Generally, a creditors’ committee or individual creditors seek derivative standing to sue when the debtor-in-possession (DIP) refuses to bring suit. Recently, the Second Circuit addressed a “converse situation” of first impression in In re Smart World Technologies, LLC: that is, whether derivative standing is approriate in the Rule 9019 settlement context when the debtor is alleged to be unjustifiably pursuing a claim and/or refusing to settle.
The Second Circuit’s opinion provides many important lessons to bankruptcy litigators. One is that the buck apparently stops with the debtor-in-possession when it comes to pursuing and/or settling litigation claims. Another is that zealous advocacy of your client’s interests, even when everyone–including the judge–thinks you’re a moron, sometimes pays off.
In overturning the decision of the bankruptcy court, the Second Circuit stated:

We conclude that while authority to pursue a Rule 9019 motion may, in certain limited circumstances, be vested in parties to the bankruptcy proceeding other than the debtor-in-possession, those circumstances are not present here…. We do not rule out that in certain, rare cases, unjustifiable behavior by the debtor-in-possession may warrant a settlement over the debtor’s objection, but this is not such a case.

In passing, the Second Circuit did not hide it’s displeasure at the bankruptcy court’s having apparently ruled more on emotion, than on a developed record:

[H]aving searched the record in vain for anything more than a conclusory statement from the bankruptcy court as to the merits of Smart World’s claims against Juno, we find it difficult to understand how the lower courts could have formed such a firm opinion that Smart World’s claims lacked viability.

At the Rule 9019 hearing, for instance, Smart World’s counsel stated “[w]e think Your Honor needs to make a record here, and make findings as to the range of reasonableness as to the settlement.” Counsel further offered to provide testimony as to “the factual circumstances underlying the various claims” and a “calculation based on [the witness’s] knowledge of the potential value of the claims.” The bankruptcy court brushed the offer aside, stating “[t]here’s no need for him to do that.” Even WorldCom’s counsel pointed out to the bankruptcy court that it had not heard Smart World’s explanation of its “theory of recoveries, claims and damages,” a fact that the court found untroubling….

Other aspects of the proceedings below further persuade us that derivative standing was not appropriate. First, the bankruptcy judge from the beginning repeatedly and frankly expressed his strong preference for settlement over litigation, suggesting that his evaluation of Smart World’s claims may have been colored by his own desire to “get this matter out of [his] hair” and to “eliminate the litigation.”
Second, the repeated stays and adjournments imposed by the court prevented Smart World from conducting any meaningful discovery…. The bankruptcy court was apparently under the impression that settlement was possible without discovery, but as Smart World’s lawyers tried to point out at the first settlement hearing in February 2001, the case could not easily “settle … without discovery.” In the absence of a more fully developed record, we fail to see how the bankruptcy court, let alone Smart World, could have weighed the proposed settlement against the potential value of its claims.
Third, and of more serious consequence, the bankruptcy court seems to have ignored several signs that the interests of the settling parties were in conflict with those of the estate, thereby rendering creditor derivative standing inappropriate.
In short, this case is a poster child for why the Code and Rule 9019 authorize only the debtor-in-possession to pursue or settle the estate’s legal claims, and why the derivative-standing exception to that policy is narrow: As a general matter, other parties to a bankruptcy proceeding have interests that differ from those of the estate and thus are not suited to act as the estate’s legal representative.

Make your record. That’s the moral of this story.
© Steve Jakubowski 2005