Can the Claims of Individual Creditors Be Assigned to a Litigation Trust for Prosecution?

In at least in some circuits, an assignment without more is not necessarily enough to distinguish Caplin and clothe the trustee with standing to pursue the assigned claim. A bankruptcy trustee risks losing standing if the assignment does not benefit the estate. For example, consider a plan that provides that the creditors would assign their claims to the trustee to litigate them, and the trustee would distribute the proceeds of the litigated claims directly to the individual assigning creditors. The proceeds arguably never become part of the estate because as soon as they are collected, they must be distributed (or in any event are earmarked for distribution). The Ninth Circuit so held in the analogous case of Williams v. California 1st Bank, 859 F.2d 664, 665 (9th Cir. 1988), where the trustee offered to prosecute assigned claims on behalf of creditors and also offered to distribute proceeds directly to the assigning creditors (and none to non-assigning creditors) after deducting the trustee's legal costs. Under those facts, the assigning creditors remained the true parties in interest, because the assignment merely switched the person suing ' the trustee instead of the creditor ' without changing the fact that the assigning creditors retained the entire upside of any victory. Accordingly, the Williams court held that the trustee lacked standing despite the assignments.

Compare that situation with one in which the trustee distributes the proceeds of the litigated claims first to the estate and then pro rata to all of the estate's creditors. In re Bogdan, 414 F.3d at 510; Steinberg v. Kendig (In re Ben Franklin Retail Stores, Inc.), 225 B.R. 646 (N.D. Ill. 1998). Here, the estate and not the assigning creditors are the “true parties in interest,” because the upside of the litigation belongs to the estate. The Williams court seemed willing to sanction this second type of assignment, but held that a trustee lacks standing to sue on behalf of assigning creditors under the first type of assignment. No court of appeals other than the Ninth Circuit in Williams has yet confronted similar facts.

Clarity Lacking

Thus, two things remain unclear after Williams: first, whether other circuits would adopt its reasoning, and second, whether it applies not only to bankruptcy trustees, but to post-confirmation state law trustees appointed under a plan. Regarding the second point, other courts have sanctioned litigation trusts that litigate assigned claims from creditors and distribute the proceeds only to those assigning creditors. Kirschner v. Bennett (In re Refco), 2008 U.S. Dist. LEXIS 37214, at *6-7 (S.D.N.Y. 2008); Lasala v. Bordier et Cie, 519 F.3d at 127, n.1. For example, the Refco plan created two trusts: a litigation trust to assert estate causes of action on behalf of all creditors and a “private action trust” to assert private actions assigned by participating creditors, the proceeds of which would be distributed only to those participating creditors. Id. Thus, even if courts outside the Ninth Circuit were to adopt the Williams reasoning, they might not extend that reasoning to state law litigation trustees. Among other things, there does not appear to be a statutory reason why a post confirmation trust must benefit the estate, whereas that certainly is the task of a Chapter 7 or 11 trustee.

Policy of Flexibility ' Can There be Too Much?

Ultimately, allowing a trustee to pursue assigned claims permits a level of flexibility in reorganizing or liquidating a debtor's assets that is desirable to achieve efficient administration of the reorganization or liquidation. In re CBI, 529 F.3d at 459. Indeed, the Third Circuit recently noted that liquidation and litigation trusts are a “gratifying testament to the flexibility and creative license that [C]hapter 11 accords parties in fashioning plans of reorganization.” LaSala, 519 F.3d at 127 n1. Holding otherwise would “unnecessarily hamstring [the parties].” In re CBI, 529 F.3d at 459.

The outer limits of this flexibility is unclear. What is clear from the case law is that trustees, whether bankruptcy or state law, cannot as a general matter assert claims owned by creditors. But, under CBI, Bogdan and arguably LaSala, they can if the creditor elects to assign its cause of action to the estate. The Ninth Circuit Williams decision ' if followed in other circuits ' would narrow the scope of permissible assignments, so that bankruptcy trustees (but perhaps not litigation trusts) can only assert assigned claims that benefit the entire estate, not just the assigning creditors.

