Crystal Ball Required?

Part One of this article, which appeared in last month's issue of The Bankruptcy Strategist, discussed the facts of the Nortel case in detail and analyzed some of the many novel substantive legal issues relating to the prepetition equipment returns that constituted a large portion of the transfers at issue. Part Two herein discusses some of the complex issues that arose in connection with discovery of electronic documents in the Nortel case.

The Dispute over Insolvency-Related Electronic Documents

360 filed its bankruptcy petition in June 2001. The Committee filed the avoidance action against Nortel in January 2003. In an effort to rebut the statutory presumption that 360 was insolvent during the applicable time period, Nortel served numerous, wide-ranging discovery demands seeking, among other things, documents relating to 360's financial condition during the months preceding its bankruptcy filing. The parties proceeded to engage in discovery for over three years, during which time the Committee produced hundreds of thousands of pages of documents in hard copy format, as well as over 500,000 additional pages of electronic documents, including all known, non-privileged e-mails containing any reference to Nortel.

Notwithstanding that 360 had significantly downsized around the time of its bankruptcy filing, it took considerable steps to preserve important documents, including information stored electronically. Despite these efforts, and 360's subsequent production of all known responsive documents in its possession (including all known e-mail communications and other documents relating to the business relationship between 360 and Nortel), Nortel filed a motion in August 2006 seeking an adverse inference on the issue of solvency, arguing that 360 had not completely fulfilled its obligation to preserve electronic information relevant to that issue. Nortel's position was that 360 had a duty to preserve all documents potentially relating to solvency, including any potentially responsive electronic information, and that such duty was triggered immediately upon the event of bankruptcy filing because 360 was on notice as of that time that avoidance actions might be brought against some creditors, which in turn might require litigation in connection with the issue of solvency. Nortel then focused principally on an alleged failure by 360 to properly preserve all prepetition e-mail communications, contending that there might be information relevant to 360's general financial condition buried within such communications.

As an initial matter, the very idea that the Committee ' which was granted the sole right to prosecute avoidance actions pursuant to 360's plan of reorganization and prosecuted the case against Nortel ' could have had 'knowledge' that certain electronic information might be relevant to future litigation as of the petition date defies logic, as the Committee did not even exist at that time. Nevertheless, it might be argued that, because a trustee or a committee stands in the shoes of a debtor when prosecuting a cause of action derived from the debtor, and is therefore subject to the same defenses as could have been asserted by the defendant had the action been instituted by the debtor, the knowledge of the debtor may be imputed to such entities in this context. See Collier on Bankruptcy ' 323.03[2].

In any event, the Committee's position was that 360 had taken all reasonable and appropriate steps to preserve such electronic information, albeit that notwithstanding these efforts, some electronic data allegedly relating to 360's financial condition that existed on the petition date may not have been preserved. In this regard, the Committee argued that a preference plaintiff cannot reasonably be expected to know, at the time of filing a bankruptcy petition, precisely what evidence might be relevant to future avoidance actions, and simply preserving every shred of electronic information is often not a realistic course of action. Indeed, a company newly in bankruptcy usually can ill afford the enormous costs, in terms of scarce dollars and manpower, of preserving a complete and accessible record of the entirety of its electronic data.

In support of its position, Nortel cited Kronisch v. U.S., 150 F.3d 112 (2d Cir. 1998), and Zubulake v. UBS Warburg, LLC, 220 F.R.D. 212 (S.D.N.Y. 2003). Kronisch held that a plaintiff's duty to preserve documents and evidence generally arises at the time a party 'should have known that the evidence may be relevant to future litigation' ' even if litigation has not yet been commenced. In Zubulake, the court, applying Kronisch to electronic documents, held that a litigant's duty to preserve certain electronic backup tapes arose several months before the litigation had commenced.

