Fox Attacks ‘Hen House’: A Renewed Challenge to Creditors’ Derivative Standing

by Wendell H. Adair, Jr., Sayan Bhattacharyya, A. Victor Glaser

Nov 1, 2004

(TMA Global)

A trustee or, more commonly, the debtor-in-possession in the case of a Chapter 11 corporate reorganization acts as an estate’s representative after commencement of a bankruptcy case. The Bankruptcy Code delineates the representative’s powers and duties, granting the individual the ability to sue and to be sued on behalf of the estate and imparting a fiduciary obligation to the estate and its creditors.

Despite this obligation, disagreements often arise in bankruptcy proceedings as to whether the trustee or debtor-in-possession truly is acting in the best interests of the estate. In many cases, creditors allege that the estate’s representative is not pursuing claims that could add value to the estate.

In such cases, bankruptcy courts historically have granted creditors a qualified right to bring actions on the estate’s behalf. Although no specific provision in the Bankruptcy Code covers this practice, courts conferring derivative standing on creditors have generally cited pre-Bankruptcy Code practice and various policy considerations for their decisions. [1]

The ‘Hen House’ Case

The U.S. Supreme Court’s 2000 decision in Hartford Underwriters Ins. Co. v. Union Planters Bank [ 2] addressed the validity of a creditor’s derivative standing. Also known as the “Hen House” case, Hartford Underwriters arose out of the bankruptcy of Hen House Interstate, Inc. In that case, Hartford Underwriters Insurance Co., unaware of Hen House’s pending Chapter 11 proceeding, provided Hen House with workers’ compensation insurance during its attempted reorganization. When the reorganization failed and the case was converted to Chapter 7 liquidation, Hartford found itself with more than $50,000 of unpaid insurance premiums.

Subsequently, Hartford sought to charge the premiums to Hen House’s primary secured creditor under Section 506(c) of the Bankruptcy Code, which states that “[t]he trustee may recover from property securing an allowed secured claim the reasonable, necessary costs and expenses of preserving, or disposing of, such property to the extent of any benefit to the holder of such claim.” Hartford argued that its provision of insurance had preserved the value of the secured creditor’s collateral and it should therefore be able to recover on its claim as an administrative expense.

In considering the case, the Supreme Court focused narrowly on the issue of whether the Bankruptcy Code, under Section 506(c), gave an administrative claimant authority to seek recovery unilaterally. Rejecting arguments based on prior practice, as well as general policy considerations, the court directed its attention to the specific language of the provision and, in particular, the phrase “the trustee may.” Espousing a “plain meaning approach” to interpreting the statute, the court found that the power to invoke Section 506(c) lay exclusively with the trustee, and thus, no other party had the right to pursue administrative claims.

The Hartford Underwriters holding seemed to be limited to the issue of whether creditors have independent standing to use the collateral surcharge provisions of Section 506(c) of the Bankruptcy Code rather than raising a question as to the continued legitimacy of creditors’ derivative standing. Indeed, the Supreme Court specifically reserved judgment on the practice of conferring derivative standing on creditors to pursue avoidance actions, despite the fact that similar language giving the right to commence such actions solely to “the trustee” is found in the Bankruptcy Code’s avoidance provisions. [3]

Cybergenics

The issue of creditors’ derivative standing to bring avoidance actions on behalf of a bankruptcy estate came to a head two years later in the Chapter 11 proceeding of Cybergenics Corporation. [4] In Cybergenics, the creditors’ committee sought permission from the bankruptcy court to pursue certain fraudulent transfers that the debtor-in-possession had refused to pursue. After the bankruptcy court granted the request, the U.S. District Court reversed.

The District Court, and subsequently a three-judge panel of the 3d Circuit Court of Appeals, concluded that the “rather well established” practice of permitting creditors to initiate derivative avoidance actions could not survive the Supreme Court’s reasoning in Hartford Underwriters. [5] Following the rationale from Hartford Underwriters, the 3d Circuit rejected prior practice and policy considerations in determining that the plain meaning of the Bankruptcy Code provisions that grant “the trustee” the power to commence an avoidance action are an exclusive grant of power belonging to the debtor, and as such, no other party in interest –– including a creditor or a creditors’ committee –– could exercise these powers.

The Cybergenics decision raised a stir throughout the bankruptcy bar and was squarely in conflict with more than a decade of established case law from various circuits across the country, including decisions of the 2d, 5th, 6th, 7th, and 9th Circuit Courts of Appeals. [6]

Ultimately, however, the 3d Circuit vacated the panel opinion after voting to rehear the case en banc. On May 29, 2003, the 3d Circuit reversed itself and concluded that Hartford Underwriters should be construed narrowly to its circumstances and that the language of the avoidance power sections of the Bankruptcy Code did not preclude a creditors’ committee from commencing an avoidance action in the debtor’s name. [7]

The 3d Circuit acknowledged that the Bankruptcy Code does not explicitly empower a bankruptcy court to confer derivative standing on a creditors’ committee to pursue an avoidance action. Nevertheless, it concluded that the legislators’ intent to encourage creditor participation in the bankruptcy proceeding and the longstanding practice of authorizing creditors to bring avoidance actions on behalf of an estate, together with the bankruptcy court’s equitable powers, provided sufficient grounds to allow bankruptcy courts to confer derivative standing on creditors in these circumstances. The court noted that “derivative standing is a prudent way for bankruptcy courts to remedy lapses in a trustee’s execution of its fiduciary duty.” [8]

The en banc decision in Cybergenics brought the 3d Circuit back in line with the majority of circuits and seemed to ensure the continued viability of creditors’ derivative standing in avoidance actions.

