Ability of Creditors' Committees to Prosecute Estate Claims Given a Boost in Delaware Bankruptcy Courts
The practice of conferring "derivative standing" on official creditors' committees or individual creditors to assert claims on behalf of a bankruptcy estate in cases where the debtor or a bankruptcy trustee is unwilling or unable to do so is well-established. However, until recently, Delaware bankruptcy courts have uniformly limited the practice in cases where applicable non-bankruptcy law provides that creditors do not have standing to bring claims on behalf of certain entities.
U.S. Bankruptcy Judge Craig D. Goldblatt of the U.S. Bankruptcy Court for the District of Delaware recently broke ranks on this issue in In re Pack Liquidating, LLC, 2024 WL 409830 (Bankr. D. Del. Feb. 2, 2024). The court ruled that state law cannot prevent a creditors' committee from being conferred with standing to prosecute claims on behalf of a bankruptcy estate if otherwise appropriate under the Bankruptcy Code. It held that any state law purporting to abridge the power of a bankruptcy court to confer derivative standing upon a committee or creditor in an appropriate case is preempted. The court accordingly granted the motion of a creditor's committee to prosecute estate breach of fiduciary claims despite a provision in Delaware law limiting derivative standing to the members or assignees of a Delaware limited liability company ("LLC").
Derivative StandingStanding 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, the debtor-in-possession ("DIP"), a bankruptcy trustee, creditors, equity interest holders, official 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 Bankruptcy Code, such as lien and transfer avoidance. Many Bankruptcy Code provisions deal with claims or causes of action belonging to the debtor prior to filing for bankruptcy, which become part of the debtor's bankruptcy estate on the petition date. Standing to prosecute estate claims is expressly given by the Bankruptcy Code to a bankruptcy trustee (or DIP, by operation of section 1107(a) of the Bankruptcy Code).
Most courts, however, will allow official creditors' committees to commence litigation on behalf of the estate under narrowly defined circumstances. These courts reason that: (i) certain provisions of the Bankruptcy Code imply a qualified right to derivative standing for official creditors' committee, including: (a) section 1109(b) (discussed above); (b) section 1103(c)(5), which provides that a creditors' committee may "perform such … services as are in the interest of those represented"; (c) section 503(b)(3)(B), which provides that the court may grant priority in payment for the expenses of a "creditor that recovers, after the court's approval, for the benefit of the estate any property transferred or concealed by the debtor"; and/or (ii) derivative standing is an appropriate exercise of the court's broad equitable powers under section 105(a) of the Bankruptcy Code to "issue any order, process, or judgment that is necessary or appropriate to carry of the provisions" of the Bankruptcy Code. See generally Collier on Bankruptcy ¶ 1103.05[6][a] (16th ed. 2024).
In one of the seminal cases addressing this issue, the U.S. Court of Appeals for the Second Circuit Court held in Unsecured Creditors Committee of Debtor STN Enterprises, Inc. v. Noyes (In re STN Enterprises), 779 F.2d 901 (2d Cir. 1985), that, in considering an official creditors' 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 (i.e., the time and expense for such litigation is justified given the likelihood of success in such litigation). The Second Circuit later refined the doctrine of "derivative standing" in Commodore Int'l Ltd. v. Gould (In re Commodore Int'l Ltd.), 262 F.3d 96 (2d Cir. 2001). In Commodore, the court ruled that a committee may bring suit even if the trustee or DIP does not unjustifiably refuse to do so as long as: (i) the trustee or DIP 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.
The Third Circuit articulated a slightly different standard for derivative standing in another seminal decision—Official Committee of Unsecured Creditors of Cybergenics Corp. v. Chinery, 330 F.3d 548 (3d Cir. 2003). In Cybergenics, the court held that, to be granted derivative standing, a movant must demonstrate that: (i) the DIP or trustee has unjustifiably refused either to pursue the claim or to consent to the movant's prosecution of the claim on behalf of the estate; (ii) the movant has alleged colorable claims; and (iii) the movant has received leave to sue from the bankruptcy court.
