Bankruptcy Court Shields Equity Sponsors Serving as Secured Lenders from Individual Creditor Seeking to Litigate Subordination and Recharacterization Claims Released by the Debtor

by Goodwin

In the chapter 11 cases of Optim Energy, LLC and its affiliated debtors (the “Debtors”), on May 13, 2014, Judge Brendan Shannon of the Bankruptcy Court for the District of Delaware denied a creditor’s request for leave to pursue litigation claims on behalf of the estate against secured lenders that were also the Debtors’ direct and indirect owners.[1]

These claims sought to recharacterize as equity or equitably subordinate the sponsors’ secured debt and sought damages for alleged breaches of fiduciary duty (collectively, the “Claims”). Rejecting this request, the court found that the moving creditor failed to assert a viable cause of action for each of the Claims, even assuming the alleged facts were true. In doing so, Judge Shannon reaffirmed that there is a high bar for creditors seeking to derivatively pursue claims on behalf of a bankruptcy debtor’s estate.


At the outset of the Optim Energy case, the Debtors’ direct and indirect non-debtor equityholders – ECJV Holdings, LLC (“ECJV”) and Cascade Investments, L.L.C. (“Cascade”) – provided the Debtors with debtor-in-possession (“DIP”) financing. Cascade and ECJV also held pre-petition debt secured by first priority liens on substantially all of the Debtors’ assets. The order approving the DIP financing provided for a release and waiver by the Debtors of all claims against Cascade and ECJV, however, it also preserved the rights of “a party in interest with requisite standing other than the Debtors or an appointed committee” to sue Cascade and ECJV. The largest unsecured creditor – Walnut Creek Mining Company (“Walnut Creek”) – sought leave of the bankruptcy court for derivate standing to pursue the Claims on behalf of the Debtors’ bankruptcy estates.

Derivative Standing Denied

In considering Walnut Creek’s request, the court applied the Third Circuit test for creditors obtaining derivative standing to pursue estate claims set forth in the Cybergenics case, which requires the creditor to demonstrate:  “(i) the [DIP] has unjustifiably refused to pursue the claim or refused to consent to the moving party's pursuit of the claim on behalf of the [DIP]; (ii) the moving party has alleged colorable claims; and (iii) the moving party has received leave to sue from the bankruptcy court.”[2]

With respect to the second requirement – whether a colorable claim has been asserted – the court applied the pleading standard applicable to a motion to dismiss. That standard requires that the allegations contain “sufficient factual matter, accepted as true, to ‘state a claim to relief that is plausible on its face’” and that “[t]hreadbare recitals of the elements of a cause of action, supported by mere conclusory statements, do not suffice.” As to each of the Claims – breach of fiduciary duty, recharacterization, and equitable subordination – the court held that that Walnut Creek did not sufficiently plead a colorable claim.

Breach of Fiduciary Duty Waived in the Governing LLC Agreement

The court easily concluded that no claim for relief was plausibly stated with respect to breaches of fiduciary duties because the Debtors’ operating agreements included an explicit waiver of any fiduciary duty owed by any member or manager of the Debtors. Because such waivers are permissible and enforceable under Delaware law governing LLCs, the court held that these claims were not colorable.

Hallmarks of Recharacterization Not Present

Next the court addressed Walnut Creek’s claims that the pre-bankruptcy secured debt owed to Cascade and ECJV should be recharacterized as an equity investment. The loan that was the target of Walnut Creek’s recharacterization (and equitable subordination) claims arose from a series of transactions in 2007 that included, among other things, the Debtors’ acquisitions of certain assets financed by Wells Fargo. Cascade and ECJV guaranteed the Debtors’ obligations to Wells Fargo pursuant to a Guaranty Agreement and subordinated their guaranty claims to the Debtors’ obligations to Wells Fargo.

The Debtors agreed to reimburse Cascade and ECJV for amounts paid under the Guaranty Agreement pursuant to a Reimbursement Agreement and secured their obligations by granting Cascade and ECJV security interests in substantially all of their assets. On the eve of the bankruptcy, Cascade and ECJV caused the Debtors to repay the outstanding obligations to Wells Fargo. As a result, the Debtors’ obligations under the Reimbursement Agreement matured and Cascade and ECJV held secured claims against the Debtors at the outset of the case.

In support of its recharacterization claim, Walnut Creek alleged that: (i) the Debtors were inadequately capitalized at the time of these transactions; (ii) no prudent lender would have entered into the Guaranty Agreement; (iii) no debt was owed at the time the Debtors granted Cascade and ECJV security interests; (iv) Cascade and ECJV waived fees due under the Reimbursement Agreement on at least one occasion; (v) the Debtors’ obligations to Cascade and ECJV were subordinated to the Debtors’ obligations to Wells Fargo; and (vi) Cascade and ECJV made certain capital contributions to the Debtors for the purpose of paying down the Wells Fargo debt. The court rejected each of these arguments as supporting a claim for recharacterization.

