Opinion ID: 3013106
Heading Depth: 1
Heading Rank: 5

Heading: Does Derivative Standing for Creditors’

Text: Committees Advance Congress’s Goals? Lincolnshire submits that the Bankruptcy Code provides many explicit remedies for situations where, as here, a 38 debtor unreasonably refuses to pursue an action on behalf of the estate. Its implication is that, by providing bankruptcy courts with a range of remedies, Congress intended for that range to be comprehensive, and it notes that it is not for courts to substitute their policy judgment for Congress’s. See Hartford Underwriters, 530 U.S. at 1314 (“[W]e do not sit to assess the relative merits of different approaches to various bankruptcy problems. . . . Achieving a better policy outcome — if what petitioner urges is that — is a task for Congress, not the courts.”). We agree, at least insofar as policy rationales cannot override contrary text. But as explained supra, there is no text to override because the Code itself anticipates derivative standing. The critical question is thus whether bankruptcy courts’ equitable powers are sufficient to allow them to confer the derivative standing that the Code anticipates. For the reasons set forth above, we believe that they are. Indeed, the very fact that equitable powers are at issue renders public policy concerns more important than they were in Hartford Underwriters, for as the Supreme Court has said, “there is inherent in the Courts of Equity a jurisdiction to . . . give effect to the policy of the legislature.” Mitchell, 361 U.S. at 292 (emphasis added). See also 11 U.S.C. § 105(a) (empowering a bankruptcy court to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title”). Put another way, although we concluded above that bankruptcy courts have equitable power to confer derivative standing upon creditors’ committees to avoid fraudulent transfers in this situation, it is important to support that conclusion by assessing the public policy concerns underpinning Chapter 11. Despite the existence of other potential remedies, we are satisfied that derivative standing in this instance achieves Congress’s policy goals. We will proceed first by exploring those goals, and then by assessing the adequacy of the other remedies Lincolnshire identifies. A. The Salutary Effects of Derivative Standing for Creditors’ Committees Before bankruptcy, a debtor’s management and its most powerful creditors typically try to “work out” the debtor’s 39 financial distress. In this process, managers frequently experience pressure to take extreme measures to protect the company. (Brief of Amicus Law Professors at 9.) They may make extraordinary concessions to providers of critical services, such as granting new liens on unencumbered property, agreeing to an excessive rate of interest, committing to lavish retention bonuses, or doing virtually anything else to avoiding filing for bankruptcy. See, e.g., Eduardo Porter & Mitchell Pacelle, Judge Increases Severance Pay to Former Enron Employees, Wall St. J., Aug. 29, 2002, at A3 (discussing multi-million dollar retention bonuses paid by Enron insiders before bankruptcy). Whether or not these radical actions are ultimately successful, they often reduce the assets available to the debtor’s creditors. The Bankruptcy Code’s avoidance powers are intended, inter alia, to deter this kind of managerial overreaching and to encourage creditors to allow a debtor a measure of breathing room. See H.R. Rep. No. 95-595, at 177 (1977) (“By permitting the trustee to avoid prebankruptcy transfers that occur within a short period before bankruptcy, creditors are discouraged from racing to the courthouse to dismember the debtor during [its] slide into bankruptcy.”). Fraudulent avoidance actions, such as those provided for in § 544(b), are intended to afford unsecured creditors peace of mind, for those creditors are usually the principal victims of managerial misfeasance. Although fraudulent transfers are of concern in many chapters of the Bankruptcy Code, including in Chapter 7 liquidations, they present a particularly vexing problem in reorganizations conducted under Chapter 11. The premise of a reorganization is to ensure that the debtor emerges from bankruptcy as a viable concern. This explains why trustees are a fixture in Chapter 7 liquidations, but they are exceptional in Chapter 11 — it is thought that a debtor’s existing management will be more familiar with the company than would be a court-appointed trustee, and that it would therefore be better able to guide the debtor back into solvency. See Sharon Steel Corp., 871 F.2d at 1226 (“It is settled that appointment of a trustee should be the exception, rather than the rule.”); 7 Collier on Bankruptcy 40 ¶ 1104.02[1] (15th rev. ed. 1998) (noting that appointment of a trustee in a Chapter 11 case is an “extraordinary” remedy). In Chapter 11 cases where no trustee is appointed, § 1107(a) provides that the debtor-in-possession, i.e., the debtor’s management, enjoys the powers that would otherwise vest in the bankruptcy trustee. Along with those powers, of course, comes the trustee’s fiduciary duty to maximize the value of the bankruptcy estate. This situation immediately gives rise to the proverbial problem of the fox guarding the henhouse. If no trustee is appointed, the debtor — really, the debtor’s management — bears a fiduciary duty to avoid fraudulent transfers that it itself made. One suspects that if managers can devise any opportunity to avoid bringing a claim that would amount to reputational self-immolation, they will seize it. See, e.g., Louisiana World Exposition v. Fed. Ins. Co., 858 F.2d 233 (5th Cir. 1988). For that reason, courts and commentators have acknowledged that the debtor-in-possession “often acts under the influence of conflicts of interest.” Canadian Pa. Forest Prod. Ltd. v. J.D. Irving, Ltd. (In re Gibson Group, Inc.), 66 F.3d 1436, 1441 (6th Cir. 1995). These conflicts of interest can arise even in situations where there is no concern that a debtor’s management is trying to save its own skin. For example, a debtor may be unwilling to pursue claims against individuals or businesses, such as critical suppliers, with whom it has an ongoing relationship that it fears damaging. Id. at 1439. Finally, even if a bankrupt debtor is willing to bring an avoidance action, it might be too financially weakened to advocate vigorously for itself. In any of these situations, the real losers are the unsecured creditors whose interests avoidance actions are designed to protect. The possibility of a derivative suit by a creditors’ committee provides a critical safeguard against lax pursuit of avoidance actions. Amicus Law Professors explain that parties to bankruptcy workouts are typically sophisticated, and that they understand that their actions will likely be scrutinized after the fact. (Law Professors’ Brief at 10.) They also understand that, even though a debtor’s management may be reluctant to pursue an avoidance action, a creditors’ committee will not be so hesitant. Therefore, the 41 mere threat of a creditors’ committee suit is often a potent deterrent to overreaching by creditors and insiders. See In re W. Pac. Airlines, Inc., 219 B.R. 575, 577-78 (Bankr. D. Colo. 1998) (discussing a creditors’ committee’s “watchdog” role). This deterrent effect remains important even after commencement of the bankruptcy case itself.8 B. Potential Drawbacks of Derivative Standing for Creditors’ Committees 1. Might derivative suits dissipate the value of the estate? Despite these clear benefits stemming from derivative standing, amicus Professor Sharfman identifies reasons 8. Large corporate debtors routinely seek so-called “first-day” orders, in which they ask the bankruptcy court to approve such urgent matters as key-employee retention plans, the payment of pre-petition claims of critical vendors, and, most important, going-forward financing for the case. (Law Professors’ Brief at 11.) The parties affected by these orders (e.g., the key employees, critical vendors and lenders) often demand that the debtor waive other claims that it might have against them, such as avoidance actions. Post-petition financing orders in particular can present difficult problems for bankruptcy courts because they are extremely complex, often including provisions that cross-collateralize or “white wash” prepetition security interests. See David Kurtz & Rena Samole, Bankruptcy Law & Practice Update: New Developments in an Uncertain Economy: A Satellite Program, First Day Orders, at 2 (PLI Commercial Law Practice Course Handbook Series No. A0-00, 2001). Similarly, major vendors will often demand that the debtor release preference or comparable claims as the quid pro quo for doing business with the debtor. A court facing motions for first-day orders has a difficult choice. If it disapproves of the order, it could simply refuse to issue it on the theory that the parties would renegotiate and eliminate any offending provisions. Alternatively, it could table the motion and explore the claim’s underlying merits. But either choice is problematic, for first-day orders are by their nature extremely urgent — without an order approving financing for critical vendors, for example, the debtor might collapse before reorganization can occur. The possibility of a derivative suit by a creditors’ committee serves Congress’s goals when, by granting fist-day orders, bankruptcy courts nevertheless reserve to the creditors’ committees the right to investigate and pursue claims that would otherwise be released in those orders. (Law Professors’ Brief at 13.). 