In re Smart World Technologies, LLC
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- Before:
- Walker, Newman, Jacobs
COPYRIGHT MATERIAL OMITTED
Lawrence P. Gottesman, Bryan Cave LLP, New York, NY, (Rebecca Tapie and Karine Louis, of counsel, Brown Raysman Millstein Felder & Steiner LLP, New York, NY), for Appellee Juno Online Services, Inc.
Laurence May (Rochelle R. Weisburg, of counsel, and Leonard H. Gerson, on the brief), Angel & Frankel, P.C., New York, NY, for Appellee Official Committee of Unsecured Creditors.
Thomas R. Califano (Eric B. Miller, of counsel), Piper Rudnick LLP, Baltimore, MD, for Appellees WorldCom Technologies, Inc. and UUNET Technologies, Inc.
G. Eric Brunstad, Jr., Bingham McCutchen LLP, Hartford, CT, Amicus Curiae urging reversal.
Before: WALKER, Chief Judge, NEWMAN and JACOBS, Circuit Judges.
JOHN M. WALKER, JR., Chief Judge.
Debtors-appellants Smart World Technologies, LLC, Freewwweb, LLC, and Smart World Communications, Inc. (collectively, “Smart World“) appeal from an unreported decision
On appeal, Smart World argues that as debtor-in-possession, it alone was entitled
BACKGROUND
I. The Sale
Smart World began providing free internet service in 1996. As of June 2000, it had approximately 1.7 million registered subscribers, 750,000 of whom actively used its internet services. Smart World, however, was unable to run its business profitably and sought a purchaser for its most valuable asset, its list of subscribers. On June 29, 2000, it entered into an agreement with Juno, a competing internet service provider who was the sole bidder. Under the agreement, terms of which were set forth in a “Term Sheet,” Smart World agreed to sell its subscriber list to Juno and to continue referring subscribers to Juno through its distribution network. As part of the transaction, Juno required Smart World to file for bankruptcy and to conduct the sale under
Under the Term Sheet, Juno was not required to pay Smart World for subscribers unless the subscribers were deemed “qualified.”4 Compensation for qualified subscribers was to be paid partly in cash and partly in Juno stock, with the percentage to be paid in stock increasing with the number of qualified subscribers referred.5
The bankruptcy court approved the sale on July 19, 2000.
II. The Good-Faith Hearing and the Adversary Proceeding
Soon after the sale was approved, relations between the parties soured. According to Smart World, Juno circumvented the process established in the agreement for tracking subscribers referred to Juno by causing a “database dump” on the very day the sale was approved. The database dump allegedly prevented Smart World from identifying how many of its subscribers became qualified subscribers, and thus, how much Juno owed Smart World. When Smart World raised these allegations before the bankruptcy court, the court scheduled a hearing for September
Juno‘s response to the scheduling of the good-faith hearing was twofold. First, Juno refused to respond to Smart World‘s discovery requests, complaining that they were overly broad and burdensome. When the bankruptcy court ordered Juno to expedite discovery, Juno dumped tens of thousands of documents on Smart World‘s counsel just days before the hearing.6 Second, Juno commenced a declaratory action in an adversary proceeding, which subsumed the good-faith allegations raised by Smart World.
Specifically, Juno‘s complaint, filed just days after the bankruptcy court decided to hold the good-faith hearing, addressed the precise issues regarding implementation of the Term Sheet raised by Smart World. Juno denied that it had engaged in a database dump and instead asserted that Smart World had “concoct[ed] false claims relating to the implementation of the Term Sheet . . . in an effort to extract additional and unearned consideration from Juno.” According to Juno, it was Smart World, and not Juno, who had impeded implementation of the agreement. In fact, Juno argued, Smart World had not only “failed to fully implement critical elements [of the Term Sheet],” but in addition Smart World‘s three most senior officers had in effect extorted Juno, “threaten[ing] to immediately resign . . . unless Juno immediately paid [them] salaries in excess of the amounts previously authorized by the Court,” a demand to which Juno allegedly felt that it had to yield. In short, Juno maintained, Smart World‘s accusations of wrongdoing were part of a wholesale “effort to extract additional consideration from Juno . . . and to obtain other modifications to the Term Sheet.”
