Weathering the Storm: Does the Bankruptcy Code Restrict a Liquidation Trustee’s Power after Plan Confirmation?


Reversing the decision of the United States District Court for the Northern District of Illinois, the Seventh Circuit (the “Court”) held in Grede v. Bank of New York Mellon, et al., No. 09-3121 (7th Cir. Mar. 18, 2010) that neither the Bankruptcy Code (the “Code”) nor the Supreme Court’s decision in Caplin v. Marine Midland Grace Trust Co., 406 U.S. 416 (1972) apply to the activities of a post-confirmation liquidating trustee appointed in a liquidating trust created by a confirmed plan of reorganization. Specifically, a liquidating trustee is not barred from pursuing litigation on behalf of third-party investors who voluntarily assign their claims to the trustee pursuant to terms of a confirmed plan.

The facts of Grede are as follows: Sentinel Management Group Inc. (“Sentinel”) was a futures commissions merchant and investment manager that filed for Chapter 11 protection in 2008. During the case, a Chapter 11 trustee was appointed while Sentinel’s business was being wound down. Pursuant to the confirmed plan, the Chapter 11 trustee became the liquidating trustee of the post-confirmation Sentinel Liquidation Trust (the “Liquidation Trust”). During the bankruptcy case, Sentinel’s investors alleged they had been defrauded out of hundreds of millions of dollars, not only by Sentinel’s management, but also by The Bank of New York Mellon (“BNYM”), Sentinel’s lender and clearing bank. Pursuant to the confirmed plan, and as permitted under the terms of the liquidating trust instrument, these investors assigned their claims to the Liquidation Trust for prosecution against BNYM.

Following the plan effective date, BNYM objected to the trustee’s pursuit of the assigned third-party claims on two grounds: (i) the assignments were a collusive attempt to manufacture jurisdiction and (ii) the trustee lacked authority under the Code to pursue the investors’ claims. Grede at pp. 2-3. The District Court granted BNYM’s motion to dismiss the lawsuit brought by the liquidating trustee, relying on the Supreme Court’s decision in Caplin, as well as the Ninth Circuit’s decision in Williams v. California 1st Bank, 859 F.2d 664 (9th Cir. 1988), holding that the Caplin ruling applied even after confirmation of a plan.

The Caplin case dealt with a Chapter X Trustee’s power during a bankruptcy case to assert, on behalf of investors, claims of misconduct by the Indenture Trustee. The Supreme Court affirmed the lower court decision that the Chapter X Trustee lacked the requisite standing to prosecute these claims during the bankruptcy case.

In Caplin, the Supreme Court identified three reasons for not allowing a bankruptcy trustee to assert the third-party claims of individual investors: First, the court held that the Bankruptcy Act of 1898 did not give a trustee such a power, nor did it give bankruptcy judges the power to transfer third-party claims to a trustee. Caplin, 406 U.S. at 428-29. Second, the court reasoned that, as the damage suffered by the investors was as much the fault of the debtor as of the third-party defendant, the debtor might have had the obligation to reimburse the third-party defendant for any amounts the trustee recovered. Id. at 429-31. Third, as the trustee conceded, any suit it made would not pre-empt suits by the individual investors themselves, allowing for the possibility of inconsistent or double recoveries. Id. at 431-4.

The issue before the Seventh Circuit in Grede was whether a post-confirmation liquidating trustee of a liquidation trust created under a confirmed plan can prosecute creditors’ direct claims (as opposed to estate claims) assigned to it as provided in the plan. On appeal, BNYM raised two threshold objections, arguing that the trustee had engaged in collusive maneuvering of jurisdiction and that the trustee lacked authority to pursue the litigation. Grede at pp. 4.

On review, the Seventh Circuit first addressed the flaws in BNYM’s jurisdictional objections, noting that many of the investors were not residents of New York and their claims exceeded $75,000, thus providing a basis for diversity jurisdiction. The Court also noted that the investors could have sued BNYM as a class. Furthermore, as the trustee was already pursuing Sentinel’s estate claims against BNYM, supplemental jurisdiction could have allowed the joinder of the investors’ claims, for the sake of judicial economy. The Court noted that a collusive assignment is a genuine jurisdictional problem, and stated that an assignment will be treated as collusive when the sole function is to shift litigation from state to federal court. After a review of the assignments in question in Grede, the Court ruled that the assignments did not move the litigation from state to federal court. Instead, the assignments facilitated efficient aggregation of claims, and that the Court therefore possessed subject matter jurisdiction. Grede at pp. 3-5.

The Seventh Circuit then addressed the merits of the District Court’s decision, analyzing the application of the Caplin standard to the case at bar. The Court noted that none of the three reasons the Supreme Court gave for denying a Chapter X trustee’s power to act in Caplin applied in the present instance. First, the Court held that while the Code governs the powers of a trustee in bankruptcy, “the terms of the plan of reorganization (and of the trust instrument) govern the permissible duties of a trustee after bankruptcy.” (emphasis in original). Once a plan has been confirmed and the debtor has exited bankruptcy, the terms of the Code no longer regulate a trustee’s conduct. Grede at pp. 5-7. Caplin’s second reason in support of its ruling was that the third-party claims might create a right of subrogation which would require the debtor to reimburse BNYM for anything the trustee collects. The Grede Court ruled that such result was not possible in the face of the allegations, and even if it had been, the time to raise such issue expired upon confirmation. Grede at pp. 7. Finally, Caplin’s third reason, the possibility of inconsistent or duplicative recoveries was not a concern here, as the Liquidating Trust only held claims which were voluntarily assigned to it by investors. “By proceeding on the investors’ voluntary assignments rather than a bankruptcy judge’s directive,” Caplin’s final concern was avoided. Grede at pp. 7.

The Court also noted that BNYM’s contention that unsuccessful litigation of the investors’ claims would dilute the estate’s assets was an argument properly made by the Liquidating Trust’s beneficiaries, not the defendant in such litigation. American law recognizes few instances where a litigant may invoke the rights of a third-party, and the facts before the Court did not give rise to such an instance. Grede at pp. 8.

Conclusion. This holding is significant as relating to constituent negotiations regarding the terms of post-confirmation trust instruments established by confirmed reorganization plans. In Grede, pursuant to the plan, investors voluntarily assigned their claims against BNYM to the liquidating trust for post-confirmation prosecution. Grede is a warning to all plan constituents that the terms of the confirmed plan and post-confirmation trust instrument, not the Bankruptcy Code nor the rule established in Caplin, govern the powers of a liquidation trustee after plan confirmation. These issues must be addressed prior to the confirmation of a plan. After a plan is confirmed providing for a liquidation trust, the trust’s provisions and rights created thereunder will control.

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