Tag: Bankruptcy

Common Attornment Provision Held Ineffective After Master Lease and Sublease Rejected in Bankruptcy by Debtor-Sublandlord

Posted in the National Law Review an article by attorney  Howard J. Berman of  Greenberg Traurig regarding a subtenant of commercial office space was permitted to vacate its leased premises after the rejection of the master lease and sublease by the debtor-sublandlord:

GT Law

In Green Tree Serv., LLC v. DBSI Landmark Towers LLC,1 a case that is significant for landlords and leasing attorneys, the Eighth Circuit recently held that a subtenant of commercial office space was permitted to vacate its leased premises after the rejection of the master lease and sublease by the debtor-sublandlord, notwithstanding an attornment provision in the sublease requiring the subtenant to attorn2 to the landlord when the landlord either terminates the master lease or otherwise succeeds to the interest of the sublandlord under the master lease.

Because the Eighth Circuit’s decision hinges on an interpretation of an attornment provision that is common in many sublease agreements, landlords and practitioners must be careful to draft attornment provisions that do not run afoul of the decision.

 

 

In a strict construction of the attornment provision, the court determined that because the master lease was rejected by the debtor-sublandlord and not terminated by the landlord, the attornment provision was never triggered. Because the Eighth Circuit’s decision hinges on an interpretation of an attornment provision that is common in many sublease agreements, landlords and practitioners must be careful to draft attornment provisions that do not run afoul of the Eighth Circuit’s decision.

In Green Tree, the landlord leased an office building to the debtor, DBSI Landmark Towers Leaseco, LLC (“DBSI”), under a master lease. DBSI then subleased the property to Green Tree Servicing, LLC (“Green Tree”). The master lease agreement between the landlord and tenantsublandlord DBSI required that any sublease include a provision providing for the subtenant to attorn to the landlord in certain circumstances. The sublease agreement entered into between DBSI and subtenant Green Tree required Green Tree to attorn to the landlord if the “[landlord] ‘terminates the Master Lease’ or ‘otherwise succeeds to the interest of [DBSI] under the foregoing Lease.’” 3

After tenant DBSI filed for bankruptcy, it rejected its master lease as well as its sublease with Green Tree pursuant to order of the bankruptcy court. In its motion to reject, DBSI indicated that the sublease would be terminated as a result of the rejection. In response, Green Tree exercised its rights under section 365(h) of the Bankruptcy Code (which allows a tenant whose lease is rejected by a debtor-lessor to either remain in possession or treat the lease as terminated) to treat the sublease as terminated.4 Although sublandlord DBSI did not object to Green Tree’s election to terminate the sublease, the landlord objected, claiming that the terms of the sublease required subtenant Green Tree to attorn to the landlord.5Green Tree then commenced an action in Minnesota state court seeking a declaration that the sublease was terminated and that it could vacate its premises. The landlord removed the case to federal court and cross-claimed for a judgment affirming the sublease.

The Eighth Circuit rejected Green Tree’s argument that because it exercised its right to terminate the sublease under section 365(h) it had no obligation to the landlord under the attornment provision in the sublease, stating “nothing in section 365(h) indicates that a debtor-lessor’s rejection of a lease extinguishes a third party’s rights and obligations under the lease.”6 The court then analyzed the language of the attornment provision strictly and determined that it would be triggered only when the landlord terminates the master lease or otherwise succeeds to the interest of sublandlord DBSI.7 Because DBSI and not the landlord rejected the master lease in DBSI’s bankruptcy case and because DBSI rejected and terminated the sublease, the court held that the attornment provision was never triggered and that subtenant Green Tree was free to vacate the premises. 8In reaching this conclusion, the court noted that DBSI never assigned its contractual interest in the sublease to the landlord prior to DBSI’s rejection and termination of the sublease and that the landlord “could not succeed to the interest in the sublease that no longer existed . . . .”9 Here, the only contractual interest to survive under the sublease was the landlord’s right to attornment, which right was not triggered.10

In light of the court’s strict interpretation of the attornment provision, landlords must be careful to include language in attornment provisions in both the master lease and sublease making it clear that a subtenant must attorn to the landlord in the event that a master lease and/or sublease is rejected under section 365 of the Bankruptcy Code by a debtor-sublandlord.

1__F. 3d__, 2011 WL 3802800 (8th Cir. Aug. 30, 2011).