III. Delays in the Adversary Proceeding
Between August 2000, when Juno commenced the declaratory action, and September 2003, when the bankruptcy court approved settlement, the adversary proceeding stalled, essentially because Juno repeatedly represented to the bankruptcy court that settlement was imminent and because the court openly supported settlement rather than litigation. From the beginning, Smart World‘s efforts to prosecute its own claims and to engage in discovery were frustrated.
In October 2000, Smart World applied to the bankruptcy court for retention of special litigation counsel on a contingency basis. Juno opposed the application and instead asked the court for a “standstill agreement,” which would allow settlement negotiations to proceed. The court granted Juno‘s request, giving the parties until November 8, 2000 to come to an agreement. With the acquiescence of Smart World‘s creditors, Juno deliberately excluded Smart World from the ensuing negotiations.
When the parties failed to settle by November 2000, litigation resumed, and the bankruptcy court approved Smart World‘s request to retain litigation counsel on a contingency basis. Soon after, Smart World filed its answer and counterclaims7
On February 7, 2001, the bankruptcy court held a hearing on the purported settlement at which Smart World‘s principal creditor, WorldCom, characterized the settlement as a “confidential” agreement between Juno and WorldCom:
I think we need to be fair here. World Com [and Juno] started settlement discussions just with themselves in early December. [Counsel for Juno] had previously uniformly taken the position that [Smart World] has no economic stake and he didn‘t want to include [Smart World] in any settlement negotiations.
WorldCom‘s lawyer further asserted:
We don‘t have a fiduciary duty to anyone else and we don‘t want to have that handle put upon us . . . . [W]e were not motivated by the merits of the claims. We were motivated by what we see as a deteriorating situation both in this case and at Juno, and we felt a settlement that we could get paid upon quickly was better than nothing. That was our motivating factor. We didn‘t need discovery because of the way we approached it. Other people may need confirmatory discovery, but that was not our approach to this matter.
Juno‘s earlier claim that a settlement had been reached proved to be inaccurate; however, promising the bankruptcy court that settlement was imminent, Juno requested another “standstill of the [adversary] litigation,” to allow negotiations to continue and to avoid further discovery by Smart World. When the court indicated its intention to grant a thirty-day stay, Smart World argued that the case could not “settle . . . without discovery,” to which the court responded that it would allow “discovery as to the settlement proposal only,” but “not [as it pertains to] the adversary [proceeding].” The court also expressed its strong preference for settlement and its deep reluctance to allow the adversary suit to continue.
The thirty-day standstill stretched into months. In October 2001, nearly eight months later, with no settlement reached, Smart World moved to recommence prosecution of the adversary proceeding. Juno opposed the motion. The bankruptcy court repeatedly adjourned the motion.
Five months later, on March 26, 2002, the bankruptcy court held a hearing at which it summarily denied Smart World‘s motion to recommence the adversary proceeding. The bankruptcy judge‘s explanation was that “I have been on the bench about 17 years, [and] I know when we should have a settlement and when we should have a litigation.” Relying on the assurances of counsel for Juno and the creditors that a settlement would soon be reached, the bankruptcy court agreed to “one more adjournment” until June 2002. The court stated unequivocally that if no settlement was reached by June, it would “turn [Smart World‘s counsel] loose” to conduct discovery and litigate the adversary claims.
When that date arrived, however, and the parties still had not settled, the bankruptcy court lost its strong resolve. Instead, the bankruptcy court ordered mediation, which proved unsuccessful.
IV. The Rule 9019 Motion
In May 2003, almost three years after Juno had commenced its adversary suit, and over two years after proceedings, including any meaningful discovery, had been stayed, Juno and Smart World‘s creditors filed a motion pursuant to
Smart World objected to the settlement. Smart World contended, inter alia, (1) that the settlement was not reasonable because it did not require Juno to pay even its admitted liability to Smart World; (2) that the settlement improperly recognized a substantial secured claim in favor of WorldCom, though “the liens securing the WorldCom claim are highly suspect and its claim is overstated“; (3) that the settlement was premature because Smart World — absent meaningful discovery — had not been able adequately to evaluate the likely success of its claims against Juno; and (4) that the court should not approve a settlement of Smart World‘s claims by the creditors because Smart World was actively pursuing them. Finally, and most pertinent on appeal, Smart World challenged appellees’ “standing to pursue settlement over debtors’ objection.”