Zubulake, however, recognized that, at least to the extent the electronic data are not easily accessible, a blanket rule requiring preservation of all electronic data would 'cripple' large corporations, and that a litigation hold 'does not apply to inaccessible backup tapes ' which may continue to be recycled on the schedule set forth in the company's policy.' Instead, Zubulake determined that, as a general rule, a party 'need not preserve all backup tapes even when it reasonably anticipates litigation.' Moreover, because a debtor's statutorily presumed insolvency is rarely litigated and virtually any financial information in the company's possession might arguably be relevant to such an analysis, it would be inherently unreasonable to expect a debtor in possession to preserve every shred of electronic data as of the petition date. [Note, in the Nortel case, the Committee maintained that 360 properly preserved everything that it was required to as of a sufficiently early date under Zubulake and all applicable authority. The facts concerning exactly what was preserved by 360 and the manner in which it was preserved were extremely complex and specific to 360, however, and accordingly are not discussed at length herein.]

Because the Nortel case was settled by Nortel's payment of $45.5 million to the Committee before Nortel's motion was adjudicated, the court did not render a decision on Nortel's request for an adverse inference. Nevertheless, because, as discussed below, the applicable case law does not contain a clear, bright-line delineation of the timing and scope of a plaintiff's obligation to preserve electronic information in anticipation of potential future avoidance actions, the parties' arguments provide context for the discussion that follows.

Analysis of Applicable Law

Zubulake was one of the first published opinions to analyze in detail a party's obligation to preserve large quantities of information stored solely in electronic format, and, together with four other opinions in the same case, all of which discuss related electronic discovery issues, remains highly influential. Yet properly applying its holding to avoidance actions is challenging. Zubulake was an employment discrimination case, and the evidence at issue consisted of internal communications of the employer specifically contemplating that an employment discrimination lawsuit might be imminent. In other words, in Zubulake, as in many cases, the identity of the plaintiff and defendant and the factual basis of the cause of action were all readily apparent before the case was commenced.

Bankruptcy avoidance actions differ significantly from this typical model, however. They involve causes of action that arise only by subsequent operation of law (and therefore are often unforeseeable by the parties at the time of the transfers at issue or on the petition date) and may not be filed until years after the commencement of a debtor's main case and, in many instances, long after the debtor has either emerged from reorganization or been liquidated. Any efforts to identify huge quantities of raw electronic data and prepare it for production to unknown future defendants could be prohibitively costly, not to mention speculative. Perhaps for this reason, among the extensive case law and materials discussing the Zubulake opinion during the more than four years since its issuance, there is extremely little analysis of the case's application in the context of bankruptcy avoidance actions.

Nevertheless, it is entirely possible that a bankruptcy court interpreting Zubulake could find that a plaintiff's duty to preserve evidence arises either at the time the petition was filed or, at the latest, once an avoidance action is contemplated. Because avoidance actions are very common, they are at least generally foreseeable as of the petition date in many cases. Accordingly, the safest course of action for a practitioner, notwithstanding Zubulake's finding that a party generally 'need not preserve all backup tapes even when it reasonably anticipates litigation,' is to advise a client to begin preserving any potentially responsive electronic data, at least in its existing format on a network and/or on a backup tape, as early in a bankruptcy case as possible in the event it cannot be done prior to the filing. See Zubulake v. UBS Warburg, LLC, 229 F.R.D. 422 (S.D.N.Y. 2004) (recommending among other things that counsel identify and safely store all backup media to prevent its inadvertent destruction).

Although adequately preserving electronic data on a server or a backup device can be difficult in itself, actually producing the information may be far more costly and arduous, particularly if the data are originally stored in a format that is not readily accessible. Some relief may be available, however. courts have observed that as the universe of discoverable material 'has expanded exponentially,' discovery has become 'not just about uncovering the truth, but also about how much of the truth the parties can afford to disinter.' See Zubulake v. UBS Warburg, LLC, 217 F.R.D. 309 (S.D.N.Y. 2003). For this reason, although litigants continue to be burdened with considerable electronic production obligations, courts have ordered that the costs of doing so be shared under certain circumstances. See Id., Zubulake v. UBS Warburg, LLC, 216 F.R.D. 280 (S.D.N.Y. 2003). Rule 26(f)(3) of the Federal Rules of Civil Procedure, as revised in 2006, also reflects a similar concern about the costs and burden involved with production of electronic documents, expressly requiring parties to confer regarding a proposed discovery plan regarding 'any issues relating to disclosure or discovery of electronically stored information, including the form or forms in which it should be produced.'

