Creditors' Committee Denied Standing to Bring Derivative Claims on Behalf of LLC Debtor in Bankruptcy

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The practice of conferring "derivative standing" on official creditors' committees to assert claims on behalf of a bankruptcy estate in cases where the debtor or a bankruptcy trustee is unwilling or unable to do so is a well-established means of generating value for the estate from litigation recoveries. However, in a series of recent decisions, the Delaware bankruptcy courts have limited the practice in cases where applicable non-bankruptcy state law provides that creditors do not have standing to bring claims on behalf of certain entities. The latest of these rulings was handed down recently by Judge Karen B. Owens in the chapter 11 cases of Dura Automotive Systems, LLC and its affiliates (collectively, "Dura"). The court ruled that an official creditors' committee could not be granted derivative standing to prosecute claims against Dura's prepetition lenders because Delaware's limited liability company ("LLC") law restricts standing to prosecute actions on behalf of an LLC to its members and their assigns. See In re Dura Automotive Systems, LLC, No. 19-12378 (KBO) (Bankr. D. Del. June 9, 2020) (unpublished bench ruling).

The court's approach adopted in Dura Automotive has not been followed in most other cases. Many other bankruptcy courts, including the New York bankruptcy court overseeing the chapter 11 cases filed in February 2020 by The McClatchy Co. and its affiliates, have granted standing to committees in cases involving LLCs organized under state laws with restrictions similar to Delaware's LLC law.

Derivative Standing

Standing is the ability to commence litigation in a court of law. It is a threshold issue—a court must determine whether a litigant has the legal capacity to pursue claims before the court can adjudicate the dispute. In the bankruptcy context, various provisions of the Bankruptcy Code confer standing on various entities (e.g., the debtor, the debtor-in-possession ("DIP"), a bankruptcy trustee, creditors, equity interest holders, official committees, and indenture trustees) to, among other things, participate generally in a bankruptcy case or commence litigation involving causes of action or claims that either belonged to the debtor prior to filing for bankruptcy or are created by the Bankruptcy Code.

The right to participate generally in a chapter 11 case is more explicit. Section 1109(b) of the Bankruptcy Code provides that any "party in interest," including the debtor, the trustee, a committee of creditors or equity security holders, a creditor, an equity security holder, or an indenture trustee "may appear and may be heard on any issue" in a chapter 11 "case." This general right to participate, however, does not confer standing upon every party in interest to engage in litigation expressly contemplated by other provisions of the Bankruptcy Code, such as lien and transfer avoidance. Many Bankruptcy Code provisions deal with claims or causes of action belonging to the debtor prior to filing for bankruptcy, which become part of the debtor's bankruptcy estate on the petition date. Standing to prosecute such estate claims is expressly given by the Bankruptcy Code to the bankruptcy trustee (or the DIP, by operation of section 1107(a) of the Bankruptcy Code).

Most courts, however, will allow official creditors' committees to commence litigation on behalf of the estate under narrowly defined circumstances, reasoning that certain provisions of the Bankruptcy Code imply a qualified right to derivative standing for official creditors' committee, including: (i) section 1109(b); (ii) section 1103(c)(5), which provides that a creditors' committee may "perform such … other services as are in the interest of those represented"; and (iii) section 503(b)(3)(B), which provides that the court shall grant administrative priority in payment for the expenses of "a creditor that recovers, after the court's approval, for the benefit of the estate any property transferred or concealed by the debtor." Courts have also reasoned that derivative standing is an appropriate exercise of the court's broad equitable powers under section 105(a) of the Bankruptcy Code to "issue any order, process, or judgment that is necessary or appropriate to carry out the provisions" of the Bankruptcy Code. See generally Collier on Bankruptcy ¶ 1103.05[6][a] (16th ed. 2020).

One of the seminal cases addressing this issue is Unsecured Creditors Committee of Debtor STN Enterprises, Inc. v. Noyes (In re STN Enterprises), 779 F.2d 901 (2d Cir. 1985). In STN Enterprises, the U.S. Court of Appeals for the Second Circuit Court ruled that, in considering an official creditors' committee's request for leave to sue a director for misconduct, a court is required to consider whether the debtor unjustifiably failed to initiate suit against the director and whether the action is likely to benefit the debtor's estate (i.e., the time and expense for such litigation is justified given the likelihood of success in such litigation).

