Rutgers Law School’s Professor Keith Sharfman, an outspoken critic of “creditor derivative standing” in bankruptcy (see Sharfman, Derivative Suits in Bankruptcy, 10 Stan. J. L. Bus. & Fin. 1 (2004)), took note in a recent guest blog post on Ideoblog of a case from the Fourth Circuit, Scott v. National Century Financial Enterprises, Inc. (In re Baltimore Emergency Services II, Corp.), 2005 WL 3470039 (4th Cir., 12/20/05), which “denied creditors standing in the particular case and cast doubt on whether creditor standing could ever be available.” Given the proliferation of litigation being commenced in bankruptcy courts “for the benefit of” and “on behalf of” aggrieved creditors left holding the bag, and the diverse decisions of courts across the land, the question of a plaintiff’s standing to commence adversary litigation in the bankruptcy context has gained increased importance in the past several years.
The Baltimore Emergency Services II case is a worthwhile read. In it, the Fourth Circuit actually ruled very narrowly, holding that the plaintiffs lacked standing to seek a preliminary injunction against the chapter 11 debtor’s former CEO who “oversaw the debtors’ business operations, guided them into bankruptcy, and then abruptly jumped ship [by seeking] to undermine the debtors by securing for himself their workforce and their most valuable contracts.” If any case cried out for a court’s acceptance of creditor standing (with or without the debtor’s consent), it is this one (which had the support of the lead secured creditor and the creditors’ committee, whose aggregate claims against the debtor exceeded $430 million).
The opinion in Baltimore Emergency Services II begins by first examining the doctrine of “derivative standing,” which itself — according to the Court — encompasses two situations: first, when the trustee or debtor-in-possession refuses to bring suit on its own; second, when the trustee or debtor-in-possession grants consent. The Court stated:

[S]ome of our sister circuits allow [a] creditors’ committee under certain narrow conditions to file an action in bankruptcy court in place of the debtor-in-possession or trustee. See, e.g., Smart World Techs., LLC v. Juno Online Servs., Inc. (In re Smart World Techs., LLC), 423 F.3d 166, 176 & n. 15 (2d Cir. 2005). The Bankruptcy Code does not expressly permit such parties to initiate adversary proceedings. See, e.g., Unsecured Creditors Comm. of Debtor STN Enters., Inc. v. Noyes (In re STN Enters.), 779 F.2d 901, 904 (2d Cir. 1985). Derivative standing is thus an implicit exception to the “general rule” whereby the Bankruptcy Code assigns to the trustee or debtor-in-possession “the privilege of prosecuting” various actions on behalf of the estate. 7 Collier on Bankruptcy � 1109.05[1] (Alan N. Resnick & Henry J. Sommer eds., 15th ed. rev. 2005); id. at nn. 3-5 (citing cases).
Our sister circuits that acknowledge the doctrine have allowed a bankruptcy court to grant derivative standing to a creditor or creditors’ committee in two limited circumstances. First, several circuits have recognized such standing when the trustee or debtor-in-possession unreasonably refuses to bring suit on its own. See, e.g., In re Smart World Techs., 423 F.3d at 176; Official Comm. of Unsecured Creditors of Cybergenics Corp. ex rel. Cybergenics Corp. v. Chinery, 330 F.3d 548, 583 (3d Cir. 2003) (en banc); Fogel v. Zell, 221 F.3d 955, 965 (7th Cir. 2000); Canadian Pac. Forest Prods. Ltd. v. J.D. Irving, Ltd. ( In re Gibson Group, Inc.), 66 F.3d 1436, 1440-41 (6th Cir. 1995); La. World Exposition v. Fed. Ins. Co., 858 F.2d 233, 247-48 (5th Cir. 1988). Second, two circuits have permitted creditor derivative actions when the trustee or debtor-in-possession grants consent. See In re Smart World Techs., 423 F.3d at 176 n. 15; Avalanche Mar., Ltd. v. Parekh (In re Parmetex, Inc.), 199 F.3d 1029, 1031 (9th Cir.1999). It is this latter type of derivative standing that is at issue in this case….
It is far from self-evident that the Bankruptcy Code permits creditor derivative standing. Strong arguments exist on both sides of the debate, as evidenced by the differing opinions offered in the Third Circuit’s recent en banc consideration of the matter. See Cybergenics, 330 F.3d 548. The issue in Cybergenics was whether a creditors’ committee could sue under 11 U.S.C. § 544(b) to avoid a fraudulent transfer when the debtor-in-possession had unreasonably refused to do so itself. See Cybergenics, 330 F.3d at 552, 555. The majority found such derivative actions to be permissible, relying upon three provisions of the Bankruptcy Code that appeared to implicitly condone them, see id. at 559-67, the equitable power of bankruptcy courts, see id. at 567-69, bankruptcy court practice prior to the enactment of the Code, see id. at 569-72, and various policy considerations, see id. at 572-80. A four-judge dissent, however, found that the Bankruptcy Code no where authorizes the practice, see id. at 582-84 (Fuentes, J., dissenting), that equity provides no basis for expanding the class of potential plaintiffs beyond its statutory boundaries, see id. at 584-86, that pre-Code practice cannot supplement the statutory text, see id. at 586-87, and that Congress is the proper body for weighing different policy concerns, see id. The outcome in Cybergenics itself has only added further fuel to the debate. Compare, e.g., Alan R. Lepene & Sean A. Gordon, The Case for Derivative Standing in Chapter 11, 11 Am. Bankr. Inst. L. Rev. 313 (2003) (favoring derivative standing), with Keith Sharfman, Derivative Suits in Bankruptcy, 10 Stan. J.L. Bus. & Fin. 1 (2004) (opposing derivative standing).

