Sigh of Relief: Derivative Actions Safe for Now

The facts confronting the circuit in the Cybergenics appeal are really quite common within the bankruptcy practice. In that Chapter 11 case, the Official Committee of Unsecured Creditors sued to reverse certain transactions as fraudulent transfers under Section 544(b). Initially, the Committee asked Cybergenics, the debtor-in-possession, to prosecute the fraudulent transfer claims, but Cybergenics refused. The Committee then obtained court authorization to bring the claims derivatively for the benefit of the estate. In due course, the Committee sued the debtor's principal and several entities, seeking to recover millions of dollars that the Committee alleged were fraudulently transferred. Eventually, these defendants moved to dismiss on various grounds, including the Committee's lack of capacity to assert a Section 544(b) claim.

On appeal, a Third Circuit panel, relying on a strict reading of the phrase 'trustee may' in Section 544, held that the plain language of the statute precluded the Committee from asserting the claim. To support its conclusion, the Panel relied on Hartford, where the Supreme Court strictly interpreted the very same phrase as used in Section 506(c). There, the Supreme Court held that only the trustee or debtor-in-possession could use the recovery power granted by Section 506(c) to surcharge a secured creditor. Therefore, the Third Circuit panel reasoned that the lower court could similarly not authorize a creditors' committee to bring suit under Section 544 derivatively. The Committee then moved for rehearing en banc, which the Third Circuit granted.

The Circuit's Decision

The Circuit's en banc opinion begins with an effort to put the Hartford decision in its proper context. First, the court noted that, while Hartford interpreted the provision 'the trustee may' conclusively, the Supreme Court specifically declined to address the ability of interested parties to act derivatively on behalf of a trustee or debtor-in-possession, as evidenced by a footnote explicitly to that effect.

Second, the circuit court distinguished the situation in Hartford from that of the Cybergenics case. While the creditor in the Hartford case acted unilaterally to recover against a secured creditor pursuant to Section 506(c), the Committee in the Cybergenics case was proceeding with the court's permission, after debtor's refusal to pursue a fraudulent transfer action under Section 544(b). That distinction, the Circuit contended, made all the difference. The issue was not whether a non-trustee has the right to unilaterally circumvent the Code's remedial scheme, but whether a bankruptcy court has the equitable power to craft a remedy when the Code's envisioned scheme breaks down.

Moving quickly past the plain-language restrictions of Hartford, the court embraced earlier Supreme Court decisions that espoused a 'holistic' approach to Bankruptcy Code interpretation. The Circuit urged that just such an approach had to be employed in Cybergenics because reading Section 544(b) in isolation created 'incoherence.' Section 544(b) had to be viewed as merely an important part of the entire Chapter 11 framework. In fact, it is only by considering other Code sections ' specifically, Sections 1107(a), 1109(b), 1103(c)(5), and 503(b)(3)(B) ' that Section 544(b) can be properly interpreted.

The court began tying these Sections to 544(b) one by one. First, because a trustee is the exception to the rule in the Chapter 11 context, any interpretation of Section 544(b) must refer to Section 1107(a), which establishes that the use of the word 'trustee' in Section 544 can also mean a debtor-in-possession. This would indicate that a multi-section reading of Section 544(b) is needed. Second, Section 1109(b) empowers a party-in-interest, including a creditors' committee, to raise, appear, and be heard on any issue in a case under Chapter 11. In the circuit court's view, Section 1109(b) supported the Committee's position because it showed Congress' intent for creditors' committees to play a vibrant and central role in Chapter 11 adversary proceedings. That Section thus offered support for the Committee's argument that it may pursue avoidance action derivatively.

Third, Section 1103(c)(5), which authorizes a committee to 'perform such other services as are in the interest of those represented,' also supported the Committee's pursuit of this derivative action. While the court did agree with appellees that this Section alone could not support the derivative pursuit of avoidance claims, it was sufficient when combined with the other analyzed provisions.

Finally, the last piece of the puzzle is Section 503(b)(3)(B). That Section allows for the priority payment of 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.' The circuit court rejected appellee's arguments that this Section should be narrowly interpreted, favoring instead what it called the Section's 'natural meaning.' That is, Section 503(b)(3)(B) allows a court to compensate a creditors' committee pursuing derivative actions on behalf of a debtor's estate. By implication, therefore, the pursuit of those types of actions is authorized by Congress and the Bankruptcy Code.

Pulling all these Sections together, then, the circuit court ruled that the 'most natural reading' of the Code is that Congress recognized and approved a derivative standing for creditors' committees, as part of their 'robust and flexible role' in representing the bankruptcy estate, even in adversarial proceedings. As further support for its holding, the court cited both Second and Seventh Circuit cases that reached this very same conclusion.