Conclusion

As noted in Zubulake, the increasing maintenance of documents in electronic formats has given rise to unique questions as to the timing and scope of a party's duty to preserve such evidence, making it more difficult than ever for litigants to craft policies and procedures that ensure all relevant documents are preserved. The singular issues arising in the context of bankruptcy avoidance actions make this task even more complex, and significant uncertainty remains. Unless and until a court holds that a less stringent rule than the Zubulake standard should apply in the avoidance action context, however, the safest course is to advise a debtor in possession to preserve any electronic data potentially relevant to such an action as early as possible, whether that be prior to or just after commencement of a bankruptcy case, but in no event later than the time at it can be demonstrated that the commencement of avoidance actions was first contemplated.

Norman N. Kinel is the founder and co-chair of the Bankruptcy and Corporate Reorganization Department and Timothy A. Solomon is a bankruptcy associate at Dreier LLP, which represented the Committee of Unsecured Creditors in the litigation discussed in this article.

As experienced Chapter 11 bankruptcy practitioners know, when a company suffers severe financial distress and faces the prospect of imminent bankruptcy, its record-keeping procedures can break down, even if they were previously adequate. Indeed, a company faced with abrupt layoffs or departures may find that employees have misplaced, removed, or even intentionally destroyed important documents. This problem can be particularly acute with respect to corporate information maintained exclusively in an electronic format, such as e-mail communications. Notwithstanding the efforts and directives of a company's executives and counsel, such data may be lost as e-mail folders are purged, master tapes are over-written, computers are sold or discarded, network servers are shut down, information technology personnel are given their walking papers and offices are shuttered. Any destruction or loss of important documents not only complicates the general administration of a bankruptcy estate, but also can potentially lead to significant adverse consequences in future litigation, including actions to recover avoidable transfers.

Despite these risks, collection and preservation of large amounts of electronic data in anticipation of hypothetical avoidance litigation that will most likely take place years in the future ' if ever ' is hardly a company's, or counsel's, top priority at the time of a bankruptcy filing, particularly because such activities can require the expenditure of significant resources. Nevertheless, to prevent future litigation difficulties from arising in connection with the prosecution of avoidance actions,
it is important for a practitioner advising a company heading into or newly in bankruptcy to begin to preserve all electronic data immediately.

The question of the timing and scope of a debtor's obligation to preserve and produce documents maintained in an electronic format recently arose in an avoidance action commenced by the Official Committee of Unsecured Creditors (the 'Committee') against Nortel Networks Inc. ('Nortel') in connection with the Chapter 11 cases of 360networks (USA) inc. and related entities ('360'). Nortel challenged 360's insolvency at the time of the relevant transfers and then sought an adverse inference on that issue, arguing that 360 had failed to take timely and adequate steps to preserve all electronic information responsive to Nortel's discovery demands related to solvency. Given the size of the case ' the Committee sought to avoid and recover transfers in the aggregate amount of over $101 million, making the preference action one of the largest ever commenced against a single defendant ' and the potentially all-or-nothing nature of a solvency defense, the timing and scope of 360's duty to preserve the electronic data became an issue of critical importance.

Part One of this article, which appeared in last month's issue of The Bankruptcy Strategist, discussed the facts of the Nortel case in detail and analyzed some of the many novel substantive legal issues relating to the prepetition equipment returns that constituted a large portion of the transfers at issue. Part Two herein discusses some of the complex issues that arose in connection with discovery of electronic documents in the Nortel case.

The Dispute over Insolvency-Related Electronic Documents

360 filed its bankruptcy petition in June 2001. The Committee filed the avoidance action against Nortel in January 2003. In an effort to rebut the statutory presumption that 360 was insolvent during the applicable time period, Nortel served numerous, wide-ranging discovery demands seeking, among other things, documents relating to 360's financial condition during the months preceding its bankruptcy filing. The parties proceeded to engage in discovery for over three years, during which time the Committee produced hundreds of thousands of pages of documents in hard copy format, as well as over 500,000 additional pages of electronic documents, including all known, non-privileged e-mails containing any reference to Nortel.

