In Official Committee of Unsecured Creditors v. Halifax Fund, L.P. (In re Applied Theory Corp.),1 the Second Circuit, in a per curiam opinion, held that an official committee of unsecured creditors (the "Committee"), under the circumstances, did not have the right to commence an adversary proceeding seeking the equitable subordination of claims held by insiders of a Chapter 11 debtor. The Applied Theory court rebuffed the Committee's characterization of its claim as a direct claim that the Committee could prosecute without the bankruptcy court's permission. The Second Circuit refused to create bright line rule, based on the Seventh Circuit authority cited by the Committee, allowing creditors and creditors' committees to bring actions for equitable subordination without judicial authorization. The Second Circuit's analysis raises the question whether, in the Second Circuit, a creditors' committee could ever suffer a direct injury sufficient for it to bring a direct cause of action. Moreover, although its Applied Theory decision is certainly not in conflict with the current jurisprudence on the issue of committee or creditor standing to bring suit in bankruptcy cases, unlike in its previous three decisions on the issue, the Second Circuit declined to further liberalize the implied right of a creditors' committee or individual creditor to assert certain causes of action owned by the debtor's estate in bankruptcy.
In Applied Theory, the Committee asserted an equitable subordination claim pursuant to Section 510(c) of the Bankruptcy Code against certain lenders that were also insiders of the debtor.2 According to the Committee, the insider lenders used their influence over the debtor to transform a substantial amount of convertible unsecured debt into secured debt for inadequate consideration and during a time when the debtor's finances were strained.3 The Bankruptcy Court for the Southern District of New York, Judge Gerber presiding, refused to allow the Committee to litigate the claim on behalf of the trustee because the equitable subordination claim did not seek to redress any particularized injury sustained by any identifiable creditor, but rather constituted estate property.4 Additionally, the Chapter 11 trustee, the proper party to bring the equitable subordination action, had already investigated the claim and concluded that it was meritless.5
The Committee unsuccessfully appealed to the District Court for the Southern District of New York, which affirmed the bankruptcy court's decision as well as the bankruptcy court's finding that the claim that the Committee sought to pursue would not be directed toward a particularized injury sustained by a specific creditor.6 The district court further observed that, although the Second Circuit has interpreted the Bankruptcy Code to provide creditors' committees with a qualified right to sue on behalf of the estate, the exercise of such right is subject to certain conditions.7 Specifically, a creditors' committee must secure bankruptcy court approval to sue, and then, even with bankruptcy court permission, a creditors' committee can only bring suit under limited circumstances (e.g., the trustee or debtor consents or unjustifiably fails to pursue the claim at issue).8 The district court also concluded that the bankruptcy court, in coming to its decision, had correctly applied the factors set forth by the Second Circuit in In re STN Enterprises.9 Specifically, the bankruptcy court had properly considered whether the claim that the Committee sought to pursue was colorable and likely to benefit the bankruptcy estate.10
Subsequently, the Committee appealed to the Second Circuit, arguing that STN was inapplicable and that the Committee did not need to secure the bankruptcy court's authority to have standing to bring an equitable subordination claim.11 Arguing that STN was inapplicable, the Committee cited In re Vitreous Steel Products Co.,12 a decision in which the Seventh Circuit held that an unsecured creditor could assert a claim for equitable subordination because the creditor was acting in its own interest rather than in the interest of all unsecured creditors.13 The Second Circuit disagreed that STN was inapplicable, refused to create a new rule based on the Seventh Circuit Vitreous Steel decision, and affirmed the judgment of the district court.14
Rejection of Creditors' Committee's Derivative/Direct Distinction and Refusal to Adopt Rule Based Only on Seventh Circuit Precedent
The Applied Theory court rejected the Committee's argument that STN was inapplicable because the Committee's equitable subordination action was a direct and not a derivative action.15 The Committee had argued that, unlike fraudulent transfer and preference actions, the applicable Bankruptcy Code provision (Section 510(c)) does not expressly vest the power to bring equitable subordination claims exclusively in the trustee.16 The Second Circuit declined the Committee's invitation to "adopt a bright-line rule" allowing a creditors' committee, a group of creditors or an individual creditor to bring equitable subordination claims without judicial authorization, where the Committee's argument was grounded in the non-Second Circuit Vitreous Steel decision.17
The Seventh Circuit in Vitreous Steel held that an unsecured creditor had standing to bring an equitable subordination claim because, "unlike a trustee, the individual creditor seeking equitable subordination 'is not acting in the interests of all the unsecured creditors' and 'individual creditors have an interest in subordination separate and apart from the interests of the estate as a whole.'"18 The Applied Theory court pointed out that the Second Circuit had previously commented on the close alignment of the interests of debtors-in-possession and creditors' committees in Commodore Int'l Ltd. v. Gould (In re Commodore Int'l Ltd.).19 Quoting a decision from the Ninth Circuit Bankruptcy Appellate Panel, the Second Circuit in Commodore observed that "'[a]n unsecured creditors' committee has a close identity of interests with' the debtor-in-possession insofar as the latter is obligated to pursue all actions that are in the best interest of the creditors and the estate."20
Like the bankruptcy court and the district court, the Second Circuit in Applied Theory found that it was clear in this instance that the equitable subordination claim that the Committee wished to pursue "would not be directed toward any particularized injury suffered by any creditor."21 The Committee simply did not show an interest of its own in equitable subordination that was distinct from the interest of the bankruptcy estate, and thus failed to establish why it should be allowed to step into the trustee's shoes in this instance.22 The court noted that, no matter how the Committee tried to characterize it, the Committee's equitable subordination claim essentially boiled down to an assertion of harm to the debtor generally and would seek to subordinate the insider lenders' claims to those of other creditors.23 Unlike an individual creditor, a creditors' committee lacks the right to assert such claims against other creditors.24 Stated differently, the Second Circuit concluded that the "Committee has not sustained an injury for which a 'direct' claim might otherwise be available."25
