Cybergenics II Sounds Great But Will It Work

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Dec/Jan 2002

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Appellate courts have the luxury of making ground-breaking legal pronouncements without
worrying (too much) about how they are actually implemented. This is especially so in
bankruptcy practice, where legal principles must be road-tested in a highly practical,
result-oriented court system. A recent example of this occurred in the pending Sealed
Air adversary proceeding<a href="#1" name="1a">1</a> in the W.R. Grace & Co. bankruptcy case,<a href="#2" name="2a">2</a> where the
district court, sitting as a bankruptcy court, had to apply the Third Circuit Court
of Appeals's recent decision in the <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Committee of Unsecured Creditors of
Cybergenics Corp. v. Chinery, 304 F.3d 316, 2002 WL 31102712
(3d Cir., Sept. 20, 2002)</a>.

Cybergenics II turned the bankruptcy world (at least in the Third Circuit, which
includes Delaware) on its head by holding that an official creditors' committee in
a chapter 11 case lacks derivative capacity to sue to recover an alleged
fraudulent transfer under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §544</a>. Prior to Cybergenics II, it was
generally accepted that a creditors' committee could sue under §544(b) in place of
the trustee (or debtor-in-possession), the real party in interest. While
acknowledging that granting a committee derivative capacity to sue under §544(b) was
a "rather well-established practice,"<a href="#3" name="3a">3</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… WL 31102712</a> at *4, the Third
Circuit held that the words "the trustee may" means that only a trustee (or a
debtor-in-possession) may prosecute a §544(b) avoidance action. As such, the
appointment of a trustee and, in pending cases, substitution of the trustee as
plaintiff in place of the committee, was required where the estate held a viable
fraudulent transfer claim but was faced with a recalcitrant debtor-in-possession
(DIP) who refused to bring it. 2002 WL 31102712 at *14.

Meanwhile, in the W.R. Grace bankruptcy case, the district court had previously
appointed the official committee of asbestos personal injury claimants and the official
committee of asbestos property damage claimants to prosecute fraudulent transfer avoidance
actions to recover the value of certain former subsidiaries that W.R. Grace had sold
pre-petition. The potential recovery to the bankruptcy estate was substantial. If
successful, the suit might yield recovery of more than $3.8 billion; this is
compared to the $2.7 billion book value for all of W.R. Grace's other assets.
W.R. Grace, as DIP, had refused to prosecute these actions because it disputed
that the transfers were fraudulent.

The district court then directed that pre-trial preparations be completed on an
expedited basis in order that the adjudication of the Sealed Air adversary proceeding
not otherwise delay resolution of the chapter 11 case. The parties complied
diligently, and within a six-month period, they expended in excess of $16.7
million collectively in legal fees and expenses in preparing for trial. The parties,
the bankruptcy case and district court were now deeply invested in bringing this
litigation to a conclusion. About 10 days before start of the trial, however, the
appeals court handed down Cybergenics II.

Faced with this threshold challenge to the committees' capacity to sue, the district
court stayed the trial and solicited motions suggesting how best to salvage the case
and bring the substantive issues to trial. The opinion that followed provides an
interesting and instructive example of how the district court struggled to apply
Cybergenics II in a just and practical manner in the context of a pending complex
commercial litigation with so much at stake.

The first motion considered by the district court was by Sealed Air, one of the
defendants, requesting that the district court simply dismiss the action. It contended
that it did not waive the affirmative defense of lack of capacity to sue, the very
basis for the Cybergenics II decision. Sealed Air argued that the appointment of
a trustee, the remedy prescribed by Cybergenics II, would be untimely because
Federal Rule of Civil Procedure 17(a) requires that the proper party-in-interest
be substituted into an action within "a reasonable time" after the objection to the
existing plaintiffs' status. It claimed that the "reasonable time" began to run upon
the filing of its affirmative defense of lack of standing. The district court rejected
this argument, holding that a "reasonable time" in the context of the Sealed Air

adversary proceeding must be calculated from the date Cybergenics II was decided,
not the date Sealed Air's affirmative defense was filed. As such, the district court
denied Sealed Air's motion to dismiss.

The district court next considered various parties' motions for the appointment of
an examiner with expanded powers (i.e., the ability to prosecute as well as
investigate) under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §1104(c)</a>. These parties suggested that, based
on §1106(b) of the Bankruptcy Code, an examiner could also perform the duties
of a trustee that the court ordered. The district court noted that several other
courts have authorized an examiner to prosecute fraudulent transfers avoidance actions
after a debtor's refusal to do so. The district court, however, was not convinced.
It reasoned that this remedy would run afoul of two fundamental principles enunciated
in Cybergenics II: that the decision to bring a §544(b) avoidance action is
the sole prerogative of the trustee (or DIP), and that a literal reading of the
Bankruptcy Code precludes a finding that a debtor's refusal to bring such action is
not the same as an order from a court to that effect. Moreover, the district court
had misgivings as to whether an examiner prosecuting a fraudulent transfer action is
consistent with the more general concept of an examiner under the Bankruptcy Code.
Accordingly, the district court declined to appoint an examiner with expanded powers
to continue to prosecute the fraudulent transfer avoidance action.