2The term “attorn” means ‘“[t]o agree to be the tenant of a new landlord.’” Id. at *1 n. 5 (quoting Black’s Law Dictionary,
147 (9th ed. 2009)).

3Green Tree Serv., 2011 WL 3802800 at *1

411 U.S.C. § 365(h)(1)(A) provides in pertinent part:

If the trustee rejects an unexpired lease of real property under which the debtor is the lessor and –

(i) if the rejection by the trustee amounts to such a breach as would entitle the lessee to treat such lease as terminated by virtue of its terms, applicable nonbankruptcy law, or any agreement made by the lessee, then the lessee under such lease may treat such lease as terminated by the rejection . . .

5 See Green Tree Serv., 2011 WL 3802800 at *1.
6 Id. at *2 (citation omitted).
7 Id. at *3.
8 Id. at *3.
9 Id.
10Id.

©2011 Greenberg Traurig, LLP. All rights reserved.

Unsecured Creditors Beware! The Western District of Texas Bankruptcy Court Declares an Unsecured Creditor Cannot Have Its Cake (Unsecured Claim) and Eat It Too (Post-Petition Legal Fees)

Recently posted in the National Law Review an article by Evan D. Flaschen, Renée M. Dailey, Mark E. Dendinger of Bracewell & Giuliani LLP about the issue of whether an unsecured creditor can recover post-petition legal fees under the Bankruptcy Code:

Bankruptcy courts have long debated the issue of whether an unsecured creditor can recover post-petition legal fees under the Bankruptcy Code. In the recent decision of In re Seda France, Inc. (located here(opens in a new window)), Justice Craig A. Gargotta of the United States Bankruptcy Court for the Western District of Texas denied an unsecured creditor’s claim for post-petition fees. In doing so, the Court has once again left the unsecured creditor with a bad taste in its mouth by declaring that an unsecured creditor seeking post-petition fees is asking permission to have its cake (a claim for principal, interest and pre-petition legal fees under applicable loan documents) and eat it too (a claim for post-petition legal fees).

Proponents of the view that an unsecured creditor cannot recover post-petition legal fees point to section 506(b) of the Bankruptcy Code, which allows as part of a creditor’s secured claim the reasonable attorneys’ fees and costs incurred during the post-petition period, and note the Bankruptcy Code is silent on anunsecured creditor’s right to post-petition legal fees. Essentially, the argument is since Congress provided for post-petition fees for secured creditors, it could have explicitly provided for post-petition fees for unsecured creditors but chose not to. Proponents of the alternative view cite the Second Circuit decision United Merchants and its progeny, where those courts refused to read the plain language of section 506(b) as a limitation on an unsecured creditor’s claim for recovery of post-petition legal expenses. The theory is that while the Bankruptcy Code does not expressly permit the recovery of an unsecured creditor’s claim for post-petition attorneys’ fees, it does not expressly exclude them either. The basic tenant is that if Congress intended to disallow an unsecured creditor’s claim for post-petition legal fees it could have done so explicitly.

In Seda, Aegis Texas Venture Fund II, LP (“Aegis”) timely filed a proof of claim in Seda’s Chapter 11 bankruptcy case claiming its entitlement to principal, interest and pre-petition attorneys’ fees under its loan documents with Seda as well as post-petition attorneys’ fees for the duration of the case. Aegis made various arguments in support of the allowance of its post-petition legal expenses including: (1) the explicit award of post-petition fees to secured creditors under section 506(b) does not mean that such a provision should not be implicitly read into section 502(b) (i.e., unim est exclusion alterius (“the express mention of one thing excludes all others”) does not apply), (2) the United States Supreme Court decision in Timbers does not control as Timbers denied claims of anundersecured creditor for unmatured interest caused by a delay in foreclosing on its collateral, (3) the right to payment of attorneys’ fees and costs exists pre-petition and it should be irrelevant to the analysis that such fees are technically incurred post-petition, (4) because the Bankruptcy Code is silent on the disallowance of an unsecured creditor’s post-petition attorneys’ fees, these claims should remain intact, and (5) recovery of post-petition attorneys’ fees and costs is particularly appropriate where, as in Seda, the debtor’s estate is solvent and all unsecured creditors are to be paid in full as part of a confirmed Chapter 11 plan.

