As we have noted before, one of the advantages of a bankruptcy filing is bringing most claims held by or against the debtor into one forum—the bankruptcy court—to be resolved as part of administration of the bankruptcy case. That being said, often a threshold question must be asked—does the claim against a nondebtor belong to the debtor or a third party who alleges it was damaged. This is no trivial matter. Courts look to see whether the nondebtor party’s injury “flowed through”—meaning was derivative—of the injury sustained by the debtor. If it was, this derivative claim belongs to the debtor, can be pursued by the debtor in the bankruptcy court as property of the estate, and the proceeds distributed to creditors. If the injury to the nondebtor did not flow through the debtor—meaning it was direct—the claim belongs to the creditor, can be pursued by the creditor outside of the bankruptcy process, and the proceeds go only to that creditor. If this sounds confusing, it can be. This distinction between “derivative” and “direct” claims was recently reviewed by the U.S. Fifth Circuit Court of Appeals in Matter of Buccaneer Resources, 912 F.3d 291 (5th Cir. 2019).
The Debtor Fired Its CEO Prior to Bankruptcy
According to the opinion, Buccaneer, along with its affiliates, was an oil exploration and production company. The opinion notes that “although companies that hit gushers get the attention, Buccaneer had the more common experience for oil and gas ventures: it never struck it big.” By January 2014, as Buccaneer declined, all of its senior secured debt was held by Meridian Capital CIS Fund, secured by a blanket lien against all of Buccaneer’s assets. Buccaneer filed a chapter 11 case in May 2014 in the U.S. Bankruptcy Court for the Southern District of Texas.
Curtis Burton was CEO of Buccaneer Resources since its founding in 2006. Buccaneer fired Burton shortly before the bankruptcy. Burton claimed his termination violated the terms of his employment contract, triggering a claim in the amount of three years’ salary. Burton also contended that Meridian was involved in the wrongful termination. Burton was one of four board members. He alleged the other three had close ties to, and in some cases, were appointed by Meridian. Certain emails showed Meridian found certain of Buccaneer’s assets “intriguing”, which could benefit Meridian if someone other than Burton was CEO. Meridian allegedly also informed the board that it would no longer invest or loan money to Buccaneer if Burton remained the CEO.
Buccaneer’s Chapter 11 plan included a release of any potential lender liability and other claims it had against Meridian in exchange for a payment of $10 million to the bankruptcy estate. Meanwhile, Burton sued Meridian, several of Meridian’s affiliates, and individual advisers to Meridian, in state court for tortious interference with contract and “tagalong” claims of conspiracy and assisting. Meridian removed the action to federal court, arguing that the claims belonged to Buccaneer’s bankruptcy estate and were released by the Buccaneer-Meridian settlement. The Bankruptcy Court disagreed, and the U.S. District Court for the Southern District of Texas affirmed. Meridian appealed to the Fifth Circuit.
CEO’s Injury Was Direct, Not Derivative
The court began its analysis by noting the question of whether the bankruptcy estate or a creditor can pursue a claim against third parties “is a recurring issue in bankruptcy law.” Courts in the Fifth Circuit “focus on whether the creditor suffered a direct injury or one that is derivative of an injury to the debtor.” If the creditor was harmed only because of harm to the debtor, then the claim is derivative and belongs to the estate. Only the bankruptcy trustee has standing to pursue such claims for the benefit of all creditors. The court noted in a footnote that other circuits use the terms “personal” and “general” instead of “direct” or “derivative,” but the analysis apparently is the same.
A clear case of a direct creditor claim against a third party is when there is no harm to the debtor. However, the court noted that even if the debtor was also harmed, “the creditor may also have a claim if the asserted injury does not flow from injury to the debtor.” In other words, the same set of events may give rise to separate claims against the third party by the estate and the creditor.
The court then reviewed Fifth Circuit decisions illustrating the distinction between direct and derivative claims. Bondholders who relied on false information from a consulting firm when deciding to invest in a debtor held direct claims against the firm because only the bondholders were harmed. Similarly, school districts that were misled by a health plan administrator had direct claims not dependent on harm to the debtor’s health benefits provider. Conversely, when third parties lured a debtor into transferring oil and gas assets, the creditors held derivative claims against the third party because their harm (reduced recoveries) was derivative of the harm suffered by the debtor (the loss of oil and gas assets). Similarly, when a bank aided and abetted a debtor’s managers to encumber the debtor’s assets with new liens, creditors’ claims against the bank were derivative because the debtor’s previously unencumbered assets were now liened. In these cases, the claims belonged to the estate and only the estate could pursue them.
In this case, the court concluded Burton’s harm—improper firing without paying the required severance—did not depend on any harm to Buccaneer. In fact, Burton had withdrawn his claim against the estate. Also, the court noted that Burton’s firing may have saved Buccaneer money, at least according to Meridian. The court reasoned, “The injury to Burton flowed through Buccaneer’s actions—allegedly taken at Meridian’s request—but not through an injury to the debtor.” It would be improper for Buccaneer’s creditors to receive a recovery if the conduct did not harm the debtor.
Meridian argued that Burton’s claims were actually disguised lender liability claims. Meridian reasoned that the improper conduct was control of Buccaneer, which led to Barton’s firing, making it a derivative harm. The court distinguished the derivative nature of the conduct from the direct nature of the harm. Barton’s injury, the court reasoned, did not depend on any harm to Buccaneer, even though the same conduct may have separately harmed Buccaneer as well. Finally, the court noted that Barton’s potential recovery against Meridian would not harm the debtor’s reorganization or creditors since the harm was not derivative to any harm to the estate. The court affirmed the decisions of the bankruptcy and district courts holding Burton held a direct claim.
Conclusion: Practitioners’ Analysis
When a bankruptcy case is filed, practitioners representing clients who may hold claims against both the debtor and nondebtor must analyze whether the claims are just derivative of the debtor’s claims and cannot be asserted directly by the creditor. The consequences of not being able to assert a direct claim can be significant for the claimant. Conversely, when resolving claims asserted by a debtor, one must examine whether there are direct claims outside of the bankruptcy process held by nondebtors based on the same occurrences that will not be covered by the debtor’s release. As the Buccaneer decision shows, the distinction between direct and derivative claims is not a trivial matter.
Andrew C. Kassner is the chairman and chief executive officer of Drinker Biddle & Reath, a national law firm with more than 635 lawyers in 12 offices. He chaired the corporate restructuring group for almost 20 years. He can be reached at email@example.com or 215-988-2554.
Joseph N. Argentina Jr. is an associate in the firm’s corporate restructuring practice group in the Philadelphia and Wilmington, Delaware, offices. He can be reached at firstname.lastname@example.org or 215-988-2541.