The district court then considered various motions to appoint a limited purpose
trustee. The district court observed that, in the first instance, the Bankruptcy
Code does not provide for a limited purpose trustee. The district court viewed the
appointment of a limited purpose trustee in much the same way as an examiner with
expanded powers. Moreover, the district court believed that as a practical matter,
the appointment of a limited purpose trustee was inherently problematic and raised the
potential for conflicts in a shared exercise of fiduciary duties with a DIP. For
these reasons, the district court denied the motion to appoint a limited trustee.

The district court next considered the motions for appointment of a plenary trustee,
a remedy consistent with the holding in Cybergenics II. While interests of providing
certainty and finality of the Sealed Air adversary proceeding would be served by the
appointment of a plenary trustee, the district court found that the grounds for the
appointment of a trustee under §1104(a) of the Bankruptcy Code had not been
established by clear and convincing evidence. The district court was hesitant to impose
such a harsh and disruptive remedy in the bankruptcy case, which it considered to be
a "last resort." The district court was unwilling to hold that W.R. Grace's refusal
or inability to prosecute the fraudulent transfer avoidance actions in the face of the
court's own determination that they were worth prosecuting was itself enough to justify
the appointment of a trustee. The district court also declined to find that, under
the facts of the case, W.R. Grace's decision not to prosecute the fraudulent
transfer avoidance actions was inimical to the best interest of the estate and its
creditors. Believing that the case had not arrived at the point where the "last
resort" must be taken, the district court denied the motion to appoint a plenary
trustee.

Finally, the district court considered the motion by the asbestos property damage
committee to reset the adversary proceeding for trial and to let the parties remain
in the case notwithstanding the holding of Cybergenics II. While disagreeing with
that committee's rationale, the district court agreed that this was the better way for
the Sealed Air adversary proceeding to go forward. Its decision that the case go
forward regardless of the holding in Cybergenics II was based on two reasons.
First, the court wanted to protect the substantial investment of time and resources
by all parties in the litigation. Second, the court held that this was a sensible
and pragmatic choice given the uncertain procedural posture of Cybergenics II. In
order to avoid the wasteful effect of delaying the trial and imposing further prejudice
to the defendants by the continuing uncertainty, the district court relied on its
inherent equitable powers under §105(a) of the Bankruptcy Code to relax the rule
of Cybergenics II in this unique situation. Its decision considered the procedural
context of Cybergenics II, in which a petition for rehearing was pending and the
decision was not yet final. In order to avoid possible additional costs and
substantial disruption to the bankruptcy case in the event that Cybergenics II is
subsequently set aside,<a href="#4" name="4a">4</a> the district court was convinced that the trial should move
ahead, leaving the committees in place as the parties-plaintiff.

Anticipating that some party would almost certainly request leave to file an
interlocutory appeal, the district court sua sponte certified its order for interlocutory
appeal pursuant to <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §1292(b)</a>.

The Sealed Air adversary proceeding opinion revealed the district court's struggle
to balance adherence with a harsh rule imposed in a pending case with its deep concern
about providing a just and equitable result with over $3.8 billion at stake. While
the unique set of facts and circumstances of the Sealed Air adversary proceeding
greatly influenced the district court's ultimate decision to let the litigation proceed
without a substitution of the committees as plaintiffs, the other 260 pending
committee-brought cases in the Third Circuit may provide similarly challenging situations
with which bankruptcy courts will have to struggle. Moreover, if the appointment of
a trustee is the sole remedy for prosecuting avoidance actions refused to be brought
by recalcitrant DIPs, the dynamics of many existing and future bankruptcy cases are
likely to be skewed.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Official Committee of Asbestos Personal Injury Claimants and Official Committee of Asbestos Property Damage Claimants of W.R. Grace
& Co. v. Sealed Air Corporation and Cryovac Inc., Adv. No. 02-2210 (Lead Docket) (Bankr. D. Del., Oct. 24,
2002) (the "Sealed Air adversary proceeding"). <a href="#1a">Return to article</a>

<a name="2">2</a> In re W.R. Grace & Co., et al, Case Nos. 01-1139 through 01-1200, is an asbestos-related chapter 11 case pending
in the U.S. Bankruptcy Court for the District of Delaware. <a href="#2a">Return to article</a>

<a name="3">3</a> There are 261 pending cases in the Third Circuit in which a committee was prosecuting actions on behalf of a trustee or
debtor-in-possession in a bankruptcy case. <a href="#3a">Return to article</a>

<a name="4">4</a> Ironically, on the same day the opinion in the Sealed Air adversary proceeding was handed down, the Second Circuit Court of Appeals
reached a contrary conclusion from Cybergenics II in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Murad (In re Housecraft Indus. USA Inc.), ___ F.3d ____, 2002
WL 31388883 (2d Cir. Oct. 24, 2002)</a>. The stage is now set for a possible split in the circuits. <a href="#4a">Return to article</a>

Journal Authors

Leonard P. Goldberger

Journal Date

Sunday, December 1, 2002 - 12:00

Bankruptcy Rule

2002