Cybergenics II Sounds Great But Will It Work

Cybergenics II Sounds Great But Will It Work

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Appellate courts have the luxury of making ground-breaking legal pronouncements without worrying (too much) about how they are actually implemented. This is especially so in bankruptcy practice, where legal principles must be road-tested in a highly practical, result-oriented court system. A recent example of this occurred in the pending Sealed Air adversary proceeding1 in the W.R. Grace & Co. bankruptcy case,2 where the district court, sitting as a bankruptcy court, had to apply the Third Circuit Court of Appeals's recent decision in the Official Committee of Unsecured Creditors of Cybergenics Corp. v. Chinery, 304 F.3d 316, 2002 WL 31102712 (3d Cir., Sept. 20, 2002).

Cybergenics II turned the bankruptcy world (at least in the Third Circuit, which includes Delaware) on its head by holding that an official creditors' committee in a chapter 11 case lacks derivative capacity to sue to recover an alleged fraudulent transfer under 11 U.S.C. §544. Prior to Cybergenics II, it was generally accepted that a creditors' committee could sue under §544(b) in place of the trustee (or debtor-in-possession), the real party in interest. While acknowledging that granting a committee derivative capacity to sue under §544(b) was a "rather well-established practice,"3 2002 WL 31102712 at *4, the Third Circuit held that the words "the trustee may" means that only a trustee (or a debtor-in-possession) may prosecute a §544(b) avoidance action. As such, the appointment of a trustee and, in pending cases, substitution of the trustee as plaintiff in place of the committee, was required where the estate held a viable fraudulent transfer claim but was faced with a recalcitrant debtor-in-possession (DIP) who refused to bring it. 2002 WL 31102712 at *14.

Meanwhile, in the W.R. Grace bankruptcy case, the district court had previously appointed the official committee of asbestos personal injury claimants and the official committee of asbestos property damage claimants to prosecute fraudulent transfer avoidance actions to recover the value of certain former subsidiaries that W.R. Grace had sold pre-petition. The potential recovery to the bankruptcy estate was substantial. If successful, the suit might yield recovery of more than $3.8 billion; this is compared to the $2.7 billion book value for all of W.R. Grace's other assets. W.R. Grace, as DIP, had refused to prosecute these actions because it disputed that the transfers were fraudulent.

The district court then directed that pre-trial preparations be completed on an expedited basis in order that the adjudication of the Sealed Air adversary proceeding not otherwise delay resolution of the chapter 11 case. The parties complied diligently, and within a six-month period, they expended in excess of $16.7 million collectively in legal fees and expenses in preparing for trial. The parties, the bankruptcy case and district court were now deeply invested in bringing this litigation to a conclusion. About 10 days before start of the trial, however, the appeals court handed down Cybergenics II.

Faced with this threshold challenge to the committees' capacity to sue, the district court stayed the trial and solicited motions suggesting how best to salvage the case and bring the substantive issues to trial. The opinion that followed provides an interesting and instructive example of how the district court struggled to apply Cybergenics II in a just and practical manner in the context of a pending complex commercial litigation with so much at stake.

The first motion considered by the district court was by Sealed Air, one of the defendants, requesting that the district court simply dismiss the action. It contended that it did not waive the affirmative defense of lack of capacity to sue, the very basis for the Cybergenics II decision. Sealed Air argued that the appointment of a trustee, the remedy prescribed by Cybergenics II, would be untimely because Federal Rule of Civil Procedure 17(a) requires that the proper party-in-interest be substituted into an action within "a reasonable time" after the objection to the existing plaintiffs' status. It claimed that the "reasonable time" began to run upon the filing of its affirmative defense of lack of standing. The district court rejected this argument, holding that a "reasonable time" in the context of the Sealed Air adversary proceeding must be calculated from the date Cybergenics II was decided, not the date Sealed Air's affirmative defense was filed. As such, the district court denied Sealed Air's motion to dismiss.

The district court next considered various parties' motions for the appointment of an examiner with expanded powers (i.e., the ability to prosecute as well as investigate) under 11 U.S.C. §1104(c). These parties suggested that, based on §1106(b) of the Bankruptcy Code, an examiner could also perform the duties of a trustee that the court ordered. The district court noted that several other courts have authorized an examiner to prosecute fraudulent transfers avoidance actions after a debtor's refusal to do so. The district court, however, was not convinced. It reasoned that this remedy would run afoul of two fundamental principles enunciated in Cybergenics II: that the decision to bring a §544(b) avoidance action is the sole prerogative of the trustee (or DIP), and that a literal reading of the Bankruptcy Code precludes a finding that a debtor's refusal to bring such action is not the same as an order from a court to that effect. Moreover, the district court had misgivings as to whether an examiner prosecuting a fraudulent transfer action is consistent with the more general concept of an examiner under the Bankruptcy Code. Accordingly, the district court declined to appoint an examiner with expanded powers to continue to prosecute the fraudulent transfer avoidance action.