The Second Circuit later refined the doctrine of "derivative standing" in Commodore Int'l Ltd. v. Gould (In re Commodore Int'l Ltd.), 262 F.3d 96 (2d Cir. 2001). In Commodore, the court ruled that a committee may bring suit even if the trustee or DIP does not unjustifiably refuse to do so as long as: (i) the trustee or DIP consents; and (ii) the court finds that the litigation is (a) in the best interests of the estate and (b) necessary and beneficial to the fair and efficient resolution of the bankruptcy proceedings.

The Third Circuit articulated a slightly different standard for derivative standing in Official Committee of Unsecured Creditors of Cybergenics Corp. v. Chinery, 330 F.3d 548 (3d Cir. 2003). In Cybergenics, the court held that, to be granted derivative standing, a movant must demonstrate that: (i) the DIP or trustee has unjustifiably refused either to pursue the claim or to consent to the movant's prosecution of the claim on behalf of the estate; (ii) the movant has alleged colorable claims; and (iii) the movant has received leave to sue from the bankruptcy court.

Many other courts, including courts of appeals, have also countenanced the concept of derivative standing. See, e.g., PW Enters., Inc. v. N.D. Racing Comm's (In re Racing Servs., Inc.), 540 F.3d 892, 904 (8th Cir. 2008); Fogel v. Zell, 221 F.3d 955, 965 (7th Cir. 2000); Canadian Pacific Forest Prods. Ltd. v. J.D. Irving, Ltd. (In re Gibson Grp., Inc.), 66 F.3d 1436, 1446 (6th Cir. 1995).

Different rules regarding derivative standing exist under state corporation laws. For example, under Delaware law, although the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for fiduciary infractions, some courts have concluded that the creditors of an insolvent Delaware LLC do not because Delaware's LLC Act expressly limits such standing to "[a] member or an assignee of a limited liability company interest." 6 DEL. C. § 18–1001. See, e.g., CML V, LLC v. Bax, 6 A.3d 238, 241 (Del. Ch. 2010), aff'd, 28 A.3d 1037 (Del. 2011), as corrected (Sept. 6, 2011).

On the basis of this statutory limitation, Delaware bankruptcy courts have denied standing to various entities, including official creditors' committees, creditors, and bankruptcy trustees, seeking to prosecute causes of action on behalf LLC debtors or their creditors. See, e.g., In re HH Liquidation, LLC, 590 B.R. 211, 284 (Bankr. D. Del. 2018) (committee denied derivative standing to prosecute breach of fiduciary duty claims); In re PennySaver USA Publ'g, LLC, 587 B.R. 445, 467 (Bankr. D. Del. 2018) (chapter 7 trustee denied derivative standing to prosecute claims for alleged breach of fiduciary duties owed to an LLC's creditors); see also In re Citadel Watford City Disposal Partners, L.P., 603 B.R. 897, 905-06 (Bankr. D. Del. 2019) (granting a motion to dismiss a breach of fiduciary duty claim asserted by a creditors' committee because the creditors of a limited partnership lack standing to sue derivatively under Delaware law and because the creditors of an LLC lack derivative standing to sue under Wyoming law and, as predicted by the court, North Dakota law). But see In re Golden Guernsey Dairy, LLC, 548 B.R. 410, 413 (Bankr. D. Del. 2015) (ruling that a chapter 7 trustee, which under the Bankruptcy Code is the sole representative of the estate with the ability to sue and be sued, had standing to bring breach of fiduciary duty claims against the president and a managing member of a Delaware LLC whether such claims are direct or derivative in nature).

Dura Automotive

Tennessee-based auto parts manufacturer Dura filed for chapter 11 protection in October 2019 in the Middle District of Tennessee. After venue of the cases was transferred to the District of Delaware, the bankruptcy court approved the sale of substantially all of Dura's North American and European assets in May 2020 for $66 million and certain litigation recoveries to affiliates of Bardin Hill Investment Partners LP and the Charlton Group Inc. It was then anticipated that the cases would be converted to chapter 7 liquidations and a trustee would liquidate Dura's remaining assets.