The Seda Court rejected Aegis’ arguments and held that an unsecured creditor is not entitled to post-petition attorneys’ fees even where there is an underlying contractual right to such fees and unsecured creditors are being paid in full. With respect to Aegis’ argument on the proper interpretation of sections 506(b) and 502(b), the Court cited the many instances in the Bankruptcy Code where Congress expressed its desire to award post-petition attorneys’ fees (e.g., section 506(b)), and found that Congress could have easily provided for the recovery of attorneys’ fees for unsecured creditors had that been its intent. Regarding Aegis’ argument that Timbers does not control, the Court held that in reaching its decision on the disallowance of a claim for unmatured interest the Timbers Court found support in the notion that section 506(b) of the Bankruptcy Code does not expressly permit post-petition interest to be paid to unsecured creditors. The SedaCourt held this ruling should apply equally to attorneys’ fees to prohibit recovery of post-petition fees and expenses by unsecured creditors. The Court further held that section 502(b) of the Bankruptcy Code provides that a court should determine claim amounts “as of the date of the filing of the petition,” and therefore attorneys’ fees incurred after the petition date would not be recoverable by an unsecured creditor. In response to Aegis’ argument that non-bankruptcy rights, including the right to recover post-petition attorneys’ fees should be protected, the Seda Court noted that the central purpose of the bankruptcy system is “to secure equality among creditors of a bankrupt” and that an unsecured creditor’s recovery of post-petition legal fees, even based on a contractual right, would prejudice other unsecured creditors. The Court held this is true even in the case where the debtor was solvent and paying all unsecured creditors in full. The Court noted that a debtor’s right to seek protection under the Bankruptcy Code is not premised on the solvency or insolvency of the debtor and, therefore, the solvency of the debtor has no bearing on the allowance of unsecured creditors’ post-petition legal fees.

Seda is the latest installment in the continued debate among the courts whether to allow an unsecured creditor’s post-petition attorneys’ fees. The Seda Court is of the view that an unsecured creditor cannot recover post-petition legal fees for the foregoing reasons, most notably that the Bankruptcy Code is silent on their provision and public policy disfavors the recovery of one unsecured creditor’s legal expenses incurred during the post-petition period to the prejudice of other unsecured creditors. Depending on the venue of the case, there will undoubtedly be many more instances of unsecured creditors seeking recovery of their post-petition attorneys’ fees in a bankruptcy case until the Supreme Court definitively rules on the issue. Until then, keep asking for that cake . . . .

© 2011 Bracewell & Giuliani LLP

Supreme Court Limits Bankruptcy Court Jurisdiction – Stern v. Marshall

Posted recently at the National Law Review by Prof. G. Ray Warner of Greenberg Traurig, LLP – the latest installment of the Anna Nicole Smith / J. Howard Marshall estate issue and how it impacts the jurisdiction of bankruptcy courts:   

 

In a decision that may create serious problems for bankruptcy case administration, the Supreme Court this morning invalidated part of the Bankruptcy Court jurisdictional scheme. Stern v. Marshall, No. 10-179, 564 U.S. ___ (June 23, 2011). Specifically, the Court held that the Bankruptcy Courts cannot issue final judgments on garden variety state law claims that are asserted as counterclaims by the debtor or trustee against creditors who have filed proofs of claim in the bankruptcy case.

Thus, while the Bankruptcy Court could issue a final order resolving the creditor’s claim against the estate, it could issue only a proposed ruling with respect to the counterclaim. Final judgment on the counterclaim could only be issued by the District Judge after de novo review of any matters to which a party objects. See 28 U.S.C. § 157(c).

In a five-to-four opinion by Chief Justice Roberts, the Court affirmed the Ninth Circuit Court of Appeals decision that had reversed an $88 million judgment in favor of Vickie Lynn Marshall (a/k/a Anna Nicole Smith) against E. Pierce Marshall for tortious interference with Vickie’s expectancy of a gift from her late husband J. Howard Marshall, Pierce’s father and one of the richest people in Texas.

The Court’s decision was based on constitutional principles defining the limits of Article III of the U.S. Constitution. Thus, it is likely to have implications that reach far beyond the narrow issue resolved in the instant case. The majority relies on the “public rights” doctrine to define the class of judicial matters that can be resolved by non-Article III tribunals like the Bankruptcy Courts. However, it adopts a narrower view of what constitutes “public rights” than was generally understood prior to this decision.

