1 • November 2004 Turnaround Management Assoc ia t ion

Hartford found itself with more than $50,000of unpaid insurance premiums.A

trustee or, more commonly, thedebtor-in-possession in the case of aChapter 11 corporate reorganizationacts as an estate’s representative after

commencement of a bankruptcy case. TheBankruptcy Code delineates the representa-tive’s powers and duties, granting the individualthe ability to sue and to be sued on behalf ofthe estate and imparting a fiduciary obligationto the estate and its creditors.

Despite this obligation, disagreementsoften arise in bankruptcy proceedings as towhether the trustee or debtor-in-possessiontruly is acting in the best interests of theestate. In many cases, creditors allege that theestate’s representative is not pursuing claimsthat could add value to the estate.

In such cases, bankruptcy courts histori-cally have granted creditors a qualified rightto bring actions on the estate’s behalf.Although no specific provision in theBankruptcy Code covers this practice, courtsconferring derivative standing on creditorshave generally cited pre-Bankruptcy Codepractice and various policy considerations fortheir decisions.1

The ‘Hen House’ CaseThe U.S. Supreme Court’s 2000 decision inHartford Underwriters Ins. Co. v. UnionPlanters Bank2 addressed the validity of acreditor’s derivative standing. Also known asthe “Hen House” case, Hartford Underwritersarose out of the bankruptcy of Hen HouseInterstate, Inc. In that case, HartfordUnderwriters Insurance Co., unaware of HenHouse’s pending Chapter 11 proceeding,provided Hen House with workers’ compen-sation insurance during its attempted reorga-nization. When the reorganization failed andthe case was converted to Chapter 7 liquidation,

BulletinLEGAL

collateral surcharge provisions of Section506(c) of the Bankruptcy Code rather thanraising a question as to the continued legitimacyof creditors’ derivative standing. Indeed, theSupreme Court specifically reserved judgmenton the practice of conferring derivative standingon creditors to pursue avoidance actions,despite the fact that similar language giving theright to commence such actions solely to “thetrustee” is found in the Bankruptcy Code’savoidance provisions.3

CybergenicsThe issue of creditors’ derivative standing tobring avoidance actions on behalf of a bank-ruptcy estate came to a head two years later in the Chapter 11 proceeding of CybergenicsCorporation.4 In Cybergenics, the creditors’committee sought permission from the bank-ruptcy court to pursue certain fraudulenttransfers that the debtor-in-possession hadrefused to pursue. After the bankruptcy courtgranted the request, the U.S. District Courtreversed.

The District Court, and subsequently athree-judge panel of the 3d Circuit Court of Appeals, concluded that the “rather wellestablished” practice of permitting creditors toinitiate derivative avoidance actions could notsurvive the Supreme Court’s reasoning inHartford Underwriters.5 Following the rationalefrom Hartford Underwriters, the 3d Circuitrejected prior practice and policy consider-ations in determining that the plain meaning ofthe Bankruptcy Code provisions that grant “thetrustee” the power to commence an avoidanceaction are an exclusive grant of power belongingto the debtor, and as such, no other party ininterest –– including a creditor or a creditors’committee –– could exercise these powers.

Subsequently, Hartford sought to chargethe premiums to Hen House’s primary secured creditor under Section 506(c) of theBankruptcy Code, which states that “[t]hetrustee 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 anybenefit to the holder of such claim.” Hartfordargued that its provision of insurance had preserved the value of the secured creditor’scollateral and it should therefore be able torecover on its claim as an administrativeexpense.

In considering the case, the Supreme Courtfocused narrowly on the issue of whether theBankruptcy Code, under Section 506(c), gavean administrative claimant authority to seekrecovery unilaterally. Rejecting argumentsbased on prior practice, as well as general policy considerations, the court directed itsattention to the specific language of the provi-sion and, in particular, the phrase “the trusteemay.” Espousing a “plain meaning approach”to interpreting the statute, the court found thatthe power to invoke Section 506(c) lay exclu-sively with the trustee, and thus, no other partyhad the right to pursue administrative claims.

The Hartford Underwriters holdingseemed to be limited to the issue of whethercreditors have independent standing to use the

Disagreements often arise in bank-ruptcy proceedings as to whetherthe trustee or debtor-in-possessiontruly is acting in the best interests ofthe estate.

Fox Attacks ‘Hen House’:A Renewed Challenge to Creditors’

Derivative StandingBY WENDELL H. ADAIR JR., A. VICTOR GLASER & SAYAN BHATTACHARYYA, STROOCK & STROOCK & LAVAN LLP

R E P R I N T E D F R O M

continued on page 2

CorpRenNov04LegalB.qxd 11/1/04 3:52 PM Page 34

The Cybergenics decision raised a stirthroughout the bankruptcy bar and wassquarely in conflict with more than a decadeof established case law from various circuitsacross the country, including decisions of the2d, 5th, 6th, 7th, and 9th Circuit Courts of Appeals.6

Ultimately, however, the 3d Circuitvacated the panel opinion after voting torehear the case en banc. On May 29, 2003,the 3d Circuit reversed itself and concludedthat Hartford Underwriters should beconstrued narrowly to its circumstances andthat the language of the avoidance power sections of the Bankruptcy Code did not pre-clude a creditors’ committee from commencingan avoidance action in the debtor’s name.7

The 3d Circuit acknowledged that theBankruptcy Code does not explicitly empowera bankruptcy court to confer derivative standingon a creditors’ committee to pursue an avoid-ance action. Nevertheless, it concluded thatthe legislators’ intent to encourage creditorparticipation in the bankruptcy proceedingand the longstanding practice of authorizingcreditors to bring avoidance actions on behalfof an estate, together with the bankruptcycourt’s equitable powers, provided sufficientgrounds to allow bankruptcy courts to conferderivative standing on creditors in thesecircumstances. The court noted that “derivativestanding is a prudent way for bankruptcycourts to remedy lapses in a trustee’s executionof its fiduciary duty.”8

The en banc decision in Cybergenicsbrought the 3d Circuit back in line with themajority of circuits and seemed to ensure thecontinued viability of creditors’ derivativestanding in avoidance actions.

