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Bankruptcy lawyers everywhere are breathing a sigh of relief now that the 3rd U.S. Circuit Court of Appeals has vacated its Sept. 20 decision in the case of Cybergenics Corp. v. Chinery and announced that it will be reargued before an 11-judge en banc panel. In the Sept. 20 decision in Cybergenics, a unanimous three-judge panel upheld the dismissal of a derivative action brought by a creditors committee that accused lenders and company insiders of engaging in fraudulent transfers when the companies’ assets were sold in a leveraged buyout. Writing for the court, Circuit Judge Julio M. Fuentes found that the plain language of the Bankruptcy Code and a recent decision by the U.S. Supreme Court made it clear that only the trustee or debtor-in-possession has the power to assert fraudulent transfer claims and that a creditor or creditors committee may not bring such avoidance actions derivatively. The reaction from the bankruptcy bar was swift and harsh. An article in Corporate Financing Week said the ruling “has all but ground bankruptcy court cases to a halt” and “has essentially knee-capped creditors committees, giving senior lenders relative freedom to decide unilaterally how to divvy up bankrupt-company assets.” A commentator for the American Bankruptcy Institute said the decision “departed from 100 years of settled bankruptcy law.” Lawyers for the Cybergenics unsecured creditors committee took a more formal approach to their criticism by filing a powerfully worded petition for rehearing before the full court. In their brief, attorneys Gary D. Sesser and James Gadsen of Carter, Ledyard & Milburn in New York argued that the panel’s ruling was “an unwarranted and improper extension of the Supreme Court’s decision in Hartford Underwriters Ins. Co. v. Union Planters Bank” and that it “ effectively eliminates a longstanding and salutary bankruptcy practice that predates and was unchanged by the Bankruptcy Code.” If allowed to stand, they argued, the decision “will undermine Congress’ reorganization objectives in enacting Chapter 11 of the code and deprive creditors in dozens of the largest pending bankruptcy cases of the ability to pursue hundreds of transfers involving billions of dollars for the benefit of the estates.” They also argued that the decision created uncertainty in the law because it “conflicts with the authoritative decisions of every other United States Court of Appeals that has addressed this issue, including recent decisions which postdate the Supreme Court’s decision in Hartford Underwriters.” Now the 3rd Circuit has granted the petition for rehearing en banc. Because such a decision requires a majority vote by the court’s active judges, it is considered a strong indication that the court is poised to rule in favor of the petitioner. The panel’s decision to dismiss the unsecured creditors’ derivative suit was surprising if only because the 3rd Circuit had previously revived the same suit. In 1999, U.S. District Judge Garrett E. Brown of the District of New Jersey dismissed the suit for lack of subject matter jurisdiction, holding that the fraudulent transfer claims were assets of the debtor and that because the 1996 bankruptcy asset sale sold off all of Cybergenics’ assets, the claims were no longer property of the bankruptcy estate and the committee could not raise them on the estate’s behalf. The 3rd Circuit reversed, holding that state law provides that fraudulent transfer claims belong to the creditor, and that the claims are not assets of the debtor. As a result, the court said, the claims could not have been sold as part of Cybergenics’ assets in the 1996 bankruptcy asset sale. But on remand, the defendants filed new motions to dismiss, arguing for the first time that under a plain reading of � 544(b) of the Bankruptcy Code and the reasoning of Hartford Underwriters, the committee lacked standing to bring the fraudulent transfer action because only a trustee or debtor-in-possession has such standing. Brown again dismissed the case and, on Sept. 20, the 3rd Circuit affirmed, finding that the new arguments were winners. Fuentes, in an opinion joined by Circuit Judges Anthony J. Scirica and Samuel A. Alito, found that all the fraudulent transfer provisions of Chapter 11 of the Bankruptcy Code use the phrase “the trustee may.” Despite that plain language, Fuentes said, “several courts of appeals and many bankruptcy courts have nonetheless held that creditors or creditors committees, if they meet certain requirements and with bankruptcy court approval, may bring avoidance actions and other adversary proceedings in Chapter 11 cases under ‘the trustee may’ provisions.” Other courts of appeals, Fuentes said, “have recognized that a derivative suit is at least an option for creditors or creditors committees wishing to pursue fraudulent transfer claims when the debtor-in-possession refuses to prosecute the claims.” But Fuentes said the Cybergenics case forced the 3rd Circuit to decide “whether this practice of allowing creditors and creditors committees to initiate derivative avoidance actions survives Hartford Underwriters.” In Hartford Underwriters, the high court considered whether an administrative claimant of a Chapter 7 bankruptcy estate has an independent right to bring suit under � 506(c) to recover payment of its claim. The justices were unanimous in holding that the phrase “the trustee may” means that only the trustee may utilize the recovery power granted in � 506(c). Fuentes found that the Supreme Court’s interpretation of the phrase “applies with equal force to the identical words used in � 544(b).” Although he recognized that the ruling would leave the 3rd Circuit standing alone, Fuentes found that it was the right thing to do. “While no other court of appeals has applied Hartford Underwriters to bar a Chapter 11 derivative creditor suit, we conclude that failing to do so would yield an outcome other than the one the Supreme Court would be likely to reach were the case heard there,” Fuentes wrote. Fuentes said Brown got it right when he wrote: “There is no principled basis under which the court can apply different meanings to the words ‘the trustee may’ in separate sections of the code.” In their petition for rehearing, Sesser and Gadsen argued that the panel erred by extending Hartford Underwriters. “While the panel’s application of Hartford Underwriters to this case would be unobjectionable if the committee were seeking an ‘independent right’ to recover fraudulent transfers for its own benefit, as the claimant had in Hartford Underwriters, that is not the situation here,” they wrote. “The committee is pursuing claims on behalf of the debtor-in-possession. … As the debtor-in-possession clearly has the right to pursue fraudulent transfer claims under � 544(b), the panel’s statutory analysis essentially begs the question,” they wrote. The real issue, they argued, “is not simply the authority of the committee, but the power of the bankruptcy court to authorize the committee to assert these claims on behalf of the debtor in possession when the debtor-in-possession unjustifiably refuses to act.” On that point, they said, “the bankruptcy court has ample authority to do so, as has been recognized for more than a century.” Sesser and Gadsen urged the full court to focus on a footnote in Hartford Underwriters that said its holding has “no analogous application” to the derivative right of a creditor or creditors committee to bring avoidance actions with court approval. On the basis of that footnote, they said, “the practice of authorizing creditors committees to pursue avoidance claims continued in this circuit and in other circuits following Hartford Underwriters.” If the panel’s ruling was allowed to stand, they said, it would create “an unnecessary conflict between the policies of promoting the successful rehabilitation of debtors and of maximizing the assets of the estate for the benefit of creditors through pursuit of meritorious avoidance actions.” In their closing paragraphs, Sesser and Gadsen invoked the recent spate of corporate financial scandals. “At a time when massive corporate reorganizations and allegations of wrongdoing by corporate insiders are front-page news, it is vital for the full court to consider the sweeping change to well-established bankruptcy practice set in motion by the panel decision in this case,” they wrote.

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