To bring a lawsuit, a party must have “standing,” which means it must have a sufficient interest in the lawsuit such that it has the legal capacity to pursue its claim(s) before the court. Official creditor committees (“Committees”) in chapter 11 cases often seek standing to bring lawsuits against a debtor’s control parties, lienholders, or directors and officers for their pre-bankruptcy conduct, which are frequently essential to maximizing the value of a bankruptcy estate and obtaining a recovery for unsecured creditors. These claims might otherwise be lost if a debtor’s representatives are not motivated to bring suit (which is not uncommon given existing relationships with pre-bankruptcy control parties). Accordingly, the power to seek “derivative” standing to prosecute claims that otherwise belong to a debtor or a debtor’s estate is important, particularly to Committees. This power can be limited in certain circumstances. As we previously highlighted, when the debtor is a Limited Liability Company (“LLC”) or Limited Partnership (“LP”), some bankruptcy courts have held that state law limits who can obtain derivative standing. In response, judges and case constituents (usually Committees) continue to take varying approaches to avoid losing these claims in bankruptcy proceedings.
Various states have enacted statutes that have attempted to limit who may pursue a claim on behalf of an LLC or LP. The Delaware LLC Act, for example, provides that plaintiffs in derivative actions “must be [ ] member[s] or [ ] assignee[s]” of LLCs, both when they file suit and when the complained of transaction occurred.1 In the seminal 2011 case of CML V LLC v. Bax,2 the Delaware Supreme Court interpreted the Delaware LLC Act to mean that creditors could not bring derivative claims on behalf of a Delaware LLC.
This has led to unique challenges to creditors in bankruptcy courts. In the chapter 11 cases of Dura Automotive Systems, LLC and its affiliates pending in the Delaware bankruptcy court, Judge Karen B. Owens relied on the Bax decision to deny the Committee’s motion for derivative standing, finding that permitting standing would have violated the Delaware LLC Act.3 In her ruling, Judge Owens suggested that this result could have been avoided through other means, such as the appointment of a chapter 11 trustee or examiner, and speculated that “other creative or more effective options” might later be devised to address the issue.4 In the time since the Dura Automotive decision in June 2020, several “creative” approaches have been advanced to avoid the loss of valuable estate claims.
Last July, Judge Michael E. Wiles of the Southern District of New York bankruptcy court took a direct approach. Judge Wiles outright rejected the notion that statutes like the Delaware LLC Act prohibit a court from granting derivative standing to a Committee on behalf of the estate, determining, instead, that federal bankruptcy law preempted state law.5 As Judge Wiles explained, “[t]he claims at issue here plainly belong to the debtors’ estates and may be pursued on behalf of the estates. What the committee is asking me to do . . . is to authorize the committee to act as the estate representative to pursue the claims that belong to the estates and to do so as a matter of federal bankruptcy law, not state law.”6 Given the power conferred on the court by the Bankruptcy Code, Judge Wiles found that statutes such as the Delaware LLC Act are “irrelevant” to Committee requests for derivative standing.7
The Collected Group
The issue of LLC derivative standing was also front and center in the recent chapter 11 cases of The Collected Group, LLC and certain of its affiliates.8 There, Judge Laurie Selber Silverstein of the Delaware bankruptcy court raised concerns sua sponte regarding the debtors’ failure to address the issue at the beginning of the case.9 In describing the issue, Judge Silverstein noted, “there is some case law in this jurisdiction, with which I probably disagree, but have not yet had to rule on, that suggests that a creditors’ committee cannot bring a challenge, so that, effectively, the challenge is a nullity.”10 After the court’s prompting, the prepetition secured lenders agreed to stipulate that they would not evoke the state law standing issue as a defense to any challenge brought by the Committee.11 Although this was enough to make the court comfortable with language in an interim debtor-in-possession financing package, such a stipulation alone would obviously not safeguard a Committee’s rights against third-party defendants. Other Delaware bankruptcy courts have preserved a debtor’s ability to assert claims or permitted the debtor to name the Committee as the representative of the estate to assert claims in the event that the Committee is denied derivative standing because the debtor is an LLC or LP.12
Most recently, a debtor proceeding in the Delaware bankruptcy court is attempting to bypass the derivative standing issue as part of its plan of reorganization. On July 6, 2021, the debtor in the chapter 11 cases of Medley LLC, in conjunction with the Committee, filed a plan that proposes to create a litigation trust for the purpose of maximizing the value of the debtor’s remaining assets, including causes of action.13 In doing so, the plan includes language that proposes to transfer 1% of the debtor’s equity interests to a liquidating trustee, solely for the purpose of conferring derivative standing to pursue certain causes of action.14 Arrangements like this, however, require the parties to reach an agreement with non-debtor equity holders, which are often the target of the causes of action being preserved. Clearly this is not likely to be a viable resolution of the issue in all instances.
Cases show that there is no universal approach to the derivative standing issue. Absent a circuit court decision on the issue, varying interpretations of state statutes are likely to remain. It is clear, however, that early action in bankruptcy cases can help to ensure that Committees preserve crucial claims for maximizing creditor recoveries. If you have questions related to this situation, please don’t hesitate to reach out to John Ashmead (212-574-1366), Robert Gayda (212-574-1490), Catherine LoTempio (212-574-1632), Andrew Matott (212-574-1224), or your primary contact at S&K.