Can I Borrow Your Cause of Action for a Minute? Derivative Standing in the Seventh Circuit

Contributed by Christopher Hopkins
A debtor’s prepetition causes of action and other legal interests typically become property of the debtor’s estate under section 541 of the Bankruptcy Code. In a chapter 11 case, this often leaves the trustee (or debtor in possession) with the sole authority to pursue – or not pursue – such causes of action postpetition. Although the trustee is generally required to maximize the value of the estate, situations can arise where a trustee refuses to pursue litigation that is otherwise in the estate’s best interest. A debtor in possession may, for example, refuse to pursue avoidance actions against insiders or members of management even though such actions could result in substantial recoveries for the estate. Faced with such inaction, creditors may attempt to assert such claims directly on behalf of the estate. In response, courts developed the doctrine of derivative standing, which allows creditors (typically acting through official committees) to step into the trustee’s shoes to assert claims on behalf of the estate. 
As a general matter, creditors seeking derivative standing must show that the circumstances justify usurping the trustee’s authority to administer the estate to allow the creditor to pursue the claim. The Seventh Circuit, for example, has held that derivative standing is appropriate when three elements are met: (i) the trustee unjustifiably refuses a demand to pursue the action, (ii) the creditor establishes a colorable claim or cause of action, and (iii) the creditor seeks and obtains leave from the bankruptcy court to prosecute the action for and in the name of the trustee. In Official Comm. of Unsecured Creditors v. NewKey Group, LLC (In re SGK Ventures, LLC), the United States Bankruptcy Court for the Northern District of Illinois applied this standard to a derivative standing dispute that arose when the debtor’s Official Committee of Unsecured Creditors sought derivative standing to pursue various causes of action on the estate’s behalf against a group of defendants that included insiders and shareholders of the debtor.
In SGK Ventures, the Committee commenced an adversary proceeding against certain insiders and shareholders of the debtor on behalf of the debtor’s estate alleging 19 separate causes of action, including that the defendants had received fraudulent transfers. Notably, the Committee did not obtain a court order granting it derivative standing prior to commencing the proceeding. Instead, the Committee filed a motion seeking derivative standing after filing its complaint. The defendants then filed a motion to dismiss the complaint arguing that, among other things, the Committee lacked standing to pursue the claims.
The court analyzed the derivative standing issues raised by the parties in three parts. First, the court addressed the defendants’ argument that the Supreme Court had overruled Seventh Circuit precedent authorizing derivative standing in two decisions: Hartford Underwriters Ins. Co. v. Union Planters Bank and Law v. Siegel. Second, the court considered whether derivative standing had already been conferred on the Committee prior to the commencement of the adversary proceeding pursuant to a provision in the debtor’s cash collateral order. Finally, the court decided whether the Committee was entitled to derivative standing according to the standard set forth by the Seventh Circuit in In re Perkins.
The Supreme Court Did Not Overrule the Seventh Circuit on Derivative Standing
As a threshold argument, the defendants argued that Seventh Circuit precedent authorizing derivative standing had been overruled by the Supreme Court in Hartford Underwriters and Siegel. In Hartford Underwriters, the Supreme Court held that an individual creditor could not pursue a claim for compensation under section 506(c) of the Bankruptcy Code on its own behalf. Section 506(c) authorizes the trustee to recover the reasonable, necessary costs and expenses of preserving property securing an allowed secured claim. The Supreme Court reasoned that the plain language of section 506(c) provides that only the trustee is authorized to seek payment under that section. Thus, the creditor lacked the independent right to seek payment under section 506(c). As noted by the court in SGK Ventures, however, the Supreme Court acknowledged that its decision did “not address whether a bankruptcy court can allow other interested parties to act in the trustee’s stead in pursuing recovery.” Accordingly, the court in SGK Ventures found that Hartford Underwriters did not overrule Seventh Circuit precedent authorizing derivative standing.
The court also found that the defendants’ reliance on Siegel was misplaced. In Siegel, the Supreme Court held that section 105(a) of the Bankruptcy Code does not grant bankruptcy courts the authority to take actions expressly prohibited by the Bankruptcy Code. Specifically, the Supreme Court overruled the bankruptcy court’s grant of a surcharge over certain exempt assets of the debtor on the ground that such action was expressly prohibited by section 522(k) of the Bankruptcy Code. The court held that the Supreme Court’s ruling in Siegel was inapposite to the issue of derivative standing because there is no similar provision of the Bankruptcy Code that prohibits the court from granting derivative standing.
The Cash Collateral Order Did Not Grant the Committee Derivative Standing
Prior to the filing of the Committee’s complaint, the court entered a cash collateral order that established deadlines by which the Committee had to raise certain objections to the claims of certain creditors. The order applied solely to the Committee’s objections concerning (i) the amount that the creditors were owed prepetition and (ii) any interest those creditors asserted in the debtor’s property to secure their prepetition indebtedness. Despite this limiting language, the order also included a provision that stated “[i]t is understood and agreed by the Debtor that the Committee has, and the Court hereby endorses the Committee’s, standing [to] file and prosecute any objection.” The Committee argued that this provision constituted a general grant of derivative standing, and, therefore, the Committee did not need to seek additional authorization to assert the claims in its complaint.