But this textual conclusion alone was not enough. In the Circuit's view, the missing component was the court's inherent equitable power to craft flexible remedies in situations where the Code's causes of action failed to achieve their intended purpose. The court reviewed approvingly the long-held notion that bankruptcy courts were courts of equity, and thus empowered to craft remedies to promote the Bankruptcy Code's goals. And the Circuit's analysis of all the relevant non-textual factors supported an 'equitable solution' empowering creditor committees to pursue derivative actions where a debtor unjustifiably refuses. For one thing, the practice itself traced its roots back into the pre-Code period. For another, other available options asserted by appellees ' such as the appointment of a trustee or an examiner with additional powers, or the conversion of the case ' were simply not as attractive, nor did they support Congress' intention to make the committee's role in Chapter 11 cases meaningful.

Therefore, the circuit court ruled in favor of the Committee, and reversed the district court's dismissal for lack of standing under Section 544(b). But the case will not return immediately to the district court, as the circuit court directed the original appellate panel to consider the Committee's appeal of the five other grounds for the complaint's dismissal.

Conclusion

The circuit court's decision certainly generated an audible sigh of relief from many practitioners, but it should also generate some questions about the future of Bankruptcy Code interpretation. Just as Cybergenics supports the creditors' committee's 'robust and flexible' role in the Chapter 11 process, so has it reopened the door to the courts' robust and flexible analysis of the Bankruptcy Code. Looming on the horizon is a potential appeal to the Supreme Court that will leave that door ajar or shut it firmly.

Scott D. Cousins and Luis Salazar are both members of Greenberg Traurig's National Corporate Reorganization, Bankruptcy, and Restructuring Department. Cousins heads the firm's Wilmington, DE, office. Salazar practices in the firm's Miami office.

Much to the relief of many in the Third Circuit, its long-awaited en banc ruling in the Official Committee of Unsecured Creditors of Cybergenics Corp. v. Chinery, (en banc) No. 01-3805 (May 29, 2003) disagreed with the decision of one of its panels and upheld the right of parties other than a debtor or trustee to pursue avoidance actions under the Bankruptcy Code on a derivative basis. In doing so, the court supported the well-established practice allowing these derivative actions, and eschewed a slavish plain-language interpretation of Section 544(b) in favor of a broader, multi-section reading.

The Circuit's analysis of that Section employs a 'holistic' approach that is arguably quite at odds with the now decade-old Supreme Court trend of plain-language interpretation. In fact, the circuit court took great pains to demonstrate why the plain-language holding of Hartford Underwriter Ins. Co. v. Union Planters Bank ' a case appellees and the dissent argued was controlling ' was inapplicable. With the rumored retirement of Chief Justice Rehnquist, plain-language's champion, will Cybergenics signal the end of an era, or merely a narrow exception created by necessity? Or, if appealed to the Supreme Court, will it offer a final, conclusive opportunity to establish plain language as the sole interpretive mechanism for the Code?

Summary of the Case

The facts confronting the circuit in the Cybergenics appeal are really quite common within the bankruptcy practice. In that Chapter 11 case, the Official Committee of Unsecured Creditors sued to reverse certain transactions as fraudulent transfers under Section 544(b). Initially, the Committee asked Cybergenics, the debtor-in-possession, to prosecute the fraudulent transfer claims, but Cybergenics refused. The Committee then obtained court authorization to bring the claims derivatively for the benefit of the estate. In due course, the Committee sued the debtor's principal and several entities, seeking to recover millions of dollars that the Committee alleged were fraudulently transferred. Eventually, these defendants moved to dismiss on various grounds, including the Committee's lack of capacity to assert a Section 544(b) claim.

On appeal, a Third Circuit panel, relying on a strict reading of the phrase 'trustee may' in Section 544, held that the plain language of the statute precluded the Committee from asserting the claim. To support its conclusion, the Panel relied on Hartford, where the Supreme Court strictly interpreted the very same phrase as used in Section 506(c). There, the Supreme Court held that only the trustee or debtor-in-possession could use the recovery power granted by Section 506(c) to surcharge a secured creditor. Therefore, the Third Circuit panel reasoned that the lower court could similarly not authorize a creditors' committee to bring suit under Section 544 derivatively. The Committee then moved for rehearing en banc, which the Third Circuit granted.

The Circuit's Decision

The Circuit's en banc opinion begins with an effort to put the Hartford decision in its proper context. First, the court noted that, while Hartford interpreted the provision 'the trustee may' conclusively, the Supreme Court specifically declined to address the ability of interested parties to act derivatively on behalf of a trustee or debtor-in-possession, as evidenced by a footnote explicitly to that effect.