Significantly, after examining the relevant provisions and structure of the Bankruptcy Code as well as practice in cases filed under the former Bankruptcy Act, the Third Circuit reasoned that a bankruptcy court's power to confer derivative standing on a creditors' committee in bankruptcy:
(1) may be implied from the tools that the Bankruptcy Code gives to a bankruptcy court, such as the appointment of a trustee or examiner, or dismissal or conversion of the case, to ensure that a DIP fulfills its fiduciary responsibilities;
(2) may be implied from various provisions of the Bankruptcy Code, including sections 503(b)(3)(B), 1103(c)(5), and 1109(b) (discussed previously); and
(3) is a traditional equitable power commonly deployed in cases under the former Bankruptcy Act and implicitly preserved in cases under the Bankruptcy Code as a retained equitable power.
Id. at 560–72, 576–79.
Different rules regarding "derivative standing" exist under many state corporation laws. For example, under Delaware law, although the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for fiduciary infractions, some courts have concluded that the creditors of an insolvent Delaware LLC do not because Delaware's LLC Act (6 Del. C. § 18–1001) (the "Del. LLC Act") expressly limits such standing to "[a] member or an assignee of a limited liability company." See CML V, LLC v. Bax, 6 A.3d 238, 241 (Del. Ch. 2010), aff'd, 28 A.3d 1037 (Del. 2011), as corrected (Sept. 6, 2011).
On the basis of this statutory limitation, Delaware bankruptcy courts have denied standing to various entities seeking to prosecute causes of action on behalf LLC debtors or their creditors, including official creditors' committees, creditors, or bankruptcy trustees. See, e.g., In re HH Liquidation, LLC, 590 B.R. 211, 284 (Bankr. D. Del. 2018) (committee denied derivative standing to prosecute breach of fiduciary duties claims); In re PennySaver USA Publ'g, LLC, 587 B.R. 445, 467 (Bankr. D. Del. 2018) (chapter 7 trustee denied derivative standing to prosecute claims for alleged breach of fiduciary duties to an LLC's creditors).
However, other Delaware bankruptcy courts have rejected this approach, whether expressly or without discussing the issue. See, e.g., In re Pursuit Capital Mgmt., LLC, 595 B.R. 631, 658 (Bankr. D. Del. 2018) (conferring derivative standing upon a creditor in a chapter 7 case filed by a Delaware LLC); In re Golden Guernsey Dairy, LLC, 548 B.R. 410, 413 (Bankr. D. Del. 2015) (ruling that a chapter 7 trustee, which under the Bankruptcy Code is the sole representative of the estate with the ability to sue and be sued, had standing to bring breach of fiduciary duty claims against the president and a managing member of a Delaware LLC, whether such claims are direct or derivative in nature).
Pack Liquidating
Pack Liquidating, LLC and certain affiliates (the "debtors") are Delaware LLCs that operated an e-commerce business as third-party sellers of health, beauty, and other consumer products on online marketplaces. In August 2022, the debtors filed for chapter 11 protection in the District of Delaware with the intention of winding down their affairs through an orderly liquidation. The filings came after several rounds of debt and equity financing, a collapsed merger with a special purpose acquisition company (a "SPAC") under which the debtors would have become a public company valued at $1.5 billion, and failed efforts to sell the debtors as a going concern.
The debtors' official committee of unsecured creditors alleged that the debtors' collapse was not caused by a challenged SPAC market or generally unfavorable business conditions, but by mismanagement and self-dealing by company insiders. The committee accordingly filed an adversary proceeding in September 2023 against various of the debtors' insiders and affiliates (collectively, the "Defendants") seeking, among other things, avoidance of certain allegedly fraudulent and preferential transfers made to the defendants, recharacterization of certain term loans as equity, equitable subordination or disallowance of the term loan lenders' claims, and damages for breach of fiduciary duty.
Having previously agreed in court-approved stipulations that the committee could derivatively assert the avoidance, recharacterization, equitable subordination, and disallowance causes of action, the Defendants did not challenge the committee's authority to pursue those claims. However, 10 of the 34 defendants (the "Objecting Defendants") maintained that the committee lacked standing to assert the breach of fiduciary duty claims. The committee therefore filed a motion seeking derivative standing to prosecute those claims on the debtors' behalf.
