Insights

Eighth Circuit Reaffirms Legitimacy of Derivative Standing

A bankruptcy trustee or chapter 11 debtor-in-possession (“DIP”) is entrusted in the first instance with prosecuting avoidance claims and other causes of action that are part of a debtor’s estate when it files for bankruptcy protection. However, in some cases, a trustee or DIP is either unwilling or unable (due, for example, to a lack of funds) to pursue such actions. Although the Bankruptcy Code does not unambiguously create a mechanism for conferring “standing” to prosecute estate claims on someone other than a trustee or DIP, the majority of courts recognize the concept of “derivative standing.” The Eighth Circuit Court of Appeals recently had an opportunity to reconsider the legitimacy of derivative standing, but under circumstances that it had never previously encountered. In In re Racing Services, Inc., the court of appeals ruled that derivative standing may be appropriate if a trustee or DIP consents to, or does not oppose, the prosecution of estate claims by a creditor or committee, and the doctrine is not limited to situations involving a trustee’s inability or unwillingness to prosecute such claims.

Standing

“Standing” is the ability to commence litigation in a court of law. It is a threshold issue — a court must determine whether a litigant has the legal capacity to pursue claims before the court can adjudicate the dispute. In the bankruptcy context, various provisions of the Bankruptcy Code confer standing on various entities (e.g., the debtor, a bankruptcy trustee, creditors, equity interest holders, committees, or indenture trustees) to, among other things, participate generally in a bankruptcy case or commence litigation involving causes of action or claims that either belonged to the debtor prior to filing for bankruptcy or are created by the Bankruptcy Code.

The right to participate in a chapter 11 case is more explicit. Section 1109 of the Bankruptcy Code provides that any “party in interest,” including the debtor, the trustee, a committee of creditors or equity interest holders, a creditor, or an indenture trustee, “may appear and may be heard on any issue” in a chapter 11 “case.” This general right to participate, however, does not confer standing upon every party in interest to engage in litigation expressly contemplated by other provisions of the statute, such as lien and transfer avoidance. Many of these provisions deal with claims or causes of action belonging to the debtor prior to filing for bankruptcy, which become part of its bankruptcy estate on the petition date. Standing to prosecute estate claims is expressly given by statute to a bankruptcy trustee (or DIP, by operation of section 1107(a) of the Bankruptcy Code).

Although the Bankruptcy Code does not expressly authorize anyone other than a trustee or DIP to prosecute claims belonging to the estate, many courts will allow committees or individual creditors to commence litigation on behalf of the estate under narrowly defined circumstances. In one of the seminal cases addressing this issue, the Second Circuit Court of Appeals held in In re STN Enterprises that, in considering a committee’s request for leave to sue a director for misconduct, a court is required to consider whether the debtor unjustifiably failed to initiate suit against the director and whether the action is likely to benefit the debtor’s estate.

The Second Circuit later refined the doctrine of “derivative standing” in In re Commodore International Ltd., which involved litigation brought by a creditors’ committee against various officers and directors for fraud, waste, and mismanagement. Unlike in STN Enterprises, the debtor in Commodore had not unreasonably refused to bring suit but agreed to permit the committee to litigate the claims on behalf of the estate. The court of appeals ruled that a committee may bring suit even if the debtor does not unjustifiably refuse to do so as long as: (i) the trustee or debtor consents; and (ii) the court finds that the litigation is (a) in the best interests of the estate and (b) necessary and beneficial to the fair and efficient resolution of the bankruptcy proceedings. In 2007, the Second Circuit reaffirmed the vitality of the doctrine of derivative standing in Official Comm. of Unsecured Creditors v. Halifax Fund, L.P. (In re Applied Theory Corp.), where it ruled that, without bankruptcy court approval under the doctrine, a creditors’ committee does not have standing to commence litigation seeking the equitable subordination of a claim. The Second Circuit’s approach represents the majority view. The Eighth Circuit had an opportunity to reexamine derivative standing under circumstances that presented a matter of first impression in Racing Services.

Racing Services

Racing Services, Inc. (“RS”), operated a horse-race wagering service business before filing for chapter 11 protection on February 3, 2004, in Delaware. The chapter 11 case was converted to a chapter 7 liquidation shortly after venue of the case was transferred to North Dakota. PW Enterprises, Inc. (“PW”), was the company’s largest nongovernmental unsecured creditor, asserting a claim of more than $2 million. The State of North Dakota and affiliated state entities (collectively, “North Dakota”) held a $6 million priority tax claim against RS.

Shortly before the statute of limitations on estate avoidance actions expired, PW asked the chapter 7 trustee to commence litigation against North Dakota seeking to avoid as preferential and/or fraudulent certain transfers made to North Dakota by RS prior to filing for bankruptcy that were allegedly improperly classified as “taxes.” The trustee declined to bring suit, whereupon PW filed a complaint seeking avoidance of the transfers without having obtained bankruptcy court authority to do so. Two months afterward, PW petitioned the bankruptcy court for an order authorizing it to prosecute the claims. Only North Dakota opposed the motion. The trustee filed a statement indicating that he did not oppose conferring derivative standing upon PW, provided any order granting standing made it clear that the claims and any proceeds of the litigation belonged to the estate.