Dura's official unsecured creditors' committee sought bankruptcy court authority to bring avoidance, equitable subordination, and recharacterization claims against various prepetition lenders controlled by or affiliated with former Dura manager and majority equity holder Lynn Tilton. In an order authorizing Dura to incur DIP financing, Dura, its estate, and the official creditors' committee expressly waived such claims unless "such party in interest with requisite standing … timely commence[s] an adversary proceeding or contested matter" asserting them. The committee argued that making a demand on Dura to assert the causes of action would be futile because, due to "Ms. Tilton's extensive involvement and influence over the Debtors, the Debtors are highly unlikely to bring such claims." In addition, the committee asserted that, based upon its extensive investigation, the claims stated in its proposed complaint were colorable.

Addressing court rulings that have relied on Bax as a basis for finding that the creditors of a Delaware LLC lack derivative standing in bankruptcy, the official unsecured creditors' committee argued that: (i) "none of the cases applying Bax in the bankruptcy context were decided in the procedural posture of the instant motion" (i.e., a motion made under the Third Circuit's three-part Cybergenics test); (ii) the courts in Citadel and HH Liquidation actually entered orders granting committees derivative standing before later dismissing the causes of action for lack of standing; (iii) applying Bax "would improperly supplant the applicable standard under Cybergenics in favor of a premature and claim-by-claim analysis of the merits of proposed claims"; (iv) Bax is preempted by Bankruptcy Code provisions governing the role of official unsecured creditors' committees in adversary proceedings and does not apply to avoidance, subordination, and recharacterization claims brought under the Bankruptcy Code; and (v) the appropriate time for the court to decide whether Bax applies is in the context of a motion to dismiss the complaint rather than a motion seeking derivative standing.

The Bankruptcy Court's Ruling

The bankruptcy court denied the official unsecured creditors' committee's motion for derivative standing. In an unpublished teleconference ruling, Judge Owens stated that she agreed with other Delaware bankruptcy courts that, in accordance with the relevant statute and case law applying it, only Delaware LLC members or entities holding assigned membership interests have standing to prosecute claims on behalf of the LLC. Judge Owens rejected the argument that the official unsecured creditors' committee's statutory role was impaired—or its investigation "rendered illusory"—by the inability to prosecute causes of action it perceived to be grounded in the Bankruptcy Code, rather than state law.

Judge Owens concluded that no provision in the Bankruptcy Code conflicts with (and thus preempts) the Delaware LLC standing rule. She also determined that the nature and origin of the potential causes of action are not relevant to the standing inquiry. According to Judge Owens, "[r]egardless of whether the claims arise under state law or the Code, the court must decide who may assert them." To answer that question, she stated on the record that "the court must look to the law of the debtors' state of formation."

Judge Owens also rejected the committee's argument that applying the Bax standing rule in bankruptcy would render "illusory" DIP financing order provisions that preserve the rights of committees to prosecute causes of action. She explained that "alternative remedies do exist to ensure that fiduciary duties are not neglected," including the appointment of a chapter 11 trustee or examiner. Acknowledging that these are "blunt tools," Judge Owens stated that she "suspects other creative or more effective options" could be devised to address the issue.

Judge Owens also denied the official unsecured creditors' committee's motion for an order extending the challenge period in the DIP financing order to allow a chapter 7 trustee to consider claims against the prepetition lenders after the cases were converted. According to the judge, the parties stipulated that the standing issue had to be adjudicated before conversion.