Second, the circuit court distinguished the situation in Hartford from that of the Cybergenics case. While the creditor in the Hartford case acted unilaterally to recover against a secured creditor pursuant to Section 506(c), the Committee in the Cybergenics case was proceeding with the court's permission, after debtor's refusal to pursue a fraudulent transfer action under Section 544(b). That distinction, the Circuit contended, made all the difference. The issue was not whether a non-trustee has the right to unilaterally circumvent the Code's remedial scheme, but whether a bankruptcy court has the equitable power to craft a remedy when the Code's envisioned scheme breaks down.

Moving quickly past the plain-language restrictions of Hartford, the court embraced earlier Supreme Court decisions that espoused a 'holistic' approach to Bankruptcy Code interpretation. The Circuit urged that just such an approach had to be employed in Cybergenics because reading Section 544(b) in isolation created 'incoherence.' Section 544(b) had to be viewed as merely an important part of the entire Chapter 11 framework. In fact, it is only by considering other Code sections ' specifically, Sections 1107(a), 1109(b), 1103(c)(5), and 503(b)(3)(B) ' that Section 544(b) can be properly interpreted.

The court began tying these Sections to 544(b) one by one. First, because a trustee is the exception to the rule in the Chapter 11 context, any interpretation of Section 544(b) must refer to Section 1107(a), which establishes that the use of the word 'trustee' in Section 544 can also mean a debtor-in-possession. This would indicate that a multi-section reading of Section 544(b) is needed. Second, Section 1109(b) empowers a party-in-interest, including a creditors' committee, to raise, appear, and be heard on any issue in a case under Chapter 11. In the circuit court's view, Section 1109(b) supported the Committee's position because it showed Congress' intent for creditors' committees to play a vibrant and central role in Chapter 11 adversary proceedings. That Section thus offered support for the Committee's argument that it may pursue avoidance action derivatively.

Third, Section 1103(c)(5), which authorizes a committee to 'perform such other services as are in the interest of those represented,' also supported the Committee's pursuit of this derivative action. While the court did agree with appellees that this Section alone could not support the derivative pursuit of avoidance claims, it was sufficient when combined with the other analyzed provisions.

Finally, the last piece of the puzzle is Section 503(b)(3)(B). That Section allows for the priority payment of 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.' The circuit court rejected appellee's arguments that this Section should be narrowly interpreted, favoring instead what it called the Section's 'natural meaning.' That is, Section 503(b)(3)(B) allows a court to compensate a creditors' committee pursuing derivative actions on behalf of a debtor's estate. By implication, therefore, the pursuit of those types of actions is authorized by Congress and the Bankruptcy Code.

Pulling all these Sections together, then, the circuit court ruled that the 'most natural reading' of the Code is that Congress recognized and approved a derivative standing for creditors' committees, as part of their 'robust and flexible role' in representing the bankruptcy estate, even in adversarial proceedings. As further support for its holding, the court cited both Second and Seventh Circuit cases that reached this very same conclusion.

But this textual conclusion alone was not enough. In the Circuit's view, the missing component was the court's inherent equitable power to craft flexible remedies in situations where the Code's causes of action failed to achieve their intended purpose. The court reviewed approvingly the long-held notion that bankruptcy courts were courts of equity, and thus empowered to craft remedies to promote the Bankruptcy Code's goals. And the Circuit's analysis of all the relevant non-textual factors supported an 'equitable solution' empowering creditor committees to pursue derivative actions where a debtor unjustifiably refuses. For one thing, the practice itself traced its roots back into the pre-Code period. For another, other available options asserted by appellees ' such as the appointment of a trustee or an examiner with additional powers, or the conversion of the case ' were simply not as attractive, nor did they support Congress' intention to make the committee's role in Chapter 11 cases meaningful.

Therefore, the circuit court ruled in favor of the Committee, and reversed the district court's dismissal for lack of standing under Section 544(b). But the case will not return immediately to the district court, as the circuit court directed the original appellate panel to consider the Committee's appeal of the five other grounds for the complaint's dismissal.

Conclusion

The circuit court's decision certainly generated an audible sigh of relief from many practitioners, but it should also generate some questions about the future of Bankruptcy Code interpretation. Just as Cybergenics supports the creditors' committee's 'robust and flexible' role in the Chapter 11 process, so has it reopened the door to the courts' robust and flexible analysis of the Bankruptcy Code. Looming on the horizon is a potential appeal to the Supreme Court that will leave that door ajar or shut it firmly.

Scott D. Cousins and Luis Salazar are both members of Greenberg Traurig's National Corporate Reorganization, Bankruptcy, and Restructuring Department. Cousins heads the firm's Wilmington, DE, office. Salazar practices in the firm's Miami office.