In addition, although earlier cases could be read to adopt a flexible pragmatic approach to Article III that focused only on significant threats to the Judiciary, Chief Justice Roberts takes a very firm approach, stating, “We cannot compromise the integrity of the system of separated powers and the role of the Judiciary in that system, even with respect to challenges that may seem innocuous at first blush.” Of particular interest, this case focuses on the nature of the Bankruptcy Judge as a non-Article III judge (i.e., no life tenure and no salary protection) and rejects the view that the Bankruptcy Courts are merely “adjuncts” of the Article III District Courts. Note that the “adjunct” construct was one of the foundations of the 1984 Act’s post-Northern Pipeline jurisdictional fix that created the core/non-core distinction. See Northern Pipeline Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982).

The narrow holding is that Bankruptcy Judges, as non-Article III judges, lack constitutional authority to hear and “determine” counterclaims to proofs of claim if the counterclaim involves issues that are not essential to the allowance or disallowance of the claim. Here, although the counterclaim was a compulsory counterclaim, it was a garden variety state law tort claim and did not constitute a defense to the proof of claim. Contrast this with the preference claim involved in Langenkamp v. Culp, 498 U.S. 42 (1990). The receipt of such an unreturned preference is a bar to the allowance of the claim. See 11 U.S.C. 502(d). The opinion also distinguishes Langenkamp (and the earlier pre-Code case of Katchen v. Landy, 382 U.S. 323 (1966)) on the ground that the preference counterclaims in those cases were created by federal bankruptcy law. It is unclear whether that reference establishes a second condition to Bankruptcy Court resolution of counterclaims — i.e., that the counterclaim be based on bankruptcy law in addition to its resolution being essential to claim allowance.

The Court begins its opinion by interpreting the “core” jurisdictional grant of 28 U.S.C. 157(b)(1). The Court finds the provision ambiguous, but rejects the view of the Ninth Circuit that the Bankruptcy Court’s jurisdiction to determine matters involves a two-step process of deciding both whether the matter is “core” and whether it “arises under” the Bankruptcy Code or “arises in” the bankruptcy case. The Court states that such a view incorrectly assumes there are “core” matters that are merely “related to” the bankruptcy case (and which cannot be “determined” by the Bankruptcy Court). The Court states that core proceedings are those that arise in a bankruptcy case or arise under bankruptcy law and that noncore is synonymous with “related.” Thus, since counterclaims to proofs of claim are listed as core in the statute, the Bankruptcy Court has statutory authority to enter final judgment. (Note that the opinion does not explain how a tort claim that arose before the bankruptcy and that was based on non-bankruptcy state law could be a claim “arising in” the bankruptcy case or “arising under” bankruptcy law. Possibly the fact that procedurally it arises as a counterclaim is sufficient to convert a “related” claim into an “arising in” or “arising under” claim. Cf. Langenkamp.)

The Court also rejects the argument that the personal injury tort provision of 28 U.S.C. 157(b)(5) deprives the Bankruptcy Court of jurisdiction to resolve the counterclaim. The Court holds that section 157(b)(5) is not jurisdictional and thus the objection was waived.

Although the statute authorized the Bankruptcy Court to determine the counterclaim, the Court holds that grant violates Article III. The Court rejects the view that the Article III problem was resolved by placing the Bankruptcy Judges in the judicial branch as an “adjunct” to the District Court. The Court focuses on the liberty aspect of Article III and its requirement of judges who are protected by life tenure and salary guarantees. After outlining the extensive jurisdiction of Bankruptcy Judges over matters at law and in equity and their power to issue enforceable orders, the Court states “a court exercising such broad powers is no mere adjunct of anyone.”

The Court then uses the “public rights” doctrine as the test for which matters can be delegated to a non-Article III tribunal. Although Granfinanciera v. Nordberg, 492 U.S. 33 (1989), suggested a balancing test that considered both how closely a matter was related to a federal scheme and the degree of District Court supervision (a test that arguably supports the Bankruptcy Court’s entry of a judgment on a compulsory counterclaim), the Court settles on a new test for public rights limited to “cases in which resolution of the claim at issue derives from a federal regulatory scheme, or in which resolution of the claim by an expert government agency is deemed essential to a limited regulatory objective within the agency’s authority.” The state common law tort counterclaim asserted here does not meet that test. Instead, adjudication of this claim “involves the most prototypical exercise of judicial power.”

