On Sept. 20, 2002, a panel of the Third Circuit Court of Appeals² departed from 100 years of settled bankruptcy law based on a "plain statutory language" analysis that the panel believed was mandated by the Supreme Court's decision in Hartford Underwriters Ins. Co. v. Union Planters Bank N.A.³ Under the Bankruptcy Code,⁴ the power to sue third parties on behalf of a debtor's estate is statutorily conferred upon the trustee in bankruptcy.⁵

In reorganization cases under chapter 11, the debtors' management routinely continues in possession of the property of the debtor and assumes all of the rights and powers of a trustee as a debtor-in-possession (DIP).⁶ Thus, courts have uniformly held in corporate reorganization cases that a DIP is the proper party to exercise the various rights and powers conferred upon a trustee under the Code for the benefit of the estate's creditors.

However, a significant line of authority dating back to at least 1900 provides a qualified right of creditors to sue "in the name of" the trustee if the trustee (or DIP) fails to perform its duties.⁷ When such failure to perform is alleged, the bankruptcy court has broad discretion to determine whether the interests of all creditors is best furthered by permitting someone other than the trustee or DIP to sue on behalf of the estate, and the court has historically been the intended gatekeeper of this derivative power. In appropriate instances (such as when the DIP needs to investigate claims against its own directors and officers), the statutory committee of creditors appointed in chapter 11 reorganization cases has been authorized to commence lawsuits on behalf of the estate.⁸

This practice has been upheld for decades by federal appeals courts⁹ and is in fact the common and expected practice among DIPs and creditors' committees, particularly in bankruptcy cases involving pre-bankruptcy fraud or other irregularities in which the business is nevertheless best left to management to operate. In a quest to maximize value, the parties who are best positioned to rehabilitate a company's operating performance may not be the best parties to investigate the pre-bankruptcy malfeasance of their colleagues or the board. Instead of forcing the estate to choose a team best suited for one, but not both, missions, bankruptcy courts (until Cybergenics II) had the flexibility to accommodate both objectives by authorizing committees to investigate and prosecute such causes of action on behalf of the estate.

Notwithstanding statutory and judicial support for derivative standing, a panel of the Third Circuit Court of Appeals, relying on the Supreme Court's recent decision in Hen House, held that the Bankruptcy Code's use of the phrase "the trustee may" authorizes only the trustee or DIP to sue on behalf of the estate. Although this result was explicitly not mandated by the Supreme Court in Hen House,¹⁰ the Cybergenics II panel extended the Supreme Court's "plain statutory language" analysis to foreclose a bankruptcy court even from having discretion to authorize another party to stand in the shoes of the trustee.¹¹ The Third Circuit panel concluded that the Bankruptcy Code "leaves a creditor or creditors' committee with several options should they desire that fraudulent transfer claims be prosecuted where the DIP declines to do so."¹² Specifically, a creditor or creditors' committee could either "move for the appointment of a trustee under §1104," or alternatively, a committee "could move...to dismiss the bankruptcy petition under §1112 so that it could pursue its state law avoidance claims in state court."¹³

According to the chief bankruptcy judge of Delaware, before whom the author appeared shortly after Cybergenics II was handed down, the Third Circuit panel's decision could adversely impact "hundreds" of pending actions. Indeed, if the panel's decision is not overruled en banc, the split of appellate authority would be of such significance that it warrants resolution by the Supreme Court on certiorari.

Limiting Hen House to Non-derivative Actions

The Supreme Court's Holding vs. Footnote 5

In Hen House, the straightforward issue presented was whether §506(c) of the Bankruptcy Code "allows an administrative claimant of a bankruptcy estate to seek payment of its claim from property encumbered by a secured creditor's lien."¹⁴ Because administrative expenses in bankruptcy¹⁵ do not have priority over secured claims, the claimant (Hartford Underwriters Insurance Co.) sought to invoke §506(c) of the Bankruptcy Code which provides "an important exception to the rule."¹⁶ Specifically, the claimant sought to recover for its own account (not for the benefit of reimbursing the estate) workers' compensation insurance premiums that the debtor (then a DIP) neglected to pay.¹⁷ Section 506(c) of the Bankruptcy Code permits the trustee in bankruptcy (which would include a DIP in chapter 11 cases) to recover expenses and costs attendant to maintaining a secured creditor's collateral: "The 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 such claim."¹⁸

