CHAPTER 5 Bankruptcy Litigation

JurisdictionUnited States

CHAPTER 5: Bankruptcy Litigation


Jarrett K. Vine (Polsinelli PC)

Shanti M. Katona (Polsinelli PC)

Michael M. Tamburini (Polsinelli PC)

Edward A. Phillips (Eisner Amper LLP)

Thomas W. Buck (Eisner Amper LLP)

Allen D. Wilen (Eisner Amper LLP)


The automatic stay is one of the most important tools a debtor has when it determines whether to file for bankruptcy protection. A CRO may choose to file for bankruptcy mainly to take advantage of the automatic stay in order to prohibit one creditor from taking advantage of its situation to the detriment of other creditors of a company. Upon the filing of a bankruptcy petition, the automatic stay of § 362 goes into effect.64 This stay halts all "litigation, lien enforcement and other actions, judicial or otherwise, that are attempts to enforce or collect prepetition claims ... [including] a wide range of actions that would affect property of the estate."65 Generally, the automatic stay halts creditor action against the debtor for pre-petition claims and gives the debtor breathing room to begin an orderly reorganization or liquidation.

The automatic stay is not absolute, however. Section 362(b) allows for certain litigation, claims, obligations, etc. to go forward during the bankruptcy case. For example, criminal actions against the debtor may proceed, environmental enforcement actions are not stayed, and enforcement of domestic support obligations continue.66 Numerous actions and obligations can continue despite the automatic stay, so § 362(b) demands attention.

One highly litigated exception to the automatic stay that any creditor may pursue is found under § 362(d). Section 362(d) allows the bankruptcy court to, after notice and a hearing, terminate, annul, modify or condition the automatic stay for "cause, including a lack of adequate protection of an interest in property,"67 or for actions against specific property "if the debtor does not have an equity interest in such property and such property is not necessary to an effective reorganization.68

A creditor may obtain relief from the automatic stay by filing a motion arguing that there is sufficient cause for such relief.69 The Bankruptcy Code does not define cause, therefore courts look at the totality of the circumstances to determine whether the creditor has shown cause.70 Cause can turn on the type of claim the creditor asserts or the nature and stage of the pre-petition proceedings.71 Courts have also relied on the legislative history for guidance on what constitutes to "cause":

The lack of adequate protection72 of an interest in property is one cause for relief, but is not the only cause. Other causes might include the lack of any connection with or interference with the pending bankruptcy case. Generally, proceedings in which the debtor is a fiduciary, or which involve postpetition activities of the debtor, need not be stayed because they bear no relationship to the purpose of the automatic stay, which is protection of the debtor and his estate from his creditors.73

Accordingly, a debtor must thoroughly examine the creditor's claim, and the nature and posture of the pre-petition proceedings, when presented with a motion to lift the automatic stay for cause.

Section 362(d)(2) provides that the stay may also be lifted when the debtor has no equity in the property and the property is not necessary for an effective reorganization. The movant has the burden to show a lack of equity, while the debtor has the burden to show that the property is necessary for reor-ganization.74 First, a lack of equity is shown in the "difference between the value of the subject property and the encumbrances against it."75 If the debt exceeds the value of the property, there is a lack of equity.76 Second, the debtor must show that there is "a reasonable possibility of a successful reorganization within a reasonable time,"77 and the property is necessary for that reorganization.78

Finally, an issue that is frequently litigated is whether the automatic stay of the debtor can apply to third parties, typically the debtor's directors, officers or related entities.79 Courts look to whether the litigation against a third party "could interfere with the reorganization of the debtor, would interfere with, deplete or adversely affect property of the estates or which would frustrate the statutory scheme of chapter or diminish the debtor's ability to formulate a plan of reorganization."80 Generally, however, bankruptcy courts are reluctant to extend the automatic stay to third parties.81



CROs brought on to help a flagging enterprise will be tasked with doing at least a preliminary investigation into the actions of the company's management and board. Obviously, the CRO must determine whether the actions of the management or board caused the enterprise to fail. If that proves to be the case, then the CRO must ensure that the problematic management or board member(s) no longer remain at the company. Otherwise, the CRO should endeavor to update the board and management on their fiduciary duties and the potential for claims being brought against them.


