Cybergenics: En Banc Restores the Status Quo by Allowing Creditors' Committees to Pursue Derivative Claims
Written By Berry D. Spears and C. Mark Brannum¹

Introduction

In October 2001, unsecured creditors' committees around the country got a scare when the United States District Court for the District of Delaware issued an opinion in the Cybergenics² case. The District Court’s opinion reversed the Delaware Bankruptcy Court and held that the Cybergenics creditors' committee lacked standing to bring fraudulent transfer claims under Section 544(b) of the Bankruptcy Code. Even more surprising was the Third Circuit's subsequent affirmation of the District Court’s decision. As might be expected, these decisions set a dangerous precedent and threatened to eliminate a potentially valuable arrow from the quiver of unsecured creditors' committees.

Cybergenics Background

In Cybergenics, the debtor — after selling substantially all of its assets — informed the bankruptcy court and the creditors' committee that it would not pursue any avoidance actions, including fraudulent transfer claims. The Cybergenics committee not only believed that colorable fraudulent transfer claims existed against certain lenders and insiders of the debtor under §544(b) of the Bankruptcy Code but had also requested that the debtor prosecute the fraudulent transfer claims. The debtor refused. The Cybergenics committee then sought and obtained leave from the bankruptcy court to derivatively bring the causes of action against the debtor’s lenders and insiders. Once the Cybergenics committee commenced the fraudulent transfer actions, the debtor promptly appealed to the District Court seeking to dismiss the claims brought by the Cybergenics committee on the ground that it did not have standing to bring such claims.

Why Was Cybergenics Such a Surprise?

The course of action the Cybergenics committee was attempting to pursue was not unusual. For years prior to Cybergenics, unsecured creditors' committees had long utilized the concept of derivative standing to bring causes of action against third parties when debtors refused to bring such causes of action. The concept of derivative standing was first applied in the bankruptcy context in Chatfield v. O’Dwyer³ as early as 1900. The power of a bankruptcy court to confer derivative standing was then recognized in 1931 by the Second Circuit in In re Eureka Upholstering Co.⁴ Thus, the Third Circuit was not dealing with a new judicial construct.

In the years following the Eureka decision, many bankruptcy courts and circuit courts recognized the concept of derivative standing to allow creditors' committees to bring all types of causes of actions, including avoidance actions under chapter 5 of the Bankruptcy Code, with the seminal case discussing this issue being Louisiana World Exposition, Inc. v. Federal Insurance Co.⁵ As a result of Louisiana World Exposition and its prodigy, the notion that certain causes of action, especially avoidance actions, should be preserved for unsecured creditors had become derigueur. It became commonplace for committees to regularly reserve the right to bring third-party causes of action, including avoidance actions, in post-petition debtor-in-possession financing agreements. Courts had even concluded that these types of causes of action were reserved for distribution to unsecured creditors and could not be pledged to secured creditors⁶ as part of first-day orders and were generally insulated from adequate protection liens and the grasp of post-petition financiers in local rules and procedural guidelines.⁷ As a consequence, the Cybergenics decision, which set all of this legal precedent aside, was very surprising.

Why did Cybergenics Happen?

Cybergenics did not occur in a vacuum. The result in Cybergenics actually was the logical result of an earlier United States Supreme Court decision on an unrelated section under chapter 5 of the Bankruptcy Code: Hartford Underwriters Insurance Co. v. Union Planters Bank (In re Henhouse).⁸ In Hartford Underwriters, the Supreme Court held that a committee of unsecured creditors did not have standing to bring surcharge claims under §506(c), which states that “[t]he trustee may recover from property securing an allowed secured claim the reasonable, necessary costs and expenses of preserving, or disposing of, such property to the extent of any benefit to the holder of the claim.” See 11 U.S.C. §506(c). The Hartford Underwriters court relied heavily on the “the trustee may” language of §506(c) and further found that it did not mean “the trustee and other parties in interest may.” (emphasis added.)

Section 554(b) of the Bankruptcy Code has the identical §506(c) “trustee may” language. Hence, the Cybergenics debtor relied on the Supreme Court's decision in Hartford Underwriters and argued that the Cybergenics committee did not have standing to pursue this cause of action. The debtor argued that, under Hartford Underwriters, only a trustee may bring suit under Section 544(b). The District Court agreed, and the Cybergenics committee appealed the decision to the Third Circuit. A three-judge panel of the Third Circuit court affirmed the District Court on the same grounds, and subsequently, the Cybergenics committee sought a rehearing en banc.

The En Banc Panel Restores the Status Quo

The controversy created by the District Court's opinion in Cybergenics proved only temporary as the Third Circuit, sitting en banc, reversed the District Court's opinion and authorized the Cybergenics committee to pursue derivative claims. In finding Hartford Underwriters inapplicable, the en banc panel drew a distinction between the facts of Hartford Underwriters and the case at hand. Relying upon a footnote in Hartford Underwriters, the court recognized that the Supreme Court specifically did not address whether a bankruptcy court can allow other interested parties to act in the trustee’s stead to pursue recovery under §506(c). The Hartford Underwriters petitioner did not make demand on the debtor or seek authority from the bankruptcy court to take such action in the trustee’s stead.⁹ In other words, the petitioner in Hartford Underwriters did not seek derivative standing. The Third Circuit noted that the Cybergenics committee first made a demand on the debtor and then, after the debtor unreasonably refused to bring the subject actions, sought and obtained authorization from the bankruptcy court to sue derivatively on the debtor's behalf.

