Richards Layton & Finger

Litigating Fiduciary Duty Claims in Bankruptcy Court and Beyond: Theory and Practical Considerations in an Evolving Environment

March 27, 2015

Litigation against directors and officers is ubiquitous in bankruptcy courts. Indeed, charges of director malfeasance and breach of fiduciary duty are leveled at the outset of many bankruptcy cases—whether in the hallways outside of first day hearings or creditors committee formation meetings, in early hearings, or in pre-petition letter writing campaigns aimed at encouraging or discouraging specific board actions. These charges frequently wind their way into litigation, typically later in the bankruptcy case.

While the bankruptcy field has become accustomed to this practice, it bears noting in a Stern v. Marshall world that breach of fiduciary duty and deepening insolvency are state law concepts, not portions of the Bankruptcy Code. However, bankruptcy courts try the overwhelming majority of litigation and decide most of the reported case law. Thus, director and officer litigation claims have become standard “bankruptcy litigation.” The reason is fairly straightforward: suits alleging breach of fiduciary duty and the like are much more likely to be filed when a business strategy has failed, precisely because it has failed (there isn’t much sense in challenging an objectively successful outcome), and the fact that a company has filed a bankruptcy case often means that business strategies can be characterized (not always accurately) as having failed. Moreover, the fact of bankruptcy means that a fiduciary, such as a Chapter 11 or 7 trustee, a creditors committee, or a postplan confirmation trust set up to pursue litigation claims, typically will be appointed, thereby avoiding the “collective action” problem outside of bankruptcy. And the bankruptcy process itself often makes funding for these types of suits available, for example by agreed or court ordered carve outs from a secured lender’s collateral. Taken together, this means that since no individual creditor has to fund what could be expensive litigation, director and officer claims alleging wrongdoing in the face of insolvency get pursued in bankruptcy cases more often than they do outside bankruptcy.