On May 2, 2019, Judge Kevin J. Carey of the U.S. Bankruptcy Court for the District of Delaware issued an opinion holding that a liquidation trustee who brought claims initially raised in an adversary proceeding by an unsecured creditors committee did not have standing to assert derivative claims on behalf of the debtor. See In re Citadel Watford City Disposal Partners, L.P., No. 15-11323 (Bankr. D. Del. 2019). This ruling follows a number of recent similar decisions that have left creditors and their attorneys in a precarious position going forward. The ruling raises a number of questions, including whether it is appropriate to award a premium at the time credit is extended to compensate creditors for their potential lack of legal recourse should their investment sour and their interests diverge from the properly assigned parties; whether filing for bankruptcy will offer a debtor more flexibility on the assumption that creditors may have limited recourses after filing; and, as was determinative here, the strategic considerations and manner in which creditors seek to assert claims to protect their investment in the entity after the filing.

The case arose from the bankruptcy of a group of companies bearing the name Citadel that provided fluid-management services to oil and gas producers. In June 2015, the Citadel companies filed voluntary Chapter 11 petitions; shortly thereafter, the Office of the United States Trustee appointed an Unsecured Creditors Committee (the Committee). In 2017, the Committee commenced an adversary proceeding against former officers and directors as a derivative action on behalf of Citadel. The complaint alleged a variety of misconduct, including breach of fiduciary duty, gross mismanagement, waste, fraud, fraudulent concealment, conversion, and other causes of action relating to fraudulent investment practices, commingling, self-dealing, conversion of business assets, unauthorized assignment of assets, and the loss of a lease central to the Debtors’ business.

Shortly after the Committee asserted these claims, a Chapter 11 plan of liquidation was confirmed. The Committee was then automatically dissolved. In response, the Liquidation Trustee moved to amend the caption on certain pleadings, including the complaint, to succeed in the footsteps of the Committee. The court granted the relief and an amended complaint was filed. The Litigation Trustee’s decision simply to succeed the Committee—rather than to bring the claims anew, given its authority under the plan to “investigate, prosecute, compromise and settle” all causes of action, including adversary proceedings formerly brought by “the Debtors, the Debtors’ estate or the Creditors’ Committee”—would ultimately prove fatal.

Defendant Mark Dunaway, a managing partner and director at one of the Citadel entities, moved to dismiss, arguing that under both Delaware Supreme Court precedent and Delaware statutes, creditors of an insolvent limited liability company or limited partnership do not have standing to bring a derivative action. In response, the Liquidation Trustee relied heavily on the text of the confirmation order and confirmed plan, especially the assignment provisions. According to the Litigation Trustee, those documents established that the Debtors transferred and assigned any causes of action to the Liquidation Trustee; the latter succeeded to the Debtors and their estates; and the Liquidation Trustee, therefore, had the authority and responsibility to pursue the former causes of action. The Litigation Trustee also argued that the claims were being brought on behalf of the Debtors themselves, not their investors and creditors, and that reading the complaint in a light most favorable to it should lead the court to find standing. Dunaway replied that the plan, no matter its language, could not overcome Delaware case law and statutory precedent.

The Decision

Judge Carey sided with Dunaway, dismissing the claims of the Liquidation Trustee for lack of standing. The court held that the Committee did not have standing under either the Delaware Limited Partnership Act (the LP Act) or the Delaware Limited Liability Company Act (the LLC Act), and therefore the Litigation Trustee as its successor could not, either.

For the purposes of the LP Act, the court noted that the statute defines both the right to bring an action and, most relevant to the matter at hand, what constitutes a “proper plaintiff.” Del. Code Ann. tit. 6, §17-1002 requires that a proper derivative-action plaintiff “must be a partner or an assignee of a partnership interest.” Creditors are not partners or assignees. Accordingly, there was no authority for derivative standing by the Committee. The court also held that analogous language in the LLC Act yielded the same conclusion. Under Del. Code Ann. tit. 6, §18-1002, the plaintiff in the suit must be either “a member or an assignee of a limited liability company interest,” neither of which applies to a creditor. Accordingly, there was no standing to bring the relevant claims in the first place. The fact that the plan had assigned the Committee’s causes of action to the Litigation Trustee did not help, because the latter merely stood in the shoes of the former.

The court cited a few recent cases that reached similar rulings under Delaware law. In re HH Liquidation, 590 B.R. 211, 283-85 (Bankr. D. Del. 2018), held that under the LLC Act, an unsecured creditors committee had no standing to assert derivative claims on behalf of an LLC. In re PennySaver USA Publishing, 587 B.R. 445, 466-67 (Bankr. D. Del. 2018), dismissed a Chapter 7 trustee’s derivative claims for breach of fiduciary duties purportedly owed to a Delaware LLC. Neither of those cases featured an assignment of rights, however, as was present here. The instant case establishes that notwithstanding language in both the plan and the confirmation order empowering a litigation trustee to bring a derivative action, such language does not trump case law or a statute.

The Upshot

These developments raise a number of important issues under Delaware law. To the extent that similar rulings represent a “new normal,” parties should consider their implications both at the time credit is extended, when an entity is weighing whether to file for bankruptcy, and, of course, after an entity files for bankruptcy and creditors find themselves involved in litigation to protect their investments. As a matter of litigation strategy, creditors should pay close attention to the manner in which their claims are asserted. That proved critical here, as the court rejected a claimed assignment of rights because the Committee had initiated the adversary proceeding that was currently pending. Had the same claims been brought by the Liquidation Trustee directly, standing would have been presumably found because the plan had offered an assignment to the Trustee. Going forward, attorneys may seek to advise creditors to avoid initiating the adversary proceeding to prevent a similar outcome.

Margaret A. Dale and Mark D. Harris are partners at Proskauer Rose. Peter Fishkind, an associate at the firm, contributed to the writing of this article.