The question remains whether a plan of reorganization can go one step further than any of these cases and provide for the assignment to a state law trust of the claims of all creditors in a class if that class votes in favor of confirmed plan of reorganization, for example, all bondholders' securities fraud claims. This construct would assure no inconsistent verdicts because all bondholder claims would be transferred and would utilize the provisions of the Bankruptcy Code that make a plan binding on non-consenting (or non-voting) creditors. But there are questions as to whether such a plan provision should be permitted, as the purpose of a plan generally is to provide a recovery (or not) to creditors, not to take something (control of a cause of action) away from creditors. One can expect a due process objection to depriving a creditor of property unrelated to the estate, but the counterargument is that only control of such a suit, and not the recovery on it, is changing hands ' much like a class or derivative action. As an alternative, practitioners could attempt a “check the box” in plan solicitations where each creditor separately votes first on whether she or he accepts the plan and second as to whether she or he wants her or his own claims assigned to the trust. If potential defendants believe that defenses they might have could potentially be “cleansed” by the assignment, they would surely object to either construct. Thus, as of today, it remains unclear exactly how much flexibility a court will condone in permitting a debtor to design its plan.

Conclusion

The recent decisions in CBI Holdings and Bogdan and the dicta in LaSala provide debtors with additional interesting considerations in determining how to structure a plan of reorganization which contemplates a litigation trust. Before, courts' increasingly broad applications of Caplin to situations not contemplated by that case led to uncertainty whether any trustee, whether bankruptcy trustee or state law litigation trustee, could assert creditor causes of action, even if assigned. But the Second and Fourth Circuit decisions provide potential options to debtors' counsel for the design of their plans to permit the assignment of creditor causes of action to a state law trust. An open question remains, however, of how far debtors can go to assign individual claims, particularly whether they can force all creditors to participate in a state law trust. Although recent court decisions have been shrinking Caplin's applicability, particularly to assignments of claims since they do not implicate the Caplin court's concerns, it remains to be seen just how far a plan can go without implicating those concerns once again.

Russell C. Silberglied, a member of this newsletter's Board of Editors, is a director and Cory D. Kandestin is an associate at Richards, Layton & Finger, P.A. in Wilmington, DE. The views expressed in this article are those of the authors and not necessarily of RL&F or its clients.

Last month, we asked the question: Can a plan provide that the securities claims ' which are not estate causes of action because they belong to the bondholders individually, not to the company ' will be assigned to a trust so that the trust can efficiently litigate these claims and distribute the proceeds thereof to the bondholders? As we stated last month, the issue can be traced back to the Supreme Court's decision in Caplin v. Marine Midland Grace Trust Co. , 406 U.S. 416 (1972). In Caplin, a bankruptcy trustee under the now superceded Bankruptcy Act sought to assert claims against an indenture trustee on behalf of the estate's bondholders. The Court held that the trustee lacked standing to do so. The Court found no statutory authority that would permit a trustee to assert creditor claims without creditor consent. Id. at 428.

Herein, a continuation of our discussion.

Must The Assignment Benefit the Estate?

In at least in some circuits, an assignment without more is not necessarily enough to distinguish Caplin and clothe the trustee with standing to pursue the assigned claim. A bankruptcy trustee risks losing standing if the assignment does not benefit the estate. For example, consider a plan that provides that the creditors would assign their claims to the trustee to litigate them, and the trustee would distribute the proceeds of the litigated claims directly to the individual assigning creditors. The proceeds arguably never become part of the estate because as soon as they are collected, they must be distributed (or in any event are earmarked for distribution). The Ninth Circuit so held in the analogous case of Williams v. California 1st Bank, 859 F.2d 664, 665 (9th Cir. 1988), where the trustee offered to prosecute assigned claims on behalf of creditors and also offered to distribute proceeds directly to the assigning creditors (and none to non-assigning creditors) after deducting the trustee's legal costs. Under those facts, the assigning creditors remained the true parties in interest, because the assignment merely switched the person suing ' the trustee instead of the creditor ' without changing the fact that the assigning creditors retained the entire upside of any victory. Accordingly, the Williams court held that the trustee lacked standing despite the assignments.

Compare that situation with one in which the trustee distributes the proceeds of the litigated claims first to the estate and then pro rata to all of the estate's creditors. In re Bogdan, 414 F.3d at 510; Steinberg v. Kendig (In re Ben Franklin Retail Stores, Inc.), 225 B.R. 646 (N.D. Ill. 1998). Here, the estate and not the assigning creditors are the “true parties in interest,” because the upside of the litigation belongs to the estate. The Williams court seemed willing to sanction this second type of assignment, but held that a trustee lacks standing to sue on behalf of assigning creditors under the first type of assignment. No court of appeals other than the Ninth Circuit in Williams has yet confronted similar facts.