The CRO should ensure that the company has adequate director and officer liability insurance. This includes reviewing existing insurance policies to determine whether they cover the necessary breadth of conduct and provide ample coverage.82 If there is no policy, it is incumbent on the CRO to obtain a D&O policy for the basic reason of protecting himself or herself. The best practice would be to acquire such insurance prior to any bankruptcy filing, as it may be cost-prohibitive after the filing. Further, the CRO should ensure that the company has provided all required notices to the D&O insurers. These notices typically start the process of a company's claim to payment under any D&O insurance.

Similarly, a company's governing documents may indemnify directors or officers for liability, or applicable nonbankruptcy law may provide for such in the ordinary course. This generally only applies to provisions that indemnify directors from any personal liability for payment of monetary damages for breaches of their duty of care, but not for duty of loyalty violations, good-faith violations and certain other conduct.83 Indemnity generally shields them from liability resulting from claims of negligence and, in some states, gross negligence.


In a bankruptcy proceeding, a D&O policy can become a valuable asset of the bankruptcy estate. If there was potentially wrongful conduct by the directors or officers of a company, there could be litigation over their conduct. Any recovery based on director or officer violations of their fiduciary duties to the company would become property of the company's estate.84 Thus, the D&O policy, and any action to recover on that policy, may be a valuable asset to the company once it enters bankruptcy. Alternatively, the CRO can broker with the parties as to who will be the plaintiff in such actions and thus realize the proceeds from any concomitant litigation.

Dovetailing off that point, actions for breach of fiduciary duties against directors or officers may be used by a CRO as a bargaining chip in negotiating a plan in a chapter 11 proceeding.85 A CRO should utilize counsel to weigh the probability of recovery in a fiduciary duty action against the company's directors and officers. This will help the CRO value that litigation and develop a negotiation strategy for the plan.


Fiduciary duties exist to protect corporate shareholders from wrongdoing or self-interested profiteering by those who manage the corporation.86 This is because shareholders place "special trust in and reliance on the judgment of corporate managers and expect to have their interests protected.87 Thus, "[e]quity distinguishes fiduciary relationships from straightforward commercial arrangements where there is no expectation that one party will act in the interests of the other."88 Accordingly, directors and officers, as managers of the corporation, owe fiduciary duties to the corporation and its shareholders.89

There are two fiduciary duties applicable to directors and officers: care and loyalty.90 The fiduciary duty of care requires directors to act with the utmost care in making their decisions and "inform themselves, before making a business decision, of all material information reasonably available to them."91 The duty of care reviews the process employed by directors.92

Directors breach their duty of care by acting grossly negligent.93 Gross negligence is defined as "reckless indifference to or a deliberate disregard of the whole body of stockholders or actions which are without the bounds of reason."94 Directors may breach the duty of care by making a decision that was ill advised or grossly negligent, or by an unconsidered failure to act when due attention would have prevented the loss.95

"[T]he duty of loyalty mandates that the best interest of the corporation and its shareholders takes precedence over any interest possessed by a director, officer, or controlling shareholder and not shared by the stockholders generally."96 Actions that breach the duty of loyalty include a director appearing on both sides of a transaction or obtaining a personal benefit from a transaction.97 "[A] director who receives a substantial benefit from supporting a transaction cannot be objectively viewed as disinterested or independent."98 A basic example of a breach of the duty of loyalty is insider trading.99

The duty of loyalty includes a duty to act in good faith. The duty of good faith is not a separate duty of which a breach could impose liability on a board. Rather, it is subsumed into the duty of loyalty.100 A breach of the duty of good faith is described as follows:


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