In the end, the Fourth Circuit decided to tread very cautiously, stating that “it would be ill-advised to decide this important and difficult issue here,” particularly given that “the parties, like the district court, simply presume that the doctrine exists in some form, and merely debate its proper contours.” Still, the Court held, “even if we assume, purely for purposes of argument, that derivative standing is possible where a debtor-in-possession consents to a creditor’s suit, it would nevertheless be inappropriate in this case.” The Court then looked for guidance to the Second Circuit’s decision in In re Commodore Int’l, Ltd., 262 F.3d 96, 100 (2d Cir. 2001), which provided:

A creditors’ committee [or secured creditor] may acquire standing to pursue the debtor’s claims if (1) the committee [or creditor] has the consent of the debtor in possession or trustee, and (2) the court finds that suit by the committee [or creditor] is (a) in the best interest of the bankruptcy estate, and (b) is necessary and beneficial to the fair and efficient resolution of the bankruptcy proceedings. In re Commodore Int’l, Ltd., 262 F.3d 96, 100 (2d Cir. 2001) (internal quotation marks omitted).

Here, the Fourth Circuit found that the plaintiffs “failed to satisfy any prong of the Commodore test [and] [t]hus, even if we were to recognize derivative standing in some cases, we would not permit it here.” In passing, the Court provided an instructive summary of the current state of the law regarding creditor derivative standing, saying:

