Creditor Denied Derivative Standing to Countersue Plaintiff in Chapter 7 Adversary Proceeding

The Fifth Circuit Court of Appeals and the majority of other Circuit Courts have previously held that granting a creditors’ committee in a chapter 11 case derivative standing to pursue estate causes of action is implied by 11 U.S.C. §§1103(c)(5) and 1109(b).  La. World Exposition, Inc. v. Fed. Ins. Co. (In re La. World Exposition, Inc.), 858 F.2d 233, 247 (5th Cir. 1988).  The Fifth Circuit also found a nonstatutory rational for derivative standing “in a chapter 11 case when a debtor, like a ‘fox guarding the hen house,’ has a conflict of interest in pursuing an action because of its relationship with management.”  Id.  This relief was subsequently extended to other parties in chapter 7 cases.  See Lilly v. Fed. Deposit Ins. Corp. (In re Natchez Corp of W. Va.), 953 F.2d 184, 187 (5th Cir. 1992).

Derivative standing, however, is extraordinary relief that is not easily conferred, as Judge Olack of the Southern District of Mississippi recently reminded us in In re On-Site Fuel Service, Inc., Case No. 18-04196-NPO-7 (Bankr. S.D. Miss. May 8, 2020) [Dkt. No. 330].  In that chapter 7 case, Judge Olack refused to grant derivative standing to a creditor seeking to pursue estate claims against a third-party, because the creditor:

  1. did not have the unequivocal consent of the trustee;
  2. did not demonstrate a colorable claim under Louisiana World Exposition; and
  3. had a conflict of interest with the estate.

But, the creditor in On-Site was also a defendant in an adversary proceeding commenced by the third party and therefore stood to personally gain from prosecuting estate claims.  Like the proverbial fox guarding the hen house, this creditor was not deemed to be the proper gatekeeper for protecting estate claims.

Facts

The Ruling arises from the chapter 7 case of On-Site Fuel Service, Inc. (the “Debtor“), a tank wagon fuel supply business that was placed in an involuntary bankruptcy by Mansfield Oil Company of Gainesville, Inc. (“Supplier“), a nationwide supplier of petroleum products that had entered into an agreement with the Debtor (“SAA“) to sell petroleum products directly to the Debtor’s customers.

Notwithstanding the SAA and recent business relationship with the Supplier, the Debtor (which was on life support) ceased operations prepetition and, in contravention of an exclusive option agreement with the Supplier, sold its assets in a “fire sale” to Diesel Direct, Inc. (the “Buyer“), in large part because the Debtor’s two primary stakeholders, two private equity firms (the “Private Equity Firms“), were no longer willing to infuse capital into the Debtor.

A couple of days after the fire sale, the Supplier commenced what became a heavily-litigated involuntary chapter 7 proceeding against the Debtor.  Seven months later, after a 3-day trial, the Court entered an order for relief in the involuntary case, and a chapter 7 trustee (“Trustee“) was appointed.

Two adversary proceedings were subsequently commenced.  The first adversary was by the Supplier against the Private Equity Firms and certain principals under various common-law theories relating to the Supplier becoming a strategic partner with the Debtor through the SAA.  The Supplier alleged several misrepresentations and breaches in connection with the SAA transaction, including misappropriation of approximately $5 million in funds that were earmarked for the Supplier in respect of a loan.

The second adversary was commenced by the Trustee, seeking to (a) subordinate, based on various theories, including breach of fiduciary duty and fraud, approximately $17 million in secured claims filed by the Private Equity Firms and (b) avoid the “fire sale” to the Buyer.  The Trustee’s factual allegations in its complaint mirrored many of the allegations made in the Supplier’s adversary.

Both adversaries were eventually consolidated.  Thereafter, an agent and active participant for one of Private Equity Firms (“Agent“) sought derivative standing purportedly to assert estate claims, via a third-party action, against the Supplier for alleged breaches of the SAA, other torts and claims under chapter 5 of the Code.

While the Trustee wavered several times, he ultimately did not oppose the Agent’s exercise of derivative standing over certain contractual claims–“however unlikely the chance of success”–and potential tort claims, provided the Agent would fund the litigation and any recovery inured to the benefit of the estate.

Analysis

As mentioned, the Fifth Circuit has recognized statutory and non-statutory bases for conferring derivative standing on parties other than debtors and trustees.  Under Louisiana World Exposition, a court should consider the following three factors in determining whether to grant derivative standing to an individual creditor or creditors’ committee:

  1. whether the claim is colorable;
  2. whether the debtor in possession or the trustee unjustifiably refused to pursue the claim; and
  3. whether the creditors’ committee first received leave to sue from the bankruptcy court.

858 F.2d at 247.  These factors are intended to avoid interference with the debtor or trustee and prevent creditors from pursuing weak claims.

Consent

The Agent argued that, notwithstanding the seminal case in Fifth Circuit, the test is modified when a trustee consents to derivative standing.  See PW Enters v. N.D. Racing Comm’n (In re Racing Servs., Inc.), 540 F.3d 892 (8th Cir. 2008).  Under this Eighth Circuit precedent, the question of unjustifiable refusal is replaced with the question of whether there exists a “colorable” claim.

