Restructuring

Contributed by Doron P. Kenter.
Most courts today permit creditors (most often through the official committees representing their interests) to seek court approval to bring derivative actions on behalf of a debtor’s estate.  Yet, that option is not expressly provided in the Bankruptcy Code, and creditors did not always have the opportunity to seek standing to bring such actions.  Courts and professionals continue to debate the proper circumstances in which to seek leave to file such suits, but in this installment of Throwback Thursday, we take you back to a turning point in the law on creditors’ derivative standing in bankruptcy cases.
In In re STN Enterprises, Stephen and Janice Noyes, a husband and wife, owned and operated the debtor, STN Enterprises, a dealer in antique arms.  Stephen and Janice were the only two directors of STN, and Stephen was the sole shareholder of the company.  Stephen passed away less than two years after STN’s formation, leaving Janice as the administrator of his probate estate (which estate succeeded to Stephen as the sole stockholder of STN). Less than a month later, STN commenced a voluntary petition under chapter 11 of the Bankruptcy Code.
The official committee of unsecured creditors then sought leave to commence an action against Janice individually and as administrator of her late husband’s estate.  The committee alleged that Stephen and Janice had depleted STN’s assets for their own benefit, drawing up to $2.1 million in STN checks made out to “Cash” (the proceeds of which were unaccounted for).  Accordingly, the committee alleged that Stephen and Janice had wasted STN’s corporate assets and/or made (and received) fraudulent or preferential conveyances from STN to themselves, all while STN was insolvent.  The district court denied the committee’s request to assert these claims against Stephen’s estate and against Janice (the bankruptcy judge had disqualified himself for unrelated reasons), but the committee appealed the district court’s decision to the United States Court of Appeals for the Second Circuit.
After affirming the district court’s denial of the committee’s request to sue Stephen’s estate (because the probate estate was insolvent and because the statute of limitations had run for bringing such claims against the estate), the Second Circuit reversed the district court’s denial of leave to assert derivative claims against Janice.  The Second Circuit, agreeing with an emerging majority of courts, concluded that the Bankruptcy Code implies that a creditors’ committee has a qualified right to initiate adversary proceedings in the name of the debtor.  The court noted that the right to request leave to assert derivative claims may be inferred from section 1109(b) of the Bankruptcy Code, which empowers creditors’ committees to be “heard on any issue,” and section 1103(c)(5) of the Bankruptcy Code, which charges creditors’ committees with “perform[ing] such other services as are in the interest of those represented.”  Also siding with the emerging majority, the Second Circuit concluded that directors of insolvent corporations owe fiduciary duties to their creditors and that such creditors may, therefore, assert derivative claims against directors who have breached such duties.
Accordingly, the Second Circuit held that a bankruptcy court may confer standing on the creditors’ committee to bring such derivative claims in the debtor’s name.  To determine whether standing should be conferred, the Second Circuit noted that the creditors’ committee must show that (i) the debtor unjustifiably failed to bring such an action; (ii) the claims that the committee seeks to assert are colorable and would support a recovery for the estate; (iii) such an action is likely to benefit the estate; (iv) granting the committee leave to sue is preferable to appointing a chapter 11 trustee to bring such claims; and (v) the prospective recovery justifies the costs inherent in bringing such an action (including financial costs and any delay in the bankruptcy case).
Importantly, though the Second Circuit did not require a “mini-trial” to determine the likelihood of the proposed action’s success, it did require bankruptcy courts to undertake a cost-benefit analysis in determining whether to grant creditors’ committees leave to bring derivative actions on behalf of the estate.  The Second Circuit also recognized that a committee requesting authority to bring derivative claims on behalf of the estate must demonstrate its proposed fee structure and source of funding.  The court recognized that such cost-benefit analysis would be unnecessary where the estate will not be forced to internalize any costs in connection with the litigation (for example, if the creditors will pay all fees and will only seek reimbursement from the estate if the action is successful).
Twenty-seven years have passed since the Second Circuit rendered its decision, and STN is still standing.  Since STN, debtors have been reminded repeatedly that they may not always be the ones to “drive the bus” in determining the estate’s litigation strategy.  Though creditors’ committees must prove that “STN standing” is warranted under the particular facts and circumstances of each case, such standing (if conferred) can dramatically affect the overall strategy in managing a chapter 11 case.