Creditor Derivative Standing

Like Larry, I too have just returned from a trip, albeit to a less exotic place, Miami Beach, where amazingly I had a harder time connecting to the Internet than Larry seems to have had connecting from the Far East! Go figure. In any case, it feels good to be back in New Jersey and also to have Larry back on these shores. I look forward to hearing more from Larry about how to integrate film into the basic law school curriculum. Surely there must be more to it than simply showing clips from the trial scenes in My Cousin Vinny!

Many thanks to those (like Steve Jakubowski at the Bankruptcy Litigation Blog) who commented on or wrote me regarding my posting on legal valuation. I particularly want to thank the person who called to my attention the Delaware Chancery Court’s recent decision in Nextel, a very interesting case involving the interpretation and enforcement of a valuation clause in a corporate charter. (If you thought that contracting anticipatorily for a valuation procedure prevents future valuation litigation, think again!) Thanks also to Larry for his discussion of the Audubon Quartet case involving the valuation of a nonprofit chamber music group. This case is a good example of what might be called judicial “difference splitting”—that is, the phenomenon of a court mediating among multiple expert valuations by choosing a compromise figure of its own devising. Sometimes such splits are 50-50; but sometimes they can be asymmetrical, as in the Audubon Quartet valuation, where the court, having been offered expert valuations of zero, $1.2 million, and $1.9 million, chose a figure, $1.6 million, toward the high end of the range of expert opinion. This asymmetric difference splitting phenomenon can be systematic in particular doctrinal contexts, not just anecdotal, as shown in a recent empirical study I published finding that bankruptcy judges on average do a 65-35 allocation in disputes between bankruptcy debtors and their secured creditors over the value of debtor-retained collateral.

But enough about valuation. Today I want to address a different topic: “creditor derivative standing.” Anyone who has taken a basic course in corporate law is familiar with the concept of a “shareholder derivative suit.” Briefly, it is a device whereby on behalf of the firm a firm’s shareholders can sue a third party against whom the firm has a claim. The rationale for giving shareholders derivative standing is that they have a proprietary interest in the firm and thus a substantial interest in seeing the firm’s rights vindicated, particularly in cases that the firm’s management is reluctant to bring such as cases against current officers or directors. For the same reason, limited partners have standing to sue derivatively on behalf of a partnership. Others, however, whose interests in the firm may be substantial but not proprietary, such as creditors or employees, generally lack standing bring derivative actions.

I say “generally” because there may be an exception. Some federal courts, notably the Third Circuit in a case called Cybergenics, have held that creditors can have derivative standing when the firm is bankrupt. The theory behind these bankruptcy decisions is that when a firm is insolvent it is the creditors who are the firm’s true owners and who are thus in a position analogous to that of shareholders of a solvent firm.

In a recent article, I criticize this permissive view of creditor derivative standing on several grounds, including the lack of explicit authorization of such actions by either state corporate law or the Bankruptcy Code and the potential value-reducing effects that permitting such actions might have. And I am happy to say that several federal appellate decisions have expressed skepticism about creditor derivative suits, both as a matter statutory interpretation and as a matter of bankruptcy policy. The most significant of these recent decisions are probably that of the Tenth Circuit Bankruptcy Appellate Panel in In re Fox and that of the Fourth Circuit in In re Baltimore Emergency Services. The latter, decided just last week, denied creditors standing in the particular case and cast doubt on whether creditor standing could ever be available. As Judge Wilkinson aptly put it in his opinion for a unanimous court: “We have never decided whether creditor derivative suits are permitted in the bankruptcy courts of this circuit. The question is a significant one, for limitations on standing are of paramount importance in bankruptcy proceedings. As we have recognized in an analogous Chapter 7 context, ‘[c]ourts consistently have noted a public policy interest in reducing the number of ancillary suits that can be brought in the bankruptcy context so as to advance the swift and efficient administration of the bankrupt's estate. This goal is achieved primarily by narrowly defining who has standing in a bankruptcy proceeding.’” Indeed.