Interpreted in the most restrictive fashion, this ruling might create serious problems for case administration. In proof of claim matters, the Bankruptcy Court would be limited to proposed findings on most counterclaims, with the District Court entering the final order after de novo review. Query whether the majority’s limited view of “public rights” would prevent the Bankruptcy Judge from entering final judgment in other disputes that involve the non-bankruptcy rights of non-debtor parties. Bankruptcy Courts regularly resolve inter-creditor disputes and resolve disputes regarding the non-bankruptcy rights of parties to the bankruptcy case in contexts other than claim allowance. Whether the Bankruptcy Court’s exercise of this power is constitutional may turn on how broadly the courts interpret the “cases in which resolution of the claim at issue derives from a federal regulatory scheme” prong of the “public rights” test.

©2011 Greenberg Traurig, LLP. All rights reserved.

 

Standing and In Pari Delicto Issues Arising in Bankruptcy Cases

Congrats to Rui Li of the The University of Iowa College of Law -one of  winners of the Spring 2011 National Law Review Student Legal Writing Competition:   Rui’s topic addresses whether a bankruptcy trustee has standing to bring a suit on behalf of the debtor corporation against attorneys who allegedly helped that corporation’s management with the fraud.  

1.  Introduction

Corporate and managerial fraud is pervasive in today’s economic climate. When fraud leaves a company insolvent and forced to seek protection under the Bankruptcy Code, oftentimes bankruptcy trustees commence legal actions against attorneys to generate recoveries for the benefit of the debtor’s estate. A common scenario goes something like this: A company is in dire financial straits before the fraud or is created as a vehicle for the fraud. The defendant is the corporation’s attorney, who assists the corporation in the fraud. The attorney is hired to ensure the company’s compliance with existing law. The attorney does the bidding of the company’s management in pursuance of their fraud. After the company’s collapse, the bankruptcy trustee sues the attorney for fraud, aiding and abetting fraud and legal malpractice.

Drawing upon the equitable defense that bars recovery by a plaintiff bearing fault with the defendant for the alleged harm, common law principles of agency imputation, and the Constitutional requirement that a plaintiff has standing to sue, a defendant may move to dismiss the lawsuit on the grounds that the bankruptcy trustee lacks standing to sue.

This Note provides an analysis of the issue whether the bankruptcy trustee has standing to bring a suit on behalf of the debtor corporation against attorneys who allegedly helped that corporation’s management with the fraud.

2.  The In Pari Delicto Doctrine

a) Background

In pari delicto means “at equal fault.” It is a broadly recognized equitable principle and common law defense that prevents a plaintiff who has participated in wrongdoing from recovering damages resulting from the wrongdoing.[1] The policy behind this doctrine is to prevent one joint wrongdoer from suing another for damages that resulted from their shared wrongdoing.[2] Therefore, if a bankruptcy trustee brings a claim against an attorney on behalf of the corporation, and if the corporation is involved in the corporation’s wrongful conduct which serves as the basis for the claim, the in pari delicto may bar the claim.

The use of the doctrine against bankruptcy trustees emerged in the wave of corporate frauds in the last few decades. This novel application required the introduction of an important new element: agency law. Under agency principles, if the principal acted wrongfully through an agent in the scope of that agency relationship, then the wrongdoing of the agent is attributed to the principal.  Because the acts of corporate managers in the course of their employment are imputed to the corporation, and because a bankruptcy trustee “stands in the shoes” of a debtor corporation, the fraudulent acts of the debtor’s former managers will be imputed to the trustee—unless the trustee can show that management was acting entirely on its own interests and “totally abandoned” those of the corporation to break the chain of imputation.[3]

An analysis of the equitable defense in pari delicto at issue is separable from a standing analysis.[4] “Whether a party has standing to bring claims and whether a party’s claims are barred by an equitable defense are two separate questions, to be addressed on their own terms.”[5]

b)  The Second Circuit’s Approach

In Shearson Lehman Hutton Inc. v. Wagoner, 944 F.2d 114 (2d Cir. 1991), the Second Circuit adopted the controversial approach of treating in pari delicto as a question of standing rather than an affirmative defense. Specifically, the standing analysis in the Second Circuit begins with the issue of whether the trustee can demonstrate that the third party professional injured the debtor in a manner distinct from injuries suffered by the debtor’s creditors.[6] In many jurisdictions, the question of the trustee’s standing ends here.[7] In Wagoner, the Second Circuit went further and added a second inquiry that incorporates the equitable defense ofin pari delicto.[8] By combining these two issues, the Wagoner rule blends the in pari delicto question into a rule of standing.

