Smart World vs. Real World on Settlements

Smart World vs. Real World on Settlements

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It is somewhat surprising that the slate on which the Second Circuit decided Smart World Techs. LLC v. Juno Online Servs. Inc. (In re Smart World Techs. LLC), 423 F.3d 166 (2d Cir. 2005), was blank considering the frequency of the issue in question. The question presented by Smart World was whether the Bankruptcy Code permits parties in interest, other than the debtor-in-possession (DIP), to seek approval of a settlement under Federal Rule of Bankruptcy Procedure 9019. The Second Circuit held that only the DIP can move for approval of a settlement, absent very limited exceptions.

The Facts

Smart World Technologies Inc. was a provider of Internet services. Prior to its chapter 11, it entered into a term sheet calling for the sale of its assets upon approval by a bankruptcy court. In July 2000, less than a month after the filing, the bankruptcy court approved the sale under §363 of the Code. The sale was not consummated. As a result of the buyer's (Juno) failure to close, the debtor initiated a hearing in which it alleged a lack of good faith by Juno. In response, Juno commenced a declaratory judgment action in the adversary proceeding denying a lack of good faith and accusing the DIP of deliberately failing to close the sale in order to extort a higher price.

As could be expected, settlement discussions took place and, upon the representation of Juno that "settlement was imminent," the bankruptcy court stayed the litigation in order to allow negotiations to continue. What could not have been expected was that the settlement negotiations did not include the debtor. Rather, the secured creditor and the creditors' committee negotiated with Juno. This end run was apparently successful because in January 2001, several months after the Juno suit was filed, Juno announced that a settlement had been reached.

In apparent reliance on Juno's representations regarding settlement, the bankruptcy court again stayed the adversary proceeding but allowed "discovery as to the settlement proposal only." Smart World, 423 F.3d at 171. This was done despite the filing of any motion seeking approval of a compromise under Rule 9019. Despite Smart World's motions to lift the stay, the stay remained in place for more than two years, at which time the court heard the Rule 9019 motion filed by Smart World's creditors seeking approval of a settlement.

The debtor, Smart World, opposed the motion on several grounds, most significantly on the basis that the creditors who brought the motion lacked standing to do so.

The court approved the settlement, determining (a) that the estate was insolvent, (b) that continuing the litigation was an unwise gamble of creditor money and (c) that the settlement was in the "best interests of the debtors, their estates, and their creditors and equityholders." The District Court for the Southern District of New York affirmed.1

The Second Circuit Ruling

The question raised on appeal was one of first impression. The Second Circuit first analyzed Rule 9019, which only authorizes the DIP or the trustee to bring a Rule 9019 motion, and found it consistent with other Code provisions vesting the debtor with the duty to manage its estate as a fiduciary for all parties. By contrast, citing Collier on Bankruptcy,2 the court found that a creditors' committee is only a fiduciary for its class and could not be expected to act for the best interests of others who might be affected by a settlement. Thus, the plain reading of Rule 9019 supported the debtor's position. Nor did Unsecured Creditors Comm. of Debtor STN Enters. Inc. v. Noyes (In re STN Enters.), 779 F.2d 901 (2d Cir. 1985), and its progeny help the creditors. STN applies where the debtor unjustifiably refuses to pursue an action. Here, the claim was that the debtor properly took action, but unjustifiably failed to settle it. Interestingly, Smart World barely mentions Glinka v. Murad (In re Housecraft Indus. USA Inc.), 310 F.3d 64, 70 (2d Cir. 2002), in distinguishing the STN line of cases, despite the fact that Housecraft extends the STN reasoning to allow standing for a creditors' committee to act as co-plaintiff with the debtor when the litigation is "both in the best interest of the bankruptcy estate and necessary and beneficial to the fair and efficient resolution of the bankruptcy proceedings."3 One would assume that status as a co-plaintiff would permit the filing of a 9019 motion even without the consent of the other co-plaintiff, especially if the motion is motivated by the "best interests of the bankruptcy estate."

The exception to the exclusive right of a debtor to file a Rule 9019 motion was stated in very limiting terms: "We do not rule out that in certain, rare cases, unjustifiable behavior by the DIP may warrant a settlement over the debtor's objection, but this is not such a case." Smart World, 423 F.3d at 177. The court also suggested that a motion to appoint a trustee was an acceptable alternative for a party in interest aggrieved by a debtor's failure to settle a dispute.

