Contributed by Cristine Pirro
The United States Bankruptcy Court for the District of Delaware, in CD Liquidation Co., LLC, recently enjoined a shareholder from independently pursuing claims against another shareholder in the United States District Court for the Southern District of New York, finding that those claims weren’t “personal” to the plaintiff-shareholder, but, instead, were derivative claims. The bankruptcy court, however, did give the plaintiff-shareholder something to take personally (albeit, not a claim). It noted that the plaintiff-shareholder’s arguments were “wholly without merit, bordering on, if not, bad faith [and that neither the plaintiff] nor his lawyer should think for one moment that the egregious misstatements of the record and misleading arguments were lost on the Court.” What led the bankruptcy court to have such a strong reaction to a litigation position? Perhaps the answer lies in the court’s observation that Paladini had taken a contrary position when it “benefited him to do so.”
Marcelo Paladini (the plaintiff) and John Martillo (the defendant) were, at one point, co-founders and 50% shareholders of CPS Group, Inc., the predecessor to Cynergy Data, LLC and Cynergy Data Holdings, Inc. Cynergy Holdings held the entirety of the membership interest in Cynergy Data, LLC, which provided payment process servicing to merchants. By 2007, however, Martillo was ready to sell his share of the companies.
Martillo redeemed his stock in two portions: The first in April of 2007 for $15 million, and the second in November of the same year for $31.5 million. Both redemptions were financed by several banks that entered into loan agreements with Cynergy. Between 2007 and 2009, the companies were unable to meet their financial projections, and on September 1, 2009, the companies filed for chapter 11 in bankruptcy court in the District of Delaware.
Shortly thereafter, several of Cynergy’s lenders sued Paladini in state court for his use of their loan proceeds. The state court lawsuits were stayed at Paladini’s request because Paladini successfully argued that the lenders’ claims were derivative claims belonging to Cynergy’s estate. Subsequently, Paladini brought a civil action in the United States District Court for the Southern District of New York against Martillo, asserting claims for contribution, constructive fraud, improper distribution, unjust enrichment, and/or constructive trust in connection with Martillo’s redemption of stock in Cynergy. Specifically, Paladini alleged: (i) improper distribution as a result of Martillo receiving the shares while Cynergy was insolvent, (ii) unjust enrichment due to Martillo receiving more than the shares were worth, and (iii) that the redemptions harmed Paladini by reducing the value of his shares as well as by causing creditors to file lawsuits against him. Martillo moved to dismiss the complaint, arguing, among other things, that Paladini lacked standing to pursue his lawsuit because Paladini’s claims could only be brought by the bankruptcy estate.
A few months later, the bankruptcy court entered an order confirming the companies’ joint plan of liquidation. A liquidation trustee was appointed pursuant to the plan. The plan bestowed upon the liquidation trustee the power to assert all causes of action of the debtors, including those under chapter 5 of the Bankruptcy Code. It also included a permanent injunction barring proceedings involving claims of the debtors, vested exclusive jurisdiction over estate claims with the Bankruptcy Court, and expressly provided that the Bankruptcy Court would retain jurisdiction over any estate claims brought against Martillo.
In accordance with the plan, the liquidation trustee commenced an adversary proceeding against Martillo on account of the redemptions. He also sought an injunction preventing Paladini from proceeding with the District Court action, contending that Paladini lacked standing to continue with his action.
Claims are Derivative
The bankruptcy court’s decision turned on whether the claims asserted were derivative or direct in nature. Generally, if an injury is inflicted on a corporation, a lawsuit for that injury is said to be “derivative” of the corporation. Although shareholders may feel the effects of the injury, for example, in the form of declining share value, they will not necessarily have a cause of action if the corporation, as a whole, suffers the primary harm. Because the shareholder is only secondarily harmed, any retribution would flow first to the corporation, and then to the shareholder. If, on the other hand, a shareholder suffers a “direct” injury, recovery would inure to the plaintiff-shareholder alone.
If the claims were general claims that could be brought by any creditor of the debtors, i.e. if the claims were derivative, then the liquidation trustee was the proper party to assert the claim. This is because asserted causes of action constituting property of the estate could only be properly asserted by the debtor (or, in this case, the liquidation trustee, as the debtor’s assignee). If, on the other hand, the claims could not be brought by any of the debtors’ creditors, then the claims would be considered “direct,” and Paladini would have standing to bring them.
State law determines whether the claims are direct or derivative. Whether the liquidation trustee had exclusive standing to assert those claims, therefore, hinged on the application of New York and Delaware law, which governed the debtors as New York and Delaware corporations. In this analysis, both Delaware and New York courts consider: (i) whether the corporation or the stockholders individually suffered the harm, and (ii) whether the corporation or the stockholders individually would benefit from recovery. Under both New York and Delaware law, a lawsuit based on stock redemptions that impair a corporation’s capital is considered to be designed to protect all creditors and, as such, is regarded as a general right belonging to all creditors.
The bankruptcy court, therefore, explained that a reduction in value to Paladini’s shares as a result of the stock redemption also affected other shareholders, who shared equally in the devaluation. Because Paladini could not prevail without showing an injury to the corporation, his redemption claims were derivative. The bankruptcy court employed a similar analysis to the other claims asserted by Paladini, concluding that they, too, were derivative claims.
Noting that it had authority to enforce the confirmation order, the bankruptcy court enjoined Paladini from pursuing actions vested specifically in the liquidation trustee, and ordered Paladini to stop “usurping the liquidation trustee’s exclusive power to assert claims for general harms in violation of the Plan and Bankruptcy Code section 544.” The court, however, did leave Paladini with something he could take “personally” – a warning about advancing “bad faith” arguments in the bankruptcy court.