The McClatchy Company

The U.S. Bankruptcy Court for the Southern District of New York flatly rejected the Dura Automotive approach to derivative standing in cases involving Delaware LLCs. Newspaper publisher The McClatchy Co. ("McClatchy") filed for chapter 11 protection on February 13, 2020, with a plan to sell the companies to a group of bondholders led by Chatham Asset Management LLC ("Chatham"). McClatchy's official unsecured creditors' committee and the Pension Benefit Guaranty Corporation, which would be responsible for the company's $805 million in pension liabilities, both requested investigations into McClatchy's 2018 and 2019 debt refinancings, which they allege unlawfully converted $350 million unsecured debt owed to Chatham into a secured obligation. On June 22, 2020, the committee filed a motion seeking derivative standing to bring fraudulent transfer, breach of fiduciary duty, and equitable subordination claims against Chatham and certain other defendants.

In objecting to the motion, Chatham argued that Dura Automotive and Bax "make[] clear [that] statutory creditors' committees cannot obtain derivative standing when the debtor in possession is a Delaware limited liability company." In its response, the committee stated as follows:

Citing to a single out-of-circuit unpublished order, Chatham contends that the Committee categorically cannot obtain derivative standing on behalf of Debtors that are Delaware limited liability companies—an issue that only applies to six Debtors … The Committee disagrees. STN and its progeny make clear that the Committee is not just seeking to sue derivatively on behalf of the Estates, rather, it is seeking Court authority to step in as the Estates.

On July 6, 2020, Bankruptcy Judge Michael Wiles held in an unpublished ruling that the committee's proposed complaint stated "colorable" claims. See In re The McClatchy Co., No. 20-10418 (Bankr. S.D.N.Y. July 6, 2020) (transcript of hearing—Doc. No. 641). He rejected the argument that the Delaware LLC law prevents a bankruptcy court from conferring standing on a committee to bring derivative claims on behalf of LLC debtors. According to Judge Wiles, the Delaware LLC law was not controlling and "irrelevant" to committee derivative standing requests. He explained that federal bankruptcy law, rather than state law, governs because the committee sought to bring claims that became property of the bankruptcy estate on the petition date.

Outlook

Derivative standing is an important tool to generate value for the benefit of all stakeholders in a bankruptcy case. Recent rulings in Delaware LLC chapter 11 cases denying derivative standing may ultimately reduce recoveries available to general unsecured creditors. Moreover, the courts' rationale for importing state law derivative standing requirements into the bankruptcy context is uncertain, given the role played by fiduciaries acting on behalf of the bankruptcy estate (e.g., DIPs, trustees, and official committees) and their ability to effectively represent the estate's interest in litigation matters.

Notably, there was no argument in these cases that a bankruptcy trustee could not have prosecuted the claims on behalf of the estate exercising the powers conferred on a trustee by the Bankruptcy Code, nor was there a challenge to the bankruptcy courts' power to confer derivative standing to sue upon an official creditors' committee as a representative of the estate under appropriate circumstances. Moreover, many bankruptcy courts, including Delaware bankruptcy courts, have conferred derivative standing to sue upon creditors' committees or individual creditors in cases involving LLCs, notwithstanding state laws where the debtor LLC is domiciled that purport to limit derivative standing to LLC members or their assigns. See, e.g., Official Comm. of Unsecured Creditors v. Meltzer, 589 B.R. 6, 16 (D. Me. 2018) (derivative standing conferred on the creditors' committee in a chapter 11 case filed by a Delaware LLC); In re Pursuit Capital Mgmt., LLC, 595 B.R. 631, 658 (Bankr. D. Del. 2018) (conferring derivative standing upon a creditor in a chapter 7 case filed by a Delaware LLC); In re Know Weigh, L.L.C., 576 B.R. 189, 210 (Bankr. C.D. Cal. 2017) (conferring derivative standing upon creditors in chapter 11 case of a California LLC); In Matter of Home Casual LLC, 534 B.R. 350, 354 (Bankr. W.D. Wis. 2015) (conferring derivative standing upon a creditor in a chapter 7 case filed by a Wisconsin LLC); In re SGK Ventures, LLC, 521 B.R. 842, 847 (Bankr. N.D. Ill. 2014) (LLC formed under Illinois law).

Finally, consistent with other Delaware precedent, the court's ruling in Dura Automotive did not prohibit a chapter 7 trustee from asserting claims against the Dura's majority equity holder, Lynn Tilton, or other potential defendants for breach of fiduciary duty or related claims.

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.

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