Crowdfunding in Bankruptcy: What Happens to Backers When the Project Fails? Part II: Are Class Action Proofs of Claim the Solution?

Part I of this article identified several important issues that arise when crowdfunded companies file for bankruptcy. Among the most foreseeable dilemmas is that only a handful of crowdfunding backers would file a proof of claim, allowing equity-holders to recover an unduly high share of the debtor’s assets. As previously discussed, the relatively low contribution by any one backer makes this situation especially likely.

Perhaps the best way to resolve this issue is to permit backers to file a class action proof of claim. Though not employed frequently, the Federal Rules of Bankruptcy Procedure do provide for class action procedures in bankruptcy litigation.[1] Whether to permit a class action proof of claim is a matter of judicial discretion based on the following two-step analysis: (1) whether it is beneficial to apply Bankruptcy Rule 7023, via Bankruptcy Rule 9014(c), to the claims administration process; and (2) whether the requirements of Rule 23 of the Federal Rules of Civil Procedure (“Rule 23”) have been satisfied such that a class proof of claim may properly be filed.[2] In exercising this discretion, the “pervasive theme is avoiding undue delay in the administration of the case.”[3] Rather than applying this analysis to crowdfunding backers in the abstract, this article will use crowdfunding’s greatest success story, Cloud Imperium Games (CIG), as a test case.

Would Allowing CIG’s Backers to File a Class Action Proof of Claim Benefit the Claims Administration Process?

In determining whether to allow CIG’s backers to file a class action proof of claim, the first question is whether doing so would benefit the claims administration process. To that end, courts employ a three-factor test: (1) whether the class was certified pre-petition; (2) whether the members of the putative class received notice of the bar date; and (3) whether class certification will adversely affect the administration of the estate.[4]

With respect to the first factor, it may make sense for CIG’s backers to initiate class action litigation prior to the commencement of the bankruptcy case. Even if the case is stayed by operation of § 362(a) of the Bankruptcy Code, it will be easier for backers to file a class action proof of claim if the class has already been certified.

With respect to the second factor, CIG’s characterization of the backers as donors is important.[5] If CIG fails to notify backers of a bankruptcy filing (because CIG does not consider them creditors), the backers would have a better chance of being permitted to file a class action proof of claim. Conversely, if CIG provided notice to all backers, class certification would become less likely.

Finally, with respect to the third factor, the timing of the class certification request is key: the earlier in the case, the better.[6] CIG’s backers should therefore request class certification as soon as the bankruptcy petition is filed. While it is impossible to forecast how a court might exercise its discretion, CIG’s backers can maximize their chances of obtaining class certification by moving quickly.

Could CIG’s Backers Satisfy the Requirements of Rule 23?

The next step for the court would be to determine whether CIG’s backers satisfy the requirements of Rule 23. In general, Rule 23 allows one or more members of a class to sue as a representative of all class members if:

1.     the class is so numerous that joinder of all members is impracticable;

2.     there are questions of law or fact common to the class;

3.     the claims or defenses of the representative parties are typical of the claims or defenses of the class; and

4.     the representative parties will fairly and adequately protect the interests of the class.

First, CIG’s more than 1.8 million backers almost certainly satisfy Rule 23(a)(1)’s numerosity requirement.[7] With respect to the second and third factors, all of CIG’s backers share a common question of law: whether, notwithstanding CIG’s terms of service, the crowdfunding transaction is properly characterized as a gift or a sale. If deemed a gift, CIG’s backers would not have valid claims. If deemed a sale, CIG’s backers would be unsecured creditors. The claims and defenses of the representative would therefore be typical of those of the backers at large. Finally, with respect to the fourth factor, assume for the sake of this analysis that the named representative would fairly and adequately protect the interests of the class. CIG’s backers therefore arguably satisfy the requirements of Rule 23(a).

In addition to the Rule 23(a) prerequisites, CIG’s backers would still have to fall within one of the types of class actions identified in Rule 23(b). The backers’ best argument might be under Rule 23(b)(3), which allows for class actions where “the questions of law or fact common to class members predominate over any questions affecting only individual members, and a class action is superior to other available methods for fairly and efficiently adjudicating the controversy.”[8] Once again, the sole contested issue for any of CIG’s backers is whether the crowdfunding transaction is a gift or sale. With an average pledge of $84,[9] no individual backer has an incentive to incur the legal fees necessary to litigate that issue. Moreover, any official committee of unsecured creditors that is appointed in the case is unlikely to support the backers’ position, since doing so risks diluting the claims of all other unsecured creditors. The most efficient way to adjudicate the backers’ shared contested issue is to allow CIG’s backers to file a class action proof of claim. Thus, there is a strong argument that CIG’s backers would qualify for class certification under Rule 23(b)(3).

Conclusion

While crowdfunding poses an interesting problem for bankruptcy courts, Rule 7023 seems to offer the most straightforward solution. Of course, even if crowdfunding backers are permitted to file a class action proof of claim, the validity of their claim can still be contested. However, by allowing crowdfunding backers to file a class action proof of claim, courts can at least ensure that the interests of those responsible for funding the debtor are fairly represented.