GT Alert

Third Circuit Holds Creditors’ Committee Lacks Capacity to Invoke Section 544(b) to Avoid Fraudulent Transfer Claims

October 2002
By Scott D. Cousins, William E. Chipman, Jr. and C. Michael Terribile, Greenberg Traurig, Wilmington Office

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In a possibly far-reaching decision, the Third Circuit Court of Appeals has held that only a trustee (which includes a debtor-in-possession) may invoke 11 U.S.C. § 544(b) to avoid fraudulent transfer claims. Official Committee of Unsecured Creditors of Cybergenics Corp. v. Chinery, No. 01-3805, __ F.3d __, 2002 WL 31102712 (3d Cir. (N.J.) Sept. 20, 2002). The Third Circuit based its holding on the plain language of section 544(b) of the Bankruptcy Code and the Supreme Court’s decision in Hartford Underwriters Ins. Co. v. Union Planters Bank, N.A., 530 U.S. 1 (2000). The Court’s decision rejects the common practice of bankruptcy courts allowing creditors’ committees to bring such claims derivatively. This decision promises to influence numerous cases and may have unforeseen effects on other areas of bankruptcy practice.

Summary of the Case

"This decision promises to influence numerous cases and may have unforeseen effects on other areas of bankruptcy practice."

In Cybergenics, a 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. Subsequently, the Committee obtained court authorization to bring the claims derivatively on behalf of the debtor-in-possession.

Thereafter, on defendants’ motions to dismiss, the District Court reversed, holding that the Committee did not have the capacity to assert a section 544(b) claim. In affirming the District Court, the Third Circuit relied on a strict reading of the phrase "trustee may" in section 544 to hold that the plain language of the statute precluded the Committee from asserting the claim. The Court relied on the Supreme Court’s strict statutory interpretation of the same phrase as used in section 506(c) of the Bankruptcy Code in Hartford, where the Supreme Court held that only the trustee (or debtor-in-possession) could utilize the recovery power granted by that section. Further, the Third Circuit stated that the bankruptcy court had no authority to authorize a creditor or creditors’ committee to bring suit under section 544 derivatively.

Committee Arguments and the Responses from the Court

The Committee made numerous arguments before the Third Circuit, all of which were rejected. The Committee argued that Hartford was a chapter 7 case, whereas Cybergenics was a chapter 11 case, which provides creditors’ committees with rights unavailable in a chapter 7 liquidation, citing sections 1109(b) and 1103(c)(5) of the Bankruptcy Code. The Third Circuit noted that section 1109(b) grants a creditors’ committee a broad right to be heard. It does not, however, confer authority upon a creditors’ committee to initiate an action where the trustee (or debtor-in-possession) declined to bring suit. In the Court’s view, it only establishes a right to be heard as a party when a proceeding has already been initiated by the statutorily-authorized party. Next, the Third Circuit noted that if section 1103(c)(5), a "catch all provision," is given the broad scope urged by the Committee, this "roving grant of power" to undertake any action in a committee’s interest would swallow all other conflicting Bankruptcy Code provisions and any limitations contained therein.

The Third Circuit noted that footnote 5 of the Supreme Court’s decision in Hartford declined to decide whether its analysis of section 506(c) extended to the Bankruptcy Code’s fraudulent transfer provisions or whether the pursuit of derivative claims was prohibited under the Bankruptcy Code. The Third Circuit disagreed with other courts’ reliance on footnote 5 in conferring derivative standing to creditors or creditors’ committees to bring avoidance actions. After examining the cases from other circuits, the Third Circuit found that those opinions failed (1) to give appropriate weight to the Supreme Court’s strict interpretation of the Bankruptcy Code or (2) were decided prior to Hartford.

Finally, the Committee argued that well-settled practice and policy considerations supported the right of the Committee to bring derivative fraudulent transfer actions. The Third Circuit rejected this argument stating that achieving a better policy outcome is a task for Congress, not the courts.

