What showing must creditors make to be granted the right to prosecute claims on behalf of the bankruptcy estate? Under the widely recognized standard established by the Second Circuit in In re STN Enterprises, a bankruptcy court will grant standing to a creditor where the debtor has “unjustifiably failed” to bring “colorable” claims that are “likely to benefit the reorganization estate.” 1 A recent Southern District of New York Bankruptcy Court decision, In re Sabine Oil & Gas Corp.,2 demonstrates that these discretionary standards may be applied restrictively and serves as an important reminder that bankruptcy courts take their role as gatekeepers seriously and will not rubber-stamp a request for derivative standing that may materially alter the balance of power between the debtor in possession and its creditors.
SECOND CIRCUIT STANDARD
The doctrine of derivative standing has no express statutory basis in the Bankruptcy Code. In STN Enterprises, the Second Circuit agreed with the majority of bankruptcy courts and recognized an implied right of creditors’ committees to initiate adversary proceedings in the name of a debtor in possession. To obtain so-called “STN standing,” a creditor must present a colorable claim for relief “that on appropriate proof would support a recovery,” and show that the debtor “unjustifiably failed to bring suit.”3
In Sabine, the unsecured creditors’ committee (UCC) sought STN standing to assert a variety of claims arising from a December 2014 merger between Forest Oil Corporation and Sabine Oil & Gas LLC, as well as from related financing transactions. Both companies were heavily indebted prior to the merger: Forest Oil and Sabine had approximately $900 million and $1.6 billion of funded debt, respectively. Sabine’s debt obligations were guaranteed and secured by the assets of its subsidiaries.
Forest Oil and Sabine had initially entered into a merger agreement in May 2014. The merger was put on hold when the companies learned that certain investors were shorting Forest Oil’s unsecured notes (which had risen in value when the companies announced a redemption in connection with the planned merger) and were planning to vote against the merger in an effort to drive down the trading price of the notes. To defeat this strategy, the companies restructured the merger agreement and secured amendments to the various commitment letters required to finance the merger
After the announcement of the amended merger agreement, both companies faced declining operating performance associated with commodity pricing, which threatened the combined company’s ability to comply with financial covenants contained in the commitment letters. The companies again restructured the merger agreement, eliminating the need to redeem Forest Oil’s unsecured notes and securing relief from certain of the financial covenants. The merger closed on December 16, 2014. The combined company filed for bankruptcy on July 15, 2015.
The UCC began investigating potential causes of action related to the merger, and filed a motion seeking STN standing to assert claims against parties involved with the transaction. The UCC sought, among other things, to assert constructive fraudulent conveyance claims, as well as claims for so-called “bad acts,” including intentional fraudulent transfer and breach of fiduciary duty. The UCC’s motion was vigorously contested by the debtors and other parties.
STN STANDING DENIED
The hearing on the UCC’s motion took place over the course of 15 days, and included nine days of live witness testimony from seven witnesses, over 400 exhibits, and five days of closing arguments. The duration of the hearing is an indication that all parties viewed the standing question as critically important.
The court explained that the inquiry as to whether a claim is colorable under STN is similar to that undertaken by a court on a motion to dismiss. While the issue of colorability is not designed to truncate the discovery process if a lawsuit is viable, consistent with the common meaning of colorable, the claims to be asserted must be “plausible” and “not without some merit.”4 A court will deny STN standing to pursue meritless claims, because estate funds “ought not be squandered through continued litigation” of such claims.5 When evaluating a request for STN standing, a court should weigh the likelihood of success, the anticipated costs of litigation, and the basis for recovery. In addition, a court is also permitted to consider “common sense” factors, including whether granting standing to the committee will allow the debtor to concentrate its resources on reorganization, whether the committee’s interests conflict with those of the estate, and whether the arrangement would prejudice distribution rights among creditors.6
The court ultimately denied the UCC’s request for STN standing in its entirety. Viewing the various steps of the merger as one transaction, the court found that the majority of the UCC’s claims for constructive fraudulent transfer were not colorable, because the two companies had simply refinanced their pre-merger debt with postmerger debt. With respect to the UCC’s claims for various “bad acts” related to the merger transaction, the court determined that the UCC’s theory—that Sabine’s private equity sponsor and the combined companies’ lenders had re-engineered the merger transaction to shift losses to unsecured creditors—was “implausible,” “at odds with common sense,” and “overwhelmingly contradicted by the voluminous record established” during the proceeding.7
With respect to the colorable claims, which belonged to the estates of Sabine’s subsidiaries, the court observed that, while the value of those claims could not be quantified, it likely would not exceed $68 million, while the cost of litigating the claims would be $20 million to $30 million. Weighing the costs and benefits, as well as the potential litigation risk, the court concluded that the Sabine debtors had justifiably refused to bring the claims.8
THE STRUGGLE OVER STANDING IS NOT OVER
The UCC has appealed the decision of the bankruptcy court and continues in its quest for derivative standing. Within the past week, the bankruptcy court denied the UCC’s motion for a stay pending appeal to the district court, stating that issuance of a stay would lead to the “absurd” result of ceding control of cases to “disappointed litigants.” Oral argument on the appeal has been scheduled for June 10, 2016. These developments are indicative of the challenges faced by parties seeking to overcome an adverse bankruptcy court decision.
The decision in Sabine is a warning to creditors’ committees that may reflexively seek STN standing to prosecute estate claims: The routine request for derivative standing does not mean that standing will be granted. Application of the STN standard is fact-specific and heavily dependent on subjective judicial assessment.
In Sabine, perception of the UCC’s motives may have played an important role in the court’s decision. The court seemed to be influenced by the fact that the UCC had requested standing to assert selected claims, but not other claims based on the same legal theories, and noted that the proposed claims would simply reallocate proceeds from one creditor to another without augmenting the Sabine estate. This suggests that STN standing may be more difficult to achieve in settings where the claim does not aim to bring assets into the estate. The court distinguished the facts in Sabine from those in Adelphia, where STN standing was granted, noting that the Adelphia debtors supported the UCC’s bid for standing, while the Sabine debtors did not. Finally, the court seemed unimpressed with the potential for recovery on the UCC’s claims, particularly in light of the massive amount of estate resources that would be deployed to prosecute them.
In short, the Sabine decision is a reminder that the STN standards provide a bankruptcy judge with significant discretion to deny a creditor’s request for standing if the court believes that pursuing the claims is not in the best interest of the estate or could materially impede the reorganization process.