Judge Olack said that while a different standard in consent-to-standing cases may be warranted, the arguments made by the Trustee in its response to the Agent’s derivative standing motion, as well as the Trustee’s oral statements made at the hearing on such motion, did not constitute the type of consent that would justify a departure from the standard set forth in Louisiana World Exposition.  In short, the Trustee expressed concerns as to whether the claims proposed by the Agent had any merit and only ever reluctantly consented to limited standing on certain contractual and tort claims–but not proposed preference claims–because the estate would not incur any expenses in pursuing them and would be the sole recipient of any recovery.

The Court ultimately found that the Racing Services case required something akin to unequivocal consent, because of a trustee’s role as an independent gatekeeper of meritorious claims.  See Reed v. Cooper (In re Cooper), 405 B.R. 801 (bankr. N.D. Tex. 2009).  In addition, cases such as On-Site require coordination of litigation responsibilities with a trustee; something that was lacking in this case due to tension between the Trustee’s equitable subordination claims against the Private Equity Firms and the Agent’s proposed estate claims against the Supplier.

Colorable Claim

A “colorable” claim generally refers to one that could survive a motion to dismiss under Rule 12(b)(6) of the Federal Rules of Civil Procedure.  “To survive a motion to dismiss, a complaint must contain sufficient factual matters, accepted as true, to ‘state a claim for relief that is plausible on its face.'” Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009).  A claim is plausible “when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for misconduct alleged.”  Id.

Here, the Court had difficulty in finding the Agent’s claims as “colorable,” because, significantly, the Agent failed to prepare a draft third-party complaint to share with the Court and only loosely referred to its potential contractual and tort claims in its motion.  While the Agent attempted to bolster its claims in oral argument at the hearing on the derivative motion, the Court found that this attempt was still insufficient, especially since the Agent could not explain a key concept to its proposed estate claims, i.e., how the SAA created some type of fiduciary relationship between the Supplier and Debtor.

Accordingly, when added to the Trustee’s equivocation on the merits of the proposed estate claims, the Court found that the alleged claims (asserted in conclusory fashion) did not give rise to colorable claims, thereby failing to meet the standards under Louisiana World Exposition.

Conflict

Finally, the Court found a third, independent ground to deny the Agent’s standing motion.  Judge Olack held that a conflict of interest would arise if the Agent was prosecuting claims on behalf of the Trustee in the first adversary proceeding brought by the Supplier, while, at the same time, defending against equitable subordination claims brought by the Trustee against the Private Equity Firms, because the nucleus of operative facts supporting the Agent’s proposed claims and Trustee’s actual claims were in complete opposition.  The Court summarized the situation as such:

The Trustee Adversary is filled with allegations of wrongful conduct by
the [] Agent, including that the [] Agent acted improperly and inequitably with respect to the estate and [Supplier].  It would create an absurd result to allow the []Agent, acting on behalf of the estate, to compel the estate to adopt a factual narrative to prosecute claims against [the Supplier] for its alleged wrongful conduct, while at the same time, in the same consolidated trial, and with the same group of attorneys to allow the [] Agent to defend claims by the Trustee based on an entirely different factual narrative . . . . [I]t would place the [] Agent ‘on both sides of the v.’ in the adversary proceedings.

In essence, if the Agent successfully prosecuted its proposed estate claims against the Supplier, this would defeat the Trustee’s claims against the Private Equity Firms, which Judge Olack thought were the largest potential source of recovery for the On-Site estate.  The Court therefore found that eliminating this conflict by not allowing derivative standing was in the best interest of the estate.

The attorney-client privilege further exposed a fatal flaw in conferring derivative standing in this case, because the Court did not want to provide the Agent with attorney-client privileged information that it otherwise would be entitled to if it was acting on behalf of the estate.  See Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 358 (1986) (holding that in corporate bankruptcy cases, the chapter 7 trustee acquires the debtor’s attorney-client privilege.”).  Such conflict of interest was the precise reason another court denied derivative standing to an administrative claimant in another case. See Robert F. Craig, P.C. v. Greenlight Capital Qualified, L.P. (In re Prosser), 469 B.R. 228 (D.V.I. 2012).

Takeaway

Standing to sue on behalf of a bankruptcy estate is generally reserved to fiduciaries who are not self-interested and are looking out after the interests of all stakeholders.  If an individual claimant seeks to meet the high burden of acquiring derivative standing, it should, at a  minimum, illustrate sound and well-reasoned claims through a draft complaint.  In On-Site, the Agent failed to show that the estate had meritorious claims against the Supplier, and this along with the Trustee’s equivocation on the merits and the other problems arising from the self-interest of the Private Equity Firms, left the Court with the difficult task of conferring derivative standing to the Agent under Fifth Circuit precedent.  When viewed in this light, Judge Olack’s thoughtful opinion might be seen as more of a public service to future litigants confronted with similar fact patterns.

 

 

Partner at FisherBroyles, LLP