Notwithstanding that 360 had significantly downsized around the time of its bankruptcy filing, it took considerable steps to preserve important documents, including information stored electronically. Despite these efforts, and 360's subsequent production of all known responsive documents in its possession (including all known e-mail communications and other documents relating to the business relationship between 360 and Nortel), Nortel filed a motion in August 2006 seeking an adverse inference on the issue of solvency, arguing that 360 had not completely fulfilled its obligation to preserve electronic information relevant to that issue. Nortel's position was that 360 had a duty to preserve all documents potentially relating to solvency, including any potentially responsive electronic information, and that such duty was triggered immediately upon the event of bankruptcy filing because 360 was on notice as of that time that avoidance actions might be brought against some creditors, which in turn might require litigation in connection with the issue of solvency. Nortel then focused principally on an alleged failure by 360 to properly preserve all prepetition e-mail communications, contending that there might be information relevant to 360's general financial condition buried within such communications.

As an initial matter, the very idea that the Committee ' which was granted the sole right to prosecute avoidance actions pursuant to 360's plan of reorganization and prosecuted the case against Nortel ' could have had 'knowledge' that certain electronic information might be relevant to future litigation as of the petition date defies logic, as the Committee did not even exist at that time. Nevertheless, it might be argued that, because a trustee or a committee stands in the shoes of a debtor when prosecuting a cause of action derived from the debtor, and is therefore subject to the same defenses as could have been asserted by the defendant had the action been instituted by the debtor, the knowledge of the debtor may be imputed to such entities in this context. See Collier on Bankruptcy ' 323.03[2].

In any event, the Committee's position was that 360 had taken all reasonable and appropriate steps to preserve such electronic information, albeit that notwithstanding these efforts, some electronic data allegedly relating to 360's financial condition that existed on the petition date may not have been preserved. In this regard, the Committee argued that a preference plaintiff cannot reasonably be expected to know, at the time of filing a bankruptcy petition, precisely what evidence might be relevant to future avoidance actions, and simply preserving every shred of electronic information is often not a realistic course of action. Indeed, a company newly in bankruptcy usually can ill afford the enormous costs, in terms of scarce dollars and manpower, of preserving a complete and accessible record of the entirety of its electronic data.

In support of its position, Nortel cited Kronisch v. U.S. , 150 F.3d 112 (2d Cir. 1998), and Zubulake v. UBS Warburg, LLC , 220 F.R.D. 212 (S.D.N.Y. 2003). Kronisch held that a plaintiff's duty to preserve documents and evidence generally arises at the time a party 'should have known that the evidence may be relevant to future litigation' ' even if litigation has not yet been commenced. In Zubulake, the court, applying Kronisch to electronic documents, held that a litigant's duty to preserve certain electronic backup tapes arose several months before the litigation had commenced.

Zubulake, however, recognized that, at least to the extent the electronic data are not easily accessible, a blanket rule requiring preservation of all electronic data would 'cripple' large corporations, and that a litigation hold 'does not apply to inaccessible backup tapes ' which may continue to be recycled on the schedule set forth in the company's policy.' Instead, Zubulake determined that, as a general rule, a party 'need not preserve all backup tapes even when it reasonably anticipates litigation.' Moreover, because a debtor's statutorily presumed insolvency is rarely litigated and virtually any financial information in the company's possession might arguably be relevant to such an analysis, it would be inherently unreasonable to expect a debtor in possession to preserve every shred of electronic data as of the petition date. [Note, in the Nortel case, the Committee maintained that 360 properly preserved everything that it was required to as of a sufficiently early date under Zubulake and all applicable authority. The facts concerning exactly what was preserved by 360 and the manner in which it was preserved were extremely complex and specific to 360, however, and accordingly are not discussed at length herein.]

Because the Nortel case was settled by Nortel's payment of $45.5 million to the Committee before Nortel's motion was adjudicated, the court did not render a decision on Nortel's request for an adverse inference. Nevertheless, because, as discussed below, the applicable case law does not contain a clear, bright-line delineation of the timing and scope of a plaintiff's obligation to preserve electronic information in anticipation of potential future avoidance actions, the parties' arguments provide context for the discussion that follows.