In Wagoner, the sole stockholder, director, and president of a corporation had used the proceeds of notes to finance fraudulent stock trading.[9] After the corporation became insolvent, the trustee brought claims against the defendant, an investment bank, for breach of fiduciary duty in allowing the company’s president to engage in inappropriate transactions.[10] The court held that because the president participated in the alleged misconduct, his misconduct must be imputed to the corporation and the bankruptcy trustee. This rationale derives from the agency principle that underlies the application of in pari delicto to corporate litigants: the misconduct of managers within the scope of their employment will normally be imputed to the corporation.[11] The court ruled that the trustee lacked standing to sue the investment bank for aiding and abetting the president’s alleged unlawful activity.[12] By adopting the Wagoner rule, the Second Circuit upped the ante by making an equitable defense a threshold question of standing at the motion-to-dismiss stage, rather than an affirmative defense better resolved on summary judgment or at trial.

c)  Approaches of Other Circuits

Although the Wagoner rule still prevails in the Second Circuit, a majority of other courts have declined to follow it, including the First, Third, Fifth, Eighth, Ninth and Eleventh Circuits. These circuits have “declined to conflate the constitutional standing doctrine with the in pari delicto defense.”[13] “Even if an in pari delictodefense appears on the face of the complaint, it does not deprive the trustee of constitutional standing to assert the claim, though the defense may be fatal to the claim.”[14]

The Eighth Circuit held that in pari delicto cannot be used at the dismissal stage.[15] On a motion to dismiss, the court is generally limited to considering the allegations in the complaint, which the court assumes to be true in ruling on the motion.[16] Because in pari delicto is an affirmative defense requiring proof of facts that the defendant asserts, it is usually not an appropriate ground for early dismissal.[17] An in pari delicto defense may be successfully asserted at the pleading stage only where “the facts establishing the defense are: (1) definitively ascertainable from the complaint and other allowable sources of information, and (2) sufficient to establish the affirmative defense with certitude.”[18] Thus, the in pari delicto defense is generally premature at this stage of the litigation, and the court must deny the motion to dismiss.

The existence of a possible defense does not affect the question of standing.[19]Standing is a constitutional question, and all a plaintiff must show is that they have suffered an injury that is fairly traceable to the defendant’s conduct and that the requested relief will likely redress the alleged injury.  In this matter, the First, Third, Fifth, Eighth, and Eleventh Circuits’ approach is more convincing. Those courts hold that whether a trustee has standing to bring a claim and whether the claim is barred by the equitable defense of in pari delicto are two separate questions and that the in pari delicto defense is appropriately set forth in responsive pleadings and the subject of motions for summary judgment and trial.

3.  Standing Issues The Trustees Face 

a)  Background

The next question is whether the bankruptcy trustee fulfills the constitutional requirement of standing. Article III specifies three constitutional requirements for standing. First, the plaintiff must allege that he has suffered or will imminently suffer an injury. Second, he must allege that the injury is traceable to the defendant’s conduct. Third, the plaintiff must show that a favorable federal court decision is likely to redress the injury.[20]

A critical issue in evaluating whether a trustee or receiver has standing to sue is whether the claim belongs to the corporate debtor entity or to the individual investors of the corporate debtor. The Supreme Court held in Caplin v. Marine Midland Grace Trust Co. of New York, 406 U.S. 416, 433-34 (1972), that a bankruptcy trustee has standing to represent only the interests of the debtor corporation and does not have standing to pursue claims for damages against a third party on behalf of one creditor or a group of creditors. Although the line is not always clear between the debtor’s claims, which a trustee has statutory authority to assert, and claims of creditors, which Caplin bars the trustee from pursuing, the focus of the inquiry is on whether the trustee is seeking to redress injuries to the debtor that defendants’ alleged conduct caused.[21]

b)  The Shifting Focus of the Second Circuit

In Wagoner, the Second Circuit held that the corporation and the trustee did not have standing to bring a claim because a “claim against a third party for defrauding a corporation with the cooperation of management accrues to creditors, not to the guilty corporation.”[22] The rationale for this rule is “though a class of creditors has suffered harm, the corporation itself has not.”[23] Without cognizable injury, the trustee representing the debtor corporation failed to meet the constitutional standing requirement.

