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An Introduction to Litigation Trusts

Paige Holden Montgomery and Casey Burton

An Introduction to Litigation Trusts
Bill Varie via Getty Images

Over the past decade, Chapter 11 bankruptcy proceedings have yielded a number of "litigation trusts"—trusts whose raison d'être is solely the pursuit of certain litigation interests belonging to the debtor's estate at the time of the bankruptcy petition.  While litigation trusts are a relatively new creature, they are becoming more common as a category of litigants because their sole purpose is to pursue litigation and their activities are generally funded by an initial cash allocation from the bankruptcy estate. Courts have only just begun to address some of the important issues related to the existence of litigation trusts and their use to pursue claims on behalf of the creditors of an emerging debtor.

A. The Creation, Purpose, and Rationale of Litigation Trusts

What is a litigation trust, and how is it created?

A litigation trust is a trust created for the benefit of creditors of a debtor to prosecute and distribute the proceeds of certain causes of action belonging to the debtor that are transferred to the litigation trust as part of the bankruptcy plan. Post-confirmation litigation trusts are permitted under section 1123(b)(3)(B) of the Bankruptcy Code.  11 U.S.C. § 1123(b)(3)(B) ("a plan may provide for the retention and enforcement by the debtor, by the trustee, or by a representative of the estate appointed for such purpose, of any such claim or interest"); see also In re Acequia, Inc., 34 F.3d 800, 808 (9th Cir. 1994) ("[The] aim [of section 1123(b)(3)(B)] was to make possible the formulation and consummation of a plan before completion of the investigation and prosecution of causes of action such as those for previous insider misconduct and mismanagement of the debtor.").

Rationale and purpose for the creation of a litigation trust.

A litigation trust, like other trusts, is a creature of contract.  A litigation trust is formed through the agreement between the debtor and its creditors—the debtor's plan of reorganization—to create a trust and endow that trust with certain assets (in the form of causes of action) in the hope that those assets can be utilized to provide an additional cash recovery for the creditors. But it is also a creature of bankruptcy law, and a primary purpose of bankruptcy law is the repayment of the debtor's creditors. In many corporate bankruptcies, this is largely accomplished through the reorganization of the debtor's debts and ownership interests and/or the orderly sale of the debtor's assets as a going concern. Where those actions do not result in payment in full to all categories of creditors, the litigation trust has been used in recent years as an attempt to bridge the gap between what was recovered and what was owed. Allocating certain of the debtor's unliquidated claims for pursuit by a trust allows for the possibility of additional recovery to the creditors.  The main rationale for the creation of a litigation trust, therefore, is to maximize value for the creditors by establishing an entity focused on pursuing and liquidating certain legal causes of action owned by the debtor. 

Other reasons to create a litigation trust include that it allows an entity other than the debtor to pursue the cause of action and permits the reorganized debtor's management to focus on running its business after emergence from bankruptcy proceedings. In many instances, the claims transferred to the litigation trust are those that the existing management of the debtor is perceived as being reluctant to pursue. Frequently, the claims transferred to litigation trusts are those brought against former directors or officers, or persons with whom the current directors and officers have close ties.

Another rationale for creating a litigation trust is to provide some chance at a recovery to the creditors with the lowest priority, generally the general unsecured creditors. From a debtor's perspective, transfer of claims to a litigation trust for the primary benefit of unsecured creditors may avoid a costly and time-consuming valuation and cramdown fight.  From a senior creditor's perspective, contribution of claims to a trust for the benefit of the junior creditor may be the consideration for a release of estate claims against the senior creditor.  

Important provisions in litigation trust agreements.

Most litigation trusts share a number of common traits.  The first, and most important trait, shared by all litigation trusts is that they have as their sole purpose the prosecution of causes of action belonging to the debtor and paying the proceeds to certain creditors of the debtor in order to comply with Treasury Regulation § 301.7701-4(d) and Revenue Procedure 94-45. Another commonality among litigation trusts is that the beneficiaries of the litigation trust are usually the most junior creditors receiving payment under the plan of reorganization. 

There are also significant differences among trusts. One common variation among trust agreements is the scope of cooperation required between the reorganized debtor and the litigation trust.  Because the reorganized debtor will often maintain control of the documents and persons with knowledge relating to the various causes of action transferred to the litigation trust, the nature and scope of the cooperation is important.  Some litigation trust agreements include fairly broad cooperation clauses such as one where the reorganized debtor is required to "cooperate" with the litigation trust in the prosecution of its claims. SemGroup Litigation Trust Agreement § 1.2(d); see also Tronox Litigation Trust Agreement § 2(a)(iv) & (ix) (requiring reorganized debtor to "use reasonable efforts to cooperate with" the litigation trustee).

