Whose Claim Is It, Anyway?

It is often assumed that only creditor claims against a debtor are affected by the debtor's bankruptcy filing, and that rights against third parties are not. While the logic and simplicity of that assumption are appealing, nothing could be further from the truth in many bankruptcy situations. There is an inherent tension between the claims that may be asserted by creditors against non-debtor parties and those that are in the exclusive realm of the trustee. Not only is this line-drawing an analytical challenge, its outcome may be entirely different depending upon the court involved and the law being applied. Understanding the courts' treatment of this division of claims (as inconsistent as it is) is essential to a successful litigation strategy, whether on behalf of individual creditors or a trustee.

The Issue

Creditors may have claims against third parties based upon either bargained-for contractual rights or rights arising from the wrongdoing of those parties. Either way, a creditor will naturally look to potential sources of recovery other than the debtor, whose bankruptcy filing necessarily carries with it a diminished capacity to make the creditor whole. Likewise, the trustee (or debtor in possession) may also have claims against other parties that can bring funds into the estate for the benefit of all of the creditors. The division between individual creditor claims and trustee claims is often clear. For example, the trustee has the exclusive right to pursue avoidance claims for preferences, fraudulent transfers, and the like. On the other hand, individual creditors may have independent claims against third parties for whom the estate has no claims, such as direct contractual obligations or tort liability unrelated to the debtor.

There are many instances, however, in which both individual creditors and the trustee may assert claims against the same third parties, arising out of the same or related events. When a creditor and a trustee target the same defendant, it is not always easy to determine which is entitled to pursue the claim. Despite a relative abundance of circuit-level decisions addressing this issue, the answer is often unclear. Nevertheless, there are some guidelines that can be used to work through the issue and develop the best strategy for each case.

Testing the Assumptions

There are several common assumptions about the effect of bankruptcy that we all make, at least initially. Among them are these: 1) creditor claims against non-debtor defendants are not discharged or otherwise affected by the debtor's bankruptcy filing; 2) the automatic stay applies only to actions against the debtor or its property, and not to actions against other parties; and 3) guarantees or joint obligations of third parties are not affected by the bankruptcy of the primary debtor, and creditors retain their rights against those parties regardless of the bankruptcy. These assumptions seem fundamental, but are they? In reality, each of them may turn out to be entirely wrong.

The Nature of Third-Party Claims

If a claim, by its nature, belonged to the debtor and thereby became property of the estate upon filing, it is a claim that can be asserted by the trustee. On the other hand, if it is a claim that could only be asserted by a particular creditor and it is not bestowed on the estate through the granting of the trustee's avoidance powers, it is the creditor's claim to bring, not the trustee's. Examples of such creditors' claims would include third-party guarantees and specific torts, such as fraud, committed by the third party against a specific creditor, and not others. Even those creditor claims may feel the impact of bankruptcy, as discussed below, but for the most part they allow the creditor to pursue independent remedies against a third party.

Most difficult are claims that may arguably be asserted both directly by creditors and also by a trustee against the same non-debtor defendants. Claims based upon alter ego or piercing of the corporate veil against parent companies, shareholders, or other non-debtors fall into this category and have generated a significant body of case law, which sheds both light and confusion on the issue.

Alter Ego Claims ' Opposite Results in Identical Cases

Alter ego or piercing theories offer hope to creditors that are left unpaid by their primary debtor. These theories may permit a creditor to overcome the separate corporate identity of the primary debtor and seek recourse from those that control it. They are generally based on a series of factors such as excessive domination and control of the entity, failure to respect corporate separateness, inadequate capitalization, and use of the entity for some improper purpose. Outside of the bankruptcy context, a creditor is free to pursue alter ego defendants for its own benefit. When the primary debtor is in bankruptcy, however, those same defendants may provide a source of payment for the creditor body as a whole if the trustee is able to bring that recovery into the estate. This sets up a fundamental conflict between the individual creditor and the trustee. How this conflict is resolved will determine whether the assets of alter ego defendants go only to the suing creditors or to the trustee for the benefit of all creditors. Considerable law has developed at the circuit court level, but it has not yielded uniform results.