The district court then considered various motions to appoint a limited purpose trustee. The district court observed that, in the first instance, the Bankruptcy Code does not provide for a limited purpose trustee. The district court viewed the appointment of a limited purpose trustee in much the same way as an examiner with expanded powers. Moreover, the district court believed that as a practical matter, the appointment of a limited purpose trustee was inherently problematic and raised the potential for conflicts in a shared exercise of fiduciary duties with a DIP. For these reasons, the district court denied the motion to appoint a limited trustee.

The district court next considered the motions for appointment of a plenary trustee, a remedy consistent with the holding in Cybergenics II. While interests of providing certainty and finality of the Sealed Air adversary proceeding would be served by the appointment of a plenary trustee, the district court found that the grounds for the appointment of a trustee under §1104(a) of the Bankruptcy Code had not been established by clear and convincing evidence. The district court was hesitant to impose such a harsh and disruptive remedy in the bankruptcy case, which it considered to be a "last resort." The district court was unwilling to hold that W.R. Grace's refusal or inability to prosecute the fraudulent transfer avoidance actions in the face of the court's own determination that they were worth prosecuting was itself enough to justify the appointment of a trustee. The district court also declined to find that, under the facts of the case, W.R. Grace's decision not to prosecute the fraudulent transfer avoidance actions was inimical to the best interest of the estate and its creditors. Believing that the case had not arrived at the point where the "last resort" must be taken, the district court denied the motion to appoint a plenary trustee.

Finally, the district court considered the motion by the asbestos property damage committee to reset the adversary proceeding for trial and to let the parties remain in the case notwithstanding the holding of Cybergenics II. While disagreeing with that committee's rationale, the district court agreed that this was the better way for the Sealed Air adversary proceeding to go forward. Its decision that the case go forward regardless of the holding in Cybergenics II was based on two reasons. First, the court wanted to protect the substantial investment of time and resources by all parties in the litigation. Second, the court held that this was a sensible and pragmatic choice given the uncertain procedural posture of Cybergenics II. In order to avoid the wasteful effect of delaying the trial and imposing further prejudice to the defendants by the continuing uncertainty, the district court relied on its inherent equitable powers under §105(a) of the Bankruptcy Code to relax the rule of Cybergenics II in this unique situation. Its decision considered the procedural context of Cybergenics II, in which a petition for rehearing was pending and the decision was not yet final. In order to avoid possible additional costs and substantial disruption to the bankruptcy case in the event that Cybergenics II is subsequently set aside,4 the district court was convinced that the trial should move ahead, leaving the committees in place as the parties-plaintiff.

Anticipating that some party would almost certainly request leave to file an interlocutory appeal, the district court sua sponte certified its order for interlocutory appeal pursuant to 28 U.S.C. §1292(b).

The Sealed Air adversary proceeding opinion revealed the district court's struggle to balance adherence with a harsh rule imposed in a pending case with its deep concern about providing a just and equitable result with over $3.8 billion at stake. While the unique set of facts and circumstances of the Sealed Air adversary proceeding greatly influenced the district court's ultimate decision to let the litigation proceed without a substitution of the committees as plaintiffs, the other 260 pending committee-brought cases in the Third Circuit may provide similarly challenging situations with which bankruptcy courts will have to struggle. Moreover, if the appointment of a trustee is the sole remedy for prosecuting avoidance actions refused to be brought by recalcitrant DIPs, the dynamics of many existing and future bankruptcy cases are likely to be skewed.


1 Official Committee of Asbestos Personal Injury Claimants and Official Committee of Asbestos Property Damage Claimants of W.R. Grace & Co. v. Sealed Air Corporation and Cryovac Inc., Adv. No. 02-2210 (Lead Docket) (Bankr. D. Del., Oct. 24, 2002) (the "Sealed Air adversary proceeding"). Return to article

2 In re W.R. Grace & Co., et al, Case Nos. 01-1139 through 01-1200, is an asbestos-related chapter 11 case pending in the U.S. Bankruptcy Court for the District of Delaware. Return to article

3 There are 261 pending cases in the Third Circuit in which a committee was prosecuting actions on behalf of a trustee or debtor-in-possession in a bankruptcy case. Return to article

4 Ironically, on the same day the opinion in the Sealed Air adversary proceeding was handed down, the Second Circuit Court of Appeals reached a contrary conclusion from Cybergenics II in Glinka v. Murad (In re Housecraft Indus. USA Inc.), ___ F.3d ____, 2002 WL 31388883 (2d Cir. Oct. 24, 2002). The stage is now set for a possible split in the circuits. Return to article

Journal Date: 
Sunday, December 1, 2002