42 why it might be harmful from a policy perspective. He first argues that, although the purpose of derivative suits is presumably to maximize the value of the estate, academic research has shown that such suits frequently result in awards only large enough to pay the litigants’ legal bills. See Roberta Romano, The Shareholder Suit: Litigation Without Foundation?, 7 Journal of Law, Economics and Organization 55 (1991); Jonathan R. Macey & Geoffrey P. Miller, The Plantiffs’ Attorney’s Role in Class Action and Derivative Litigation: Economic Analysis and Recommendations for Reform, 58 U. Chi. L. Rev. 1 (1991). Sharfman submits that creditors’ derivative suits are even less likely to add value than are shareholders’ derivative suits, for the possibility of setting aside transfers as fraudulent would make it riskier for financially distressed firms to persuade potential lenders and suppliers to do business. (Sharfman Brief at 14.) The Supreme Court recognized this concern in Hartford Underwriters, where it stated that “[t]he possibility of being targeted . . . by various administrative claimants could make secured creditors less willing to provide postpetition financing.” 530 U.S. at 13. We are untroubled by this argument. To be sure, there are situations where derivative suits recover only enough to pay the lawyers, but that concern is lessened by the need to obtain bankruptcy court approval before pursuing an action. There is no inherent reason why a debtor would be able to prosecute an avoidance claim more cheaply than a creditors’ committee could, so there is no reason why a creditor suing derivatively would dissipate more value than would a debtor suing directly. Likewise, although the possibility of an avoidance action might trouble a prospective supplier or lender, that is an argument not against derivative standing, but against avoidance actions generally. Congress, however, has clearly decided that such actions are valuable to the Chapter 11 process, and we will not second-guess that judgment. The concern that derivative suits might be “value-dissipating” is adequately served by affording a debtor the deference normally accorded pursuant to the business judgment rule. When a debtor’s action is beyond the scope of that deference, however, Congress’s intent is best served by ensuring that an action is filed, even if by a creditors’ committee. At all 43 events, the Bankruptcy Court in this case concluded that the estate ought to have brought the avoidance claim in question. 2. Might bankruptcy courts be unable to identify meritorious claims? Professor Sharfman also takes issue with the idea that a bankruptcy court can serve as a competent gatekeeper for the purpose of deciding when to authorize derivative standing. He submits that the idea that “judges in bankruptcy cases will permit only value enhancing derivative litigation to go forward (rather than all litigation that is merely colorable) is more wishful thinking than serious argument. It is often hard to tell at the outset when permission to prosecute derivative litigation is sought whether a claim is meritorious, and judges understandably can make mistakes.” (Sharfman Brief at 15) (citing Frank H. Easterbrook & Daniel R. Fischel, The Economic Structure of Corporate Law 102 (1991)). From this observation, he concludes that “creditors could well recover more in the aggregate if creditor derivative suits were impermissible across the board.” (Id. at 16.) It is doubtless true that judges, like trustees or debtors, sometimes lack sufficient information to determine ex ante whether a claim is value-enhancing or merely colorable. But it does not follow that creditors would likely recover more if derivative suits were impermissible. First, this assumes that the debtor-in-possession would be better able to identify valuable claims than a bankruptcy court would be. There is no reason this should be true, for, as discussed above, conflicts of interest can often cloud debtors’ judgment — it is difficult objectively to determine whether a potential action is meritorious when one would be a defendant in that action. Second, this argument assumes that creditors’ committees are rather unsophisticated, for it predicts that the estate, and hence its creditors, would be better off if no avoidance actions took place. If that were true, presumably creditors’ committees would know it, and would not seek to bring the sort of action at issue today. Third, this critique overlooks the fact that the choice at hand is not between 44 derivative actions and no actions. Instead, if a bankruptcy court cannot authorize a derivative suit when it concludes that a debtor is unreasonably refusing to pursue an action, it will likely take the alternative step of ordering the debtor itself to pursue that action. That step is unlikely to yield a vigorous prosecution of the claim, yet