The bankruptcy court denied PW’s motion, concluding that PW failed to show that the trustee abused his discretion or acted unjustifiably in failing to pursue the avoidance claims. The court did not address PW’s argument that a creditor may proceed derivatively if the trustee either consents or offers no opposition. A bankruptcy appellate panel affirmed the bankruptcy court on appeal, ruling that the court properly denied PW’s request for derivative standing because PW did not seek court authority prior to filing the avoidance complaint. It too declined to address PW’s consent/nonopposition argument. PW appealed to the Eighth Circuit.

The Eighth Circuit’s Ruling

The court of appeals reversed. It acknowledged that its 1996 ruling in In re Lauer had created uncertainty and conflicting views among lower courts in the circuit on the availability of derivative standing. In Lauer, the Eighth Circuit affirmed denial of standing to creditors seeking to prosecute avoidance actions because they failed to allege that the trustee was “unable or unwilling” to pursue the claims on behalf of the estate, stating that “[a]bsent evidence that the trustee cannot be relied upon to assert [avoidance claims], claims to avoid preferential transfers may not be brought by creditors.” Courts applying Lauer, however, have disagreed as to what constitutes inability or unwillingness on the part of a bankruptcy trustee or chapter 11 debtor-in-possession because Lauer did not detail what showing is required to establish these pre-conditions to derivative standing.

Emphasizing that, if conferred routinely, derivative standing “could usurp the central role” played by a trustee or debtor-in-possession as a representative of the estate, the Eighth Circuit ruled that any creditor seeking such standing must establish that: (i) it petitioned the trustee to prosecute the claims and the trustee refused; (ii) the claims are colorable; (iii) it sought court permission to prosecute the claims; and (iv) the trustee’s refusal to prosecute the claims was unjustifiable. A claim is colorable, the court explained, if it would survive a motion to dismiss. At a minimum, the Eighth Circuit noted, the creditor must provide the court with specific reasons why it believes the trustee’s refusal to prosecute is unreasonable. According to the court, although the particular circumstances of the case will dictate whether any refusal is unreasonable, the “universe of circumstances” is “somewhat limited,” and the bankruptcy court must weigh the costs that would be incurred in prosecuting claims against any anticipated benefit:

At one end of the spectrum, a trustee almost certainly abuses his discretion by refusing to bring a creditor’s claim that, if successful, would clearly benefit the estate. At the other end, a trustee certainly does not abuse his discretion by refusing to bring a claim that would yield insignificant benefits to the estate. A more difficult situation, however, is when the creditor establishes that its claims, if successful, would offer more than marginal benefits to the estate but not necessarily a windfall. . . . In short, we trust that bankruptcy judges will, in the first instance, refine the contours of when derivative standing is appropriate.

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At bottom, the determination of whether the trustee unjustifiably refuses to bring a creditor’s proposed claims will require bankruptcy courts to perform a cost-benefit analysis. . . . While by no means exhaustive, among the factors the court should consider in conducting this analysis are: (1) “[the] probabilities of legal success and financial recovery in event of success”; (2) the creditor’s proposed fee arrangement; and (3) “the anticipated delay and expense to the bankruptcy estate that the initiation and continuation of litigation will likely produce.” . . . We do not suggest, however, that the bankruptcy court “undertake a mini-trial” in evaluating a creditor’s request for derivative standing. . . . But the bankruptcy court must support its decision to grant or deny standing with a written or oral explanation that reflects it conducted the appropriate cost-benefit analysis.

Having articulated the general rule on derivative standing, the Eighth Circuit proceeded to address a matter of first impression before it — namely, the propriety of derivative standing in cases where a bankruptcy trustee or DIP consents to, or does not oppose, the prosecution of estate claims by a creditor or committee. The court adopted the approach articulated by the Second Circuit on this issue in Commodore. It ruled that derivative standing may be conferred upon a creditor in cases where the trustee consents and the bankruptcy court finds that prosecuting the claims is: (i) in the best interest of the estate, and (ii) “necessary and beneficial to the fair and efficient resolution of the bankruptcy proceedings.” The court emphasized, however, that bankruptcy courts should not “passively view the trustee’s consent as a proxy that a proposed derivative action is ‘necessary and beneficial.’ ” A bankruptcy court, the Eighth Circuit cautioned, has an obligation to scrutinize carefully the predicates for derivative standing in cases involving both a trustee’s consent or unreasonable refusal.