The Supreme Court held that "the natural reading of the text" specifically "the trustee may," requires an interpretation that only the trustee—not individual claimants—may charge administrative costs and expenses against the collateral of a secured creditor.¹⁹ In footnote 5 to the unanimous Supreme Court opinion, the court expressly stated that it "do[es] not address whether a bankruptcy court can allow other interested parties to act in the trustee's stead in pursuing recovery under §506(c)."²⁰ The court noted that "[w]hatever the validity of that practice, it has no analogous application here, since petitioner did not ask the trustee to pursue payment under §506(c) and did not seek permission from the bankruptcy court to take such action in the trustee's stead. Petitioner asserted an independent right to use §506(c), which is what we reject today."²¹

No "Established Pre-Code Practice" Found in Hen House

The Supreme Court dismissed the administrative claimant's argument that the ability of administrative creditors to surcharge a secured creditor's collateral was an established pre-Code practice under the former Bankruptcy Act of 1898 and that such practice was not intended to be overruled by the Bankruptcy Code's permissive use of the words "the trustee may."²² The reason for dismissing such an argument, however, was that the petitioner was unable to establish a bankruptcy practice "sufficiently widespread and well recognized to justify the conclusion of implicit adoption by the Code."²³ Significantly, the court was not convinced that a random administrative creditor's right to surcharge a secured creditor's collateral was "the type of 'rule' that...Congress was aware of when enacting the Code."²⁴ In any event, the court held that §506(c) of the Bankruptcy Code—the only statute relied on by the petitioner—was sufficiently unambiguous to require no interpretation beyond its plain meaning.²⁵

The Cybergenics II panel took the Supreme Court's footnote reference to derivative standing in Hen House as standard procedure for an issue not addressed but for which the same analysis should probably apply.²⁶ While it is true that Hen House did not involve a claimant seeking to invoke derivative standing on behalf of the estate, the court affirmatively (and deliberately, based on the oral argument before the court) concluded in footnote 5 that derivative standing cases "have no analogous application here." Moreover, the court appeared to agree with the Seventh Circuit's Xonics Photochemical decision, which (like the Hen House court) rejected a creditor's independent right to sue and noted in dicta that the creditor could have sought leave of the court to assert a derivative action.²⁷

The Record of Oral Argument Is Telling

The reasons behind footnote 5 in Hen House are clear from the oral argument before the court held on March 20, 2000. Indeed, the theme of derivative standing permeated the questions by the justices of the court. These questions demonstrated the court's careful thought in ensuring that no court would read Hen House as having analogous application to the derivative standing cases:

Q: I know, but what I am trying to do for my own purposes is to find an analogy, and I know it's a rough analogy, but I would like to know just for my own purposes what happens, and it must happen often, of when a trustee doesn't bring a lawsuit to get some money for the estate, that a big creditor thinks he ought to bring. [How] [d]oes bankruptcy normally work—this can't be unusual.

A: It's not unusual.

Q: And in such circumstances, there are two possibilities. One is that you bring a suit to sue the trustee and make him do it. Another possibility is, you bring your own lawsuit but it—somehow you're standing in the shoes of the trustee.

A: Both exist...[Y]ou can seek what is known as derivative standing.

Q: Fine. Now, if that's so in that circumstance, why shouldn't that be so in this circumstance?

A: Because in this circumstance, Hartford didn't follow that procedure. Hartford didn't ask the trustee to act, and Hartford didn't go to the bankruptcy court to force the trustee to act, and Hartford didn't go to the bankruptcy court having made a record on that subject and said, you know, somebody needs to sue Union Planters because we think there's a pretty good 506(c) claim...²⁸

* * *

Q: If we assume that is correct, then, if we assume that is a proper practice, then if Hartford had done two things differently, Hartford would be entitled to recover, I take it, on the assumption that there may be a derivative action, and the two different things are, number 1, Hartford would have to have gone to the trustee, and the trustee would have had to indicate refusal.

* * *

Q: And number 2, Hartford, bringing its suit, would have to have captioned it, Hartford ex rel, or trustee ex rel Hartford, rather than Hartford, and if those two facts had been different, assuming derivative actions are appropriate, Hartford could recover here. Am I right, or am I missing something?²⁹

Thus, reading footnote 5 and the entirety of the Hen House decision, in light of the questions posed by the court at oral argument, more than merely passing mention must be given the Supreme Court's statement that derivative standing cases "have no analogous application here." The question, then, is whether Hen House has application to derivative standing cases.