The bankruptcy court conducted a Rule 9019 hearing on August 19, 2003, at which, in substance, it dismissed all of Smart World‘s objections. The bankruptcy court
When Smart World attempted to argue the merits of its claims against Juno — for example, by trying to demonstrate the number of qualified subscribers Juno had obtained from Smart World and the ways in which Juno had breached the Term Sheet — the court again displayed its hostility to Smart World‘s position by refusing to hear Smart World. At one point, the court explicitly disallowed any argument as to the merits of Smart World‘s claims:
[COUNSEL FOR SMART WORLD]: Our position is to evaluate the merits of the claim —
THE COURT: You know what? That is what I warned your . . . colleague about. I don‘t need for you all to do that. Right now we‘re looking at the reasonableness of the settlement.
Having concluded that any discussion, and presumably meaningful evaluation, of the merits of Smart World‘s claims were unnecessary, the bankruptcy court announced its intention to approve the settlement. The bankruptcy court stated that it would allow Smart World to pursue its claims only upon a condition Smart World was unable to meet: the posting of a supersedeas bond securing the amount of the settlement for the estate.
V. Rulings Below
In September 2003, the bankruptcy court approved the Rule 9019 settlement. It found that the “Debtors’ estates are insolvent,” that Smart World‘s refusal to join in the settlement was “unreasonable in view of the risks, expense and delay that would be posed by further litigation of the Action, as well as in view of the insolvency of the Debtors’ estates,” that “[c]ontinuation of the Action would amount to equity gambling with the recovery that would otherwise go to the creditors,” and that the settlement was in the “best interests of the Debtors, their estates and their creditors and equity holders.” As to the creditors’ standing to pursue the settlement over Smart World‘s objection, the bankruptcy court found a legal basis in various provisions of the Bankruptcy Code giving creditors the right to intervene and endowing the bankruptcy court with equitable powers.
The district court affirmed. While recognizing that the creditors’ standing to pursue a Rule 9019 settlement over the objections of the debtor-in-possession raised an issue of first impression, the district court found that under
This appeal followed.
DISCUSSION
The primary issue before us raises a question of first impression, as both lower courts recognized. Did the bankruptcy
I. Rule 9019 and the Role of the Debtor-in-Possession
We begin with the language of Rule 9019, which authorizes only the trustee, or debtor-in-possession,10 to bring a motion for settlement: “On motion by the [debtor-in-possession] and after notice and a hearing, the court may approve a compromise or settlement.”
That the Rule vests authority to settle or compromise solely in the debtor-in-possession is hardly surprising in light of the numerous provisions in the Bankruptcy Code establishing the debtor‘s authority to manage the estate and its legal claims. For instance, when a chapter 11 case is filed, an automatic stay applies that enjoins all entities from, inter alia, engaging in “any act[s] . . . to exercise control over property of the estate.”
Rule 9019 is also consistent with the debtor-in-possession‘s role as legal representative of the bankruptcy estate, set forth in
Indeed, the Code not only authorizes the chapter 11 debtor to manage the estate‘s legal claims, but in fact requires the debtor to do so in a way that maximizes the estate‘s value. Under the Code, the debtor-in-possession is held “accountable for all property [of the estate] received.”
Similarly, the debtor‘s duty to wisely manage the estate‘s legal claims is implicit in the debtor‘s role as the estate‘s only fiduciary.12 See Wolf v. Weinstein, 372 U.S. 633, 649-50 (1963) (observing that debtor-in-possession has fiduciary duty to the estate). As fiduciary, the debtor bears the burden of “maximiz[ing] the value of the estate,” Commodity Futures Trading Comm‘n v. Weintraub, 471 U.S. 343, 352 (1985), including the value of any legal claims. Courts have thus concluded that in some instances, fiduciary duty requires the chapter 11 debtor to pursue a cause of action, see Louisiana World Exposition v. Fed. Ins. Co., 858 F.2d 233, 246 (5th Cir. 1988), but in other instances may require settlement, see In re Energy Coop., Inc., 886 F.2d 921, 927 (7th Cir. 1989).