The court's sympathies were clearly with the debtor. Unlike the STN circumstances, which the court noted will more frequently involve claims against the debtor's principals, in the Rule 9019 situation, "we think it less likely that the debtor's principals will be motivated by reasons that conflict with the best interests of the estate." Id.

The court had a more difficult time with the §1109(b) argument, especially in light of its Term Loan Holder Comm. v. Ozer Group LLC (In re Caldor Corp.), 303 F.3d 161 (2d Cir. 2002), decision. In Caldor, the Second Circuit held that creditors had an unconditional right to intervene in adversary proceedings under chapter 11. Citing the Rules Enabling Act,4 the appellees in Smart World argued that the right to intervene must encompass the right to propose a settlement.5

Not so, said the Second Circuit. Relying on the Supreme Court's Hartford Underwriters Ins. Co. v. Union Planters Bank NA, 430 U.S. 1 (2000), decision and on two S.D.N.Y. bankruptcy decisions, the court held that intervention was less than an STN-type derivative standing and did not permit the intervener to "take over the estate's litigation." Smart World, 423 F.3d at 183.6

Did the Court Go Too Far?

Without doubt, the circuit court was frustrated with the handling of the case by the court. Its failure to allow the adversary proceeding to go forward, the unwillingness of the trial court to even listen to debtor's counsel and the failure to allow any meaningful evaluation of the merits of the debtor's claims all were cited. Perhaps that resulted in what is a strongly worded and broad decision. Unlike, for example, In re Lionel Corp.,7 where the exception swallowed the rule, the court in Smart World repeatedly narrowed its "unjustifiable behavior" exception and repeatedly trumpeted its faith in the debtor's adherence to its fiduciary duties. It does not take very many cases involving closely held, middle-market debtors to know that (1) directors, if any exist, go deaf, dumb and blind shortly after counsel begins the corporate governance lecture about duties to creditors; (2) the principals of such debtors are often emotionally involved in the adversary proceedings and evaluate them differently than a third party might; (c) counsel generally serves at the direction of management despite case law stating that counsel's duty runs to the court and the estate;8 and (d) owner/ equityholders have nothing to lose by litigating in the hope of a home run when settlements acceptable to creditors bring them nothing. In a similar situation (no reported decision) in Connecticut, the judge, faced with a motion to appoint a trustee based on an argument that the debtor's principal was managing litigation for his own equity interest rather than for the creditors, refused to appoint a trustee and instead exacted a pledge from debtor's counsel that counsel understood and reaffirmed that his principal duty was to the court and that, consistent with that duty, counsel would somehow insure that a reasonable settlement offer would be brought before the court, even over the client's objection.

Real World Interests of Creditors

While the creditor parties in Smart World were heavy-handed in their dismissive attitude toward the debtor, in the real world they were the true holders of the risk associated with the litigation.

Seeking appointment of a trustee is an unrealistic, impractical alternative. The litigation on the trustee motion would itself be lengthy and expensive, might yield an undesired result if management is operationally capable and could benefit the litigation defendants by forcing a public exposure of all the weaknesses in the debtor's case as part of the process of meeting the standards for a trustee.

The Smart World decision also gives little guidance as to how a party in interest can properly raise the "unjustifiable behavior" issue. Should the procedure be to seek authority to file a Rule 9019 motion? If so, the decision gives little hope for success based on the plain language of the Rule. What status would the debtor have if such a motion is approved over its objection? Since intervenor status is not sufficient to force a settlement under Smart World, and since the right to settle implies "ownership of the debtor's claims,"9 must the movant, in order to justify its right to settle the estate's case, then step into the debtor's role as plaintiff? This could be especially troubling where creditors' committee counsel isn't willing to adopt the contingent fee arrangement of debtor's counsel after the committee takes "ownership" or in situations where a secured creditor is entitled to the litigation recovery but has no interest in having its counsel in a fiduciary relationship with any other party.

Less than two weeks before Smart World, Judge Robert E. Gerber of the Southern District issued a lengthy decision in the Adelphia Communications Corp. v. Riggs (In re Adelphia Communications Corp.), 285 B.R. 848, 850 (Bankr. S.D.N.Y. 2002), case on a motion by the creditors' committee seeking to be allowed to prosecute claims as "co-plaintiff" with the debtors. Judge Gerber reviewed the Second Circuit case law regarding prosecution of actions by committees10 and called such practice "long-standing," "nearly universally recognized" and "a salutary (and many might say essential) element of the chapter 11 process." The court granted the motions. In so doing, Judge Gerber said that the court's role was to protect the estate (emphasis in original) and ensure that litigation is a "sensible expenditure of estate resources."11 Why shouldn't the same approach apply to settlement? Allowing a committee to act as a co-plaintiff based on a "benefit to the estate" standard in the prosecution of claims should be sufficient precedent for a similar standard in the settlement of claims.

