On occasion I have thought that a chapter 11 bankruptcy case is somewhat analogous to a trip on a plane in a few ways. Among other analogous events, consider checking a bag and then forgetting to pick it up on the conveyor belt after the flight lands. It would be easy enough to do – as the bag is riding in the cargo hold, perhaps it was simply forgotten. If that has ever happened to you, it likely you went back to pick up the bag from the airport. On the other hand, in a chapter 11 bankruptcy case, if the debtor-in-possession doesn’t pick up all of its assets when it exits bankruptcy, it will lose them forever.
To understand how a cause of action could just go away after plan confirmation, it is helpful to understand the legal distinction between the original entity which filed bankruptcy and the debtor-in-possession, or DIP.
I. The Bankruptcy Estate is Something Separate
When any bankruptcy case is filed, an estate (not unlike a trust) is immediately created and all of the assets of the entity are immediately and automatically transferred to the estate pursuant to the bankruptcy code.
- When the bankruptcy case is filed as a chapter 7 liquidation, a 3rd party is appointed to manage and liquidate that estate for the benefit of the creditors.
- In a chapter 11 reorganization bankruptcy case, the estate is usually managed by the filing entity- the DIP, which is given possession of the estate to administer for the benefit of the creditors.
As a practical matter, a typical chapter 11 bankruptcy case looks like business as usual by the debtors prior management, but legally, the debtor is acting as a trustee over the bankruptcy estate which was created upon filing.
The distinct, but parallel, existence of the estate from the DIP is important when considering the effect of confirming a chapter 11 plan. When a chapter 11 plan is confirmed, one of the effects is to re-vest assets into the debtor who will then operate under the plan going forward.
The rub is: anything that is not transferred out of the estate to the debtor does not belong to the debtor. This is where the cause of action issue comes up.
II. Take it or Leave It
A cause of action (or perhaps an affirmative defense) is an asset of the debtor before filing bankruptcy and it remains so during bankruptcy. As an asset of the estate, it must be transferred under the plan to the debtor in order for the debtor to use it after confirmation of the plan.
Among others, the Fifth Circuit has held that if a cause of action is not specifically and unequivocally reserved and transferred to the debtor post plan confirmation, it will not belong to the debtor post confirmation.
More simply, if the confirmed plan does not sufficiently identity a cause of action which will leave the estate and be given back to the debtor after plan confirmation, that cause of action functionally disappears. So, if the DIP doesn’t take the cause of action, it leaves it.
III. The Recent Case
The recent Rossco Holdings v. McConnell case in the Fifth Circuit provides a good excuse to write about the topic. The opinion was entered last week. In the case, post-confirmation chapter 11 debtors sued their alleged attorneys for malpractice in connection with the bankruptcy case.
The attorney/defendants moved to dismiss the lawsuit asserting that the confirmed plans of the plaintiffs did not transfer the causes of action from the DIPs to the debtors after confirmation. Therefore, the plaintiffs would have no right to bring the lawsuit.
The Fifth Circuit agreed and affirmed the dismissal of the lawsuit because the plaintiff/debtors did not specifically enough transfer the claims back into the debtor from the estate and therefore they no longer existed.
IV. Things to Consider
The first thing to consider if you are a lender, is that if you are being sued by a post-confirmation debtor you should review the plan to see if the plan properly transferred the claim from the estate into the post-confirmation debtor.
Additionally, the opinion also denies a couple of the plaintiffs’ arguments simply because they were raised too late in the proceedings – particularly with regard to choice of law. In short, the plaintiffs attempted too late to argue that 9th circuit law (which is more favorable for the plaintiff than 5th circuit law) applied and thus waived the argument.
In summary: All of the assets of the pre-bankruptcy debtor are along for the ride once in bankruptcy. However, if a cause of action is not properly transferred by the DIP to the debtor upon exit, that cause of action will not belong to the post-confirmation debtor.
The opinion is here.