Finally, the Eighth Circuit faulted the bankruptcy appellate panel for its apparent imposition of a per se rule barring a creditor or committee from commencing litigation on behalf of the estate unless it first obtains court permission. Such a blanket rule against retroactive approval, the court of appeals emphasized, could result in “needless dismissals and refilings” or forfeiture of meritorious derivative claims. Provided the standard for derivative standing has been met, the court of appeals remarked, “bankruptcy courts may retroactively grant a creditor derivative standing.”

Outlook

Racing Services is consistent with the approach adopted by the majority of courts on the issue of derivative standing. Under this approach, a stakeholder other than a DIP or trustee is permitted under certain circumstances to prosecute claims on behalf of the bankruptcy estate, particularly where the estate lacks sufficient unencumbered cash to fund litigation of colorable claims. As part of its broad equitable powers, the bankruptcy court acts as the gatekeeper for derivative standing, and its discretion in exercising those powers is considerable.

Still, some courts reject derivative standing as illegitimate, based upon the Bankruptcy Code’s express reference to a “trustee” (and by inclusion, a debtor-in-possession) in specifying who may prosecute avoidance actions belonging to the estate. The most notable adherent to this view (albeit temporarily) was the Third Circuit Court of Appeals, which ruled in 2002 in Official Committee of Unsecured Creditors of Cybergenics Corp. v. Chinery (In re Cybergenics Corp.) that, based upon the express language of section 544(b) of the Bankruptcy Code and the Supreme Court’s 2000 ruling in Hartford Underwriters Ins. Co. v. Union Planters Bank, N.A., only a bankruptcy trustee has the authority to commence avoidance litigation that could have been brought by a creditor under applicable state law outside of bankruptcy. The court of appeals did an about-face on the issue the following year, vacating its original ruling and concluding that the scope of a bankruptcy court’s equitable powers is sufficiently broad to encompass the discretion to delegate standing to a creditor or committee under appropriate circumstances. Despite the Third Circuit’s imprimatur, a handful of courts continue to reject derivative standing. In addition, the Fourth Circuit, although it has never decided the issue directly, observed in its 2005 ruling in Scott v. National Century Fin. Enters., Inc. (In re Baltimore Emergency Servs. II Corp.) that “[i]t is far from self-evident that the Bankruptcy Code permits creditor derivative standing.”

The Second Circuit recently added yet another chapter to the evolution of the doctrine of derivative standing. In Official Committee of Equity Security Holders of Adelphia Comm. Corp. v. Official Committee of Unsecured Creditors of Adelphia Comm. Corp. (In re Adelphia Comm. Corp.), the court of appeals affirmed a district court ruling dismissing an official equity committee’s challenge of an order confirming Adelphia’s chapter 11 plan. The equity committee challenged the plan confirmation order on the grounds that the bankruptcy court lacked the power to transfer derivative claims that the committee had been authorized to prosecute to a litigation trust established under the plan, the proceeds of which would benefit unsecured creditors. According to the Second Circuit, a court “may withdraw a committee’s derivative standing and transfer the management of its claims, even in the absence of that committee’s consent, if the court concludes that such a transfer is in the best interests of the bankruptcy estate.”

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PW Enterprises, Inc. v. North Dakota Racing Commission (In re Racing Services, Inc.), 540 F.3d 892 (8th Cir. 2008).

Unsecured Creditors Committee of Debtor STN Enterprises, Inc. v. Noyes (In re STN Enterprises), 779 F.2d 901 (2d Cir. 1985).

Commodore Int’l Ltd. v. Gould (In re Commodore Int’l Ltd.), 262 F.3d 96 (2d Cir. 2001).

Official Comm. of Unsecured Creditors v. Halifax Fund, L.P. (In re Applied Theory Corp.), 493 F.3d 82 (2d Cir. 2007).

Official Comm. of Unsecured Creditors of Cybergenics Corp. v. Chinery (In re Cybergenics Corp.), 330 F.3d 548 (3d Cir. 2003).

Fogel v. Zell, 221 F.3d 955 (7th Cir. 2000).

Avalanche Mar., Ltd. v. Parekh (In re Parmetex, Inc.), 199 F.3d 1029 (9th Cir. 1999).

Canadian Pac. Forest Prods. Ltd. v. J.D. Irving, Ltd. (In re Gibson Group, Inc.), 66 F.3d 1436 (6th Cir. 1995).

La. World Exposition v. Fed. Ins. Co., 858 F.2d 233 (5th Cir. 1988).

Nagle v. Lauer (In re Lauer), 98 F.3d 378 (8th Cir. 1996).

Hartford Underwriters Ins. Co. v. Union Planters Bank, N.A., 530 U.S. 1 (2000).

Scott v. National Century Fin. Enters., Inc. (In re Baltimore Emergency Servs. II Corp.), 432 F.3d 557 (4th Cir. 2005).

Official Committee of Equity Security Holders of Adelphia Comm. Corp. v. Official Committee of Unsecured Creditors of Adelphia Comm. Corp. (In re Adelphia Comm. Corp.), 544 F.3d 420 (2d Cir. 2008).

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