Clarity Lacking

Thus, two things remain unclear after Williams: first, whether other circuits would adopt its reasoning, and second, whether it applies not only to bankruptcy trustees, but to post-confirmation state law trustees appointed under a plan. Regarding the second point, other courts have sanctioned litigation trusts that litigate assigned claims from creditors and distribute the proceeds only to those assigning creditors. Kirschner v. Bennett (In re Refco), 2008 U.S. Dist. LEXIS 37214, at *6-7 (S.D.N.Y. 2008); Lasala v. Bordier et Cie , 519 F.3d at 127, n.1. For example, the Refco plan created two trusts: a litigation trust to assert estate causes of action on behalf of all creditors and a “private action trust” to assert private actions assigned by participating creditors, the proceeds of which would be distributed only to those participating creditors. Id. Thus, even if courts outside the Ninth Circuit were to adopt the Williams reasoning, they might not extend that reasoning to state law litigation trustees. Among other things, there does not appear to be a statutory reason why a post confirmation trust must benefit the estate, whereas that certainly is the task of a Chapter 7 or 11 trustee.

Policy of Flexibility ' Can There be Too Much?

Ultimately, allowing a trustee to pursue assigned claims permits a level of flexibility in reorganizing or liquidating a debtor's assets that is desirable to achieve efficient administration of the reorganization or liquidation. In re CBI, 529 F.3d at 459. Indeed, the Third Circuit recently noted that liquidation and litigation trusts are a “gratifying testament to the flexibility and creative license that [C]hapter 11 accords parties in fashioning plans of reorganization.” LaSala, 519 F.3d at 127 n1. Holding otherwise would “unnecessarily hamstring [the parties].” In re CBI, 529 F.3d at 459.

The outer limits of this flexibility is unclear. What is clear from the case law is that trustees, whether bankruptcy or state law, cannot as a general matter assert claims owned by creditors. But, under CBI, Bogdan and arguably LaSala, they can if the creditor elects to assign its cause of action to the estate. The Ninth Circuit Williams decision ' if followed in other circuits ' would narrow the scope of permissible assignments, so that bankruptcy trustees (but perhaps not litigation trusts) can only assert assigned claims that benefit the entire estate, not just the assigning creditors.

The question remains whether a plan of reorganization can go one step further than any of these cases and provide for the assignment to a state law trust of the claims of all creditors in a class if that class votes in favor of confirmed plan of reorganization, for example, all bondholders' securities fraud claims. This construct would assure no inconsistent verdicts because all bondholder claims would be transferred and would utilize the provisions of the Bankruptcy Code that make a plan binding on non-consenting (or non-voting) creditors. But there are questions as to whether such a plan provision should be permitted, as the purpose of a plan generally is to provide a recovery (or not) to creditors, not to take something (control of a cause of action) away from creditors. One can expect a due process objection to depriving a creditor of property unrelated to the estate, but the counterargument is that only control of such a suit, and not the recovery on it, is changing hands ' much like a class or derivative action. As an alternative, practitioners could attempt a “check the box” in plan solicitations where each creditor separately votes first on whether she or he accepts the plan and second as to whether she or he wants her or his own claims assigned to the trust. If potential defendants believe that defenses they might have could potentially be “cleansed” by the assignment, they would surely object to either construct. Thus, as of today, it remains unclear exactly how much flexibility a court will condone in permitting a debtor to design its plan.

Conclusion

The recent decisions in CBI Holdings and Bogdan and the dicta in LaSala provide debtors with additional interesting considerations in determining how to structure a plan of reorganization which contemplates a litigation trust. Before, courts' increasingly broad applications of Caplin to situations not contemplated by that case led to uncertainty whether any trustee, whether bankruptcy trustee or state law litigation trustee, could assert creditor causes of action, even if assigned. But the Second and Fourth Circuit decisions provide potential options to debtors' counsel for the design of their plans to permit the assignment of creditor causes of action to a state law trust. An open question remains, however, of how far debtors can go to assign individual claims, particularly whether they can force all creditors to participate in a state law trust. Although recent court decisions have been shrinking Caplin's applicability, particularly to assignments of claims since they do not implicate the Caplin court's concerns, it remains to be seen just how far a plan can go without implicating those concerns once again.

Russell C. Silberglied, a member of this newsletter's Board of Editors, is a director and Cory D. Kandestin is an associate at Richards, Layton & Finger, P.A. in Wilmington, DE. The views expressed in this article are those of the authors and not necessarily of RL&F or its clients.