If a court holds that alter ego claims belong to the estate and may be pursued by the trustee, it generally follows that such claims may not be pursued by individual creditors. See, e.g., Steyr-Daimler-Puch of America Corp. v. Pappas, 852 F.2d 132 (4th Cir. 1988); SI Acquisition, Inc. v. Eastway Delivery Service, Inc. (In re S.I. Acquisition, Inc.), 817 F.2d 1142 (5th Cir. 1987). Where courts have gone the other way and held that a trustee may not assert alter ego claims, then only individual creditors may bring those claims. See, e.g., Steinberg v. Buczynski, 40 F.3d 890 (7th Cir. 1994); Mixon v. Anderson (In re Ozark Restaurant Equipment Co.), 816 F.2d 1222 (8th Cir. 1987), cert. denied sub nom. Jacoway v. Anderson, 484 U.S. 848.

There is no uniform answer as to whether claims involving alter ego or piercing theories belong exclusively to the trustee or to individual creditors. Courts of appeals in several circuits have held that these claims belong to the trustee. See, e.g., Baillie Lumber Co. v. Thompson (In re Icarus Holding, LLC), 391 F.3d 1315 (11th Cir. 2004), 413 F.3d 1293 (11th Cir. 2005 (after determination of certified question of state law by Georgia Supreme Court); Honigman v. Comerica Bank (In re Van Dresser Corp.), 138 F.3d 945 (6th Cir. 1997); St. Paul Fire and Marine Ins. Co. v. Pepsico, Inc., 884 F.2d 688 (2nd Cir. 1989); Louisiana World Exposition v. Federal Ins. Co., 858 F.2d 233 (5th Cir. 1988); Steyr-Daimler-Puch (4th Cir.); Koch Refining v. Farmers Union Central Exchange, Inc., 831 F.2d 1339 (7th Cir. 1987), cert. denied, 485 U.S. 906 (1988); SI Acquisition (5th Cir.). In other cases courts have held that alter ego claims may only be asserted by individual creditors, and not by the trustee. See, e.g., Spartan Tube and Steel, Inc. v. Himmelspach (In re RCS Engineered Products Co.), 102 F.3d 223 (6th Cir. 1996); Steinberg (7th Cir.); Ozark (8th Cir.); Cumberland Oil Corp. v. Thropp, 791 F.2d 1037 (2nd Cir. 1986). Not only are there differences among the circuits, but different outcomes within the same circuit.

Generalizations by circuit do not work, but there are certain common threads in the cases that at least provide a rational basis for analysis. First, it is generally agreed that the nature of claims, including alter ego claims, is determined by state law. Thus, for example, in Ozark, the trustee was not permitted to bring the claims, because under Arkansas law the debtor corporation itself could not have done so. In Icarus, on the other hand, the trustee was permitted to bring alter ego claims because Georgia state law would have allowed the debtor to assert them.

Second, in contrast to the types of claims that can be brought by the trustee under the strong-arm powers of 11 U.S.C. ' 544, alter ego and piercing claims are available to the trustee only by inclusion in the debtor's estate under Section 541. If the debtor can assert the claim, the trustee can do so, but otherwise not. See, e.g., Steinberg, 40 F.3d at 892.

Third, courts have applied another layer of analysis, making a distinction between “general” and “personal” claims. In order for the trustee to assert such claims, they must be general, in the sense that they apply equally to all creditors. See, e.g., Icarus, 391 F.3d at 1321. Koch, 831 F.2d at 1348-49. If the defendants' acts or the damages suffered by a creditor are peculiar to that creditor, as opposed to applying to creditors generally, then courts are more likely to allow the claim to be brought by the creditor. See, e.g., Steinberg, 40 F.3d at 892-93; Cumberland, 791 F.2d at 1042 (fraud specifically directly to the creditor plaintiff).

Therefore, if alter ego claims against non-debtor parties could have been brought by the debtor under state law, and if they involve generalized acts and damages equally applicable to all creditors, it is likely that they will be regarded as claims exclusively to be brought by the trustee. Otherwise, individual creditors are probably free to assert the claims, unless the bankruptcy court affirmatively orders otherwise.

