Litigating Fiduciary Duty Claims in Bankruptcy Court and Beyond: Theory and Practical Considerations in an Evolving Environment

March 27, 2015

Publication| Bankruptcy & Corporate Restructuring

Litigation against directors and officers is ubiquitous in bankruptcycourts. Indeed, charges of director malfeasance and breach of fiduciary duty areleveled at the outset of many bankruptcy cases—whether in the hallways outside offirst day hearings or creditors committee formation meetings, in early hearings, orin pre-petition letter writing campaigns aimed at encouraging or discouragingspecific board actions. These charges frequently wind their way into litigation,typically later in the bankruptcy case.

While the bankruptcy field has become accustomed to this practice, it bearsnoting in a Stern v. Marshallworld that breach of fiduciary duty and deepeninginsolvency are state law concepts, not portions of the Bankruptcy Code.However,bankruptcy courts try the overwhelming majority of litigation and decide most ofthe reported case law. Thus, director and officer litigation claims have becomestandard “bankruptcy litigation.”The reason is fairly straightforward: suits allegingbreach of fiduciary duty and the like are much more likely to be filed when abusiness strategy has failed, precisely because it has failed (there isn’t much sense inchallenging an objectively successful outcome),and the fact that a company hasfiled a bankruptcy case often means that business strategies can be characterized (not always accurately) as having failed.Moreover, the fact of bankruptcy meansthat a fiduciary, such as a Chapter 11 or 7 trustee, a creditors committee, or a postplanconfirmation trust set up to pursue litigation claims, typically will beappointed, thereby avoiding the “collective action” problem outside of bankruptcy. And the bankruptcy process itself often makes funding for these types of suitsavailable, for example by agreed or court ordered carve outs from a secured lender’scollateral. Taken together, this means that since no individual creditor has to fundwhat could be expensive litigation, director and officer claims alleging wrongdoingin the face of insolvency get pursued in bankruptcy cases more often than they dooutside bankruptcy.

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