May 20, 2014

Bankruptcy Court Shields Equity Sponsors Serving as Secured Lenders from Individual Creditor Seeking to Litigate Subordination and Recharacterization Claims Released by the Debtor

In a recent case — In re Optim Energy, LLC — the Delaware Bankruptcy Court denied an individual creditor’s request to pursue the subordination or recharacterization of the claims of secured lenders who were also the debtors’ equity sponsors. The court also denied the creditor’s attempt to pursue claims for alleged breaches of fiduciary duty. In its decision, the court reaffirmed the high bar for individual creditors seeking to pursue claims against other parties on behalf of a bankruptcy debtor’s estate as opposed to a debtor or an official committee of creditors. The decision further reassures sponsors who provide credit before and after bankruptcy to their portfolio companies that bankruptcy courts will not easily allow individual creditors to attack the protections granted to the sponsors as lenders if the sponsor loans are made with proper documentation and the sponsor has not acted inequitably for its own gain.

In the chapter 11 cases of Optim Energy, LLC and its affiliated debtors (the “Debtors”), on May 13, 2014, Judge Brendan Shannon of the Bankruptcy Court for the District of Delaware denied a creditor’s request for leave to pursue litigation claims on behalf of the estate against secured lenders that were also the Debtors’ direct and indirect owners.[1] 

These claims sought to recharacterize as equity or equitably subordinate the sponsors’ secured debt and sought damages for alleged breaches of fiduciary duty (collectively, the “Claims”). Rejecting this request, the court found that the moving creditor failed to assert a viable cause of action for each of the Claims, even assuming the alleged facts were true. In doing so, Judge Shannon reaffirmed that there is a high bar for creditors seeking to derivatively pursue claims on behalf of a bankruptcy debtor’s estate.


At the outset of the Optim Energy case, the Debtors’ direct and indirect non-debtor equityholders – ECJV Holdings, LLC (“ECJV”) and Cascade Investments, L.L.C. (“Cascade”) – provided the Debtors with debtor-in-possession (“DIP”) financing. Cascade and ECJV also held pre-petition debt secured by first priority liens on substantially all of the Debtors’ assets. The order approving the DIP financing provided for a release and waiver by the Debtors of all claims against Cascade and ECJV, however, it also preserved the rights of “a party in interest with requisite standing other than the Debtors or an appointed committee” to sue Cascade and ECJV. The largest unsecured creditor – Walnut Creek Mining Company (“Walnut Creek”) – sought leave of the bankruptcy court for derivate standing to pursue the Claims on behalf of the Debtors’ bankruptcy estates.

Derivative Standing Denied

In considering Walnut Creek’s request, the court applied the Third Circuit test for creditors obtaining derivative standing to pursue estate claims set forth in the Cybergenics case, which requires the creditor to demonstrate:  “(i) the [DIP] has unjustifiably refused to pursue the claim or refused to consent to the moving party's pursuit of the claim on behalf of the [DIP]; (ii) the moving party has alleged colorable claims; and (iii) the moving party has received leave to sue from the bankruptcy court.”[2]  

With respect to the second requirement – whether a colorable claim has been asserted – the court applied the pleading standard applicable to a motion to dismiss. That standard requires that the allegations contain “sufficient factual matter, accepted as true, to ‘state a claim to relief that is plausible on its face’” and that “[t]hreadbare recitals of the elements of a cause of action, supported by mere conclusory statements, do not suffice.” As to each of the Claims – breach of fiduciary duty, recharacterization, and equitable subordination – the court held that that Walnut Creek did not sufficiently plead a colorable claim.

Breach of Fiduciary Duty Waived in the Governing LLC Agreement

The court easily concluded that no claim for relief was plausibly stated with respect to breaches of fiduciary duties because the Debtors’ operating agreements included an explicit waiver of any fiduciary duty owed by any member or manager of the Debtors. Because such waivers are permissible and enforceable under Delaware law governing LLCs, the court held that these claims were not colorable.

Hallmarks of Recharacterization Not Present

Next the court addressed Walnut Creek’s claims that the pre-bankruptcy secured debt owed to Cascade and ECJV should be recharacterized as an equity investment. The loan that was the target of Walnut Creek’s recharacterization (and equitable subordination) claims arose from a series of transactions in 2007 that included, among other things, the Debtors’ acquisitions of certain assets financed by Wells Fargo. Cascade and ECJV guaranteed the Debtors’ obligations to Wells Fargo pursuant to a Guaranty Agreement and subordinated their guaranty claims to the Debtors’ obligations to Wells Fargo.

The Debtors agreed to reimburse Cascade and ECJV for amounts paid under the Guaranty Agreement pursuant to a Reimbursement Agreement and secured their obligations by granting Cascade and ECJV security interests in substantially all of their assets. On the eve of the bankruptcy, Cascade and ECJV caused the Debtors to repay the outstanding obligations to Wells Fargo. As a result, the Debtors’ obligations under the Reimbursement Agreement matured and Cascade and ECJV held secured claims against the Debtors at the outset of the case.