Committee Options from the Court

The Third Circuit noted that a creditor or committee is left with several options should they desire to pursue fraudulent transfer claims where the debtor-in-possession refuses to do so. These options include the following:

1. Section 1103(c)(4) expressly authorizes a creditors’ committee to move for the appointment of a trustee under section 1104; or
2. As "a party in interest," a Committee can move to dismiss the bankruptcy petition under section 1112, so that individual creditors may pursue state law avoidance claims in state court; or
3. The Third Circuit noted in footnote 11 of the opinion that section 1123(b)(3)(B) of the Bankruptcy Code may permit a plan of reorganization to designate a representative, including a committee to enforce certain claims, such as avoidance claims, for the estate’s benefit.

Possible Wide-Ranging Effects

By refusing to allow the Committee to substitute a trustee as the real party in interest under Fed. R. Civ. P. 17(a), the Third Circuit has left open the question of whether its ruling may have an effect on pending derivative litigation commenced by committees other than pursuant to a confirmed plan as provided for by section 1123(b)(3)(B). Rule 17(a) states that "[n]o action shall be dismissed on the ground that it is not prosecuted in the name of a real party in interest until a reasonable time has been allowed" for the substitution of such party. The Third Circuit concluded that the Committee’s decision not to seek the appointment of a trustee at any point in the proceeding, and pursue its claims on its own, was not an "understandable mistake" which would support the substitution of a real party in interest under Rule 17(a). It is uncertain whether the courts within the Third Circuit will apply the holding in Cybergenics to currently-pending cases or dismiss this portion of Cybergenics as dicta.

It is unclear at this point what effect the Cybergenics case will have upon certain standard provisions in many debtor-in-possession financing orders. For example, bankruptcy courts within the Third Circuit might feel compelled to limit releases by debtors of their prepetition secured lenders that provide DIP financing. While these provisions were frequently contained in interim DIP Orders entered by bankruptcy courts within the Third Circuit, the court may, instead, permit such provisions only in final DIP orders after formation of any committees. Similarly, debtors and secured lenders will certainly have to address how the investigation of the liens and security interests of prepetition secured lenders will be conducted. Pre-Cybergenics, such investigations were almost exclusively conducted by creditors’ committees. Post-Cybergenics, perhaps counsel for a creditors’ committee will insist upon retaining the right to investigate such claims while leaving the right to pursue such claims pre-confirmation with the debtor. If after its investigation the creditors’ committee believes that meritorious claims against the lenders should be pursued, and the debtor refuses to pursue such claims, there would appear to be a solid basis for the court to order the appointment of a chapter 11 trustee.

Footnote 11 of the Cybergenics case suggests that under section 1123(b)(3)(B), a plan of reorganization may empower a trustee to retain a representative to enforce avoidance claims, presumably including a creditors’ committee. In cases where a plan cannot be confirmed in less than two years, committees may be barred from pursuing such claims as a result of the two-year statute of limitations to bring avoidance actions under section 546(a) of the Bankruptcy Code.

In another recent Third Circuit opinion, issued just three days after the Cybergenics opinion, the Court suggests in footnote 7 that the Office of the United States Trustee might have standing to bring a preference action under section 307 of the Bankruptcy Code. Under that section, the U.S. Trustee "may raise and may appear to be heard on any issue in any case or proceeding under this title but may not file a plan pursuant to 1121(c)" of the Bankruptcy Code. 11 U.S.C. § 307. The exact same language appears in section 1109(b), which was rejected as a basis for the Committee to bring an avoidance action in Cybergenics. This footnote certainly appears to be inconsistent with the Third Circuit’s holding in Cybergenics. See In re Pillowtex, Inc., No. 01-2775, ___ F.3d ___, n.7, 2002 WL 31104187 (3d Cir. Sept. 23, 2002) (Sloviter, J.).

The Third Circuit in Cybergenics declined to follow the opinions of other circuit courts which have approved the right of creditors’ committee to bring derivative fraudulent transfer actions, including the Second, Fifth, Sixth, Seventh and Ninth Circuits (the Eighth Circuit has recognized that derivative suits are at least an option). Thus, there is a split of authority in the Circuits and Supreme Court review appears ripe.

© 2002 Greenberg Traurig

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