Relying principally on HH Liquidation and PennySaver—in which the courts relied on Bax—the Objecting Defendants argued that the bankruptcy court could not grant derivative standing to the committee to assert the breach of fiduciary duty claim because the Del. LLC Act limits such standing to LLC members or their assigns.
The Bankruptcy Court's Ruling
The bankruptcy court granted the committee's motion for derivative standing to pursue the breach of fiduciary duty claims.
Judge Goldblatt acknowledged that, in accordance with rule-of-law principles and ordinary commercial sense for courts with business dockets, he was "loathe to break with the only [] written opinions by judges of this Court to have addressed the topic [i.e., HH Liquidation and PennySaver ]." Pack Liquidating, 2024 WL 409830, at *2. However, Judge Goldblatt explained, he was not bound to follow those rulings, which, moreover, "can[not] be squared with the Third Circuit's en banc opinion in In re Cybergenics, which treats the authority to grant a committee derivative standing to pursue an estate claim as one that stems from the Bankruptcy Code rather than state law." Id.
The bankruptcy court emphasized that any standing conferred upon a creditors' committee to assert claims on behalf of the estate is distinct from standing to prosecute derivative claims under state law. According to Judge Goldblatt, the bankruptcy derivative standing contemplated by Cybergenics derives from the Bankruptcy Code rather than state law and is therefore unaffected by state laws like the Del. LLC Act:
The unmistakable implication of Cybergenics is that the action it contemplated is one whose fundamental authority is the Bankruptcy Code. The painstaking Cybergenics opinion, written by then-Chief Judge Becker, did not rely in any way on the existence of a state-law authority for a shareholder or creditor to assert a derivative action. A federal bankruptcy court's ability to authorize a Cybergenics action therefore is not affected by the [Del. LLC Act]. That statute limits who can be a plaintiff in a state-law derivative action. By its terms, it is directed to suits filed in the Court of Chancery. It does not purport to address who may be a plaintiff in a proceeding authorized by the federal Bankruptcy Code.
Id. at *7.
The bankruptcy court in Pack Liquidating agreed with the analysis in Cybergenics regarding the sources of a bankruptcy court's authority (described above) to confer derivative standing upon a creditors' committee to prosecute claims on behalf of the bankruptcy estate. Id. at **7–10.
According to Judge Goldblatt, "the central point is that each of these reasons points unmistakably to the Bankruptcy Code rather than state law as the source of authority for granting committee standing." Id. at *7. For this reason, he noted, authorizing a creditors' committee to prosecute an estate cause of action does not conflict with Bax, and even if it did, state law would be preempted under principles of federal supremacy. Id. at **2, 11–13.
Having determined that the power to grant derivative standing in bankruptcy derives from the Bankruptcy Code, rather than state law, the bankruptcy court considered whether the committee had satisfied the prerequisites for such standing under Cybergenics. The court ruled that the committee had met its burden. Among other things, Judge Goldblatt explained: (i) the committee's claims were colorable; (ii) the debtors unjustifiably refused to prosecute the claims; and (iii) prosecuting the claims would likely benefit the bankruptcy estate. Id. at **19–22.
The bankruptcy court accordingly ruled that the committee had standing to assert the breach of fiduciary duty claims against the objecting defendants as well as those defendants that had not opposed the committee's motion for derivative standing.
Outlook
The decision whether or not to grant derivative standing to creditors is a landmark moment in contested restructurings that significantly alters the negotiating leverage of debtors and creditors. In rejecting the approach adopted by other Delaware bankruptcy judges in cases involving LLC debtors, the court focused on the distinctions between derivative standing in bankruptcy and non-bankruptcy cases.
The resulting uncertainty is a cautionary tale for LLC debtors and creditors/investors that may have the expectation based on previous rulings that certain kinds of derivative claims cannot be prosecuted if an LLC files for bankruptcy.