In re Fox

In a decision that once again raises the issue that had seemed to be laid to rest, the 10th Circuit’s Bankruptcy Appellate Panel (BAP) recently held that a creditor seeking to prosecute an avoidance action on behalf of a debtor’s estate had no standing to do so and that the only party with such standing was the debtor-in-possession itself. [9] In In re Fox , an individual debtor transferred real estate to his wife and then filed a Chapter 11 petition. When the debtor refused to prosecute a fraudulent transfer action against his wife to recover property for the benefit of his estate, one of Fox’s creditors tried to sue to recover the property on behalf of the estate. The bankruptcy court held that the creditor could not commence such an action, and the 10th Circuit BAP affirmed that decision.

The Fox court held that it was constrained by the language of Section 548 of the Bankruptcy Code, which states that “the trustee” may avoid fraudulent transfers. The court recognized that the 3d Circuit en banc decision in Cybergenics , among other courts, had stretched the statute to confer standing on creditors’ committees, especially when the debtor-in-possession had refused to prosecute legitimate fraudulent transfer claims.

However, noting a lack of authority in the 10th Circuit, the BAP held that the Supreme Court’s decision in Hartford Underwriters was controlling. Accordingly, the BAP turned once again to a literal construction of the Bankruptcy Code’s use of the term “the trustee.” The Fox court recognized that the plain language of the statute arguably conflicted with public policy. The court determined, however, that public policy concerns alone were not sufficient reasons to ignore the statutory language:

Cybergenics discusses many reasons why it would be good policy for parties other than the trustee to bring derivative complaints, and it is hard to disagree with the reasons set forth by the majority [in that case]. We, however, believe this reasoning is best considered by Congress, and it is not up to us to create a remedy for creditors it has not granted to them, especially when that right is given exclusively to the trustee. Here the statute is absolute and allows us no discretion to vary from what it says. [10]

At Odds

The Fox decision, like the vacated Cybergenics decision before it, is clearly at odds with the majority’s thinking on this issue. It remains to be seen if other courts will follow the Fox court’s lead, forming a split between the circuits that could result in the Supreme Court taking on the issue. Until such time, creditors and creditors’ committees must once again be on guard for the possibility that a request to commence a derivative avoidance action will be denied.

______________________________________________________

[1] See, e.g., Unsecured Creditors Committee v. Noyes (In re STN Enterprises), 779 F.2d 901, 904 (2d Cir. 1985); In re Toledo Equipment Co., Inc., 35 B.R. 315, 317 (Bankr. N.D.Ohio 1983); In re Monsour Medical Center, 5 Bankr. 715, 718 (Bankr. W.D.Pa. 1980).

[2] 530 U.S. 1 (2000).

[3] Hartford Underwriters , 530 U.S. at 13 n. 5.

[4] In re Cybergenics Corp ., No. 96-37203 (Bankr. D.N.J. August 19, 1996).

[5] Official Committee of Unsecured Creditors of Cybergenics Corp. v. Chinery, 304 F.3d 316 (3d Cir. 2002), vacated, reh’g en banc granted, 310 F.3d 785 (3d Cir. 2002).

[6] See, e.g., In re Commodore Intern. Ltd., 262 F.3d 96, 100 (2d Cir. 2001); In re Gibson Group, Inc., 66 F.3d 1436, 1440 (6th Cir. 1995); In re Sufolla, Inc., 2 F.3d 977, 979 n.1, (9th Cir. 1993); Matter of Vitreous Steel Products Co., 911 F.2d 1223, 1231 (7th Cir. 1990); Louisiana World Exposition v. Federal Ins. Co., 858 F.2d 233, 247 (5th Cir. 1988); In re STN Enterprises, 779 F.2d 901 (2d Cir. 1985). In fact, within two months of the Cybergenics decision, the 2d Circuit Court of Appeals reaffirmed the validity of the practice within the 2d Circuit of a creditors’ committee having standing to commence avoidance actions in its decision in In re Housecraft Industries USA, Inc., 310 F.3d 64 (2d Cir. 2002). It should be noted that Housecraft makes no reference at all to the Hartford Underwriters decision, thereby establishing a split between two of the most prominent bankruptcy circuits.

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

[8] Id. at 572.

[9] In re Fox , 305 B.R. 912 (B.A.P. 10th Cir. 2004).

[10] Id. at 916.



 

Wendell H. Adair Jr.
Partner
Stroock & Stroock & Lavan LLP
wadair@stroock.com

Adair can be reached at (212) 806-5870.

Sayan Bhattacharyya
Stroock & Stroock & Lavan LLP
sbhhattacharyya@stroock.com
Bhattacharyya can be reached at (212) 806-5723.
A. Victor Glaser
Associate
Stroock & Stroock & Lavan LLP
vglaser@stroock.com
Glaser can be reached at (212) 806-5547.

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