Academic journal article Stanford Journal of Law, Business & Finance

Derivative Suits in Bankruptcy

Academic journal article Stanford Journal of Law, Business & Finance

Derivative Suits in Bankruptcy

Article excerpt


It is a fundamental tenet of corporate law that creditors, unlike shareholders, may not bring derivative suits on a firm's behalf1-even if the firm is, or is nearly, insolvent.2 Corporate law affords creditors who are unhappy with a corporate debtor's management various remedies, such as the right (in limited circumstances) to put the firm into receivership3 or to sue the directors and officers directly for breaches of fiduciary duty.4 But the derivative suit is not among them.

The formal rationale for denying derivative standing to creditors is that a derivative suit is an assertion of ownership rights, and (in contrast to shareholders) creditors lack a proprietary interest in the debtor entity.5 While some commentators have questioned the wisdom of corporate law's rule against creditor derivative standing,6 the rule whatever its merits has long endured and is likely here to stay.

One might suppose, on the theory that nonbankruptcy entitlements are protected in bankruptcy unless there is an express federal policy to the contrary,7 that creditor derivative suits would be just as unavailing in bankruptcy as they are outside of it. But the supposition would be wrong. For although corporate law forbids and the Bankruptcy Code does not expressly allow creditor derivative suits,8 courts have permitted creditors in corporate bankruptcy cases to bring them anyway.9 And even though the Supreme Court held in Hartford Underwriters Insurance Co. v. Union Planters Bank, N.A. that creditors could not assert on behalf of a bankruptcy estate a right that the Bankruptcy Code expressly reserves to the bankruptcy trustee,10 some lower courts have read that decision narrowly and have continued to permit creditors to assert derivatively claims that the Code apparently reserves to the trustee11-though one court has reserved judgment on the practice12 and another has repudiated it.13

This article evaluates the legal arguments and policy rationales that courts have offered for permitting creditor derivative suits in bankruptcy. Most of these arguments and rationales are discussed at length in the Third Circuit's recent en banc decision in Cybergenics,14 a case in which I and eight other bankruptcy scholars participated (on opposing sides) as amid curiae.15 Because of its comprehensive treatment of the issues and its centrality to the doctrinal and policy debate, Cybergenics is used here as a vehicle through which to explore the various doctrines and policies that bear on whether derivative litigation can and should be permitted in bankruptcy.

Part I summarizes the decision in Cybergenics. Parts II and III evaluate, respectively, the legal and policy arguments made in Cybergenics regarding the permissibility and desirability of derivative suits in bankruptcy. Part IV concludes that the rationales offered for permitting derivative suits in bankruptcy are unpersuasive, recommends that courts cease permitting creditors to prosecute them, and urges Congress to amend the Bankruptcy Code to proscribe them expressly.

I. The Cybergenics Decision

In 1985, Scott Chinery founded L&S Research Corporation, a seller of nutritional supplements for bodybuilding and weight loss.16 Nine years later, in a leveraged buyout transaction, L&S sold its assets for $110.5 million to a Lincolnshire Management subsidiary, which for purposes of the acquisition was called "Cybergenics," the label under which L&S had been selling its products. Lincolnshire's investment proved unwise, as Cybergenics got into financial trouble soon after the buyout transaction and filed for bankruptcy two years later.

Following a court-supervised auction at which Cybergenics' assets were sold for $2.65 million, the debtor-in-possession moved to dismiss the bankruptcy case, but the unsecured creditors' committee objected on the ground that creditors could benefit from pursuit of avoidance of fraudulent transfer claims against Chinery, L&S, Lincolnshire, and its lenders. …

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