Post-Hen House Derivative Standing Cases

The threat of unintended consequences of Hen House had been considered by several bankruptcy courts³⁰ and one appellate panel³¹ prior to the Third Circuit panel's decision in Cybergenics II. In those cases that have given in-depth consideration to the established underpinnings of derivative standing cases, Hen House has been found not to bar non-trustee actions brought on behalf of the estate if such derivative actions are approved by the bankruptcy court. The common theme in these bankruptcy court decisions is that because Hen House clearly stated that cases like Xonics, which upholds derivative standing, "were not analogous" to the controversy being decided by the Supreme Court, "it follows that [Hen House] is not analogous here."³²

In the post-Hen House case of Commodore International Ltd., a panel of the Second Circuit Court of Appeals had occasion to uphold and even expand its seminal decision on derivative standing, Unsecured Creditors Committee v. Noyes (In re STN Enterprises).³³ Although not expressly distinguishing (or even mentioning) Hen House, the Commodore panel reaffirmed the Second Circuit's rule of permitting derivative standing for creditors' committees when a trustee or DIP failed or declined to bring suit, and such suit is demonstrated to be in the best interests of the bankruptcy estate. Commodore further clarified that the DIP's reasons for refusal to bring suit need not be the subject of protracted litigation if the DIP is willing to confer its authority upon the creditors' committee. While the bankruptcy court is still required to determine that a potential derivative suit is necessary and beneficial to the estate, upholding agreements to confer standing consensually provide for a "reasonable and practicable division of labor between the creditors' committee and the DIP or trustee."³⁴

The Cybergenics II court declined to follow any of the post-Hen House lower courts based on the Supreme Court's deference to the "plain statutory language" of the text of the Bankruptcy Code and found that the Second Circuit's Commodore decision was distinguishable because the creditors' committee's authority was conferred by agreement of the DIP.³⁵ However, deference to the whole of the text³⁶ of the Bankruptcy Code, as demonstrated below, would have produced the opposite result than that reached by the panel in Cybergenics II.

Pre-Code Practice Was Intentionally Continued by Congress

Bankruptcy Act §64(a)(1) Became Bankruptcy Code §503(b)(3)(B)

The Supreme Court has held that "[w]hen Congress amends the bankruptcy laws, it does not write 'on a clean slate.'"³⁷ In that regard, the court has been careful not to accept arguments that would interpret the Code "to effect a major change in pre-Code practice that is not the subject of at least some discussion in the legislative history."³⁸ Indeed, in Hen House, the Supreme Court went to considerable lengths to examine whether there was any established and widespread pre-Code practice relating to independent rights of administrative creditors to surcharge collateral, and it expressly found that none existed. Contrary to the claimant's hollow interpretive attempts in Hen House, there is no question that, notwithstanding trustee primacy, "[i]t has been the settled law since 1898 that creditors may recover property for the benefit of the estate."³⁹

A recent bankruptcy court decision not considered by the Cybergenics II panel thoroughly studied the pre-Code practice of derivative standing of creditors to prosecute estate actions. In In re Godon Inc., the bankruptcy court noted that such rights were judicially developed and were recognized by the Eighth Circuit Court of Appeals as early as 1900.⁴⁰ In 1903, Congress amended the Bankruptcy Act of 1898 "to make explicit what had already been determined to be implicit:"⁴¹

(a) The debts to have priority, in advance of the payment of dividends to creditors, and to be paid in full out of bankrupt estates, and the order of payments shall be: (1)...; where property of the bankrupt, transferred or concealed by him either before or after the filing of the petition, is recovered for the benefit of the estate of the bankrupt by the efforts and at the cost and expense of one or more creditors, the reasonable costs and expenses of such recovery;...⁴²

However, these rights of derivative standing were not unlimited. In keeping with the primacy of a trustee, creditors needed to obtain permission either from the trustee or the court before acting.⁴³ No less a judicial authority than Judge Learned Hand (then circuit judge) explained the rationale for permitting creditor derivative suits, conditioned upon obtaining authorization from the court:

The receiver is responsible for the collection of the assets, and he alone can authorize charges against them. If any creditor, petitioning or other, learns facts which lead him to suppose that property has been concealed, he may, and indeed he should, advise the receiver, and if the receiver prove[s] slack, he may apply to the referee [bankruptcy judge] to stir him to action. The referee or the [district] judge may then authorize the creditor to proceed, and he will be entitled to his reward under [§64(a)(1)], but not otherwise.⁴⁴

