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Hospital's Bankruptcy Examiner Identifies Millions of Dollars in Unauthorized Payments; Cites Law Firm for Breach of Duty

February 15, 2011

In a case illustrating the effective use of a bankruptcy examiner, the examiner appointed by the court in the North General Hospital bankruptcy case has concluded that the hospital made over $3 million in unauthorized post-bankruptcy filing payments to the detriment of unsecured creditors. Prior to its bankruptcy filing, North General Hospital and certain related corporate debtors operated a hospital in the Harlem section of Manhattan. Unable to successfully restructure its debts or consummate a merger or sale, North General filed a chapter 11 bankruptcy petition in July 2010 in order to liquidate its remaining assets. Notably, the examiner determined that the debtors' counsel breached its fiduciary obligations and failed to provide the debtors with adequate legal advice regarding the payments.

The bankruptcy examiner, who was appointed in response to a motion filed by the United States Trustee alleging various improprieties by the debtors, took only three weeks to issue a 30-page report ("Report") that detailed numerous categories of unauthorized post-petition payments made by John Maher, North General's executive vice president and chief financial officer. The unauthorized payments include payments to vendors on account of pre-petition claims and payments to employees for pre-petition vacation benefits and expense reimbursements. While recognizing Maher's lack of bankruptcy experience and reliance on certain draft motions that had either never been filed or modified significantly as factors in the unauthorized payments, the examiner concluded that the unauthorized payments were largely attributable to a lack of communication between Maher and the debtors' bankruptcy counsel. According to the examiner, had counsel reviewed the weekly cash flow reports provided by the debtors, the unauthorized payments would have been immediately apparent.

In his Report, the examiner recommended that a representative of the estate commence litigation against the recipients to recover a majority of the unauthorized payments for the benefit of the estates and their creditors. Citing its failure to properly advise the debtors with respect to the unauthorized payments, the examiner also recommended that the law firm representing the debtors be required to disgorge some of the $1.3 million in fees it has received and/or disallow certain future fees. The examiner likewise urged that debtors' counsel be required to seek retroactive court approval for certain severance payments made to upper-level employees and a $175,000 increase in Mr. Maher's salary made post-petition.

The United States Bankruptcy Code provides for the appointment of a bankruptcy examiner to investigate the debtor with respect to allegations of fraud, dishonesty, incompetence, misconduct or mismanagement. Typically, in chapter 11 cases where a bankruptcy trustee has not been appointed, the court will order the appointment of an examiner upon the request of any party in interest or the United States Trustee upon a determination that such appointment is in the best interests of the creditors or the estate. Further, the Bankruptcy Code provides for the appointment of an examiner if "the debtor's . . . unsecured debts . . . exceed $5,000,000." The courts are split as to whether appointment of an examiner is mandatory in cases where the debt threshold is met, or whether the courts nonetheless retain discretion as to the appointment of an examiner in such cases. Where the court finds that the case warrants appointment of a bankruptcy examiner, the court will direct the United States Trustee to make the appointment.

Traditionally, bankruptcy examiners are employed to pursue investigations into the financial affairs of the debtor. Recent chapter 11cases, however, have seen the role of bankruptcy examiners expand to include a diverse array of investigative functions. The scope of an examiner's duties is defined by the court order authorizing the examiner's appointment and varies depending on the particular circumstances of each case.

Importantly, fees incurred by an examiner are paid from funds of the bankruptcy estate. Thus, as exemplified by the North General case, the benefits that can result from appointment of an examiner (such as the identification of lucrative claims or causes of action) often come at very little cost to individual creditors. In cases where mismanagement or wrongdoing on the part of the debtor is suspected, creditors should consider requesting the appointment of an examiner. An effective bankruptcy examiner can identify additional claims and sources of recovery for the estate, thereby enhancing the expected return to creditors.