Creditors pre-petition derivative action

Author: LegalEase Solutions

QUESTION PRESENTED

Whether, under Illinois and Ohio law, a creditor, directly or through a bankruptcy trustee, can bring a derivative action in a bankruptcy proceeding for pre-petition breaches of fiduciary duty by officers and/or directors of a corporation?

 SHORT ANSWER

Under Illinois and Ohio law, a bankruptcy trustee may bring these types of derivative actions on behalf of creditors and/or the bankruptcy estate. Creditors do not have standing to bring these types of claims.

RESEARCH FINDINGS

  1. Standing to Bring Derivative Claims for Breach of Fiduciary Claims Under Illinois Law

Under Illinois law, once a company files for bankruptcy, only the trustee has standing to bring derivative claims against officers or directors based on pre-petition breaches of fiduciary duties. The Gourmet Center, Inc. v. Fox (In re Sage Enterprises, Inc.), was an adversary proceeding filed within the Chapter 7 involuntary bankruptcy proceedings of Sage Enterprises.[1] In the adversary proceeding, Gourmet alleged, among other claims, that the directors of Sage Enterprises owed the company’s creditors, including Gourmet, fiduciary to Sage’s creditors.[2] Specifically, Gourmet alleged that those duties “included a duty not to use corporate assets to improve their individual positions to the detriment of Sage’s creditors and a duty to be forthright and candid as trustees of the corporate trust.”[3] Gourmet further alleges, that the two directors named in the complaint “were aware of Sage’s insolvency and the risk that creditors who had extended credit terms would not be paid in full” and that they “breached their duties to all of Sage’s creditors by causing Sage to stop payments to Gourmet and other suppliers in order to reduce their personal liability under the Guarantees” and “when they made false, or at least reckless, assurances of full payment to Gourmet.”[4] Under Illinois law, breach of fiduciary actions against corporate directors are generally regarded as derivative claims.[5]

Both the directors and another creditor who had been named in the complaint, LaSalle, filed motions to dismiss Gourmet’s complaint.[6] With regard to the breach of fiduciary duty claims, the directors acknowledged that they owed fiduciary duties to the company’s creditors but that Gourmet’s complaint failed to allege a claim for breach of those duties, while LaSalle moved to dismiss the claim on the basis that Illinois law did not recognize a breach of fiduciary duty claim under the circumstances alleged by Gourmet.[7]

With regard to the breach of fiduciary duty claim, the Bankruptcy Court for the Northern District of Illinois found that Gourmet lacked standing bring its claims against the company and LaSalle.[8] In support for its holding, the court noted first that “once a company or an individual files bankruptcy, the bankruptcy trustee becomes the representative of the estate with standing to advance causes of action that the debtor could have commenced before the filing of the bankruptcy petition.”[9] As such, the court found, “only a trustee “has standing to assert a general claim on behalf of the creditors; he cannot, however, bring the personal claims of individual creditors.”[10] Accordingly, if the action was indeed a derivative action, a creditor would not, under Illinois law, have standing to bring the claim.[11] Rather, for Gourmet’s breach of fiduciary duty claim to move forward, the court had to decide whether the claim was personal to Gourmet, for which Gourmet would have standing, or “common to the corporation and its creditors,” for which only the trustee would have standing.[12]

The court then examined the alleged scheme upon which the claims were based, in which the defendant directors “made false promises of full payment to on-credit suppliers in order to convince those suppliers to ship” to determine whether it was sufficiently personal to Gourmet as a creditor to convey standing to bring the claim.[13]  The court noted that Gourmet’s complaint alleged a scheme which “resulted in a purported misuse of funds… to pay a secured creditor ahead of the unsecured creditors, in order to benefit [the Defendant directors] individually” and that, as such, “Gourmet alleges a general injury, not an injury significantly different from the injuries to creditors in general resulting from the purported breach of fiduciary duty.”[14] Because the claims for breaches of fiduciary duty and inducement of breach as pleaded in Gourmet’s were general, the court held that that “they belong to the estate and only the Trustee has standing to bring them.”[15]

There is also bankruptcy case law in Illinois reinforcing the principle that derivative actions based on claims of pre-petition breach of fiduciary duties by officers or directors of a corporation can only be raised by the trustee (or, if applicable, the debtor-in-possession) once a bankruptcy filing has occurred.  Official Unsecured Creditors’ Committee of Hearthside Baking Co., Inc. v. Cohen was also an adversary proceeding filed within the Chapter 11 bankruptcy proceedings of Hearthside Banking Co, Inc. brought by the unsecured creditors’ committee and one of two directors of the company against the other director (“Defendant Director”) and the co-trustees managing the interest of a deceased former owner of the corporation (“Defendant Trustees”). [16] The matter was initially filed in state court and Unsecured Creditors’ Committee subsequently moved to remove it to the bankruptcy court and to consolidate it with their previously filed adversary alleging similar claims.[17] The Defendants sought to have the bankruptcy court abstain from hearing the action and remand it back to state court.[18] As part of their argument for abstention and remand by the bankruptcy court, the Defendants alleged that the bankruptcy court lacked subject matter jurisdiction over nineteen of the claims alleged in the underlying complaint, including:

