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The 3rd U.S. Circuit Court of Appeals invalidated a widely used mechanism by which Chapter 11 creditors could, with bankruptcy court permission, sue to avoid fraudulent transfers. In Cybergenics Corp. v. Chinery, 01-3805, decided Sept. 20, the court affirmed a trial judge’s finding that creditors are not proper parties to bring avoidance claims under 11 U.S.C. 544(b). “Based on the plain statutory language and the Supreme Court’s analysis in Hartford Underwriters [Ins. Co. v. Union Planters Bank, 530 U.S. 1 (2000)], we hold that only a trustee or debtor-in-possession has the power to invoke �544(b) to avoid fraudulent transfers, and that a court may not authorize a creditor or creditors’ committee to bring suit under �544 derivatively,” wrote Judge Julio Fuentes, joined by Judges Anthony Scirica and Samuel Alito Jr. The Cybergenics ruling make the 3rd Circuit the first to disallow such suits, which are lodged when debtors fail to bring avoidance claims. Now, if a debtor will not sue, creditors will now have to seek appointment of a trustee to bring an avoidance action, says the defendants’ lawyer, Brian Molloy, a partner with Wilentz, Goldman & Spitzer in Woodbridge, N.J. However, one of the creditors’ lawyers, Gary Sesser, a partner with New York’s Carter, Ledyard & Milburn, points out that it is not clear that a court can appoint a Chapter 11 trustee for the sole purpose of bringing a lawsuit. Other bankruptcy lawyers are reading the opinion with interest. The ability of creditors to sue in place of the debtors was a “safety valve” that is now lost, says Michael Sirota, a partner with Hackensack, N.J.’s Cole, Schotz, Meisel, Forman & Leonard. Bruce Buechler, a partner with Roseland, N.J.’s Lowenstein Sandler, says the ruling will force creditors to seek appointment of operating trustees to bring suit even if putting a trustee in charge is not otherwise in the debtor’s best interest. For example, a closely held or family-owned company may be reluctant to sue shareholders or insiders, who could be family members. But the company might have installed new management, so that appointing a trustee to run the business is counterproductive, Buechler says. As Buechler points out, the alternatives to derivative suits present their own problems. Creditors can push for quick confirmation of a reorganization plan that provides for an estate representative to pursue claims, but they run the risk that the limitations period will run before the plan is adopted. He says that another approach — to dismiss the bankruptcy action and pursue the claim in state court — ignores the reasons the Chapter 11 petition was filed and sacrifices the ability to sell assets clear of liens. The effect of the ruling is already being felt. On Sept. 24, U.S. District Judge Alfred Wolin of the District of New Jersey postponed a trial scheduled to start Monday in an action against Sealed Air Corp. by creditors of Chapter 11 debtor W.R. Grace. According to Henry Wasserstein, who represents Sealed Air, a packaging-supplies company in Saddle Brook, N.J., Wolin gave the parties until Monday to file letter briefs explaining how the Cybergenics ruling impacts their case. Wasserstein is a partner with the New York firm of Skadden, Arps, Slate, Meagher & Flom. The Grace creditors’ lawyer, Brad Friedman, a partner with New York’s Milberg Weiss Bershad Hynes & Lerach, did not return a call requesting comment.

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