In re FoxIn a decision that once again raises the issuethat had seemed to be laid to rest, the 10thCircuit’s Bankruptcy Appellate Panel (BAP)recently held that a creditor seeking toprosecute an avoidance action on behalf of a debtor’s estate had no standing to do so andthat the only party with such standing was thedebtor-in-possession itself.9 In In re Fox, anindividual debtor transferred real estate to hiswife and then filed a Chapter 11 petition.When the debtor refused to prosecute afraudulent transfer action against his wife torecover property for the benefit of his estate,

one of Fox’s creditors tried to sue to recoverthe property on behalf of the estate. The bank-ruptcy court held that the creditor could notcommence such an action, and the 10thCircuit BAP affirmed that decision.

The Fox court held that it was constrainedby the language of Section 548 of theBankruptcy Code, which states that “thetrustee” may avoid fraudulent transfers. Thecourt recognized that the 3d Circuit en bancdecision in Cybergenics, among other courts,had stretched the statute to confer standing oncreditors’ committees, especially when thedebtor-in-possession had refused to prosecutelegitimate fraudulent transfer claims.

However, noting a lack of authority in the10th Circuit, the BAP held that the SupremeCourt’s decision in Hartford Underwriterswas controlling. Accordingly, the BAP turnedonce again to a literal construction of theBankruptcy Code’s use of the term “thetrustee.” The Fox court recognized that theplain language of the statute arguablyconflicted with public policy. The court deter-mined, however, that public policy concernsalone were not sufficient reasons to ignore thestatutory language:

Cybergenics discusses many reasons why itwould be good policy for parties other thanthe trustee to bring derivative complaints,and it is hard to disagree with the reasonsset forth by the majority [in that case]. We,however, believe this reasoning is best considered by Congress, and it is not up to us to create a remedy for creditors it hasnot granted to them, especially when thatright is given exclusively to the trustee.Here the statute is absolute and allows usno discretion to vary from what it says.10

At OddsThe Fox decision, like the vacatedCybergenics decision before it, is clearly atodds with the majority’s thinking on thisissue. It remains to be seen if other courts willfollow the Fox court’s lead, forming a splitbetween the circuits that could result in theSupreme Court taking on the issue. Until suchtime, creditors and creditors’ committees mustonce again be on guard for the possibility thata request to commence a derivative avoidanceaction will be denied.

1 See, e.g., Unsecured Creditors Committee v.Noyes (In re STN Enterprises), 779 F.2d 901,904 (2d Cir. 1985); In re Toledo Equipment Co.,Inc., 35 B.R. 315, 317 (Bankr. N.D.Ohio 1983);In re Monsour Medical Center, 5 Bankr. 715,718 (Bankr. W.D.Pa. 1980).

2 530 U.S. 1 (2000).3 Hartford Underwriters, 530 U.S. at 13 n. 5.4 In re Cybergenics Corp., No. 96-37203 (Bankr.

D.N.J. August 19, 1996).5 Official Committee of Unsecured Creditors of

Cybergenics Corp. v. Chinery, 304 F.3d 316 (3dCir. 2002), vacated, reh’g en banc granted, 310F.3d 785 (3d Cir. 2002).

6 See, e.g., In re Commodore Intern. Ltd., 262F.3d 96, 100 (2d Cir. 2001); In re Gibson Group,Inc., 66 F.3d 1436, 1440 (6th Cir. 1995); In reSufolla, Inc., 2 F.3d 977, 979 n.1, (9th Cir.1993); Matter of Vitreous Steel Products Co.,911 F.2d 1223, 1231 (7th Cir. 1990); LouisianaWorld Exposition v. Federal Ins. Co., 858 F.2d233, 247 (5th Cir. 1988); In re STN Enterprises,779 F.2d 901 (2d Cir. 1985). In fact, within twomonths of the Cybergenics decision, the 2dCircuit Court of Appeals reaffirmed the validityof the practice within the 2d Circuit of a credi-tors’ committee having standing to commenceavoidance actions in its decision in In reHousecraft Industries USA, Inc., 310 F.3d 64(2d Cir. 2002). It should be noted thatHousecraft makes no reference at all to theHartford Underwriters decision, thereby estab-lishing a split between two of the most promi-nent bankruptcy circuits.

7 Official Committee of Unsecured Creditors v.Chinery (In re Cybergenics Corp.), 330 F.3d 548(3d Cir. 2003).

8 Id. at 572.9 In re Fox, 305 B.R. 912 (B.A.P. 10th Cir. 2004).

10 Id. at 916.

Wendell H. Adair Jr.,A. Victor Glaser, and Sayan Bhattacharyya are with Stroock & Stroock & Lavan LLP’s FinancialRestructuring Group in New York. Adair can be reached at (212) 806-5870 orwadair@stroock.com,Glaser can be reached at (212) 806-5547 orvglaser@stroock.com,and Bhattacharyya can be reached at (212) 806-5723 orsbhhattacharyya@stroock.com.

Dedicated To Corporate Renewal November 2004 • 2

The Cybergenics decision raised astir throughout the bankruptcy barand was squarely in conflict withmore than a decade of establishedcase law…

continued from page 1

LEGAL BULLETIN

CorpRenNov04LegalB.qxd 11/1/04 3:52 PM Page 35