First, the court found that the age of the transactions, the absence of any allegation that the Debtors could not pay operating costs during the seven years prior to the chapter 11 filings, the financing provided by Wells Fargo in 2007, and the absence of expanded equity rights being granted to Cascade and ECJV in connection with the Transactions, all contradicted the allegation of inadequate capitalization.

Concluding that the Debtors were not inadequately capitalized, the court found unpersuasive the argument that no third-party lender would have provided a guaranty of the Wells Fargo loans. In addition, the court rejected the argument that a guaranty provided by an insider is per se evidence of undercapitalization. As with the Guaranty Agreement, the court found nothing unusual about security interests being granted to secure the obligations owed under the Reimbursement Agreement.

Similarly, the court rejected the argument that waiving fees and entering into a forbearance agreement are indicia of an equity relationship. Rather, the court reasoned: “[i]n the case of a pre-existing lender, it is legitimate for the lender to take actions to protect its existing loans, including extending additional credit or granting forbearance.”  As the debt to Cascade and ECJV was subordinated only to the debt owed to Wells Fargo – and not all of the Debtors’ obligations – and subordination of guarantor claims is customary, the court found that the mere subordination of the Cascade and ECJV debt did not support recharacterization.

Lastly, as the equity contributions made by Cascade and ECJV were unrelated to the subject transactions, in the court’s view the mere fact of such contributions also did not support the recharacterization claim.

Notably, while the court recognized the dual role of Cascade and ECJV as equity and debt holders, Judge Shannon concluded: “the transactions described above clearly demonstrate that the parties were able to clearly identify and document debt versus equity arrangements.”

No Grounds for Subordination of Insiders’ Claims

In considering Walnut Creek’s allegations that the claims of Cascade and ECJV should be equitably subordinated to other creditors’ claims due to their inequitable conduct, the court applied heightened scrutiny because Cascade and ECJV were insiders of the Debtors.

Notwithstanding this more exacting standard, the court found no support for an equitable subordination claim because, even accepting Walnut Creek’s allegations as true, the requisite “inequitable conduct” on the part of Cascade and ECJV was not plausibly pled. Rather, “[i]t [was] merely alleged that Cascade and ECJV performed under their guarantees on the Wells Fargo Credit Facility, guarantees that had been in existence for almost seven years.”

Author’s Comments

Judge Shannon’s decision highlights  the importance of sufficiently pleading  the estate causes of action when creditors seek standing to sue third parties on behalf of a bankruptcy debtor’s estate. . To do so could require costly and time consuming discovery, which may or may not be possible during the time available under a DIP financing order.

Accordingly, while debtor waivers and creditor challenge rights are commonplace in DIP financing orders, the precise language used to document the nature and scope of the creditor challenge rights may certainly impact creditors in asserting such challenges. Parties in interest affected by such provisions in DIP financing orders should carefully review such language to determine, not only the scope of any liability releases to be challenged and the time period required to assert such challenges, but also what is procedurally required to assert a challenge and what is substantively required to survive a motion to dismiss.

The decision is also instructive in that it affirms the efficacy in the chapter 11 context of Delaware law regarding the waiver of fiduciary duties in an LLC operating agreement. Yet, as was the true in the Optim Energy case, such a waiver can have a material adverse impact on third parties who did not have an opportunity to challenge or negotiate the waiver when it was documented. Judge Shannon was not called upon to address whether in the context of refusing creditor standing to pursue estate claims such a fiduciary duty waiver should (or should not be) enforceable as a matter of public policy. It is an open question whether another court would rule differently on this point if presented with a different set of facts.

The part of the decision that may bring comfort to equity sponsors is the court’s analysis of the recharacterization and equitable subordination claims. The court affirmed that mere insider status or holding both debt and equity are insufficient to support claims for recharacterization and equitable subordination.

The court also affirmed that actions taken in accordance with contractual rights are insufficient to support these claims, even if such actions adversely impact a debtor and its unsecured creditors. To the extent courts follow Optim Energy, it will be very difficult for a party in interest to obtain derivative standing to pursue estate causes of action unless that party can plead substantial facts to support the elements of the claims; mere recitation of the elements of the cause of action or conclusions will not suffice.

Wasting no time, Walnut Creek filed an appeal the day after Judge Shannon issued his opinion. It will be interesting to see if the district court shares Judge Shannon’s views that the alleged facts do not support colorable claims for breach of fiduciary duty, recharacterization, or equitable subordination.

[1] In re Optim Energy, LLC, No. 14-10262 (BLS), 2014 Bankr. LEXIS 2155 (Bankr. D. Del. May 13, 2014).

[2] Official Committee of Unsecured Creditors of Cybergenics Corp. ex rel. Cybergenics Corp. v. Chinery, 330 F.3d 548 (3d Cir. 2003).

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this informational piece (including any attachments) is not intended or written to be used, and may not be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Goodwin | Attorney Advertising

Written by:


Goodwin on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.


JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at:

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.