The authority to recoup costs, pursuant to §64(a)(1) of the Bankruptcy Act, of a creditor who brings suit on behalf of the estate was expressly continued by Congress in enacting the Bankruptcy Code in 1978. The Report of the Commission on the Bankruptcy Laws of the United States explicitly stated, in the context of what is now §503(b)(3)(B) of the Bankruptcy Code, "[the new proposed section] continues the policy of §64a(1) and allows a creditor to recover expense incurred which actually benefits the estate."⁴⁵ The only issue that remained in dispute prior to actual enactment of the Bankruptcy Code was whether the creditor needed to obtain prior court approval in order to recoup costs in service to the estate, and the resulting text in §503(b)(3)(B) "represents a compromise"⁴⁶ within Congress and requires prior court approval. Section 503(b)(3)(B) of the Bankruptcy Code currently provides, in pertinent part:

(b) After notice and a hearing, there shall be allowed administrative expenses...including—

(3) the actual, necessary expenses...incurred by—

(B) a creditor that recovers, after the court's approval, for the benefit of the estate any property transferred or concealed by the debtor;...⁴⁷

Thus, contrary to the suggestion in Cybergenics II that the Bankruptcy Code provides no statutory authority for creditors or creditors' committees to bring derivative actions on behalf of the estate, §503(b)(3)(B) of the Bankruptcy Code, and its predecessor, §64(a)(1) of the Bankruptcy Act, provide the requisite textual support. Interestingly, the Third Circuit panel in Cybergenics II considered and dismissed the import of §503(b)(3)(B) in its discussion of one post-Hen House bankruptcy court decision, In re Blount.⁴⁸ It appears that the Third Circuit panel construed §503(b)(3)(B) as merely providing authority to recover "various administrative expenses" without considering that the statute contemplates a creditor first "recover[ing], after the court's approval, for the benefit of the estate any property transferred or concealed by the debtor."⁴⁹ Under the Third Circuit panel's restrictive construction, a creditor has authority to recoup administrative expenses in connection with recovering property for the benefit of the estate, but that creditor could not be authorized to recover the property in the first place. Such a literal reading of the Bankruptcy Code is belied by the well-established practice of derivative standing in bankruptcy and, more textually, would render §503(b)(3)(B) of the Bankruptcy Code, and its predecessor statute, internally inconsistent.

The Cybergenics II panel also cast Blount as a decision that supposedly agreed that the Supreme Court's decision in Hen House threatened the validity of derivative standing cases. Blount in fact held the opposite to be true:

Section 503(b)(3)(B), therefore, must be interpreted to provide statutory authority for a court to approve a creditor to act instead of a trustee, and thus provides an express statutory grant of the authority of the court to confer derivative standing upon creditors to pursue actions that will lead to recovery of property transferred or concealed by the debtor, for the benefit of the estate.⁵⁰

In addition, the pre-Code practice of courts having discretion to permit derivative standing was prevalent, even without a textual reference to §64(a)(1) of the Bankruptcy Act, based in large part on the power of courts to have flexibility as gatekeepers to ensure an estate's value was maximized. In addition to several lower court cases,⁵¹ the Supreme Court itself confirmed the propriety of permitting an entity other than the trustee to maintain an estate's cause of action during the pendency of a trustee's tenure. In Meyer v. Fleming,⁵² a case discussed by Justice Breyer at oral argument in Hen House,⁵³ a substantial but minority shareholder of a debtor commenced a derivative suit on behalf of the debtor pre-bankruptcy alleging that the defendant and the debtor had conspired to violate antitrust laws. After the commencement of the debtor's bankruptcy case, a trustee was appointed for the debtor, and the defendant moved to dismiss the suit on the grounds that the action "had become vested in [the debtor's] bankruptcy trustee and could no longer be asserted" by the shareholder.⁵⁴ Refusing to dismiss the suit, the Supreme Court held that while the bankruptcy trustee may be the proper party by statute to commence a new suit or take control of the existing lawsuit, the bankruptcy court had the inherent power to determine how best to proceed.⁵⁵ Significantly, the Supreme Court noted, in dicta, that if the action had been sought to be commenced by the shareholder after the debtor's bankruptcy case was commenced, "it could be done only with the consent of the bankruptcy court, [f]or it has exclusive authority to determine how causes of action which have a become part of the bankruptcy estate shall be enforced."⁵⁶