Effect of the Automatic Stay

Contrary to the normal assumption that actions against third parties are not stayed by ' 362, it is generally held that creditors are stayed from asserting claims that the trustee may assert. This is true even though creditors would otherwise have the right to pursue these claims. Section 362(a)(3), staying acts to obtain or exercise control over property of the estate, is construed to prevent creditors from taking the benefit of claims that could otherwise be used by the trustee to bring value into the estate. See, e.g., Steyr-Daimler-Puch, 852 F.2d at 136; SI Acquisition, 817 F.2d at 1150. Creditors do not have the option of filing suit against non-debtor parties and sorting things out with the trustee later, since that may be in direct violation of the automatic stay. On the other hand, they will at the very least want to assure that all viable claims are being brought by the trustee if not brought by creditors themselves.

Discretionary Injunctions

Even if actions against non-debtors are not automatically stayed, they can be enjoined by the bankruptcy court under its ' 105 injunctive powers. For example, in AH Robins Co. v. Piccinin, 788 F.2d 994 (4th Cir. 1986), the distinction between actions automatically stayed by ' 362 and those that should be stayed by injunction under ' 105 was blurred. The court declared that in “unusual circumstances” the stay of ' 362(a)(1) or (3) may be deemed to extend to actions against non-debtor parties. Those circumstances might exist when suit is brought against a party with absolute indemnity rights against the debtor. The court went on, however, to invoke its ' 105 injunctive powers to enjoin actions against parties with indemnity rights and against co-defendants who would otherwise exhaust common insurance coverage to the detriment of the estate. Case law applying this injunctive power is not consistent, however. See, e.g., Solidus Networks, Inc. v. Excel Innovations, Inc. (In re Excel Innovations, Inc.), 502 F.3d 1086 (9th Cir. 2007) (reversing preliminary injunction against third party litigation because lower court did not properly apply standard requirments for issuing a preliminary injunction); Fisher v. Apostolou, 155 F.3d 876 (7th Cir. 1998) (enjoining creditor claims involving the same acts as claims brought by the trustee); Credit Alliance Corp. v. Williams, 851 F.2d 119 (4th Cir. 1988) (declining to enjoin creditor action against guarantor); Lynch v. Johns-Manville, Sales Corp., 710 F.2d 1194 (6th Cir. 1983) (refusing to enjoin creditor actions against co-defendants of debtor).

The risk for individual creditors is that a court may enjoin actions against non-debtors even if the creditor plaintiffs are fully entitled to bring those actions, if the result would be to divert assets from the estate and allow competition for assets between creditors and the trustee. The opportunity for trustees is to get the first shot at suing non-debtor defendants who may contribute assets to the estate that would otherwise be consumed by competing creditors.

Strategic Considerations

Creditors pursuing claims against non-debtors should be aware of potential conflict with the trustee and should be wary of violating the automatic stay. At the same time, however, both the factual and legal basis for claims should be thoroughly analyzed at the outset, to assure that claims that are within the creditors' domain are not unwittingly lost. There may be room for both creditors and the trustee to make the most of their positions by coordinating claims against non-debtors. To the extent that creditors and the trustee wish to pursue common defendants, there may be a symbiotic approach in which both creditors and the trustee join in and cooperatively pursue litigation, either by joining all claims in a single action or carefully coordinating more than one ongoing case.

This approach can enable the trustee to enjoy some litigation support from private parties, while allowing the creditors an active role in maximizing returns from that litigation. In some cases, the creditors and the trustee may be able to negotiate an agreed sharing of litigation proceeds, as well as costs, reflecting the relative proportions of the claims that they each hold. Rather than battling among themselves over how to divide up claims against the same defendants, they can reduce their individual cost burden and maximize total recoveries.

Because the same facts can give rise to a mixture of claims, between those held by the creditors and those held by the trustee, this may be the only practical way to allow the parties to maximize returns, not only for themselves, but for all creditors. Cooperation may also allow the plaintiffs to minimize the negative impact of things such as the in pari delicto defense that may saddle the trustee with the effects of the debtor's wrongdoing, as well as allow the trustee to avoid defenses that may be peculiar to specific creditors. Joining in a cooperative litigation effort may be the best way to avoid conflict between creditors and the trustee and focus all parties' efforts on obtaining recovery from other wrongdoers.

Jack L. Smith is a partner at Holland & Hart LLP in Denver. A member of this newsletter's Board of Editors, he may be reached at [email protected].

