On March 24, 2008, Judge Brendan L. Shannon of the U.S. Bankruptcy Court in Delaware, authorized the committee of unsecured creditors in the Fedders North America, Inc. bankruptcy to file a lawsuit on behalf of the bankruptcy estate. See In re Fedders North American, Inc., Case No. 07-11176-BLS (Bankr. Del.). I know this is a couple of weeks old, but I wanted to track down some of the pleadings in this case and actually see what the issues were before the Court before I posted something about the new committee case being filed. I am glad I did because the argument before Judge Shannon posed an interesting question: what is the appropriate standard to determine whether a creditors' committee should be granted standing to sue on behalf of the debtor's estate?
The lawsuit alleges claims against three distinct groups: (a) the Inside Directors are charged with treating Fedders as "their personal piggy bank" by extracting "lavish compensation, interest-free personal loans and rich severance packages" at a time when they knew the company was collapsing; (b) the Outside Directors are charged with "turning a blind eye to all of the Insiders' and Lenders' misconduct; and (c) the Lenders are charged with aiding and abetting or conspiring with the Inside Directors by closing on loans they knew would default simply to "pocket large fees" or to obtain "interest at the LIBOR rate -- plus 12%."
Filing what amounted to Rule 12(b)(6) motions to dismiss, each set of defendants argued that the claims were not "colorable" because they could not prevail on the merits, for various reasons, and the cost to the estate would outweigh the potential benefit. For instance, the Inside Directors argued that the majority, if not all, of the claims asserted against them were simply "duty of care" claims that were barred under the applicable law. As a result, no colorable claim existed and the committee should not be allowed to pursue the claim. The Lenders argued that the theory of recovery simply made no rational sense whatsoever because it presupposed that the defendants would have loaned millions and millions of dollars (knowing that those loans were already or would immediately be in default) simply to obtain closing fees, personal bonuses on the loan or a higher rate of interest. As the Lenders argued, banks simply aren't in the business of loaning money that they know is going to be defaulted and subject to bankruptcy proceedings.
Judge Shannon raised an interesting issue with respect to the standards governing how a bankruptcy judge, or any judge for that matter, determines if a claim is "colorable" and worthy of pursuit by a committee. As Judge Shannon noted in his ruling from the bench on March 24, 2008:
"[T]hat analysis, while often the subject of discussion between counsel, is actually more subtle and much more complicated a test. And how the standard under Rule 12(b)(6) applies or should apply here is, is difficult for me to walk through. There is a temptation to go through and essentially conduct a motion to dismiss hearing. And in some respects that's where counsel's argument on both sides went. And I cannot believe that is the appropriate analysis. Rather, I think when we consider colorability, the threshold consideration the Court has is that this is at a stage prior to the commencement of litigation, and as a general proposition, in normal civil litigation, this is prior to the commencement or exchange of formal discovery. So the allegations, the sufficiency of the allegations simply cannot be to a Rule 12(b)(6) standard, because we haven't filed the complaint yet...So I can't assume that ... the standard requires a line by line, claim by claim analysis...I simply don't believe that that can be the standard. In the present case, the Committee has made substantial allegations against a number of different parties...And based upon the ... threshold allegations that the Committee has made both in its motion and in its complaint, I'm satisfied that they have articulated colorable claims only so far for purposes of whether this Court should authorize the commencement of the litigation."
Transcript at 97-98.
What is interesting is that Judge Shannon both appears to reject a claim-by-claim analysis in favor of a colorability in toto analysis. In other words, taken as a whole, the creditors' committee's proposed complaint seemed viable and stated causes of action, but Judge Shannon was quick to point out that he did not go so far as to actually employ a Rule 12(b)(6) analysis to those claims. And, in doing so, he also implies that so long as the claims are substantial (in that they are serious and worth large amounts of dollars?) the claims are colorable. In making this decision, he appears to part ways with In re G-I Holdings, Inc., 313 B.R. 612, 628 (Bankr. D.N.J. 2004), aff'd in part, rev'd in part, 2006 WL 1751793 (D.N.J. June 21, 2006).
In re G-I Holdings, Inc. appears to clearly import the Rule 12(b)(6) motion to dismiss standard into the colorability analysis, stating that "[b]ecause the creditors' committee is not required to present its proof, the first inquiry is much the same as that undertaken when a defendant moves to dismiss a complaint for failure to state a claim." Id. at 631. The court then goes on to further discuss motions to dismiss standards, even going so far as stating that if an affirmative defense is revealed on the face of the pleadings that such a claim should not be allowed to proceed. See id. ("A complaint may be subject to dismissal for the failure to state a legally cognizable claim when an affirmative defense appears on its face.").
Judge Shannon's approach certainly seems to make more intuitive sense given the nature of a pre-litigation request to sue. After all, in many cases where derivative standing is being sought there is no complaint on file or even a proposed complaint for a court to examine under a Rule 12(b)(6) standard. But at the same time, why allow someone to waste the court's time and expose defendants to unnecessary costs when there is no chance a claim would survive an initial challenge to the pleadings.
It will be interesting to see if Judge Shannon's "substantial claim" analysis will be imported into future colorability cases.