In support of its recharacterization claim, Walnut Creek alleged that: (i) the Debtors were inadequately capitalized at the time of these transactions; (ii) no prudent lender would have entered into the Guaranty Agreement; (iii) no debt was owed at the time the Debtors granted Cascade and ECJV security interests; (iv) Cascade and ECJV waived fees due under the Reimbursement Agreement on at least one occasion; (v) the Debtors’ obligations to Cascade and ECJV were subordinated to the Debtors’ obligations to Wells Fargo; and (vi) Cascade and ECJV made certain capital contributions to the Debtors for the purpose of paying down the Wells Fargo debt. The court rejected each of these arguments as supporting a claim for recharacterization.

First, the court found that the age of the transactions, the absence of any allegation that the Debtors could not pay operating costs during the seven years prior to the chapter 11 filings, the financing provided by Wells Fargo in 2007, and the absence of expanded equity rights being granted to Cascade and ECJV in connection with the Transactions, all contradicted the allegation of inadequate capitalization.

Concluding that the Debtors were not inadequately capitalized, the court found unpersuasive the argument that no third-party lender would have provided a guaranty of the Wells Fargo loans. In addition, the court rejected the argument that a guaranty provided by an insider is per se evidence of undercapitalization. As with the Guaranty Agreement, the court found nothing unusual about security interests being granted to secure the obligations owed under the Reimbursement Agreement.

Similarly, the court rejected the argument that waiving fees and entering into a forbearance agreement are indicia of an equity relationship. Rather, the court reasoned: “[i]n the case of a pre-existing lender, it is legitimate for the lender to take actions to protect its existing loans, including extending additional credit or granting forbearance.”  As the debt to Cascade and ECJV was subordinated only to the debt owed to Wells Fargo – and not all of the Debtors’ obligations – and subordination of guarantor claims is customary, the court found that the mere subordination of the Cascade and ECJV debt did not support recharacterization.

Lastly, as the equity contributions made by Cascade and ECJV were unrelated to the subject transactions, in the court’s view the mere fact of such contributions also did not support the recharacterization claim.

Notably, while the court recognized the dual role of Cascade and ECJV as equity and debt holders, Judge Shannon concluded: “the transactions described above clearly demonstrate that the parties were able to clearly identify and document debt versus equity arrangements.”

No Grounds for Subordination of Insiders’ Claims

In considering Walnut Creek’s allegations that the claims of Cascade and ECJV should be equitably subordinated to other creditors’ claims due to their inequitable conduct, the court applied heightened scrutiny because Cascade and ECJV were insiders of the Debtors.

Notwithstanding this more exacting standard, the court found no support for an equitable subordination claim because, even accepting Walnut Creek’s allegations as true, the requisite “inequitable conduct” on the part of Cascade and ECJV was not plausibly pled. Rather, “[i]t [was] merely alleged that Cascade and ECJV performed under their guarantees on the Wells Fargo Credit Facility, guarantees that had been in existence for almost seven years.”

Author’s Comments

Judge Shannon’s decision highlights  the importance of sufficiently pleading  the estate causes of action when creditors seek standing to sue third parties on behalf of a bankruptcy debtor’s estate. . To do so could require costly and time consuming discovery, which may or may not be possible during the time available under a DIP financing order.

Accordingly, while debtor waivers and creditor challenge rights are commonplace in DIP financing orders, the precise language used to document the nature and scope of the creditor challenge rights may certainly impact creditors in asserting such challenges. Parties in interest affected by such provisions in DIP financing orders should carefully review such language to determine, not only the scope of any liability releases to be challenged and the time period required to assert such challenges, but also what is procedurally required to assert a challenge and what is substantively required to survive a motion to dismiss.

The decision is also instructive in that it affirms the efficacy in the chapter 11 context of Delaware law regarding the waiver of fiduciary duties in an LLC operating agreement. Yet, as was the true in the Optim Energy case, such a waiver can have a material adverse impact on third parties who did not have an opportunity to challenge or negotiate the waiver when it was documented. Judge Shannon was not called upon to address whether in the context of refusing creditor standing to pursue estate claims such a fiduciary duty waiver should (or should not be) enforceable as a matter of public policy. It is an open question whether another court would rule differently on this point if presented with a different set of facts.

The part of the decision that may bring comfort to equity sponsors is the court’s analysis of the recharacterization and equitable subordination claims. The court affirmed that mere insider status or holding both debt and equity are insufficient to support claims for recharacterization and equitable subordination.

The court also affirmed that actions taken in accordance with contractual rights are insufficient to support these claims, even if such actions adversely impact a debtor and its unsecured creditors. To the extent courts follow Optim Energy, it will be very difficult for a party in interest to obtain derivative standing to pursue estate causes of action unless that party can plead substantial facts to support the elements of the claims; mere recitation of the elements of the cause of action or conclusions will not suffice.

Wasting no time, Walnut Creek filed an appeal the day after Judge Shannon issued his opinion. It will be interesting to see if the district court shares Judge Shannon’s views that the alleged facts do not support colorable claims for breach of fiduciary duty, recharacterization, or equitable subordination.



[1] In re Optim Energy, LLC, No. 14-10262 (BLS), 2014 Bankr. LEXIS 2155 (Bankr. D. Del. May 13, 2014).

[2] Official Committee of Unsecured Creditors of Cybergenics Corp. ex rel. Cybergenics Corp. v. Chinery, 330 F.3d 548 (3d Cir. 2003).