Rule 2004: A Powerful Tool with Potential for Abuse

To nonbankruptcy lawyers, Rule 2004 seems too good to be true. It appears to allow virtually anyone to obtain documents or testimony from any other person on any subject tangentially related to a bankruptcy. Not surprisingly, then, clever lawyers will attempt to push its boundaries. A recent opinion in the Cambridge Analytica bankruptcy examines and quashes one such attempt.

A Rule 2004 examination is a powerful tool. It allows any interested party (e.g., a creditor) to examine any person regarding “acts, conduct, or property or to the liabilities and financial condition of the debtor, or to any matter which may affect the administration of the debtor's estate, or to the debtor's right to a discharge.”[1] In a chapter 11 case, Rule 2004 examinations are even broader. They include “the operation of any business and the desirability of its continuance, the source of any money or property acquired or to be acquired by the debtor for purposes of consummating a plan and the consideration given or offered therefor, and any other matter relevant to the case or to the formulation of a plan.”[2] Routinely described as a “fishing expedition,” a Rule 2004 examination is “unfettered and broad.”[3]

Moreover, it offers none of the procedural safeguards of the Federal Rules of Civil Procedure that most litigators take for granted. For example, the witness has no right to representation by counsel except at the court’s discretion.[4] Only limited objections to immaterial or irrelevant questions are allowed; there is no general right to cross-examine, and no right to have issues defined in advance.[5] A Rule 2004 examination is not impacted by discovery limitations imposed by trial courts[6] or contained in laws such as the Private Securities Litigation Reform Act (PSLRA), which stays discovery while a motion to dismiss is pending.

There are, however, limits that can impede overzealous litigants from abusing the process. First, Rule 2004 is discretionary. A court may but is not required to allow the examination.[7] Courts typically require that the party seeking the examination show that the proposed examination is necessary to establish the party’s claim or to advance some other bankruptcy goal.[8] Courts will also balance the need for the examination against its cost.[9]

Second, the scope is not quite as broad as sometimes described. At base, the purpose of a Rule 2004 examination is to provide information that would be helpful in administering the estate. Thus, examinations may be used to discover assets, examine transactions or detect wrongdoing.[10] However, the “examination of a witness as to matters having no relationship to the debtor’s affairs or no effect on the administration of his estate is improper.”[11] In other words, the examination should pertain to some matter that the bankruptcy court has the power to resolve.[12] So, for example, an interested party can use a Rule 2004 examination to identify potential causes of action that the debtor holds, but not to evaluate causes of action that may impact a third party in which the debtor has an interest.[13]

Third, parties cannot use Rule 2004 to take discovery related to a pending proceeding. Once a lawsuit, adversary proceeding or contested matter has commenced, the parties must take discovery in accordance with the standard discovery rules and not Rule 2004.[14] However, the mere fact that one or more of the parties to a Rule 2004 examination is engaged in related litigation does not bar the examination if the information sought is relevant to the bankruptcy.[15]

So clever litigants have attempted to game the system. They have acquired claims and sought Rule 2004 examinations arguing that matters to be examined had some bankruptcy purpose. The most recent example occurred in Cambridge Analytica’s bankruptcy.

Cambridge Analytica, the controversial political consulting firm that allegedly used data mined illegally from Facebook, is in bankruptcy. A plaintiff in a suit against Facebook purchased a $650 claim from a creditor post-petition. Based on her $650 claim, the plaintiff sought a Rule 2004 examination of the debtor.[16] The court denied her request, finding that the plaintiff sought the examination not for any bankruptcy purpose but instead to support her litigation against Facebook. The court reasoned that the plaintiff had no real interest in the bankruptcy because her claim was nominal and she acquired it post-petition: “The Court would set a very troubling precedent by allowing the [plaintiff’s] Rule 2004 Motion to go forward. Such a result would incentivize parties to purchase nominal claims in bankruptcy solely to pursue their outside litigation agendas.”[17]

The Cambridge Analytica court was not the first court to find a litigant’s reasons for seeking a Rule 2004 examination to be pretextual. Nor was it the first court to rely on the relationship between the value of the movant’s claim and the cost of the proposed examination as a basis for finding the reason given for the examination to be a pretext.

In Sandomedics, a litigant sought to evade the pending proceeding rule by having an affiliate purchase a claim and seek a Rule 2004 examination.[18] In that case, KIPU was engaged in litigation with ZenCharts, an affiliate of the debtor. KIPU’s affiliate, Tilius, purchased a $12,000 claim post-petition. After purchasing the claim, Tilius sought a Rule 2004 examination of ZenCharts, arguing that the examination was relevant to the bankruptcy.[19] The court denied the Rule 2004 motion, holding that Tilius’s motives were improper. The court noted that Tilius became a creditor by acquiring a small claim post-petition and that the cost of the examination and related motion practice far exceeded the value of the claim. The court reasoned that the only legitimate motive for a small creditor to participate in a bankruptcy would be to maximize the value of its claim. By spending more than the claim was worth, Tilius demonstrated that it was not seeking to maximize its claim but instead to assist its affiliate’s separate litigation.[20]

Although neither Cambridge Analytica nor Sandomedics cited it for this purpose, a 2002 opinion in the Enron case supports their position. In Enron, a class plaintiff sued Enron’s accountants and lawyers for securities fraud. Stymied in its attempt to take discovery in its class action by the discovery stay imposed by the PSLRA,[21] the class plaintiff sought a Rule 2004 examination of the lawyer and accountant.[22] In support, the class plaintiff argued that it needed the examination to prepare a motion seeking to require bankruptcy filings by two Enron subsidiaries.[23]

The court began by noting that the class plaintiff could not use Rule 2004 to evade the discovery limits imposed by the PLSRA.[24] It then examined the class plaintiff’s bankruptcy rationale. Noting that the timing of the class plaintiff’s interest in the two subsidiaries (on the heels of objections to the Rule 2004 motion) was suspicious, the court found that the class plaintiff’s claimed motive was a pretext. The court reasoned that the class plaintiff had no good reason to seek the bankruptcy of the subsidiaries. If the subsidiaries belonged in bankruptcy, the creditors’ committee or debtor would move to put them there.[25] Moreover, the class plaintiff had no financial interest in the bankruptcy. According to the court, it was highly unlikely that the unsecured creditors would be paid in full, leaving nothing for the subordinated securities fraud claims asserted by the class plaintiff.[26] As the class plaintiff had no financial interest in the estate, it had no rational interest in its administration. Thus, it sought the examination to circumvent the PLSRA discovery stay.[27]

Rule 2004 remains a powerful tool, but courts and practitioners should remain aware of its potential for abuse.