Other agreements may provide a more tailored description of the scope of cooperation.  Litigation trust agreements can also require that the reorganized debtor provide the litigation trust with relevant documents and access to employees who may have knowledge of the facts relevant to the claims. SemGroup Litigation Trust Agreement § 1.2(c); see also Idearc Litigation Trust Agreement § 2.9 (debtor to comply with reasonable information requests and provide access to and preserve documents and electronically stored information); Tronox Litigation Trust Agreement § 2(a)(iv) (reorganized debtor required to provide documents and access to employees to litigation trust). It is not unusual for disputes to arise between debtors and litigation trusts concerning the required level of "cooperation" as well as what sorts of access to employees and documents is appropriate.

The definition of the causes of action that are transferred to the litigation trust will also shape the actions of the litigation trust, as the description of those rights can differ widely in scope. In some instances, those rights broadly include all causes of action that may be asserted by the debtor arising prior to the effective date of the plan. See SemGroup Plan of Reorganization § 1.83.

Some transfers of rights are limited to causes of action arising under Chapter 5 of the Bankruptcy Code, (See Extended Stay Plan of Reorganization § 1.89 (transferring to the litigation trust certain Chapter 5 claims and "any other potential claims, causes of action, charges, suits or rights of recovery referenced in the Examiner's Report")), claims against former officers, previously filed adversary proceedings,(See Tronox Plan of Reorganization §§ I.A.5, IV.C.5.) claims against specified entities, or certain types of claims (such as securities claims, contract claims, or even claims covered by insurance). See FairPoint Litigation Trust Agreement § 1.2(a) (transferring to the litigation trust only those claims against Verizon Communications); see also In re Resorts Int'l, Inc., 372 F.3d 154 (3d Cir. 2004) ("The assets assigned to the Litigation Trust were claims originally held by the debtor, Resorts International, Inc., against Donald J. Trump and affiliated entities, arising from Trump's 1988 leveraged buyout of the Taj Mahal Resort.").

In addition, certain claims or parties can be specifically carved out from transfer; for example, the plan could carve out causes of action arising from the ordinary course of the debtor's business. See SemGroup Plan of Reorganization § 1.83. In many cases, the most valuable rights transferred are the ability to bring avoidance actions, such as preference and fraudulent transfer actions, to recover funds to the estate. 

B. Common Issues in Litigation Involving a Litigation Trust

The rationale, purposes, and important provisions of the litigation trust agreement and plan of reorganization should be taken into account when determining strategy, settlement, and what factual/legal theories to pursue in litigation involving a litigation trust. These agreements not only provide a litigation trust with its purpose, but also define its rights with regard to a number of important litigation issues. Review of the reported opinions from cases involving litigation trusts as well as the authors' experiences illustrate that there are six common areas of dispute and motion practice related to lawsuits brought by litigation trusts:

Access to people and documents.

Although housing a debtor's litigation rights in a separate entity is intended at least in part to reduce the work required for the reorganized debtor, the reorganized debtor is often heavily involved in discovery and trial of the case. The reorganized debtor may be required to produce documents, and its employees with relevant knowledge will often be called upon to testify in deposition and at trial. Even when the reorganized debtor is not faced with deposition or trial testimony by its current and former employees, litigation trusts often request the cooperation of the reorganized debtor in other ways, including requiring large document productions, interviewing current and former employees, and making intermittent demands for specific information. The degree of availability of this information will depend upon the terms of the plan of reorganization and litigation trust agreement.  If not provided for under the terms of those documents, the reorganized debtor will be treated like any third-party witness and may require a subpoena before production of documents or witnesses.

The effect of lawsuits by litigation trusts on the reorganized debtor.

Another aspect of lawsuits by litigation trusts is the impact those suits can have on the reorganized debtor's business relationships. For example, efforts by the litigation trust to recover against vendors for payments made before the bankruptcy filing may have an adverse effect on ongoing business relationship between vendors and the reorganized debtor.  Even where claims are not brought against entities with which there are ongoing business relationships, it is possible that such entities may be called upon to produce documents or provide testimony. In most instances, maintaining the reorganized debtor's relationships with its business counterparts is an important consideration for the litigation trust and its beneficiaries, as well as the debtor. From the litigation trust's perspective, causing the debtor—which has control over the documents and people necessary to prosecute the trust's claims—business difficulties may result in a much less amicable relationship between the entities.  Similarly, the beneficiaries of the litigation trust—generally pre-petition—creditors of the debtor, may also have a continuing creditor relationship with the debtor that could be impacted by the litigation trust's activities.

