United States: Cyberginics Redux: Derivative Standing Again Under Fire

Last Updated: September 13 2004
Article by Mark G. Douglas

In the October 2002 edition of the Business Restructuring Review (vol. 1, no. 7), we discussed a highly controversial decision handed down by the Court of Appeals for the Third Circuit addressing the power of a bankruptcy court to authorize a creditors' committee to commence avoidance litigation on behalf of a bankruptcy estate. In In re Cybergenics ("Cybergenics I") the Third Circuit ruled that only a bankruptcy trustee (and by implication, a chapter 11 debtor-in-possession ("DIP")) may prosecute estate claims to avoid fraudulent transfers. Rejecting an extensive body of contrary authority and longstanding bankruptcy practice, the Court reasoned that a creditors' committee cannot prosecute estate avoidance actions because the provision of the Bankruptcy Code authorizing such actions — section 544(b) — expressly refers to a "trustee" and, in accordance with U.S. Supreme Court precedent, should not be interpreted to encompass a committee.

The decision's implications were anything but encouraging: in accordance with current practice, committees are frequently authorized to bring litigation on behalf of the estate. Examples include cases where the debtor unjustifiably refuses to pursue colorable claims, the debtor agrees to allow the committee to sue on behalf of the estate, the estate contains insufficient resources to fund litigation or the debtor previously acknowledged the validity of a lender's liens in connection with post-petition financing or use of cash collateral. Many bankruptcy practitioners and commentators criticized the Third Circuit's ruling, contending that its reasoning was flawed and its ramifications were damaging to the bankruptcy process. Apparently, even the Third Circuit was unsure of its conviction. On November 18, 2002, it vacated the three-judge panel’s opinion after voting to rehear the case en banc.

That rehearing resulted in another ruling by the Court of Appeals on May 29, 2003 ("Cybergenics II"). In a detailed opinion exploring various sections of the Bankruptcy Code, the Code's historical antecedents, bankruptcy practice and Supreme Court precedent, the Third Circuit did an about-face. Initially, the Court examined provisions in the Bankruptcy Code authorizing the trustee to commence avoidance litigation that could have been brought by creditors outside of bankruptcy (section 544(b)), delineating the powers and standing of a chapter 11 creditors' committee (sections 1103(c) and 1109(b)) and authorizing the court to reimburse creditors for expenses incurred in recovering property improperly transferred from the estate (section 503(b)(3)(B)).

None of these, the Third Circuit concluded, explicitly authorizes a bankruptcy court to empower a committee to sue on behalf of the bankruptcy estate. Even so, the Court emphasized, the absence of explicit authority in these provisions does not end the enquiry. According to the Third Circuit, given lawmakers' intent to encourage creditor participation in a bankruptcy case and the longstanding practice of authorizing creditors to prosecute estate avoidance actions, the scope of a bankruptcy court's equitable powers is sufficiently broad to encompass the discretion to delegate standing to a creditor or committee under appropriate circumstances. In reaching this conclusion, the Court of Appeals distinguished Supreme Court precedent that it relied upon in rendering its previous ruling on this issue, finding that the context of the two cases varied enough to warrant a different conclusion.

Observing that "the Code itself anticipates the existence of derivative standing" and that "derivative standing is a prudent way for bankruptcy courts to remedy lapses in a trustee's execution of its fiduciary duty," the Third Circuit, by a margin of seven to four, reversed the district court order denying the committee derivative standing. It then remanded the case for further determinations concerning certain alternate grounds for dismissal that had not been addressed in its previous ruling. The Third Circuit thereby allied itself with the Second and Seventh Circuits in finding that derivative standing is authorized by the Bankruptcy Code. In a minority opinion, four Judges of the Court of Appeals argued that the vacated opinion should stand for the reasons previously articulated by the Court.

Renewed Threat to Derivative Standing

Just when the continued viability of derivative standing appeared to be assured, the 10th Circuit bankruptcy appellate panel entered the fray. In In re Fox, the panel adopted the rationale articulated by the Third Circuit in Cybergenics I, ruling that only a trustee or DIP can prosecute estate avoidance actions because the Bankruptcy Code expressly authorizes the "trustee" to do so.

After chapter 11 debtor Donald Fox refused to sue his wife to recover property that he fraudulently conveyed to her prior to filing for bankruptcy, one of his creditors ― United Phosphorus Ltd. ― sued her to recover the property. She sought dismissal of the proceeding for lack of standing because United Phosphorous never obtained court approval to prosecute the claim. The bankruptcy court denied her request, granting United Phosphorous retroactive authority to bring suit on behalf of the bankruptcy estate. After that authority was subsequently revoked by another bankruptcy judge selected to preside over the case, United Phosphorous appealed to the 10th Circuit bankruptcy appellate panel.

The appellate panel affirmed. According to the court, section 548 of the Bankruptcy Code expressly and unequivocally states that "[t]he trustee may avoid any transfer" that is actually or constructively fraudulent, and only a chapter 11 debtor-in-possession is statutorily conferred with the powers of a trustee. In keeping with various Supreme Court admonitions that an unambiguous statute should be applied as written, the court held that no one other than a trustee or DIP can prosecute an avoidance action under section 548.

Mindful of the policy considerations articulated in Cybergenics II concerning the benefits of authorizing committees or individual creditors to prosecute estate avoidance actions under appropriate circumstances, the panel observed that "[w]e, 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." It accordingly affirmed dismissal of the avoidance proceeding because "the statute is absolute and allows us no discretion to vary from what it says."

Analysis

It can be argued that Fox suffers from the same flaws that led to disavowal of Cybergenics I, in large part because its reliance on principles of statutory construction is too selective. The language of section 548 is admittedly unambiguous. Still, two other well established maxims of statutory construction dictate that a court should not confine its inquiry to section 548 alone in divining its meaning.

First, at least two other provisions of the Bankruptcy Code arguably conflict with the idea that estate avoidance actions can be prosecuted only by a trustee or DIP. Section 503(b)(3)(B) provides that a creditor can be compensated for expenses incurred in recovering, for the benefit of the estate, property transferred or concealed by the debtor. Similarly, section 1123(b)(3)(A) states that a chapter 11 plan may provide for the "retention and enforcement by the debtor, by the trustee, or by a representative of the estate appointed for such purpose," of estate claims. These provisions are inconsistent with the idea that prosecution of estate claims is the exclusive province of a trustee or DIP.

Next, Congress does not legislate in a vacuum. Where pre-existing law or practice related to a new statute dictates a certain course of action, the rule in question is generally deemed to retain its viability unless Congress unequivocally and expressly provides otherwise. The practice of authorizing committees and creditors to commence litigation on behalf of the estate long pre-dated the enactment of the Bankruptcy Code in 1978. Nothing in section 548 or its accompanying legislative history suggests that lawmakers intended that this practice be discontinued.

Official Committee of Unsecured Creditors v. Chinery (In re Cybergenics Corp.), 304 F.3d 316 (3rd Cir.), vacated, 310 F.3d 785 (3d Cir. 2002).

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

Hartford Underwriters Insurance Co. v. Union Planters Bank, N.A., 530 U.S. 1 (2000).

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

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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