Permitting a creditors' committee, as an intervener, to seek a court order asking a court to evaluate the reasonableness of a settlement imposes exactly the burden on the court that it should have (i.e., that of gatekeeper for all parties in interest). Presenting such a motion does not transfer "ownership" of the adversary; it sets up the identical hearing that would be held if the debtor were to move for approval of a settlement. The failure of the decision to rely more heavily on or even properly distinguish Housecraft is puzzling.

What's a Party to Do?

One lesson to be learned is that, in true STN situations, the court order should specify that the derivative plaintiff has authority to move for settlement under Rule 9019. Since debtors do not usually seek permission of the court before commencing an action, it is unclear, especially in the Second Circuit, what can be done in suits brought by the debtor to avoid problems like the one in Smart World. Another option, based on Adelphia, is to seek status as a co-plaintiff, rather than a mere intervenor in suits brought by the debtor.

A way to avoid a trustee battle is to seek the appointment of a litigation committee with at least one neutral party on it and empowering that committee to evaluate all litigation activity and participate in or be made aware of settlement offers. Privilege issues would need to be resolved in the order establishing the committee. Since ADR is frequently resorted to, it would also be necessary to have the neutral or the litigation committee present for all aspects of ADR. The litigation committee must have early access to expert reports and to strategic decisions.

Conclusion

Smart World may be good theory, but it may also be bad law due to the hurdles it imposes on creditors. It has already begun to spawn decisions restricting derivative standing for committees that cite Smart World for its language of limitation in initiating actions, not just settling them.12 More often than not, this is likely to hurt, not help, creditors. In the real world, not the Smart World, debtors try to recover for their owners and reject appropriate settlements. One hopes that creative approaches will avoid the confrontations destined to result by keeping committees at bay in adversary proceeding settlements.


Footnotes

1 Smart World Techs. LLC v. Juno Online Servs. Inc. (In re Smart World Techs. LLC), No. 03 Civ. 9467, 2004 WL 1118328 (S.D.N.Y. May 19, 2004), which affirmed the judgment of the bankruptcy court (Blackshear, C).

2 See 7 Collier on Bankruptcy ¦1103.05[2] (15th ed. rev. 1996) (a creditors' committee owes a fiduciary duty to the class it represents, not to the debtor, other classes of creditors or the estate).

3 Housecraft, 310 F.3d at 71 (citing Commodore Int'l. Ltd. v. Gould (In re Commodore Int'l. Ltd.), 262 F.3d 96, 100 (2d Cir. 2001)).

4 "[R]ules [established by the Supreme Court, such as the Rules governing practice and procedure under title 11,] shall not abridge, enlarge or modify any substantive right." 28 U.S.C. §2075.

5 See Smart World, F.3d at 180.

6 See, also, Smart World, 423 F.3d at 183 ("In creating the §1109(b) right to appear and to be heard on any issue, Congress cannot have intended to override the Code provisions in which it carved out an exclusive role for the DIP as legal representative and fiduciary of the estate").

7 See In re Lionel Corp., 722 F.2d 1063, 1066 (2d Cir. 1983) (a sale of substantially all of the assets of a chapter 11 debtor cannot be sold outside of a plan absent an "articulated business necessity").

8 See In re JLM Inc., 210 B.R. 19, 26 (2d Cir. BAP 1997) ("the attorney for the DIP may not simply resign where the client refuses the attorney's advice concerning the client's fiduciary obligations to the estate and its creditors. Counsel must do more, informing the court in some manner of derogation by the DIP").

9 See Smart World, 423 F.3d at 182.

10 See STN, 779 F.2d at 901, and Housecraft, 310 F.3d at 70.

11 See Adelphia, 285 B.R. at 850.

12 See In re Baltimore Emergency Services II Corp., No. 05-1104, 2005 U.S. App. LEXIS 28085 (4th Cir. Dec. 20, 2005).

Bankruptcy Code: 
Journal Date: 
Wednesday, March 1, 2006