The U.S. Court of Appeals for the Second Circuit, on July 9, 2007, decisively affirmed a bankruptcy court's dismissal of an equitable subordination complaint filed by a creditors' committee against eight investment fund lenders. Official Committee of Unsecured Creditors of Applied Theory Corporation v. Halifax Fund, L.P., et al. (In re Applied Theory Corporation), ___ F.3d ___, 2007 U.S. App. LEXIS 16180 (2d Cir. July 9, 2007). In its strong opinion, the court summarily rejected the committee's arguments that equitable subordination claims "may be brought directly by a creditor, creditors, or a creditors' committee, without Bankruptcy Court Approval." Id., at 4.

The investment fund defendants, as insider lenders, had, according to the committee, "used their control over [the debtor] to transform $30 million in convertible unsecured debt obligations into secured debt to the detriment of other creditors," at a time when the debtor had been "insolvent, undercapitalized, and experiencing large losses." Id., at 2. The committee asked the bankruptcy court to recharacterize the defendants' loan "as equity or subordinate [it] . . . to the claims of other creditors." Id., at 2.

Practical Relevance of Decision

A hostile, litigation-driven creditors' committee has the ability to hijack a reorganization case. The Second Circuit, like other appellate courts, urged bankruptcy courts, therefore, to vet extortionate litigation purportedly brought on behalf of the debtor's estate. See, e.g., In re Baltimore Emergency Servs. II Corp., 432 F.3d 557, 562-63 (4th Cir. 2005) (held, creditors' committee and secured creditor lacked standing to bring on behalf of debtor's estate bankruptcy, tort and contract claims; "the bankruptcy court plays a vital gatekeeper role in determining whether derivative standing is appropriate in a given case."; purpose of imposing standing limitations is to prevent "bankruptcy [cases] from being sidetracked, even temporarily, by wasteful, ancillary litigation . . . . [R]equiring a formal determination of its propriety . . . is the only way to prevent the creditor from unjustly hijacking the bankruptcy [case].").


The bankruptcy court in Applied Theory court had denied the committee permission to bring its equitable subordination claim after the debtor's Chapter 11 trustee investigated and found the claim to be meritless. According to the bankruptcy court, "the proposed claim was not directed towards any particularized injury suffered by any specific creditor." Because the trustee who had "the exclusive authority to assert such a claim . . . doubted its merit," the court declined to authorize it. 2007 U.S. App. LEXIS 16180, at 3.

The district court affirmed because the committee failed to obtain bankruptcy court approval. Id. Also, the trustee had not unjustifiably refused to sue and had not consented to the prosecution of the suit. Id., citing In re Commodore Int'l Ltd., 262 F.3d 96, 100 (2d Cir. 2001). Moreover, reasoned the district court, the bankruptcy court had found that the claim was neither colorable nor likely to benefit the debtor's estate. Id., at 4.

The Second Circuit Analysis

Affirming the lower courts, the Court of Appeals stressed that a creditor should not be allowed "to usurp the trustee's role as a representative of the estate with respect to the initiation of certain types of litigation that belong exclusively to the estate." Id., at 4, quoting Hartford Underwriters Ins. Co. v. Union Planters Bank, N.A., 503 U.S. 1, 8-9 (2000). See also Petitioning Creditors of Melon Produce, Inc. v. Braunstein, 112 F.3d 1232, 1240 (1st Cir. 1997) ("The trustee is ordinarily the appropriate party to seek equitable subordination on behalf of the estate and unsecured creditors."); Bezanson v. Bayside Enter., Inc. (In re Medomak Canning), 922 F.2d 895, 902 (1st Cir. 1990) ("Generally, an unsecured creditor may assert equitable subordination only where the Trustee has refused to do so and the court grants . . . leave to contest a claim"). Contrary to the committee's assertion, the court found that the Bankruptcy Code "contains no explicit authority for creditors' committees to initiate adversary proceedings." Id., at 4, citing, In re STN Enterprises, 779 F.2d 901, 904 (2d Cir. 1985) (held, committee must obtain prior court approval before suing; trustee or debtor-in-possession must have unjustifiably failed to sue or abused its discretion in not suing; court must also find that claim "is likely to benefit the reorganization estate."). The Second Circuit had previously held that a committee could sue, even with the debtor's consent and court approval, so long as the suit is "(a) in the best interest of the bankruptcy estate, and (b) is necessary and beneficial to the fair and efficient resolution of the bankruptcy [case]." In re Commodore Int'l Ltd., 262 F.3d 96, 100 (2d Cir. 2001); In re Housecraft Inds. U.S.A., Inc., 310 F.3d 64, 71 n.7 (2d Cir. 2002) (applying same analysis to suit brought by individual secured creditor with trustee's consent).

The committee's failure in Applied Theory to obtain court approval was fatal. As the Second Circuit explained, "sound reasons" support the requirement for prior court approval: "Reorganizations would routinely spin out of control if decisions that would commit the time and limited resources of the estate could be taken without the consent of the bankruptcy court, the entity charged by law with controlling and regulating such matters. [Such prior approval] helps prevent committees and individual creditors from pursuing adversary proceedings that may provide them with private benefits but result in a net loss to the entire estate. . . .Therefore, beyond the absence of benefit to the estate, approval to litigate is an independent justification for dismissal of this appeal." 2007 U.S. App. LEXIS 16180, at 3.

The court stressed that any proposed claim here belonged to the debtor's estate, but not to the committee. Indeed, "the committee's proposed equitable subordination claim would not be directed toward any particularized injury suffered by any creditor . . . and [it] has failed to demonstrate why it should be permitted to step into the shoes of the trustee." Id., at 7. Even more important, "the Committee is not itself a creditor, it does not have any rights held by any creditor to assert such a claim against another creditor," and, therefore, "has not sustained an injury for which a 'direct' claim might otherwise be available." Id., at 4.


  1. The standing issue remains a critical threshold issue for defendants in bankruptcy litigation. Over the past four years, bankruptcy litigators had thought that the standing issue had been settled by the Third Circuit's en banc decision in In re Cybergenics Corp., 330 F.3d 548, 583 (3d Cir. 2003) (7-4) (held, bankruptcy court could grant derivative standing to creditors' committee to bring fraudulent transfer action when debtor-in-possession unreasonably refused to sue on its own). Indeed, as noted, courts have permitted creditor derivative suits when the trustee or debtor-in-possession consents after a showing of benefit to the estate. See, e.g., In re Smart World Techs. LLC, 423 F.3d 166, 176 n.15 (2d Cir. 2005); In re Parmetex, Inc., 199 F.3d 1029, 1031 (9th Cir. 1999).
  2. The Baltimore Emergency case, noted above, now followed by Applied Theory, stresses the requirement for obtaining prior court approval based on a showing of benefit to the estate. As the Fourth Circuit explained, if such litigation is to be approved, "the consent must occur before, not after, the action is filed." 432 F.3d at 563.
  3. Despite the Cybergenics Corp. decision, a few courts have rejected a universal rule that a creditor's committee, even with prior court approval, may bring a derivative action on behalf of the debtor's estate. See e.g., United Phosphorus v. Fox (In re Fox), 305 B.R. 912 (B.A.P. 10th Cir. 2004) (declined to follow Cybergenics; held, Bankruptcy Code does not allow creditors to bring derivative suits on behalf of bankruptcy estate; only trustee may bring fraudulent transfer suit).