It is often assumed that only creditor claims against a debtor are affected by the debtor's bankruptcy filing, and that rights against third parties are not. While the logic and simplicity of that assumption are appealing, nothing could be further from the truth in many bankruptcy situations. There is an inherent tension between the claims that may be asserted by creditors against non-debtor parties and those that are in the exclusive realm of the trustee. Not only is this line-drawing an analytical challenge, its outcome may be entirely different depending upon the court involved and the law being applied. Understanding the courts' treatment of this division of claims (as inconsistent as it is) is essential to a successful litigation strategy, whether on behalf of individual creditors or a trustee.

The Issue

Creditors may have claims against third parties based upon either bargained-for contractual rights or rights arising from the wrongdoing of those parties. Either way, a creditor will naturally look to potential sources of recovery other than the debtor, whose bankruptcy filing necessarily carries with it a diminished capacity to make the creditor whole. Likewise, the trustee (or debtor in possession) may also have claims against other parties that can bring funds into the estate for the benefit of all of the creditors. The division between individual creditor claims and trustee claims is often clear. For example, the trustee has the exclusive right to pursue avoidance claims for preferences, fraudulent transfers, and the like. On the other hand, individual creditors may have independent claims against third parties for whom the estate has no claims, such as direct contractual obligations or tort liability unrelated to the debtor.

There are many instances, however, in which both individual creditors and the trustee may assert claims against the same third parties, arising out of the same or related events. When a creditor and a trustee target the same defendant, it is not always easy to determine which is entitled to pursue the claim. Despite a relative abundance of circuit-level decisions addressing this issue, the answer is often unclear. Nevertheless, there are some guidelines that can be used to work through the issue and develop the best strategy for each case.

Testing the Assumptions

There are several common assumptions about the effect of bankruptcy that we all make, at least initially. Among them are these: 1) creditor claims against non-debtor defendants are not discharged or otherwise affected by the debtor's bankruptcy filing; 2) the automatic stay applies only to actions against the debtor or its property, and not to actions against other parties; and 3) guarantees or joint obligations of third parties are not affected by the bankruptcy of the primary debtor, and creditors retain their rights against those parties regardless of the bankruptcy. These assumptions seem fundamental, but are they? In reality, each of them may turn out to be entirely wrong.

The Nature of Third-Party Claims

If a claim, by its nature, belonged to the debtor and thereby became property of the estate upon filing, it is a claim that can be asserted by the trustee. On the other hand, if it is a claim that could only be asserted by a particular creditor and it is not bestowed on the estate through the granting of the trustee's avoidance powers, it is the creditor's claim to bring, not the trustee's. Examples of such creditors' claims would include third-party guarantees and specific torts, such as fraud, committed by the third party against a specific creditor, and not others. Even those creditor claims may feel the impact of bankruptcy, as discussed below, but for the most part they allow the creditor to pursue independent remedies against a third party.

Most difficult are claims that may arguably be asserted both directly by creditors and also by a trustee against the same non-debtor defendants. Claims based upon alter ego or piercing of the corporate veil against parent companies, shareholders, or other non-debtors fall into this category and have generated a significant body of case law, which sheds both light and confusion on the issue.

Alter Ego Claims ' Opposite Results in Identical Cases

Alter ego or piercing theories offer hope to creditors that are left unpaid by their primary debtor. These theories may permit a creditor to overcome the separate corporate identity of the primary debtor and seek recourse from those that control it. They are generally based on a series of factors such as excessive domination and control of the entity, failure to respect corporate separateness, inadequate capitalization, and use of the entity for some improper purpose. Outside of the bankruptcy context, a creditor is free to pursue alter ego defendants for its own benefit. When the primary debtor is in bankruptcy, however, those same defendants may provide a source of payment for the creditor body as a whole if the trustee is able to bring that recovery into the estate. This sets up a fundamental conflict between the individual creditor and the trustee. How this conflict is resolved will determine whether the assets of alter ego defendants go only to the suing creditors or to the trustee for the benefit of all creditors. Considerable law has developed at the circuit court level, but it has not yielded uniform results.

