It is often surprising to me how often people are unaware of the fairly high risk of being sued in connection with a chapter 11 bankruptcy case when there is money in the case.  Many times, non-debtor parties’ falsely comfort themselves with the belief they will not be sued because existing management wouldn’t want to ruin a business relationship.  The reality is that in large chapter 11 cases, you are just as likely to be sued by the creditors committee as anyone else as a lender.

get sued

Bankruptcy, at its most basic, is the attempt to monetize and equitably (and constitutionally) distribute whatever assets exist of the bankrupt entity.  Outside of bankruptcy, the obvious assets are normally the tangible widgets.  Inside of bankruptcy, the causes of action also become value for trade.

To understand how a third party lender can be sued by an unknown entity on a cause of action which makes no business sense, a quick review of statutory committees is helpful.

Under the Bankruptcy Code a committee of unsecured creditors may be formed to represent the interests of the larger body of unsecured creditors.  Importantly, this committee will have its attorneys’ fees paid by the bankrupt debtor.  This committee, now funded and represented will go about to seek the best recovery for its constituents.  One source of recovery is lawsuits, which are typically unencumbered.

Of course, a committee that did not exist prior to the bankruptcy filing will not typically have standing to sue for pre-bankruptcy wrongs.  However, the Bankruptcy Code and Court’s provide a mechanism to assign those causes of action to the unsecured creditor’s committee as payment on their unsecured debt.

Meaning – if you are a lender you might get sued by a group of angry unsecured creditors after the bankruptcy is filed. The bankruptcy case of Energy Futures Holding (“EFH”) provides a good illustration.

How could that happen?  If a bankrupt debtor unjustifiably fails (or is unable) to pursue a cause of action, the unsecured creditors committee may petition the court to be permitted to pursue the cause of action.  That is what the unsecured creditors committee is currently doing in the EFH case.

In the EFH case, certain subsidiaries were obligated on the LBO debt of the holding company.  The subs didn’t receive the money and even had a provision in the loan documents which essentially said they were only obligated to the extent that the obligation wasn’t a fraudulent transfer in bankruptcy.  Nonetheless, they allegedly paid a disproportionate share of debt service which payment are alleged to be fraudulent transfers.

After the bankruptcy case was filed, the lenders included a provision in the post-petition financing agreement that the bankrupt debtors would not sue the lenders for the pre-bankruptcy payment by the subs (now debtors in bankruptcy).

After the order permitted in the post bankruptcy financing was entered, the unsecured creditors committee in the EFH case was created.  Just recently, the unsecured creditors committee has requested that it be permitted to pursue fraudulent transfer causes of action against the lenders because the Debtor has waived the ability to do so.  The total asserted liability is $8 billion.

At present, the EFH bankruptcy court has not ruled on the request by the unsecured creditors committee.  However, it would not be unusual for the Court to grant such a request.  The legal issues are somewhat technical, but the practical considerations are fairly straightforward – the $8 billion lawsuit is not going to be pursued for legal and business reasons by the bankrupt borrowers but regardless it remains a valuable asset for potential recovery for creditors.

The take home consideration for lenders is this: the lenders sought pre-bankruptcy loan language they thought would shield them from a lawsuit, the lenders sought and obtained a post-bankruptcy waiver of pursuit of the lawsuit by the borrowers – however, the lenders are now facing the prospect that the unsecured creditors committee (who did not exist until after the post-bankruptcy waiver) will sue the lenders for $8 billion.

The loan document language may be of some comfort to you.  However, as a lender, in bankruptcy it might not be the borrower who sues you.

In re Energy Future Holdings Corp., case no. 14-10979, pending in the United States Bankruptcy Court for the District of Delaware.

Motion of the EFH Official Committee for Entry of an Order Granting Derivative Standing and Authority to Prosecute and Settle Claims on Behalf of the Luminant Debtors’ Estates. [dkt 3605]