state law claims asserted between non-debtors… cover[ing] allegations of [Defendant Director’s] misappropriation of money and assets from the Debtor and [Defendant Trustees’] failure, as trustees, to act or to investigate [Defendant Director’s] alleged acts. The claims are for conversion, breach of fiduciary duty, unjust enrichment, and civil conspiracy. The claims relate to each defendant’s role in the company as either a director or officer of the Debtor and wrongful acts against the Debtor.

In finding that it had subject matter jurisdiction, the Bankruptcy Court cited to Seventh Circuit well-established precedent that derivative actions against officers, directors, and shareholders which can be enforced by either the corporation directly or the shareholders derivatively prior to bankruptcy “become the property of the estate which the trustee or the debtor-in-possession alone has the right to pursue after filing of a bankruptcy petition.”[19] Accordingly, as the derivative claims in the removed adversary proceedings belonged to the bankruptcy estate and would impact the amount of money available to estate creditors, the bankruptcy court had jurisdiction to hear the claims.[20]

  1. Standing to Bring Derivative Claims for Breach of Fiduciary Claims Under Ohio Law

Likewise, under Ohio law, once bankruptcy has been filed, the bankruptcy trustee is the only entity with standing to bring derivative claims based on pre-petition breaches of fiduciary duties on the part of corporate officers and/or directors. Creditors cannot assert these claims.

In Bash v. SunTrust Bank, Inc. (In re Ohio Business Machines), the Sixth Circuit Bankruptcy Appellate Panel (BAP), assessed, among other issues, whether the bankruptcy trustee had standing to bring a derivative breach of fiduciary duties claim against another creditor of the debtor corporation.[21] The BAP reversed the bankruptcy court’s dismissal of the trustee’s claim, holding that the trustee had standing to bring an action for breach of fiduciary duty on behalf of the debtor corporation.[22] In reaching its holding, the BAP noted that that actions for breach of fiduciary duties normally accrue to the corporation itself or its shareholders because it “it is the corporation that suffers injury when the fiduciary duties are breached,” once bankruptcy is filed, the trustee “is the only person with standing to bring those claims and the creditors are barred from asserting them.”[23]

In addition, in KMA Acquisitions Corp. v. Coleman, the Ohio Court of Appeals addressed the general ability of a creditor to bring a derivative breach of fiduciary action under Ohio law outside of the bankruptcy context. [24] The lower court, in finding that the plaintiff creditor did not having standing to bring such a claim, stated:

Plaintiff’s argument that it holds Ritzy’s rights to seek recovery from defendants is without merit. Plaintiff fails to cite any authority, nor can the court find authority which allows a creditor to bring suit against a corporation’s directors/officers for breach of fiduciary duty to the corporation. Only the corporation itself may maintain an action against the directors and officers for acts damaging to the corporation, for waste of corporate assets, or for breach of fiduciary duties…Similarly, when the corporation fails to assert a right which may be properly asserted by it, a shareholder’s derivative action may be brought to enforce a corporate claim…However, plaintiff has neither alleged that it was a shareholder of G.D. Ritzy’s, Inc. at the time of the alleged breach of fiduciary duties of defendants, nor has it asserted a derivative claim.[25]

In upholding the trial court’s finding, the court of appeals noted “plaintiff’s complaint not only fails to sufficiently allege facts which would give rise to a fiduciary relationship between the defendants and plaintiff, but the complaint also fails to allege any injury to plaintiff.” [26]

III.       Statute of Limitation for Derivative Claims Based on Breaches of Fiduciary Duties by Directors/Officers

             Although the case law does not discuss statute of limitations in the context of derivative claims brought by a trustee in bankruptcy, as the trustee is exercising claims available to the debtor corporation itself, it follows that the relevant statute limitations which would apply to the corporation itself under state law apply. Under Ohio law, breach of fiduciary duty claims are subject by statute to a four-year statute of limitations measured from when the cause of action accrued, not when the alleged breaches were discovered.[27] Under Illinois law, a five-year statute of limitations applies to breach of fiduciary claims and the statute begins to run when “the plaintiff knew or should have known through reasonable diligence of the existence of the right to sue.”[28]

  1. Conclusion

            Under Illinois and Ohio law, creditors lack standing to bring derivative claims based upon breaches of fiduciary duty by directors and/or officers of a corporation as these actions are reserved to the corporation. However, once bankruptcy proceedings have commenced, the bankruptcy trustee (as well as the debtor-in-possession, if applicable) has standing to bring these claims on behalf of the corporation and the corporation’s creditors. Such claims are subject to a four-year statute of limitations under Ohio law, measured from when the claim accrued, not when the alleged breached were discovered. Under Illinois law, such claims are subject to a five-year statute of limitation, measured from when the plaintiff knew or should have known through reasonable diligence of the right to sue.