In short, Rule 9019, which by its terms permits only the debtor-in-possession to move for settlement, is in complete harmony with the provisions of the Bankruptcy Code delineating the chapter 11 debtor‘s role. It is the debtor-in-possession who controls the estate‘s property, including its legal claims, and it is the debtor-in-possession who has the legal obligation to pursue claims or to settle them, based upon the best interests of the estate.
Despite the plain language of Rule 9019 and the clear policy of the Code, appellees nevertheless maintain that Rule 9019 need not be strictly followed. We agree with appellees that under certain circumstances, settlement of an estate‘s claim could be approved over the objections of a debtor-in-possession. For example, the Code provides that aggrieved creditors and other parties dissatisfied with a debtor-in-possession‘s conduct may seek appointment of a trustee or examiner under the Code, see
II. Derivative Standing
Appellees argue that their standing to bring a Rule 9019 motion was supported by the doctrine of derivative standing, which was first recognized by this court in Unsecured Creditors Comm. of Debtor STN Enters., Inc. v. Noyes (In re STN Enters.), 779 F.2d 901 (2d Cir. 1985) (”STN“). In that case, we held that although “no explicit authority for creditors’ committees to initiate adversary proceedings” exists in the Bankruptcy Code, creditors have an implied, qualified right to bring suit on behalf of the estate under
Until now, derivative standing has been sought only in cases where the debtor refuses to sue; here, we are faced with
As an initial matter, we note that derivative standing in the Rule 9019 context is not merely the mirror image of a typical derivative standing case, but is conceptually distinguishable. In our view, there is an important difference between pursuing an otherwise neglected claim and settling a claim that the estate is trying to pursue. The former usually involves a claim against the debtor‘s principals themselves, who refuse to litigate out of self interest. See, e.g., Cybergenics, 330 F.3d at 573; STN, 779 F.2d at 902. Derivative standing in such a case may be necessary to avoid the inherent conflict of interest that exists when those with the power to pursue a claim are those who may be the target of such a claim. In the Rule 9019 context, by contrast, it is the debtor and its principals who seek to pursue a claim on behalf of the estate, which is precisely the role of the debtor-in-possession envisioned by the Code. In such circumstances, we think it less likely that the debtor‘s principals will be motivated by reasons that conflict with the best interests of the estate. On the contrary, it is more likely that allowing creditors and other parties to bring Rule 9019 motions over a debtor‘s objection will encourage parties against whom the estate has a valid claim to delay and obstruct litigation, in the hopes that a creditor with a small interest in the estate will eventually propose a settlement disposing of the estate‘s valuable causes of action at a low price. The possibility of such perverse dynamics suggests that derivative standing will be appropriate much less frequently in the Rule 9019 context than in the usual case (i.e., where the would-be derivative plaintiff wishes to pursue a claim). We thus emphasize that a debtor-in-possession pursuing litigation is much less likely to be acting for reasons antithetical to the interests of the estate than a debtor-in-possession who refuses to sue its own principals; accordingly, a party who seeks to displace the debtor faces a heavier burden in the former case than in the latter.
That burden plainly was not satisfied here. Indeed, appellees’ showing was insufficient even under the usual standard for derivative standing. As we stated in STN, in a typical derivative standing case, “[t]he court‘s inquiries will involve in the first instance . . . a determination of probabilities of legal success and financial recovery in event of success.” STN, 779 F.2d at 905. While we noted that “the court need [not] undertake a mini-trial,” we nevertheless emphasized that the court “should assure itself that there is a sufficient likelihood of success to justify the anticipated delay and expense to the bankruptcy estate that the initiation and continuation of litigation will likely produce.” Id. at 906.16 Although both appellees and the lower courts were quick to characterize Smart
Indeed, having searched the record in vain for anything more than a conclusory statement from the bankruptcy court as to the merits of Smart World‘s claims against Juno, we find it difficult to understand how the lower courts could have formed such a firm opinion that Smart World‘s claims lacked viability. At the Rule 9019 hearing, for instance, Smart World‘s counsel stated “[w]e think Your Honor needs to make a record here, and make findings as to the range of reasonableness as to the settlement.”18 Counsel further offered to provide testimony as to “the factual circumstances underlying the various claims” and a “calculation based on [the witness‘s] knowledge of the potential value of the claims.” The bankruptcy court brushed the offer aside, stating “[t]here‘s no need for him to do that.” Even WorldCom‘s counsel pointed out to the bankruptcy court that it had not heard Smart World‘s explanation of its “theory of recoveries, claims and damages,” a fact that the court found untroubling. Indeed, at one point in the hearing, the court actually refused to listen to any argument on the merits:
[COUNSEL FOR SMART WORLD]: Our position is to evaluate the merits of the claim —
THE COURT: You know what? That is what I warned your . . . colleague about. I don‘t need for you all to do that. Right now we‘re looking at the reasonableness of the settlement.
