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Pre-petition disputed litigation against bankrupt companies

By Matthew Dundon
Posted: 3rd May 2018 09:53
Debtors regularly enter bankruptcy facing litigation which was already pending.[1] Aggressive management of pre-petition litigation can generate value for plaintiffs which is significant in absolute terms, even if sometimes modest in relation to what might have been hoped to be gained had the litigation not been interrupted by bankruptcy.
While retaining their original characteristics as lawsuits, these cases immediately take on the additional character of distressed asset claims from the perspective of both plaintiffs and their counsel, and defendants and their advisors. These new aspects are both substantive – most notably, that any settlement or judgment will be subject to compromise based upon the claims’ priority of payment under the Bankruptcy Code – and procedural, i.e., with the “automatic stay” on pre-petition proceedings, the Bankruptcy Court assumes jurisdiction over the litigation and often never hands it back, with a number of critical shifts in when and how the litigation would be adjudicated.
These litigation assets fall naturally into several categories which impact their treatment, and the strategy of legal and financial advisers concerning them:
  • Enforcement litigation relating to undisputed capital structure or contractual obligations the default of which was the proximate cause of the bankruptcy.
  • Ordinary-course litigation, including that relating to disputed business obligations: any debtor can have such litigation, and every debtor over a certain size inevitably will have some of it.
  • Litigation which was so large that the costs of defense and/or the risk of damage awards was a motivating factor in commencing the bankruptcy.
The remainder of this article focuses on the second and third categories. With respect to the first category, whether through subordination under 510(b) of the US Bankruptcy Code or through the general unwillingness of Bankruptcy Courts to award damages or costs which exceed the narrowly-construed economic value of claims, litigation causes of action relating to undisputed pre-petition obligations or interests rarely provide incremental value on top of the bankruptcy value of the obligation or interest itself.
Important considerations for litigation which retains value in bankruptcy that a savvy defendant will consider (and upon which it should consider obtaining qualified bankruptcy counsel and financial and strategic advisory services) include:
  • The potential rankings of the claim under the Bankruptcy Code, in particularly the availability of administrative expense treatment or priority treatment.
  • Seeking membership on the (highly influential) Official Committee of Unsecured Creditors, and/or membership on “ad hoc” bankruptcy groups with creditors with overlapping interests.
  • In the case of class or collective actions, complying with the additional, and difficult, requirements for the assertion of “class proofs of claim” under the bankruptcy rules.
  • Preservation of and access to insurance proceeds.
  • The economics of the bankruptcy case to the extent that they dictate the value of claims at any particular level of ranking – and the ability to use the costs and other burdens of litigation in a bankruptcy process to negotiate a more favorable recovery.
  • The specific provisions proposed by the debtors for the resolution of disputed claims, and the potential to use those provisions to get a far quicker disposition of the underlying litigation – bankruptcy courts can and do act far faster than trial courts.
Rankings:Pre-petition litigation claims will be generally be “general unsecured claims” to the extent they are allowed. Claims of government agencies, such as environmental remediation, can take higher ranking. Class action claims for workplace violations can have priority under Section 507(a)(4) of the Bankruptcy Code for unpaid wages in the six months before the petition date (including WARN Act liability to the extent established), and have even higher ranking (“administrative expense” status) for violations which continued after the petition date.
Committee Membership:Within the first weeks of a case, the US Justice Department though its regional “US Trustee” office will appoint between two to nine member “Official Committee of Unsecured Creditors” which formally represents all unsecured creditors, and which (at debtor expense) hires lawyers and financial advisers, and takes on a leading role in the case thereafter. Disputed litigation plaintiffs are eligible to apply, and not infrequently receive, seats – for example, Dundon Advisers’ litigation claimants have been appointed to seven such Committees in the past two years, for example, as have others. A large variety of “ad hoc” committees can also be formed in which litigation plaintiffs can opportunistically participate for common benefit, although contribution to such committees’ fees and expenses will usually be expected.
Class Standing:Bankruptcy Rule 7023 places the making of class claims in bankruptcy in the discretion of the Court – a higher standard than applies under Federal Rule of Civil Procedure Rule 23 and analogous state rules. A number of strategies for varying certified and purported class situations can be applied to mitigate this procedural disadvantage.
Insurance:The bankruptcy process permits debtors to isolate liabilities for which insurance coverage is available, and provide pre-petition litigation claimants the ability to be paid more than there otherwise-applicable recovery rate to the extent of the insurance coverage.
Economics:This is where there is a strong overlap between disputed litigation assets and other distressed assets, and involves a careful valuation of the enterprise, assessment of the existing capital structure and ranking of its components, and the availability of new financing and asset acquisition proceeds to fund recoveries.
Claims Resolution:The bankruptcy process has several strong incentives for resolution of consequential disputed claims, including retiring all pre-petition risks (“cleaning up” the balance sheet), finalising distribution percentages, and avoiding the significant expense of continued litigation. Virtually all litigation claimants will have an opportunity for an accelerated settlement opportunity and quick (bankruptcy) court approval of the settlement – typically with no requirement that the pre-petition trial court review or approve the settlement. In the absence of a settlement, the bankruptcy court will usually adjudicate the dispute during or shortly after the main bankruptcy case, in the latter case with a “reserve” for the portion of the distribution that would be awarded if the claim is adjudicated favorably to the plaintiff.
Matthew Dundon is a principal of Dundon Advisers LLC, an SEC-registered investment adviser established in early 2016 which specialises in distressed assets (including pre-petition litigation), non-bankruptcy litigation finance and investing, and disposition / successor management of esoteric or illiquid credit and credit-related assets. He was a portfolio manager for Pine River Capital and Advent Capital from 2010 to 2016, and a senior analyst and head of securities research at Miller Tabak Roberts Securities from 2003 to 2010. He began his career as a securities and leveraged finance attorney. He holds a JD from the University of Chicago and a BA from the University of California at Berkeley.
Matthew can be contacted on 

[1]Lawsuits which were reduced to judgments or settlements not yet paid as of the bankruptcy petition date present a very interesting, and somewhat overlapping, set of issues for consideration, but lie outside the scope of this brief article.

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