In Claridge Associates, LLC, et al. v. Anthony Schepis (In re Pursuit Capital Management, LLC), Adv. P. No. 16-50083 (LSS) (Bankr. D. Del. Nov. 2, 2018), the Honorable Laurie Silverstein held that a chapter 7 trustee was authorized to sell the right to pursue fraudulent conveyance claims to third parties, pursuant to section 363 of the Bankruptcy Code. In doing so, the Court extended the Third Circuit’s holding in Official Committee Of Unsecured Creditors of Cybergenics Corp. v. Chinery, 330 F.3d 548 (3d. Cir. 2003) (en banc) to chapter 7 cases.
Pursuit Capital Management, LLC (“Debtor”) was the general partner of two investment partnerships (the “Feeder Funds”). Two individuals were the sole owners and controlling principals (“Principals”) of the Debtor and several offshore funds and investment management companies.
By 2009, one of the Feeder Funds ceased making new investments and started to wind down. Litigation followed against the Debtor, the Principals and affiliates by various investors who had lost money.
The Debtor eventually filed for chapter 7 relief. A year later, the chapter 7 trustee filed a motion to sell all the Debtor’s assets, pursuant to section 363(b) and (f) of the Bankruptcy Code, to some of the investors who had asserted prepetition claims. The assets consisted wholly of claims against third parties, including fraudulent conveyance claims against the Principals and affiliates.
After an auction, the Court authorized the trustee to sell all rights, title and interests to any claims belonging to the Debtor, the trustee and the bankruptcy estate to the investors, in return for a recovery to the bankruptcy estate from the resulting litigation.
In the subsequent litigation brought by the purchasing investors, the defendants filed a motion to dismiss the complaint, arguing, in part, that the investors could not buy the claims and lacked standing to bring bankruptcy and state law avoidance actions against the defendants under sections 548(a)(1) and 544(b) of the Bankruptcy Code. The defendants relied primarily on the Third Circuit’s two Cybergenics decisions. See Official Comm. Of Unsecured Creditors of Cybergenics Corp. v. Chinery, 226 F.3d 237 (3d. Cir. 2000) (“Cybergencis I”); Official Comm. Of Unsecured Creditors of Cybergenics Corp. v. Chinery, 330 F.3d 548(3d. Cir. 2003) (en banc) (“Cybergenics II”).
The investors countered that Cybergenics I did not address the ability of a trustee to sell fraudulent conveyance claims and Cybergenics II authorized a bankruptcy court to use its equitable powers to permit the sale of avoidance claims to non-trustees.
Cybergenics I and II
In Cybergenics I, one of the main issues was whether a creditors’ committee in a chapter 11 case could bring a derivative action on the estate’s behalf to recover fraudulent conveyances, even if such claims might have been sold, as part of the debtor’s assets, in an earlier 363 sale. On appeal, the Third Circuit held that the committee could pursue such claims, as the prior sale did not include state law fraudulent conveyance claims, which did not belong to the debtor.
In Cybergenics II, which occurred after the remand from Cybergenics I, the main issue was whether section 544 only allows a trustee to pursue state law fraudulent transfer claims. The district court held that it did and thus dismissed the complaint, based on the Supreme Court’s holding in Hartford Underwriters’ Ins. Co. v. Union Planters Bank, 530 U.S. 1 (2000).
On the second appeal, the Third Circuit distinguished the Hartford case on the basis that it was focused on a “nontrustee’s right unilaterally to circumvent the Code’s remedial scheme,” while Cybergenics II was focused on “a bankruptcy court’s equitable power to craft a remedy when the Code’s envisioned scheme breaks down.”
The Third Circuit found that the Bankruptcy Code, pursuant to sections 1109(b) and 1103(c)(5), envisions a creditors’ committee playing a central role in a chapter 11 case and thus evidences Congressional intent to allow a bankruptcy court to grant derivative standing to committees. The Third Circuit also found that section 503(b)(3)(B) implicitly sanctions this practice, because such provision grants administrative priority claims for costs incurred in recovering transferred or concealed property of the debtor.
The Third Circuit further found refuge in the bankruptcy court’s equitable powers. According to the Third Circuit, when a trustee refuses to bring an avoidance action, the bankruptcy court can invoke its equitable powers to affect the result the Bankruptcy Code was designed to obtain. In Cybergenics II, the remedy crafted with these equitable powers was to permit the creditors’ committee to sue derivatively on behalf of the estate, provided the bankruptcy court acted as the gatekeeper for the prosecution of estate claims.
Application of Cybergenics I and II
Judge Silverstein first found that, unlike Cybergenics I, there was really no issue that the right to pursue fraudulent conveyance claims were sold, because the sale order provided for the transfer to investors of all rights, title and interest of the Debtor, trustee and the bankruptcy estate to these claims. This covered all pertinent rights.
Turning to the standing issue, the Court found that Cybergenics II recognized the ability of a court to permit a third party to employ the trustee’s avoidance powers when the Code’s envisioned scheme has broken down, provided a nontrustee does not act unilaterally, without court approval and/or supervision.
The Court then determined the ultimate question, whether the holding in Cybergenics II should be extended to chapter 7 cases. The court decided to do so, reasoning that (a) part of the statutory grounds relied on in Cybergenics II (i.e., section 503(b)(3)(B)) applies equally to chapter 7 cases and (b) the justification for a court’s use of its equitable powers, especially in the context of avoidance actions, applies equally in chapter 7 cases. The Court also found solace in In re Trailer Sources, Inc., 555 F.3d 231 (6th Cir. 2009), where the Sixth Circuit specifically extended the equitable powers sanctioned in Cybergenics II to chapter 7 cases, reasoning that such cases are particularly vulnerable to a breakdown in the Code’s scheme because a trustee often lacks funds to pursue meritorious claims.
The Court finally looked at the standard for allowing a creditor to sue derivatively. Here, since there was a gap in the Cybergenics II opinion on this issue, the Court borrowed the standards used by the Second and Seventh Circuits in In re Commodore Int’l Ltd., 262 F.3d 96 (2d. Cir. 2001) and Fogel v. Zell, 221 F.3d 955 (7th Cir. 2000).
In Commodore, the Second Circuit held that derivative standing could be granted to creditors, with approval and supervision of the bankruptcy court, (a) when a debtor unreasonably fails to bring suit or (b) where the trustee or debtor consent. Applying this standard, the Court had no problem finding that the 363 sale provided the requisite trustee consent and court approval and supervision.
The Seventh Circuit’s standard in Fogel requires an additional finding that there exists a “colorable” claim. Here, Judge Silverstein found that there was a colorable claim because the defendants had failed to test the sufficiency of the allegations in the complaint, which, in any instance, was well-plead, in the Court’s view.
Accordingly, the Court rejected the defendant’s motion to dismiss and allowed the investors to continue to prosecute their avoidance actions.
This holding is best summarized in the following quote from Judge Silverstein’s opinion:
In instances, such as this one, where a debtor’s prepetition corporate management is alleged to have engaged in fraudulent transfers immediately prior to the bankruptcy filing, stripping the debtor of any funds that a chapter 7 trustee could use to make distributions to those creditors and/or investigate management’s actions, the intended system has broken down, and it is appropriate for the bankruptcy court to use its equitable powers and craft a flexible remedy.
Pursuit Capital Management at 38. At least in Delaware, creditors in chapter 7 cases now have a new weapon with which to hold third parties liable for a debtor’s inappropriate activities prior to filing bankruptcy.