[1] 2006 WL 1722582, No. 04 A 03014, at *1 (Bankr. N.D. Ill. Apr. 28, 2006).

[2] Id. at *4.

[3] Id.

[4] Id.

[5] In re DeMert & Dougherty, Inc., 271 B.R. 821, 840 (Bankr. N. D. Ill. 2001)

[6] Gourmet, 2006 WL 172282 at *5.

[7] Id.

[8]  Id. at *18

[9] Id.  at *15 (citing Koch Refining v. Farmers Union Central Exchange, Inc., 81 F.2d 1339, 1343 (7th Cir.1987), cert. denied, 485 U.S. 906, 108 S.Ct. 1077, 99 L.Ed.2d 237 (1988)(“[R]ights of action against officers, directors and shareholders of a corporation for breaches of fiduciary duties which can be enforced by either the corporation directly or the shareholders derivatively before bankruptcy, become property of the estate which the trustee alone has the right to pursue after the filing of a bankruptcy petition”)).

[10] Id.  at *15 (citing Koch Refining, 81 F.2d at 1343).

[11] Id.

[12] Id. at * 15 (citing Koch Refining, 81 F2d at 1349; In re Agribiotech, 319 B.R. 216, 221 (D. Nev. 2004) (“Where the injury alleged is primarily to the corporation, and is injury to the plaintiff creditor only insofar as it decreases the assets of the corporation to which he must look for satisfaction of his debt, then the suit is for a tort suffered by the corporation, and properly brought by the trustee”)).

 

[13] Id. at 17.

[14] Id.

[15] Id. at 18.

[16] 391 B.R. 807, 811-12 (Bankr. N.D. Ill. 2008).  Note that this matter was initially an involuntary Chapter 7 proceeding, but was subsequently converted to Chapter 11. Id. at 812.

[17] Id.

[18] Id. at 812-13.

[19] Id. at 814 (citing Koch Refining v. Farmers Union Cent. Exch., Inc., 831 F.2d 1339, 1343–44 (7th Cir. 1987), cert. denied, 485 U.S. 906, 108 S.Ct. 1077, 99 L.Ed.2d 237 (1988) (It has also long been held that rights of action against officers, directors and shareholders of a corporation for breaches of fiduciary duties, which can be enforced by either the corporation directly or the shareholders derivatively before bankruptcy, become property of the estate which the trustee [or debtor-in-possession] alone has the right to pursue after the filing of a bankruptcy petition. The section 541 estate has been found to include any actions that a debtor corporation may have to recover damages for fiduciary misconduct, mismanagement or neglect of duty, and the bankruptcy trustee [or debtor-in-possession] succeeds to that right for the benefit of all creditors of the estate)).

[20] Id.

[21] 356 B.R. 786, at *6 (B.A.P. 6th Cir. 2007) (unpublished).

[22] Id. at *7.

[23] Id. (citing Limor v. Buerger (In re Del–Met Corp.), 322 B.R. 781, 818 (Bankr.M.D.Tenn.2005) (citing, inter alia, Pepper v. Litton, 308 U.S. 295, 307, 60 S.Ct. 238 (1939) (“While normally that fiduciary obligation is enforceable directly by the corporation, or through a stockholder’s derivative action it is, in the event of bankruptcy of the corporation, enforceable by the trustee.”); Keene Corp. v. Coleman (In re Keene Corp.), 164 B.R. 844, 853–54 (Bankr.S.D.N.Y.1994) (“Claims based upon breach of a fiduciary duty belong to a corporation, but once bankruptcy ensues, they are enforceable by the trustee. The trustee, therefore, is the only person with standing to bring those claims and the creditors are barred from asserting them.”)). See also KMA Acquisitions Corp. v. Coleman, No. 92AP–1635, 1993 WL 431201 (Ohio App. 10 Dist. October 19, 1993) (“Only the corporation itself may maintain an action against the directors and officers … for breach of their fiduciary duties”)).

[24] 1993 WL 431201, No. 92AP-1635, at *2 (Ohio Ct. App. Oct. 19, 1993) (unpublished).

[25] Id.

[26] Id.

[27] In re Keithly Instruments, Inc., Derivative Litigation, 599 F.Supp.2d 875, 907 (N.D. Ohio 2008) (citing Ohio Rev. Code Ann. § 2305.09 (2014)).

[28] In re Gaslight Club, Inc., 167 B.R. 507, 518 (1994) (citing Taylor v. Meirick, 712 F.2d 1112, 1117 (7th Cir.1983) (additional citations omitted)).