The bankruptcy court‘s written decision similarly fails to seriously evaluate the merits of Smart World‘s claims. Nowhere in its decision does the bankruptcy court discuss Smart World‘s contentions (1) that Juno had prevented Smart World from identifying subscribers referred to Juno by Smart World, (2) that Juno had deliberately tried to get out of the sale transaction because it had received a better offer, and (3) that, based on Juno‘s concessions alone, Smart World was entitled to a minimum of $5 million.19 The bankruptcy court‘s assessment of Smart World‘s position is instead confined to a few sentences, stating cursorily (1) that Smart World‘s position
Other aspects of the proceedings below further persuade us that derivative standing was not appropriate. First, the bankruptcy judge from the beginning repeatedly and frankly expressed his strong preference for settlement over litigation, suggesting that his evaluation of Smart World‘s claims may have been colored by his own desire to “get this matter out of [his] hair” and to “eliminate the litigation.”
Second, the repeated stays and adjournments imposed by the court prevented Smart World from conducting any meaningful discovery. As detailed in the history recited above, discovery was stayed in October 2000, briefly recommenced in December 2000, terminated by Juno‘s lawyers in January 2001, and thereafter never resumed. The bankruptcy court was apparently under the impression that settlement was possible without discovery, but as Smart World‘s lawyers tried to point out at the first settlement hearing in February 2001, the case could not easily “settle . . . without discovery.” In the absence of a more fully developed record, we fail to see how the bankruptcy court, let alone Smart World, could have weighed the proposed settlement against the potential value of its claims.
Third, and of more serious consequence, the bankruptcy court seems to have ignored several signs that the interests of the settling parties were in conflict with those of the estate, thereby rendering creditor derivative standing inappropriate. Juno‘s interests plainly conflicted with those of the estate, since it presumably wanted to pay out as little as possible in settlement. WorldCom, the other main proponent of settlement, likewise had considerable incentive to swiftly end the bankruptcy proceedings. The challenge by other creditors to WorldCom‘s status as the only secured creditor was cause for it to want to quickly settle and thereby avoid having its share diluted by a full and possibly adverse determination of priority.20 WorldCom‘s counsel candidly admitted that WorldCom did not view the settlement as a fiduciary, that it was primarily concerned with getting money from Juno quickly,21 and that it had not evaluated the merits of Smart World‘s claims against Juno. It is also undisputed that Smart World was excluded from certain settlement negotiations between Juno and Smart World‘s creditors, who at one point referred to the settlement as a “confidential agreement.” In short, this case is a poster child for why the Code and Rule 9019 authorize only the debtor-in-possession to pursue or settle the estate‘s legal claims, and why the derivative-standing exception
Finally, we think it significant that Smart World‘s counsel was retained on a contingency basis. In derivative standing cases, courts often view favorably the willingness of the party seeking derivative standing to absorb the costs of litigation, since such willingness not only demonstrates a belief in the merits of the claim, but also spares the bankruptcy estate from absorbing any further costs. See STN, 779 F.2d at 906 (noting that under contingent fee arrangement, pursuit of litigation would not “impose a net burden on the bankruptcy estate“); see also Louisiana World Exposition, 858 F.2d at 248 n. 15 (noting that contingent fee arrangement indicated “a limited cost factor“); cf. In re Housecraft, 310 F.3d at 71 (observing that estate “incurred no risk of loss” by consenting to derivative standing of creditor because creditor agreed to “pay for all litigation expenses, regardless of whether the lawsuit was successful“). Here, Smart World‘s counsel was retained on a contingency basis, meaning that Smart World‘s pursuit of its adversary claims would have subjected the bankruptcy estate to no risk, while allowing the estate to reap any potential award. Where a debtor-in-possession seeks to litigate and its counsel has been retained on a contingency basis, it will be even more difficult for a party seeking derivative standing to demonstrate that the estate would be better off settling the claim.