it would incur all of the costs of a derivative suit. Most fundamentally, however, the problem with the “courts cannot identify meritorious claims” critique is that it is one of futility. The proposition that a bankruptcy court cannot reliably determine when a debtor is not maximizing value is, at bottom, an argument that bankruptcy courts are not capable of doing many of the things we depend on them to do. They are, for example, instrumental in approving the bankruptcy plan itself and determining whether to appoint an examiner or trustee, and they are frequently called upon to weigh the merits of proposed firstday orders. It seems to us that we have no choice but to presume the competency of bankruptcy courts throughout the process, and we are therefore unwilling to place much stock in the claim that they are unable to determine when a debtor is unreasonably refusing to pursue an avoidance action. 3. Might derivative suits consume judicial resources? Lastly, amicus Professor Sharfman warns that determining whether a derivative suit should be maintained and, if so, who should maintain it, takes time and effort on the part of the court. The Court in Hartford Underwriters was concerned about this cost, observing that “the possibility of multiple [ ] claimants” created by “[a]llowing recovery to be sought at the behest of parties other than the trustee could [ ] impair the ability of the bankruptcy court to coordinate proceedings, as well as the trustee to manage the estate.” 530 U.S. at 12-13. Professor Sharfman points out that in the case at bar, the issue of whether the Committee could pursue a derivative claim consumed significant judicial time and effort that would not have been necessary if creditors lacked derivative standing. We disagree. Rather, we believe that the cost that Sharfman laments arises from uncertainty regarding the propriety of derivative suits, a matter resolved by this appeal. If 45 derivative standing is unambiguously permissible, it is not unduly burdensome to determine whether any particular creditor or committee should have that standing. In general, although we agree that derivative standing does not come without costs, we are satisfied that on the whole it is an immensely valuable tool for bankruptcy courts and creditors alike. It helps to deter fraudulent transfers in the first instance, and it provides courts with a viable remedy when those transfers nonetheless occur. C. Possible Substitutes for Derivative Standing for Creditors’ Committees Lincolnshire does not deny that derivative standing for creditors’ committees is potentially beneficial, but it contends that such standing is not as critical as the Committee suggests because bankruptcy courts, and committees themselves, have many other remedies available. We explore these in turn. 1. Appointment of a bankruptcy trustee Lincolnshire first argues that, although the usual Chapter 11 case proceeds without a bankruptcy trustee, a creditors’ committee can move to appoint one pursuant to § 1104. That provision allows any “party in interest” (including a creditors’ committee) to request appointment of a trustee “for cause,” or if the appointment would be “in the interests of creditors.” 11 U.S.C. § 1104(a). “Cause” to appoint a trustee may include “fraud, dishonesty, incompetence, or gross mismanagement . . . either before or after commencement of the case.” Id. § 1104(a)(1). Lincolnshire posits that a trustee’s independent nature would allow it to pursue avoidance claims without the conflicts of interest that can affect debtors-in-possession. Amici Law Professors aptly respond that disallowing derivative suits and forcing creditors’ committees to move to appoint trustees would amount to “replac[ing] the scalpel of derivative suit with a chainsaw.” (Law Professors’ Brief at 13.) Appointing a trustee in a Chapter 11 case is an “extraordinary” remedy, 7 Collier on Bankruptcy ¶ 11402[1] (15th rev. ed. 1998), and there is a corresponding “strong presumption” that the debtor should be permitted to 46 remain in possession. In re Marvel Entertainment Group, Inc., 140 F.3d 463, 471 (3d Cir. 1991). The problem is that appointing a trustee amounts to replacing much of a debtor’s high-level management, and that creates immense costs in two ways. First, there is a statutory fee (which can be substantial) to which trustees are entitled for their services. See 11 U.S.C. §§ 326(a) (setting forth fee schedule), 330(a) (setting forth trustee’s right to compensation); cf. 11 U.S.C. § 1107(a) (providing that debtors-in-possession are not entitled to statutory trustee’s fees).9 More important, however, is the cost implicit in replacing current management with a team that is less familiar with the debtor specifically and its market generally. The idea that existing management is best positioned to