sought was relevant and not unduly burdensome. The trustee argued Obler often strategized with the debtor regarding its business and relationship with its lenders and affiliates, and the internal communications might indicate the level of guidance Obler gave the debtor, provide information related to the legitimacy of Amerra's claim, and assist the trustee in evaluating potential avoidance actions. Amerra admitted that in the months before bankruptcy, it communicated extensively with the debtor, but argued the trustee already had those records, and he failed to identify what “gaps” the internal communications would explain. The court reasoned the additional documents might provide the trustee with additional context regarding the debtor's financial affairs, and were solely in Amerra's possession. Ultimately, the court granted the trustee's request, but only to the extent the internal communications related to the guidance and strategic advice that Obler and/or any other Amerra personnel provided to the debtor and its principals concerning the debtor's operations and management, the restructuring of debtor's assets and businesses, the debtor's relationship and communications with the prepetition lenders, and Amerra's transactions with the debtor and its affiliate. The court denied the broader scope requested by the trustee.

Turning to the external communications, the trustee argued that Amerra's communications with third parties, in particular a third party that may have been involved in certain fraudulent “circular” transactions, might help shed light on the nature of those transactions and reveal potential further investigation targets. The court found such communications relevant to the trustee's examination of the debtor's affairs but noted relevance alone is not sufficient to approve a Rule 2004 request. The trustee already had nearly 6,000 documents from other sources related to this third party, and had not demonstrated that he would be prejudiced if denied discovery of the internal and external communications related to the third party. As such, the trustee had not carried his burden to show good cause for the Rule 2004 request with respect to the external communications, and the court denied that request.

Finally, turning to the proposed oral examination of Obler, the court noted that under Rule 2004, “… it has been well-established that the scope of such an investigation is broad. The exploration can be in the nature of a fishing expedition.” Nevertheless, a bankruptcy court can “… limit, condition, or even forbid the use of Rule 2004 where it is used to abuse or harass.” A Rule 2004 exam cannot be used to explore matters that have no relationship to the debtor's affairs or the administration of the estate. Amerra argued that Obler and Amerra's counsel had been unable to get up to speed on many of the thousands of documents the trustee had access to, upon which Obler might be questioned, and in light of the external documents and the parties' long relationship, it would be extremely expensive and time consuming to prepare for the examination. Amerra further argued the subject matter of the exam should be limited or, alternatively, any further exams, including in connection with any adversary proceeding the trustee later commenced, should be precluded. Amerra was apparently concerned that the trustee was seeking to “ambush” Obler by questioning her on matters that she had not been able to adequately prepare, and then use the transcript against her in a future litigation deposition.

The court found nothing in the record to support Amerra's concerns and granted the oral examination, but imposed certain limits. The court limited the potential subjects to be examined, and restricted the examination to the documents that had been produced to the trustee. Furthermore, to the extent the trustee wished to conduct examinations on a subject to which documents had not been produced, the trustee was required to identify and produce to Amerra the documents it intended to discuss with Obler. Finally, the court ordered the parties to confer on a reasonable schedule for the production of the documents and the conduct of the oral exam.

Conclusion

Rule 2004 requests are not subject to the same standards as traditional civil discovery and, when contested, are not reviewed under the same standard as typical discovery disputes. That being said, there are limits to the “fishing expedition.” In this case, the court allowed discovery of the third party, but imposed limits. As is the case in all discovery matters, unreasonable and overburdensome requests will be scaled back, but Rule 2004 exams remain a powerful tool that can yield discovery of significant prelitigation information.

Andrew C. Kassner is the chairman and chief executive officer of Drinker Biddle & Reath, a national law firm with more than 635 lawyers in 12 offices. He chaired the corporate restructuring group for almost 20 years. He can be reached at [email protected] or 215-988-2554.

Joseph N. Argentina Jr. is an associate in the firm's corporate restructuring practice group in the Philadelphia and Wilmington, Delaware, offices. He can be reached at [email protected] or 215-988-2541.