Our decision today does not foreclose the possibility that in rare circumstances derivative standing might be appropriate in the Rule 9019 context. But we think that such circumstances will be rare, and we find that none are present in this case. Accordingly, we reject appellees’ claim that the doctrine of derivative standing entitled WorldCom and the Committee to settle Smart World‘s claims against Juno.
III. Section 1109(b)
Appellees also maintain that Smart World‘s creditors have standing to bring a Rule 9019 motion under
Where a conflict between a Rule and a statutory provision exists, of course, the Rules Enabling Act requires that we apply the statutory provision. But unfortunately for appellees, no such conflict exists between
The text of
First and foremost, the Supreme Court in Hartford Underwriters Ins. Co. v. Union Planters Bank, N.A., 530 U.S. 1 (2000) (”Hartford Underwriters“), construed
Our view of
Similarly, a distinction can be drawn between the right to intervene in an adversary proceeding, to which appellees are plainly entitled, and the right to take ownership of the debtor‘s claims in that adversary proceeding. The former does not equate to the latter. Intervenors’ claims are generally understood to be separate from those of the original parties to a proceeding. Cf. Local No. 93, Int‘l Ass‘n of Firefighters v. City of Cleveland, 478 U.S. 501, 528-29 (1986) (noting, in context of consent decree, that “[i]t has never been supposed that one party — whether an original party, a party that was joined later, or an intervenor — could preclude other parties from settling their own disputes and thereby withdrawing from litigation” (emphasis added)).
Two lower courts within this circuit have addressed precisely the question faced here: whether the unconditional
We agree with the reasoning of Adelphia and Sunbeam. If
Contrary to appellees’ contention, the Rules Enabling Act does not require us to ignore Rule 9019 in favor of
IV. Section 105
Finally, we turn to
The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title. No provision of this title providing for the raising of an issue by a party in interest shall be construed to preclude the court from, sua sponte, taking any action or making any determination necessary or appropriate to enforce or implement court orders or rules, or to prevent an abuse of process.
While there is some disagreement among the circuit courts as to how broadly to construe the bankruptcy court‘s
This Court has long recognized that Section 105(a) limits the bankruptcy court‘s equitable powers, which must and can only be exercised within the confines of the Bankruptcy Code. It does not authorize the bankruptcy courts to create substantive rights that are otherwise unavailable under applicable law, or constitute a roving commission to do equity.
The statutory language supports this limit on the equitable powers of the bankruptcy court. The equitable power conferred . . . by section 105(a) is the power to exercise equity in carrying out the provisions of the Bankruptcy Code, rather than to further the purposes of the Code generally, or otherwise to do the right thing. This language suggests that an exercise of section 105 power be tied to another Bankruptcy Code section and not merely to a general bankruptcy concept or objective.
New England Dairies, Inc. v. Dairy Mart Convenience Stores, Inc. (In re Dairy Mart Convenience Stores, Inc.), 351 F.3d 86, 91-92 (2d Cir. 2003) (internal quotation marks and citations omitted); see id. at 92 (finding
In light of our holding in Dairy Mart and the Supreme Court‘s pronouncement in Ahlers, we hold that the bankruptcy court‘s power to act pursuant to
In sum, we conclude that the bankruptcy court erred in granting standing to Smart World‘s creditors to settle Smart World‘s claims against Juno over Smart World‘s objections. Accordingly, we vacate the decision of the district court affirming the bankruptcy court‘s approval of the settlement and remand for further proceedings. Smart World‘s remaining objections to the settlement proceedings before the bankruptcy court are therefore moot.
CONCLUSION
For the foregoing reasons, the judgment of the district court is VACATED and the case is REMANDED for further proceedings consistent with this opinion.