rescue a debtor from bankruptcy is precisely the reason why the appointment of a trustee is exceptional in Chapter 11 reorganizations, but occurs immediately in Chapter 7 liquidations. See Kenneth N. Klee & K. John Shaffer, Creditors’ Committees Under Chapter 11 of the Bankruptcy Code, 44 S.C. L. Rev. 995, 1045, 1049 (1993) (observing generally that “the incremental costs” of a trustee usually “outweigh[ ] the benefits,” and that “maximization of value rarely lies down this path.”). In short, we believe that appointing a trustee is too drastic a step to constitute a serious alternative to allowing derivative suits by creditors’ committees. Indeed, because much of Chapter 11 is premised on allowing current management to remain in control of the debtor, it is unlikely that Congress intended to force a court to displace that management in the relatively commonplace event that a debtor makes a questionable decision not to prosecute a fraudulent avoidance claim. 2. Appointment of an examiner with authority to sue Amicus Smurfit-Stone Corporation submits that, if appointing a trustee is too radical an alternative, a creditors’ committee might instead move the court to 9. Of course, even a creditors’ committee suing derivatively is entitled to recover its costs pursuant to § 503(b)(3)(B), discussed supra. But unlike a trustee, a creditors’ committee is not entitled to a statutory fee in addition to those expenses. 47 appoint an examiner under § 1104(c). That provision states that “a party in interest” may request the appointment of an examiner “to conduct such an investigation of the debtor as is appropriate,” and that the court may order an appointment after notice and a hearing. An examiner’s duties include investigation of the debtor, the debtor’s business, and “any other matter relevant to the case or to the formation of a plan. See § 1106(b). Smurfit-Stone observes that a debtor’s management remains in place when an examiner is appointed. Perhaps most important, however, is the fact that an examiner has all “of the duties of a trustee that the court orders the debtor in possession not to perform.” 11 U.S.C. § 1106(b). At least one court has interpreted this language to mean that an examiner may initiate and pursue causes of action on behalf of the debtor. See In re Carnegie International Corp., 51 B.R. 252, 256 (Bankr. S.D. Ind. 1984). Although this alternative is less drastic than the appointment of a trustee, we nevertheless harbor doubts about its ability to substitute for derivative suit. One concern is that, like a trustee, an examiner would incur direct costs through its fees, so to that extent this remedy is inferior to the alternative of derivative suit by a creditors’ committee. The more serious problem, however, is that it is less than obvious that § 1106(b) actually does permit examiners to initiate actions on the debtor’s behalf. The full text of that section states: An examiner appointed under section 1104(d) of this title shall perform the duties specified in paragraphs (3) and (4) of subsection (a) of this section, and, except to the extent that the court orders otherwise, any other duties of the trustee that the court orders the debtor in possession not to perform. 11 U.S.C. § 1106(b). Although this catch-all language is expansive, it is subject to the interpretive canon ejusdem generis, which states that “where general words follow specific words in a statutory enumeration, the general words are construed to embrace only objects similar to those enumerated by the preceding specific words.” Circuit City Stores, 532 U.S. at 114-15 (citation omitted). Sections (3) and (4) allow the examiner to “investigate the acts, 48 conduct, assets, liabilities, and financial condition of the debtor, the operation of the debtor’s business and the desirability of the continuance of such business, and any other [relevant] matter,” and also to “file a statement of investigation.” 11 U.S.C. §§ 1106(a)(3)-(4). Critically, these sections permit only investigating and reporting on that investigation — they stop far short of authorizing examiners to litigate based on their findings. Therefore, although an examiner’s proper role in Chapter 11 proceedings is hardly at issue in this case, we conclude that § 1106(b)’s broad grant is most naturally interpreted to authorize only acts relating directly to investigation. This conclusion comports with Congress’s evident understanding of the examiner’s role, for the sponsors of the Code stated: “The investigation of the examiner is to proceed on an independent basis from the procedure of the reorganization under chapter 11 in order to ensure that the examiner’s report will be expeditious and fair.” 124 Cong. Rec. H11,103 (daily ed. Sept. 28, 1978), reprinted in 1978 U.S.C.C.A.N. 6472-73. This independent role would likely be jeopardized by an examiner’s litigation against a debtor, and we therefore do not believe that an examiner can serve as a substitute for either a trustee or a creditors’ committee for the purpose of avoiding fraudulent transfers. 