Commentators have criticized the Wagoner rule that there is no separate injury to the corporation on several grounds. First, the court’s finding that a corporation is not harmed when its assets are squandered effectively ignores the existence of the corporation during the bankruptcy process.[24] Furthermore, the Wagonercourt seems to acknowledge the trustee’s right to sue the guilty managers for damages done to the corporation. Such a construction leads to the absurd result that when management and its accomplices defraud a corporation, management can be sued on behalf of the corporation for the harm caused to the corporation, but the accomplices cannot be sued on behalf of the corporation because the corporation was not harmed.[25] Recognizing the faults of this rule, the Second Circuit recognized that there was “at least a theoretical possibility of some independent financial injury to the debtors” as a result of the defendant’s aid in the fraud.[26] Nevertheless, the court denied the plaintiff’s standing, relying on the observation that any damage suffered by the debtor was passed on to the investors, and “there was likely to be little significant injury that accrues separately to the Debtors.”[27] In other words, most of the alleged injuries in Hirsch were suffered by third parties, not by the debtors themselves. The Second Circuit shifted the focus of the Wagoner rule from lack-of-separate-injury (the first inquiry of theWagoner rule) to the in pari delicto (the second inquiry) in Breeden v. Kirkpatrick & Lockhart LLP, 336 F.3d 94 (2d Cir. 2003). In that case, the court denied the trustee standing, holding that even if there was damage to the corporation, the trustee lacked standing because of the debtor’s collaboration with the corporate insiders.[28]

c)  Approaches of Other Circuits

In Lafferty, the creditors’ committee brought an action against the debtor’s officers, directors and outside professionals, alleging that through participation in a fraudulent Ponzi scheme, the defendants wrongfully prolonged the debtor’s life and incurred debt beyond the debtor’s ability to pay, ultimately forcing the debtor into bankruptcy.[29] The Lafferty court articulated different kinds of harms to the corporation: (1) fraudulent or wrongful prolongation of an insolvent corporation’s life, (2) prolongation that causes the corporation to incur more debt and become more insolvent, and (3) diminution of corporate value had prolongation not occurred.[30] Recognizing that conduct driving a corporation deeper into debt injures not only the corporate creditors, but the corporation itself, the Third Circuit held the committee had standing to sue the outsiders on behalf of the debtor.[31]The court also noted that although the Tenth and Sixth Circuits had applied the in pari delicto doctrine to bar claims of a bankruptcy trustee, those courts assumed that the bankruptcy trustee at least has standing to bring the claim.[32]

The Eighth Circuit held that a trustee who had alleged sufficient injury traceable to the actions of the defendants had standing to sue.[33] The court held that the defendant law firm and attorneys participated in stripping the corporation’s assets and that the injury was traceable to the activities of the lawyers who engineered the transaction to the detriment of their client.[34] In addition, the Eighth Circuit noted that the Third Circuit in Lafferty and the Ninth Circuit (in Smith v. Arthur Andersen LLP 421 F.3d at 1004) rejected the argument that a cause of action for harm to an insolvent corporation belongs to the creditors rather than the corporation. The Eighth Circuit adopted the rationale of Lafferty that simply because the creditors may be the beneficiary of recovery does not transform an action into a suit by the creditors.[35]

The Ninth Circuit found that the trustee had standing to pursue breach of contracts and duties against attorneys, auditors and investment bankers where, if defendants had not concealed the financial condition of debtor, the debtor might have filed for bankruptcy sooner and additional assets might not have been spent on a failing business.[36] “This allegedly wrongful expenditure of corporate assets qualifies as an injury to the firm which is sufficient to confer standing upon the Trustee.”[37] The court stated that “We rely only on the dissipation of assets in reaching the conclusion that the debtor was harmed.”[38] “A receiver has standing to bring a suit on behalf of the debtor corporation against third parties who allegedly helped that corporation’s management harm the corporation.”[39]

To sum up, when a director or officer enlists the help of attorneys to misstate the financial health of a company, it causes significant harm to a corporation. Harms include: (1) the fraudulent and concealed accrual of debt which can lessen the value of corporate property, (2) legal and administrative costs of bankruptcy, (3) operational limitations on profitability, (4) the undermining of business relationships, and (4) failed corporate confidence.

If court were to afford standing to trustee, third parties would be deterred from negligent, reckless, or other wrongful behavior. It will provide a means for increasing attorneys’ liability for the wrongs they commit. While limitless liability for attorneys is not the solution, increasing liability will require attorneys to answer in court when they fail to detect fraud or manipulation on the part of directors and officers that a reasonable attorney would discover.