Unfortunately for the Committee, the court disagreed. The court reasoned that the scope of the “objections” to which the Committee was granted standing was limited to those categories enumerated in the order. Further, nothing in the cash collateral order accorded the committee standing to bring actions other than the objections set forth in the order, especially actions that constituted property of the estate. Accordingly, the court held that the Committee had not received a grant of derivative standing to bring the claims asserted in its complaint.
Was the Committee Entitled to Derivative Standing Anyway?
The court then applied the three-factor test established by the Seventh Circuit in In re Perkins to determine whether the Committee was entitled to derivative standing. Under the Perkins test, to establish derivative standing a creditor must: (i) demonstrate the trustee unjustifiably refused a demand to pursue the action; (ii) establish a colorable claim or cause of action; and (iii) seek and obtain leave from the bankruptcy court to prosecute the action in the name of the trustee. The defendants challenged the Committee’s derivative standing on each of the three elements. In assessing the second element—whether the Committee had established a colorable cause of action—the court considered whether the Committee had failed to state a claim for each of the 19 causes of action asserted in the complaint. It concluded that the Committee had adequately stated a claim for all but four of the causes of action. The court’s analysis concerning derivative standing focused on the first and third element.
The Committee obtained a “sufficient indication” of the debtor’s refusal to pursue the claims
The defendants argued that the Committee failed to satisfy the first Perkins element because it failed to make a formal demand on the debtor to pursue the claim, and, therefore, the debtor had not “refused” to pursue the claims prior to the filing of the Committee’s complaint. Prior to commencing its adversary proceeding, however, the Committee had filed an objection to the debtor’s motion to sell the bulk of its assets. In that objection, the Committee noted that “potential claims lie against insiders and equity stakeholders” of the debtor, which included fraudulent transfer claims. In addition, and also prior to the commencement of the adversary proceeding, the Committee had discussions with the debtor’s attorney regarding the Committee’s plans to file an avoidance action against an insider that was subsequently named as a defendant to the Committee’s adversary proceeding. In the course of these discussions, debtor’s counsel stated (i) that the debtor would not be pursuing the avoidance action against the insider, (ii) any demand by the Committee would have been “perfunctory,” and (iii) the debtor had an “undeniable conflict of interest” in that the individual defendants proposed by the Committee included members of the debtor’s management. The court concluded that the Committee’s statement of its intent to bring an action against the debtor’s insiders and the debtor’s oral refusal were sufficient to satisfy the first Perkins element because the Committee had received a “sufficient indication” that the debtor would not bring the complaint.
The Committee was entitled to “retroactive derivative standing”
The defendants also argued that the Committee failed to satisfy the third Perkins element because it failed to obtain a grant of derivative standing prior to the commencement of the adversary proceeding. The court initially agreed that the third element had “obviously not been timely satisfied by the Committee” because the Committee sought derivative standing only after filing its complaint. But as the court noted, a “great majority of decisions” have recognized that the court has discretion to grant retroactive derivative standing back to the date on which the relevant complaint was filed. The court advanced two reasons as to why a grant of retroactive derivative standing may be proper: (i) if the request for leave is otherwise appropriate, dismissing a complaint for failure to seek leave in advance may simply result in a refiling of both the request for leave and the complaint, generating unnecessary expense and delay, and (ii) the party that failed to timely obtain derivative standing may have been acting in good faith under an impending deadline for filing its complaint. The court concluded that both reasons for granting derivative standing justified granting retroactive derivative standing to the Committee.
The court reasoned that in the absence of a reason not to grant derivative standing, refusing to grant the Committee standing would simply result in a new standing motion and the re-filing of the complaint. More importantly, the court concluded that the Committee was acting in good faith under the belief that the cash collateral order included potential actions against insiders among the objections that the Committee was granted standing to pursue. Although the Committee’s belief was ultimately mistaken, the court found the Committee’s belief “reasonable and understandable.” Further, the court noted that the Seventh Circuit’s decision in Perkins stated only that untimely standing motions should be denied, not that they must be. As a result, the court determined that Perkins did not mandate the dismissal of an untimely derivative standing motion, and, therefore, retroactive standing may be granted in unusual cases. Given the unique circumstances faced by the Committee, the court concluded that the Committee was entitled to derivative standing despite the untimeliness of its complaint.
The court in SGK Ventures adopted a pragmatic approach when assessing whether the Committee met the requirements of the Seventh Circuit’s Perkins test. In unusual cases, like the one at issue in SGK Ventures, courts may interpret these requirements loosely to grant deserving creditors derivative standing despite potential deficiencies in the satisfaction of the applicable requirements.