3. Moving the court to order the debtor-in-possession to sue The third option advanced is that a creditors’ committee could move the bankruptcy court to order the debtor to file an avoidance action. In the case at bar, the Bankruptcy Court would no doubt have granted the Committee’s motion to compel that action, for it made a finding of fact that the debtor’s refusal to bring suit was unreasonable. But this solution is not realistic — given management’s sometimes severe conflicts of interest, a court order to file an avoidance action would frequently amount to instructing management to sue itself. To put it mildly, that is unlikely to result in vigorous prosecution of the claim. 4. Converting the bankruptcy case to Chapter 7 The District Court observed that if the Committee could not bring a derivative avoidance action, it might instead 49 convert the case to a Chapter 7 liquidation or dismiss the petition pursuant to 11 U.S.C. § 1112. These solutions are far more radical than even the appointment of a trustee. Converting the case to Chapter 7 would cause the immediate appointment of a trustee, the option rejected supra, and would cause dissolution of the Committee. More importantly, though, Chapter 7 proceedings are liquidations, and this option would amount to instructing management: “Pursue this action, or we will move to dissolve your company.” While that might yield results, such coercion is unlikely to yield a zealous prosecution of the claim. It also washes out the baby with the bath water, for the principal purpose of Chapter 11 is to avoid liquidating viable businesses. Moving to dismiss the bankruptcy petition makes no more sense. Bankruptcy brings with it many advantages for a debtor, such as the power to avoid union contracts and to defer or even avoid short-term financial commitments. Dismissing a bankruptcy petition might therefore be the equivalent of forcing a company to close its doors. That, of course, is hardly an alternative to derivative standing. 5. Moving the bankruptcy court to authorize a committee to bring a post-confirmation avoidance action Finally, amicus Smurfit-Stone notes that a creditors’ committee might be authorized to bring a post-confirmation avoidance action in a plan of reorganization. See 11 U.S.C. § 1123(b)(3)(B). It submits that this would give a creditors’ committee the ability to protect its interest in a variety of ways. First, although § 1121(b) provides a debtor-inpossession with 120 days of exclusivity in which to file a plan of reorganization, any extension of that period requires leave of court. See 11 U.S.C. § 1121(d). Smurfit-Stone suggests that a committee might object to any motion to extend that period unless the debtor-in-possession agrees to pursue the action itself, or to file a plan permitting the committee to pursue the action. Alternatively, a committee may safeguard its interests by filing its own plan of reorganization once the exclusivity period expires. Finally, the committee might move to terminate the exclusivity period in order to expedite the filing of its own plan. 50 These are indeed options open to committees, but like the other alternatives discussed supra, they would be far more disruptive to the reorganization process than the simple step of allowing a creditors’ committee to sue derivatively. The problem with ending exclusivity, either by moving immediately or objecting to an extension of the initial 120day window, is that it would lead immediately to a sea of direct claims that were previously channeled through the debtor. In other words, although a particular creditor might be able to sue to recover its fraudulently conveyed property, so too might every other creditor and claimant. To the extent Congress has determined that exclusivity is valuable to a reorganization, this would be a highly disruptive substitute. There is no reason to suppose that Congress intended to leave only this option available to creditors’ committees when a debtor unreasonably refuses to pursue an avoidance action. 6. Summary We conclude that, on balance, derivative standing is a valuable tool for creditors and courts alike in Chapter 11 proceedings, and we do not believe that any of the proffered alternatives could serve as a realistic substitute for that standing. Because it helps to ensure that creditors’ claims are not frustrated by fraudulent transfers, derivative standing seems clearly to “give effect to the policy of the legislature.” Mitchell, 361 U.S. at 292, and bankruptcy courts’ equitable powers therefore allow them to confer such standing upon creditors’ committees.