If a court holds that alter ego claims belong to the estate and may be pursued by the trustee, it generally follows that such claims may not be pursued by individual creditors. See, e.g., Steyr-Daimler-Puch of America Corp. v. Pappas , 852 F.2d 132 (4th Cir. 1988); SI Acquisition, Inc. v. Eastway Delivery Service, Inc. (In re S.I. Acquisition, Inc.), 817 F.2d 1142 (5th Cir. 1987). Where courts have gone the other way and held that a trustee may not assert alter ego claims, then only individual creditors may bring those claims. See, e.g., Steinberg v. Buczynski , 40 F.3d 890 (7th Cir. 1994); Mixon v. Anderson (In re Ozark Restaurant Equipment Co.), 816 F.2d 1222 (8th Cir. 1987), cert. denied sub nom. Jacoway v. Anderson , 484 U.S. 848.

There is no uniform answer as to whether claims involving alter ego or piercing theories belong exclusively to the trustee or to individual creditors. Courts of appeals in several circuits have held that these claims belong to the trustee. See, e.g., Baillie Lumber Co. v. Thompson (In re Icarus Holding, LLC), 391 F.3d 1315 (11th Cir. 2004), 413 F.3d 1293 (11th Cir. 2005 (after determination of certified question of state law by Georgia Supreme Court); Honigman v. Comerica Bank (In re Van Dresser Corp.), 138 F.3d 945 (6th Cir. 1997); St. Paul Fire and Marine Ins. Co. v. Pepsico, Inc. , 884 F.2d 688 (2nd Cir. 1989); Louisiana World Exposition v. Federal Ins. Co. , 858 F.2d 233 (5th Cir. 1988); Steyr-Daimler-Puch (4th Cir.); Koch Refining v. Farmers Union Central Exchange, Inc. , 831 F.2d 1339 (7th Cir. 1987), cert. denied, 485 U.S. 906 (1988); SI Acquisition (5th Cir.). In other cases courts have held that alter ego claims may only be asserted by individual creditors, and not by the trustee. See, e.g., Spartan Tube and Steel, Inc. v. Himmelspach (In re RCS Engineered Products Co.), 102 F.3d 223 (6th Cir. 1996); Steinberg (7th Cir.); Ozark (8th Cir.); Cumberland Oil Corp. v. Thropp , 791 F.2d 1037 (2nd Cir. 1986). Not only are there differences among the circuits, but different outcomes within the same circuit.

Generalizations by circuit do not work, but there are certain common threads in the cases that at least provide a rational basis for analysis. First, it is generally agreed that the nature of claims, including alter ego claims, is determined by state law. Thus, for example, in Ozark, the trustee was not permitted to bring the claims, because under Arkansas law the debtor corporation itself could not have done so. In Icarus, on the other hand, the trustee was permitted to bring alter ego claims because Georgia state law would have allowed the debtor to assert them.

Second, in contrast to the types of claims that can be brought by the trustee under the strong-arm powers of 11 U.S.C. ' 544, alter ego and piercing claims are available to the trustee only by inclusion in the debtor's estate under Section 541. If the debtor can assert the claim, the trustee can do so, but otherwise not. See, e.g., Steinberg, 40 F.3d at 892.

Third, courts have applied another layer of analysis, making a distinction between “general” and “personal” claims. In order for the trustee to assert such claims, they must be general, in the sense that they apply equally to all creditors. See, e.g., Icarus, 391 F.3d at 1321. Koch, 831 F.2d at 1348-49. If the defendants' acts or the damages suffered by a creditor are peculiar to that creditor, as opposed to applying to creditors generally, then courts are more likely to allow the claim to be brought by the creditor. See, e.g., Steinberg, 40 F.3d at 892-93; Cumberland, 791 F.2d at 1042 (fraud specifically directly to the creditor plaintiff).

Therefore, if alter ego claims against non-debtor parties could have been brought by the debtor under state law, and if they involve generalized acts and damages equally applicable to all creditors, it is likely that they will be regarded as claims exclusively to be brought by the trustee. Otherwise, individual creditors are probably free to assert the claims, unless the bankruptcy court affirmatively orders otherwise.