As our sister circuits that permit derivative standing have recognized, the bankruptcy court plays a vital gatekeeper role in determining whether derivative standing is appropriate in a given case. See, e.g., Cybergenics, 330 F.3d at 580 (recognizing derivative standing that “bankruptcy courts can authorize”); Fogel, 221 F.3d at 965 (recognizing derivative standing by “obtain[ing] the permission of the bankruptcy court”); In re Gibson Group, 66 F.3d at 1442 (recognizing derivative standing “if the bankruptcy court determines that certain conditions exist and certain prerequisites are met”).
Even if permitted under the Bankruptcy Code, derivative standing is the exception rather than the rule. If the former were to swallow the latter, creditors could usurp the central role that the trustee or debtor-in-possession plays as the representative of the estate. This state of affairs would be problematic, because the interests of a creditor or creditors’ committee may not always align with those of the estate. See, e.g., Official, Unsecured Creditors’ Comm. v. Stern (In re SPM Mfg. Corp.), 984 F.2d 1305, 1315 (1st Cir. 1993) (noting that an unsecured creditors’ committee “is a fiduciary for those whom it represents, not for the debtor or the estate generally”). Though the dealings between a debtor and its creditors “may be supportive and friendly,” the fact that the interests are “necessarily different” means that the relationship “must necessarily be adversarial in a sense.” Id. at 1316 (internal quotation marks omitted). Moreover, the interests of one creditor may not align precisely with those of another, since they are competing with each other to recover from the limited resources of the estate. See id. at 1317 (“No two creditors have identical interests.”).
A bankruptcy court must therefore ensure that a would-be derivative suit would not simply advance the interests of a particular plaintiff at the expense of other parties to the bankruptcy proceeding. The court’s approval acts as a critical check upon creditor actions that might, for example, “prejudice the estate and rival creditors,” or would “recover only enough to pay the lawyers.” Cybergenics, 330 F.3d at 568, 575. Although the debtor-in-possession or trustee must also have approved the suit, the additional disinterested evaluation of the bankruptcy court can prevent well-intentioned oversights or situations where a debtor is for some reason predisposed to favor particular creditors. See In re Gibson Group, 66 F.3d at 1441 (“A debtor-in-possession often acts under the influence of conflicts of interest and may be tempted to use its discretion [to avoid preferential or fraudulent transfers] to favor certain creditors over others.”). Permitting a creditor to sue in such a circumstance would undermine not only the efficiency, but also the efficacy and fairness, of the bankruptcy proceeding.

Finally, here’s some other recent cases addressing similar standing issues, with the essence of the courts’ holdings referenced parenthetically:

  • The Plan Committee v. PricewaterhouseCoopers, LLP, 2005 WL 3274494 (D.D.C., 8/31/05) (court cites Cybergenics and Commodore holdings approvingly; court holds that post-confirmation committee had derivative standing to commence malpractice and breach of contract action against company’s prepetition auditors, but only based on an additional express finding of court that claims are “both in the best interest of the estate, and necessary and beneficial to the bankruptcy proceedings” (which findings are virtually a given when the potential recovery is $70 million); court notes, however, that post-confirmation committee lacked capacity to sue under DC law because it is an “unincorporated association” that lacks the capacity to sue under DC law and cannot sue for state law causes of action unless the state confers it with the capacity to sue; court finds that DC law regarding capacity to sue is not preempted by federal bankruptcy law because “Congress expressly incorporated Federal Rule of Civil Procedure 17(b) into the bankruptcy scheme”; court states “[w]hile bankruptcy courts, as courts of equity, have been held to have the authority to permit suits by creditors’ committees as a matter of standing, see, e.g., In re Commodore, 262 F.3d at 100, plaintiff points to no authority establishing that bankruptcy courts may override state capacity to sue statutes”).
  • In re Student Finance Corporation, 2005 WL 3525741, (D. Del., 12/22/05) (court holds that chapter 7 trustee lacks standing under Bankruptcy Code section 544(a) to bring a general claim of negligent misrepresentation against the company’s former lawyers “on behalf of” all of the debtor’s creditors; parties agreed that the debtor could not bring claim on company’s behalf under Code section 541 as of commencement of bankruptcy case; court holds that scope of actions permitted by Code section 544 is limited to avoidance actions, which do not permit trustee to bring a tort claim “on behalf of” creditors).
  • Jackson v. Corporategear, LLC, 2005 WL 3527148 (S.D.N.Y., 12/21/05) (after chapter 7 corporate case closed, creditor sought to bring an alter ego action against a nondebtor; court holds that (I) “even where an alter ego claim was not listed in the schedule of assets and therefore is not deemed abandoned as set forth in § 554(c), as a matter of logic the claim can be deemed property of the estate only if there is an estate, i.e., only if the bankruptcy case is reopened; until the bankruptcy case is reopened, there is no estate, there is no trustee, and there is no reason why a creditor should be precluded from pursuing an unadministered claim against the debtor corporation,” (II) “if a claim against a debtor corporation was not administered in the Chapter 7 proceeding, it survives and can be pursued after the Chapter 7 case is closed, and (III) “[i]f the underlying claim against the debtor corporation is not extinguished, there is no logical reason why a creditor should not be able to pursue an alter ego claim against an owner of the corporation”).

    • © Steve Jakubowski 2006