In a matter of first impression, the U.S. Court of Appeals for the Second Circuit has held that creditors generally do not have standing to settle claims over the objection of the debtor under Rule 9019 of the Federal Rules of Bankruptcy Procedure.

In Smart World Technologies, LLC v. Juno Online Services, Inc. (In re Smart World Technologies, LLC), 423 F.2d 166 (2d Cir. 2005), the bankruptcy court approved the settlement of a claim over the objections of the debtor. The debtor had filed for bankruptcy pursuant to the terms of a sale agreement to sell its subscriber list free and clear of all liens under Bankruptcy Code section 363. Shortly after the sale, the debtor claimed that the creditor acted in bad faith in connection with the sale. The creditor responded by filing an adversary proceeding against the debtor claiming these allegations of bad faith were concocted to extort additional money from the creditor.

After protracted litigation, the creditor moved the bankruptcy court to approve a settlement of all claims between the parties under Rule 9019. The debtor objected to the motion for a number of reasons including that the creditor lacked standing to approve a settlement under Rule 9019 over its objections.

Derivative Standing Doctrine

The bankruptcy court dismissed the debtor’s objections and approved the settlement, and the district court affirmed. The district court opined that creditors had standing to settle claims under Rule 9019 in part because of the derivative standing doctrine recognized by the Second Circuit. The district court found that derivative standing was appropriate since the settlement was reasonable and the debtor’s position was "an unrealistic hope that continued litigation would be so wildly successful that it might yield some recovery for its equity holders."

The Second Circuit reversed. Analyzing Rule 9019, the Circuit Court held that Rule 9019 vested exclusive authority in the debtor to compromise and approve settlements. This, the court held, was consistent with the general scheme of the Code that charges the debtor with the authority and responsibility to manage the bankruptcy estate, including some of the estate’s most valuable assets—its legal claims. The court further found that a party attempting to strip the debtor of this responsibility must meet a high threshold.

The Second Circuit found its previous derivative standing holdings were distinguishable from the facts of this case. The court reasoned that normally, derivative standing is found when a creditor shows that the debtor neglected or unreasonably refused to prosecute a claim on behalf of the estate. The facts in this case were the converse. The debtor already had assumed its authority and responsibility to pursue its claim against the creditor. Moreover, a creditor moving to settle a claim would be more likely to have interests adverse to those of the estate than when a creditor attempts to prosecute a claim the debtor neglected to pursue.

The appeals court further found that the bankruptcy court had failed to conduct the type of inquiry that would enable it to analyze whether the creditor met its burden to pursue the claim under derivative standing principles. In particular, the bankruptcy court did not adequately discuss the probability of success in the litigation versus settlement, and the prospect that the creditor had an interest adverse to the estate when it brought the motion to settle. Of less importance, but nevertheless a factor, was the fact that the debtor had been prevented from prosecuting its legal claim because of a series of procedural setbacks during the bankruptcy proceeding.

Lastly, the circuit court refused to grant standing to the creditor under sections 1109 and 105 of the Bankruptcy Code, noting that the Code generally vests exclusive authority in the debtor to manage the estate, and neither section 1109 nor 105 vested the bankruptcy court with authority to imbue creditors with substantive powers that are beyond the statutory limits of the Code.

This article is presented for informational purposes only and is not intended to constitute legal advice.