Analysis of Applicable Law

Zubulake was one of the first published opinions to analyze in detail a party's obligation to preserve large quantities of information stored solely in electronic format, and, together with four other opinions in the same case, all of which discuss related electronic discovery issues, remains highly influential. Yet properly applying its holding to avoidance actions is challenging. Zubulake was an employment discrimination case, and the evidence at issue consisted of internal communications of the employer specifically contemplating that an employment discrimination lawsuit might be imminent. In other words, in Zubulake, as in many cases, the identity of the plaintiff and defendant and the factual basis of the cause of action were all readily apparent before the case was commenced.

Bankruptcy avoidance actions differ significantly from this typical model, however. They involve causes of action that arise only by subsequent operation of law (and therefore are often unforeseeable by the parties at the time of the transfers at issue or on the petition date) and may not be filed until years after the commencement of a debtor's main case and, in many instances, long after the debtor has either emerged from reorganization or been liquidated. Any efforts to identify huge quantities of raw electronic data and prepare it for production to unknown future defendants could be prohibitively costly, not to mention speculative. Perhaps for this reason, among the extensive case law and materials discussing the Zubulake opinion during the more than four years since its issuance, there is extremely little analysis of the case's application in the context of bankruptcy avoidance actions.

Nevertheless, it is entirely possible that a bankruptcy court interpreting Zubulake could find that a plaintiff's duty to preserve evidence arises either at the time the petition was filed or, at the latest, once an avoidance action is contemplated. Because avoidance actions are very common, they are at least generally foreseeable as of the petition date in many cases. Accordingly, the safest course of action for a practitioner, notwithstanding Zubulake's finding that a party generally 'need not preserve all backup tapes even when it reasonably anticipates litigation,' is to advise a client to begin preserving any potentially responsive electronic data, at least in its existing format on a network and/or on a backup tape, as early in a bankruptcy case as possible in the event it cannot be done prior to the filing. See Zubulake v. UBS Warburg, LLC , 229 F.R.D. 422 (S.D.N.Y. 2004) (recommending among other things that counsel identify and safely store all backup media to prevent its inadvertent destruction).

Although adequately preserving electronic data on a server or a backup device can be difficult in itself, actually producing the information may be far more costly and arduous, particularly if the data are originally stored in a format that is not readily accessible. Some relief may be available, however. courts have observed that as the universe of discoverable material 'has expanded exponentially,' discovery has become 'not just about uncovering the truth, but also about how much of the truth the parties can afford to disinter.' See Zubulake v. UBS Warburg, LLC , 217 F.R.D. 309 (S.D.N.Y. 2003). For this reason, although litigants continue to be burdened with considerable electronic production obligations, courts have ordered that the costs of doing so be shared under certain circumstances. See Id., Zubulake v. UBS Warburg, LLC , 216 F.R.D. 280 (S.D.N.Y. 2003). Rule 26(f)(3) of the Federal Rules of Civil Procedure, as revised in 2006, also reflects a similar concern about the costs and burden involved with production of electronic documents, expressly requiring parties to confer regarding a proposed discovery plan regarding 'any issues relating to disclosure or discovery of electronically stored information, including the form or forms in which it should be produced.'

Conclusion

As noted in Zubulake, the increasing maintenance of documents in electronic formats has given rise to unique questions as to the timing and scope of a party's duty to preserve such evidence, making it more difficult than ever for litigants to craft policies and procedures that ensure all relevant documents are preserved. The singular issues arising in the context of bankruptcy avoidance actions make this task even more complex, and significant uncertainty remains. Unless and until a court holds that a less stringent rule than the Zubulake standard should apply in the avoidance action context, however, the safest course is to advise a debtor in possession to preserve any electronic data potentially relevant to such an action as early as possible, whether that be prior to or just after commencement of a bankruptcy case, but in no event later than the time at it can be demonstrated that the commencement of avoidance actions was first contemplated.

Norman N. Kinel is the founder and co-chair of the Bankruptcy and Corporate Reorganization Department and Timothy A. Solomon is a bankruptcy associate at Dreier LLP, which represented the Committee of Unsecured Creditors in the litigation discussed in this article.