It is important to note that the Cybergenics committee did not argue that the "trustee may" language found in Section 544(b) can be read to mean "the trustee and other parties in interest may." Rather, they argued that §544(b) does not preclude the bankruptcy court from authorizing it to pursue derivative claims when a debtor or trustee improperly refuses to exercise its powers. The en banc panel agreed with the Cybergenics committee's argument, noting that the equitable remedy of authorizing the committee to sue derivatively is consistent with the Bankruptcy Code's statutory scheme.¹⁰ In addition to finding that Hartford Underwriters did not apply to the Cybergenics case, the en banc panel provided several additional reasons that justify a committee’s derivative right to sue on behalf of a debtor.

The en banc panel further reasoned that chapter 11 of the Bankruptcy Code must be interpreted as a whole. In particular, they reviewed §§1109(b), 1103(c)(5), and 503(b)(3)(B) of the Bankruptcy Code to determine whether derivative standing is a permissible equitable remedy in cases where a debtor has unreasonably refused to bring an avoidance claim under §544(b). First, §1109(b) provides that a party-in-interest (the section explicitly references a creditors' committee, among others) may raise and may appear and be heard on any issue in a case under chapter 11.¹¹ Section 1103(c)(5) provides that a committee may perform such other services as are in the interest of those represented.¹² Finally, the en banc panel reviewed §503(b)(3)(B), which allows for a creditor or party in interest to recover the costs associated with recovering property for a debtor's estate,¹³ and concluded that these sections, taken together, evidence a congressional intent that committees should play a robust and flexible role in representing the bankruptcy estate, even in adversarial proceedings.¹⁴

Next, the en banc panel also held that the ability to confer derivative standing upon creditors' committees is a straightforward application of a bankruptcy courts' equitable powers. The en banc panel noted that the intent behind the statutory scheme of the Bankruptcy Code occasionally breaks down, as it did in Cybergenics when the debtor refused to bring the fraudulent transfer claims at issue. Rather than foreclosing a remedy for the estate and its creditors, the bankruptcy court crafted a remedy with its equitable powers to allow the committee to prosecute the claims on behalf of the Debtor. As the en banc panel noted, it is in these circumstances that generally the bankruptcy court's equitable powers are most valuable. Id. at 568.

Lessons from Cybergenics

Ultimately, the Cybergenics decision became a favorable decision for unsecured creditors and unsecured creditors’ committees. More importantly, the Cybergenics decision offers insight on preserving the right to pursue derivative claims on behalf of a debtor. As a practical matter, a creditors’ committee must follow the rules of derivative standing under nonbankruptcy law. First, a creditors’ committee or an interested party should first request that the debtor pursue the claims at issue. If a debtor refuses, the creditors’ committee or interested party should evaluate the reasons the debtor is refusing to take such action and determine whose articulated reasons are reasonable and justified under the circumstances. In Cybergenics, the debtor chose not to pursue the claims because the claims were against former lenders and other insiders of the corporation. Obviously, a debtor may be reluctant to pursue claims against its lenders, especially if they have been cooperative throughout the bankruptcy case or the debtor needs the lenders’ cooperation going forward. For equally obvious reasons, a debtor may also be reluctant to pursue claims against insiders or to pursue claims against key vendors that currently supply the debtor with needed services and/or goods. All of these situations present facts in which the creditors' committee or another interested party may well be the best party to pursue these causes of action. Finally, in order to pursue these causes of action, the creditors’ committee or interested party must take the additional step of presenting these facts to the bankruptcy court and persuading that court that pursuing these claims is in the best interest of the estate and its creditors.

A creditors’ committee may circumvent this process by preserving its right to pursue derivative claims in cash collateral or financing order or other order entered early in the bankruptcy case. If this is not possible, the creditors' committee must take the necessary steps discussed above to obtain standing to pursue derivative claims. In the end, the Cybergenics opinion restores clarity in an area that was briefly muddled and should assist creditors' committees in obtaining enhanced recoveries for its constituency in situations where the debtor refuses to bring appropriate and valid causes of action.

FOOTNOTES

¹ Berry Spears is a shareholder in the bankruptcy section of Winstead Sechrest & Minick P.C. in Austin, where he also oversees the firm’s business restructuring practice. Mark Brannum is a shareholder in the bankruptcy section of Winstead’s Dallas office.
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²The Official Committee of Unsecured Creditors of Cybergenics Corp. v. Chinery, et al. 330 F.3d 548 (3rd Cir. 2003).
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³101 F. 797 (8th Cir. 1900)
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⁴48 F.2d 95 (2d Cir. 1931)
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⁵858 F.2d 233 (5th Cir. 1988), reh'g den., 864 F.2d 1147 (5th Cir. 1989)
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⁶Comments to Cash Collateral and DIP Financing checklist for the Northern District of Texas. [back to text]
⁷See Mellon Bank v. Glick (In re Integrated Testing Products Corp.), 69 B.R. 901, 905 (D.N.J. 1987); In re Sapolin Paints, Inc. 11 B.R. 930, 937 (Bankr. E.D.N.Y. 1981), but see Unsecured Creditors’ Committee v. Jones Truck Lines, Inc. (In re Jones Truck Lines, Inc.) 156 B.R. 608. [back to text]
⁸530 U.S. 1(2000).
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⁹See Hartford Underwriters, 530 U.S. at 13 n.5.
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¹⁰See Cybergenics, 330 F.3d at 559.
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¹¹See 11 U.S.C. §1109(b).
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¹²See 11 U.S.C. §1103(c)(5).
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¹³See 11 U.S.C. § 503(b)(3)(B).
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¹⁴See Cybergenics, 330 F.3d at 566.
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