4.  Conclusion

Attorneys are equipped with the tools to prevent fraud. An attorney may always report fraud to the appropriate authority or refuse to participate in the fraud. However, attorneys may not want to jeopardize important client relationships unless the consequence of inaction makes reporting more beneficial. Given the turmoil of the financial markets since 2008, increased liability for attorneys could help alleviate corporate fraud and bolster consumer confidence in this distressed market.

For the above reasons, the bankruptcy trustee has standing to bring a suit on behalf of the debtor corporation against attorneys who allegedly helped that corporation’s management with the fraud.

 

[1] Terlecky v. Hurd (In re Dublin Sec., Inc.), 133 F.3d 377, 380 (6th Cir.1997).

[2] In re Parmalat Sec. Litig., 383 F. Supp. 2d 587, 596 (S.D.N.Y. 2005).

[3] Wight v. Bank American Corp., 219 F.3d 79, 87 (2d Cir. 2000).

[4] See generally Jeffrey Davis, Ending the Nonsense: the In Pari Delicto Doctrine Has Nothing to Do with What is Section 541 Property of the Bankruptcy Estate, 21 Emory Bankr.Dev. J. 519 (2005); Gerald L. Baldwin, In Pari Delicto Should Not Bar a Trustee’s Recovery, 23-8 Am. Bankr.Inst. J. 8 (2004); Tanvir Alam, Fraudulent Advisors Exploit Confusion in The Bankruptcy Code: How In Pari Delicto Has Been Perverted To Prevent Recovery for Innocent Creditors, 77 Am. Bank. L.J. 305 (2003); Robert T. Kugler, The Role of Imputation and In Pari Delicto in Barring Claims Against Third Parties, 1 No. 14 Andrews Bankr.Litig. Rep. 13 (2004);Making Sense of the In Pari Delicto Defense: “Who’s Zoomin’ Who?” 23 No. 11 Bankr. Law Letter 1 (Nov.2003).

[5] Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co.,267 F.3d 340, 346-47 (3d Cir.2001).

[6] Wagoner, 944 F.2d at 118.

[7] R.F. Lafferty & Co., 267 F.3d at 340.

[8] Wagoner, 944 F.2d at 118.

[9] Id. at 116.

[10] Id. at 116-17.

[11] Wight, 219 F.3d at 86.

[12] Wagoner, 944 F.2d at 120.

[13] In re Senior Cottages of America LLC, 482 F.3d 997, 1003 (8th Cir. 2007) (collecting cases).

[14] Id. at 1004.

[15] Id. at 1002.

[16] Wilchombe v. Tee Vee Toons. Inc., 555 F.3d 949, 959 (11th Cir. 2009).

[17] Knauer v. Jonathon Roberts Financial Group, Inc., 348 F.3d 230, 237 n. 6 (7th Cir. 2003).

[18] Gray v. Evercore Restructuring, LLC, 544 F.3d 320, 325 (1st Cir. 2008).

[19] Novartis Seeds, Inc. v. Monsanto Co., 190 F.3d 868, 872 (8th Cir. 1999).

[20] Allen v. Wright, 468 U.S. 737, 756-58 (1984).

[21] Smith v. Arthur Andersen, LLP, 421 F.3d 989, 1002 (9th Cir. 2005).

[22] Wagoner, 944 F.2d at 120.

[23] Id.

[24] Jeffrey Davis, Ending the Nonsense: The In Pari Delicto Doctrine Has Nothing to Do with What Is § 541 Property of the Bankruptcy Estate, 21 Emory Bankr. Dev. J. 519, 525 (2005).

[25] Id. at 527.

[26] Hirsch v. Arthur Andersen & Co., 72 F.3d 1085, 1087 (2d Cir. 1995).

[27] Id.

[28] Id. at 100.

[29] Lafferty Co., 267 F.3d at 348-49.

[30] Id.

[31] Id. at 354.

[32] Id. at 358.

[33] In re Senior Cottages Of America, LLC, 482 F.3d 997.

[34] Id.

[35] Id. at 1001.

[36] Smith v. Arthur Andersen, LLP, 421 F.3d at 1003 (9th Cir. 2005).

[37] Id.

[38] Id. at 1004.

[39] Id.

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