Second Circuit Jurisprudence Regarding Standing of Creditors or Creditors' Committees to Pursue a Claim in Bankruptcy
The Second Circuit also considered the Bankruptcy Code and the applicable line of cases on creditors' committee standing. Preliminarily, the Second Circuit examined the plain language of the Code and noted that no provision of the Bankruptcy Code explicitly permits creditors' committees to commence adversary proceedings.26 Furthermore, the Court observed that a creditors' committee's general right under Section 1109(b) of the Bankruptcy Code to be heard on any issue in a Chapter 11 case does not extend so far as to permit a creditors' committee "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."27
Next, the Applied Theory court considered the existing Second Circuit case law on the issue of derivative standing to bring certain causes of action in bankruptcy on behalf of a debtor's estate.28 The Court noted that its 1985 STN decision recognized a creditors' committee's right to bring an adversary proceeding in bankruptcy, but only under limited circumstances.29 In STN, the Second Circuit had held that "'11 U.S.C. § § 1103(c)(5) and 1109(b) imply a qualified right for creditors' committees to initiate suit with the approval of the bankruptcy court' when the trustee or debtor-in-possession has unjustifiably failed to bring suit or abused its discretion in not suing to avoid a preferential transfer."30 In making such a determination, the court should consider whether the proposed claim would be "likely to benefit the reorganization estate."31
More recently, the Second Circuit expanded on STN in Commodore.32 In Commodore, the Second Circuit concluded that, in addition to the circumstance where a debtor or trustee unjustifiably fails to bring suit, a creditors' committee could also bring suit if it can obtain the debtor's consent.33 Even where the debtor consents, however, a creditors' committee's derivative standing is still conditioned on the bankruptcy court's approval, the standard for which is the bankruptcy court's determination that 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 proceedings."34
Finally, in Glinka v. Murad (In re Housecraft Industries USA, Inc.),35 the Second Circuit extended Commodore, holding that a debtor's primary secured creditor had standing to bring a fraudulent transfer action where the Chapter 7 trustee had consented and where all of the other elements of the test set forth in Commodore were satisfied.36
Application to Equitable Subordination Claim Asserted by Committee
STN and Commodore, according to the Second Circuit, "doom[ed]" the Committee's appeal because both cases clearly condition a creditors' committee's standing to bring a suit on the bankruptcy court's determination that the suit would benefit the bankruptcy estate.37 The Chapter 11 trustee and the bankruptcy court already had determined that the equitable subordination claim was not in the best interest of the estate, and the Committee did not give the Second Circuit any reason to find otherwise.38 The Second Circuit further expounded on the strong policy considerations underlying the requirement that creditors' committees obtain bankruptcy court approval before bringing a derivative action:
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. Requiring bankruptcy court approval conditioned upon the litigation's effect on the estate 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.39
In Applied Theory, the Committee tried to circumvent the STN standard by arguing that its equitable subordination claim was direct instead of derivative. Lending support to the Committee's argument is the language of Section 510(c) of the Bankruptcy Code which does not on its face limit standing to pursue equitable subordination actions to trustees or debtors-in-possession and a Seventh Circuit decision which allowed an individual creditor to bring an equitable subordination claim. The Second Circuit, however, quickly rejected the Committee's effort to recharacterize its derivative action as a direct action. The Applied Theory court simply was not persuaded that the Committee had suffered any direct injury which a direct claim could remedy. Nor would the Second Circuit create a new rule based on Seventh Circuit precedent that would allow creditors' committees and creditors to bring equitable subordination actions without prior judicial authorization.
The Second Circuit contrasted the dissimilarity of interests between individual creditors and trustees that the Seventh Circuit discussed in reaching its holding in Vitreous Steel with the comments made by the Second Circuit in Commodore regarding the close alignment of interests between debtors-in-possession and creditors' committees. Interestingly, however, the Applied Theory court did not mention that the Second Circuit in Commodore made the comments about the alignment of interests in the context of determining that a creditors' committee should be able to gain standing upon the consent of a trustee or debtor-in-possession. Indeed, the Second Circuit in Commodore was not even confronted with the issues of whether a creditors' committee could bring an equitable subordination claim or whether a claim should be characterized as direct or derivative.40 In closing, the Second Circuit addressed the main fact distinguishing the situation in Applied Theory from that in Vitreous Steel; namely that a creditors' committee, rather than an individual creditor, was seeking to assert an equitable subordination claim. According to the Applied Theory court, unlike an individual creditor, the Committee did not have the right to assert equitable subordination against another creditor, nor had it sustained a direct injury that could be remedied by a direct action.
In any event, the Second Circuit's analysis regarding the close identity of interests between debtors-in-possession and creditors' committees raises doubts as to whether a creditors' committee can ever suffer a direct injury that is separate and apart from any injury suffered by the debtor generally. Indeed, it is possible to read Applied Theory as foreclosing a creditors' committee from bringing any sort of direct action without complying with the STN/Commodore standard.
The qualified right of a creditors' committee to bring certain causes of action was first enunciated in STN, broadened in Commodore, and extended to individual creditors in Housecraft. After Applied Theory, however, creditors' committees in the Second Circuit that wish to commence certain causes of action, the pursuit of which are not expressly reserved by the Bankruptcy Code for the trustee or debtor-in-possession, now will likely still need to jump through the STN/Commodore hoops in order to gain standing. By extending the reach of STN and Commodore the Second Circuit, in Applied Theory, has for the first time in two decades halted the expansion of creditors' committees' standing.