The application of privilege and privilege disputes in a litigation trust lawsuit.

In most recent reorganizations involving litigation trusts, the plan of reorganization includes a provision preserving any attorney-client privilege and providing for the transfer or sharing of that privilege with the litigation trust. Since the litigation trust is the successor to the debtor, it may need to be able to investigate any cause of action transferred to it by examining the debtor's relevant attorney-client privileged communications, if any. The primary practical question related to the transfer or sharing of the privilege relates to the power to waive the privilege. In some instances, this issue is specifically addressed in the language of the plan of reorganization or litigation trust agreement. If there is no discussion of which entity controls the privilege, it may become a point of contention in the relationship between the litigation trust and the debtor.

Litigation trusts, standing, and jurisdiction.

As a creature of contract, a litigation trust only has standing to bring the causes of action that are expressly transferred to it. Courts have held that a claim may be dismissed based upon a lack of standing if the plan of reorganization and/or litigation trust agreement do not explicitly convey the claim.  Rahl v. Bande, 328 B.R. 387, 401 (S.D.N.Y. 2005) (holding that plaintiff lacked standing to pursue claim against auditor when litigation trust agreement conveyed only claims against officers and directors). This strategy may be especially warranted where specific types of claims are carved out; for example, where a cause of action is only transferred up to the amount of insurance coverage, a motion to dismiss any claim for amounts in excess of that insurance coverage can serve to limit the defendant's potential liability.  See, e.g., U.S. Bank Nat'l Ass'n v. Verizon Commc'ns Inc., ___ F. Supp. 2d ___, 2012 WL 4050088, at *13 (N.D. Tex. Sept. 14, 2012). Similarly, the plan may provide for a release for certain types of individuals, such as the continuing directors and officers of the company.

The application of in pari delicto to litigation trusts.

The in pari delicto doctrine is a defense frequently involved by defense for persons defending against claims by a litigation trust because courts may conclude that the bankrupt debtor was necessarily complicit in whatever wrong was allegedly perpetrated.  In essence, the in pari delicto doctrine argues that the plaintiff is equally in the wrong, and therefore cannot recover.  See, e.g., Nisselson v. Lernout, 469 F.3d 143 (1st Cir. 2006).  There are a number of different situations where in pari delicto may not apply, however, such as where the debtor was adversely dominated by the defendant or where the litigation trustee is bringing an avoidance action.  See, e.g., ASARCO LLC v. Americas Mining Corp., 396 B.R. 278, 430 (S.D. Tex. 2008) (holding that domination by defendant negated allegations of equal fault and prohibited application of in pari delicto doctrine); In re Hawaiian Telcom Commc'ns, Inc., 483 B.R. 217, 221-22 (Bankr. D. Haw. 2012) (In pari delicto defense could not be raised to avoidance claims because litigation trust brought these claims, not as successor-in-interest to debtor's prepetition causes of action, but pursuant to avoidance provisions of the Bankruptcy Code).  Depending on the facts of the case, counsel either bringing or defending a case involving a litigation trust should be familiar with the operation of the in pari delicto defense as it relates to litigation trusts.

Litigation trusts and jury trials.

Claims that arise out of or relate to a bankruptcy case may be heard in either the bankruptcy courts or the district courts. While juries are infrequently used in bankruptcy court, there are situations in which a jury trial in bankruptcy court is available.  However, the question of whether a jury trial is available is more likely to be at issue in district court. In cases where the defendant filed a proof of claim and the separate action against that defendant is somehow tied to the proof of claim, a jury may be unavailable to the plaintiff.  In particular, courts have held that where there is a preference or fraudulent transfer action, the dispute becomes integral to the restructuring of the debtor-creditor relationship and invokes the equity jurisdiction of the bankruptcy courts. See Germain v. Conn. Nat'l Bank, 988 F.2d 1323 (2d Cir. 1993) (citing Langenkamp v. Culp, 498 U.S. 42 (1990)).

Where a litigation trust, as the successor in interest to the debtor and the representative of the estate, brings a fraudulent transfer claim, it is usually subject to Bankruptcy Code Section 502(d), which disallows any claim by an entity from which property is recoverable as a fraudulent transfer. This results in a situation in which an action by a litigation trust for fraudulent transfer is not entitled to a jury trial if the defendant has filed a proof of claim in the bankruptcy proceedings.  See U.S. Bank Nat'l Ass'n v. Verizon Commc'ns Inc., 2012 WL 987539, at *5-6 (N.D. Tex. Mar. 21, 2012), reconsideration denied 2012 WL 3034707 (N.D. Tex. July 25, 2012).