Legislative History Supports Discretion to Confer Derivative Standing

1. Disappointing Creditor Involvement. Although resorting to legislative history is not necessary in light of the plain statutory language of §503(b)(3)(B) of the Bankruptcy Code and §64(a)(1) of the Bankruptcy Act, a brief look at the official congressional statements accompanying the 1978 reform legislation speaks volumes for maximizing creditor involvement, not minimizing it, and encouraging vigilance and action, not stifling them. According to the Bankruptcy Code's accompanying Report of the Committee on the Judiciary, the "Bankruptcy Act was designed in 1898 to give creditors control over the bankrupt's assets which in equity belong to them."⁵⁷ In reforming the Bankruptcy Act, the Report of the Committee noted disappointingly that "creditor control of bankruptcy cases has become a myth in all but the largest cases."⁵⁸ The Committee further explained that "[c]reditors take little interest in pursuing a bankrupt debtor [because] [t]hey are unwilling to throw good money after bad. As a result, creditor participation in bankruptcy cases is very low."⁵⁹

2. Statutory Role of Creditors' Committees. With the foregoing criticism of poor creditor participation as the backdrop, Congress repealed the Bankruptcy Act of 1898 and enacted the Bankruptcy Code. The significance of statutory creditors' committees in chapter 11 reorganization cases was expressly made part of the accompanying Report of the Committee on the Judiciary:

Under the [new legislation for reorganizations and arrangements]...[t]here will be at least one committee in each case. Because unsecured creditors are normally the largest body of creditors and most in need of representation, the bill requires that there be a committee of unsecured creditors.⁶⁰

While the foregoing references to legislative history as to the need for bankruptcy reform legislation cannot overcome the text of the Bankruptcy Code, they are certainly instructive in interpreting the practical application of Congress' broad grants of statutory authority and power.⁶¹

Statutory Authority of Court and Creditors' Committees in Chapter 11

Court's Power to "Condition" and "Limit" DIP's Trustee Rights and Powers

When Congress expressly grants broad equitable powers to bankruptcy courts, it is contrary to the text to minimize such grants by insisting that bankruptcy is a Code-based, plain language, law that requires textual support for every conceivable outcome. This is particularly true when, unlike the case in Hen House, it is the bankruptcy court's own power, not that of a single creditor, that is the subject of the legislation. In the context of the role of a DIP, it bears emphasizing that §1107(a) of the Bankruptcy Code, which confers "all the rights...and powers" of a trustee upon a DIP, is expressly subject "to such limitations or conditions as the court prescribes."⁶² This specific qualification on the DIP's rights and powers, applicable in chapter 11 cases, is in addition to the bankruptcy court's general equitable power under §105(a) to "issue any order, process or judgment that is necessary or appropriate to carry out the provisions of this title."⁶³

DIP Does Not Have All Trustee Duties

The textual differences between trustees and DIPs are even more pronounced in the context of the duties of a DIP because Congress expressly limited the duties of DIPs as compared with the duties imposed on chapter 11 trustees.⁶⁴ Although not often raised by bankruptcy courts or practitioners, §1107(a) of the Bankruptcy Code requires that a DIP "perform all the functions and duties, except the duties specified in §1106(a)(2), (3) and (4) of this title, of a trustee serving in a case under this chapter."⁶⁵ The excluded duties encompass the essential and anticipated trustee function to "investigate the acts, conduct, assets, liabilities and financial condition of the debtor...."⁶⁶ Section 1107(a) also excludes any duty of the DIP to "file a statement of [such] investigation...including any fact ascertained pertaining to fraud, dishonesty, incompetence, misconduct, mismanagement or irregularity in the management of the affairs of the debtor, or to a cause of action available to the estate."⁶⁷

Of course, creditors would expect that an estate-funded fiduciary would investigate and, if appropriate, prosecute causes of action available to the estate. But if the DIP—supposedly the exclusive estate representative where no trustee is appointed—has no duty to investigate such wrongs, who will investigate potential avoidance actions and other sources of recovery for the benefit of the estate? Congress certainly could not have envisaged that lackluster creditor participation under the Bankruptcy Act would suddenly be transformed into enthusiastic vigilantism by individual creditors who were previously reluctant "to throw good money after bad" pursuing the debtor.

Statutory Creditors' Committees Expressly Authorized to Investigate and Perform "Such Other Services"

Congress seamlessly resolved the hole left by the limited trustee duties imposed on DIPs in §1107(a) of the Bankruptcy Code by mandating⁶⁸ the appointment of a statutory unsecured creditors' committee and specifically authorizing that committee to undertake all of the investigative duties of a trustee. Section 1103(c) of the Bankruptcy Code enumerates the rights and powers of a statutory creditors' comm