Effect of the Automatic Stay

Contrary to the normal assumption that actions against third parties are not stayed by ' 362, it is generally held that creditors are stayed from asserting claims that the trustee may assert. This is true even though creditors would otherwise have the right to pursue these claims. Section 362(a)(3), staying acts to obtain or exercise control over property of the estate, is construed to prevent creditors from taking the benefit of claims that could otherwise be used by the trustee to bring value into the estate. See, e.g., Steyr-Daimler-Puch, 852 F.2d at 136; SI Acquisition, 817 F.2d at 1150. Creditors do not have the option of filing suit against non-debtor parties and sorting things out with the trustee later, since that may be in direct violation of the automatic stay. On the other hand, they will at the very least want to assure that all viable claims are being brought by the trustee if not brought by creditors themselves.

Discretionary Injunctions

Even if actions against non-debtors are not automatically stayed, they can be enjoined by the bankruptcy court under its ' 105 injunctive powers. For example, in AH Robins Co. v. Piccinin , 788 F.2d 994 (4th Cir. 1986), the distinction between actions automatically stayed by ' 362 and those that should be stayed by injunction under ' 105 was blurred. The court declared that in “unusual circumstances” the stay of ' 362(a)(1) or (3) may be deemed to extend to actions against non-debtor parties. Those circumstances might exist when suit is brought against a party with absolute indemnity rights against the debtor. The court went on, however, to invoke its ' 105 injunctive powers to enjoin actions against parties with indemnity rights and against co-defendants who would otherwise exhaust common insurance coverage to the detriment of the estate. Case law applying this injunctive power is not consistent, however. See, e.g., Solidus Networks, Inc. v. Excel Innovations, Inc. (In re Excel Innovations, Inc.), 502 F.3d 1086 (9th Cir. 2007) (reversing preliminary injunction against third party litigation because lower court did not properly apply standard requirments for issuing a preliminary injunction); Fisher v. Apostolou , 155 F.3d 876 (7th Cir. 1998) (enjoining creditor claims involving the same acts as claims brought by the trustee); Credit Alliance Corp. v. Williams , 851 F.2d 119 (4th Cir. 1988) (declining to enjoin creditor action against guarantor); Lynch v. Johns-Manville, Sales Corp. , 710 F.2d 1194 (6th Cir. 1983) (refusing to enjoin creditor actions against co-defendants of debtor).

The risk for individual creditors is that a court may enjoin actions against non-debtors even if the creditor plaintiffs are fully entitled to bring those actions, if the result would be to divert assets from the estate and allow competition for assets between creditors and the trustee. The opportunity for trustees is to get the first shot at suing non-debtor defendants who may contribute assets to the estate that would otherwise be consumed by competing creditors.

Strategic Considerations

Creditors pursuing claims against non-debtors should be aware of potential conflict with the trustee and should be wary of violating the automatic stay. At the same time, however, both the factual and legal basis for claims should be thoroughly analyzed at the outset, to assure that claims that are within the creditors' domain are not unwittingly lost. There may be room for both creditors and the trustee to make the most of their positions by coordinating claims against non-debtors. To the extent that creditors and the trustee wish to pursue common defendants, there may be a symbiotic approach in which both creditors and the trustee join in and cooperatively pursue litigation, either by joining all claims in a single action or carefully coordinating more than one ongoing case.

This approach can enable the trustee to enjoy some litigation support from private parties, while allowing the creditors an active role in maximizing returns from that litigation. In some cases, the creditors and the trustee may be able to negotiate an agreed sharing of litigation proceeds, as well as costs, reflecting the relative proportions of the claims that they each hold. Rather than battling among themselves over how to divide up claims against the same defendants, they can reduce their individual cost burden and maximize total recoveries.

Because the same facts can give rise to a mixture of claims, between those held by the creditors and those held by the trustee, this may be the only practical way to allow the parties to maximize returns, not only for themselves, but for all creditors. Cooperation may also allow the plaintiffs to minimize the negative impact of things such as the in pari delicto defense that may saddle the trustee with the effects of the debtor's wrongdoing, as well as allow the trustee to avoid defenses that may be peculiar to specific creditors. Joining in a cooperative litigation effort may be the best way to avoid conflict between creditors and the trustee and focus all parties' efforts on obtaining recovery from other wrongdoers.

Jack L. Smith is a partner at Holland & Hart LLP in Denver. A member of this newsletter's Board of Editors, he may be reached at [email protected].