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April 27, 2011 Articles

Beware of the Bankruptcy Court's "Related To" Jurisdiction

Disputes that do not fall within the court's jurisdiction are put on hold until the "related" dispute is resolved

By David B. Goodman

To litigators who are not "regulars" in Bankruptcy Court, the expansive reach of that court's jurisdiction to disputes beyond the debtor’s estate may come as a surprise. The Bankruptcy Court has the power under its "related to" jurisdiction to stay litigation concerning property that is not property of the estate but that is likely to affect the amount of property available for distribution or allocation among the estate's creditors. The Bankruptcy Court's ability to stay proceedings can extend to litigation concerning rights and interests beyond those that may be brought in the bankruptcy proceedings. This circumstance may arise in connection with direct claims against the debtor's former directors and officers when those individuals are defended through a D&O insurance policy purchased by the debtor. A case in point might involve fraud claims brought in state court by a creditor against the former directors and officers of the debtor. It may also arise from competing claims by the estate and various creditors relating to professional services such as audit services provided to the debtor. For example, creditors might bring claims against an audit firm arising from the same conduct that gives rise to a claim by the debtor against the firm. In each instance, the litigation outside bankruptcy arises from injuries arguably unique and personal to the individual creditors that brought the actions but that may impact the assets available to satisfy claims brought by the trustee for the benefit of the creditors as a whole. The practical effect of such a stay is that disputes that do not fall within the court's jurisdiction are put on hold until the "related" dispute is resolved. This provides the trustee with an opportunity to get a jump start on parties pursuing the same assets.

Perhaps the best case for the court's "related to" jurisdiction is made in the context of claims triggering insurance coverage, such as D&O coverage, even when the insurer may not ultimately be obligated to indemnify the insured against a judgment. Generally, the coverage afforded under such D&O insurance policies will be eroded by defense costs. Funds spent in defense of claims brought against the former directors and officers individually by parties other than the trustee will reduce the coverage available for claims brought by the trustee for the estate’s creditors.

The debtor’s estate includes "any action a debtor corporation may have to recover damages for fiduciary misconduct, mismanagement, or neglect of duty, and the trustee succeeds to the right to bring such actions." In re Teknek, LLC, 563 F.3d 639, 646 (7th Cir. 2009). Trustees have the sole responsibility to represent their estates by bringing actions on their behalf. Fisher v. Apostolou, 155 F.3d 876, 879 (7th Cir. 1998). However, there are circumstances, such as when a former director or officer is alleged to have defrauded a creditor, such that the creditor may have a claim, individually, that the creditors of the estate generally might not have. In such a circumstance, there may be an obligation to indemnify the former director or officer for the costs of defending against the fraud claim even if there would be no obligation to indemnify that individual for an adverse judgment. Yet the costs of that defense may substantially consume the proceeds of any D&O coverage available to for claims brought by the trustee on behalf of the estate’s creditors, generally. And in such a circumstance, the trustee may seek to stay claims brought outside the bankruptcy action pending resolution of claims brought by the trustee in the bankruptcy action for the benefit of the creditors of the estate, generally.

In Fisher, the Seventh Circuit reaffirmed that the Bankruptcy Court's "related to" jurisdiction pursuant to 11 U.S.C. § 105 presents "a question of whether the overlap between the claims of the debtor . . . and the claims of the creditors . . . against third parties . . . are so closely related that allowing the creditors to convert the bankruptcy proceeding into a race to the courthouse would derail the bankruptcy proceedings." Id. at 883. In assessing whether to grant an injunction, the court considers whether the claims in the litigation arise out of the same underlying transactions and factual allegations. Fisher, 155 F.3d at 882. Applying this analysis, courts grant "Fisher" injunctions when they find that creditors sued a debtor's agents for debts that arose out of transactions undertaken by the debtor, the creditors "stand in exactly the same position as the rest of the aggrieved [creditors], pursuing identical resources for redress of identical, if individual, harms." Id. at 881. But the court in Fisher recognized that the trustee would not have standing to pursue claims unique to individual creditors, such as fraud claims, even when those claims arise from the same conduct on which the trustee’s action was predicated. Under those circumstances, the court recognized that a stay may still be appropriate to facilitate the trustee’s ability to marshal the claims and resources of the estate for the interests of the creditors as a whole. Upon resolution of those claims, the stay would be lifted and the individual creditors would able to pursue the claims personal to them.

As a practical matter, the delay resulting from a stay entered pursuant to the Bankruptcy Court's "related to" jurisdiction may affect the resources available to satisfy judgments on these personal claims. Creditors who believed they might circumvent the reach of the Bankruptcy Court by pursuing fraud claims against the debtor's former directors and officers may find themselves waiting out claims by the trustee pursuing the same limited assets. The delay may adversely affect the ability to develop the evidence required to prove claims in the stayed actions. Counsel representing trustees should be cognizant of claims falling beyond the reach of the automatic stay but that may fall within the Bankruptcy Court's "related to" jurisdiction to maximize the resources available to satisfy the estate’s claims. And cognizance of these risks should inform parties as they develop and plead claims in circumstances in which bankruptcy may reasonably be anticipated. Finally, exercise of the Bankruptcy Court's "related to" jurisdiction opens opportunities for creative, early, and expedited settlements avoiding some of the substantial costs associated with litigating the related claims to verdict.

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