A lawsuit filed by a trustee within a bankruptcy is called an adversary proceeding. Bankruptcy trustees have broad power to file and prosecute adversary proceedings. A few bankruptcy trustees have used that broad power to file suits without doing due diligence to determine if the suits were proper, preferring instead to confine their analysis to how much money is potentially available from a deep pocket. However, the courts and Congress have taken aim at overly aggressive litigation brought by bankruptcy trustees.
By way of brief background, an adversary proceeding is an action brought by a bankruptcy trustee. It’s essentially a civil lawsuit within the bankruptcy. Adversary proceedings can seek redress under many theories. For example, a trustee may seek to recover preferential transfers or to void fraudulent conveyances. A preference is a payment that is received by a creditor of the bankrupt within 90 days (and in some cases up to a year) of the bankrupt debtor filing its bankruptcy. There are many defenses available to parties sued in a preference complaint – some create an absolute defense and some just mitigate the consequences. A fraudulent conveyance is a transfer of property by the debtor to a party that occurred within 2-4 years of the bankruptcy filing. There are also several defenses available to a party named in a fraudulent transfer complaint.
A party being sued by a bankruptcy trustee will find themselves in unfamiliar territory because most businesses do not litigate in bankruptcy court. As such, it sets up an element of unfairness because bankruptcy court is where a bankruptcy trustee earns a living. Trustees know the system, the rules, the lawyers, and they also know that they are provided considerable latitude since they are supposed to be acting for the benefit of all creditors.
Recently, however, a trustee’s discretion and power has been questioned. Checks are being put into place to curb certain abusive litigation tactics that have devolved in the context of a trustee bringing overly aggressive adversary proceedings.
Most notably, the Seventh Circuit Court of Appeals, which is the federal appellate court for the states of Illinois, Wisconsin and Indiana, invited sanctions motions to be filed against a bankruptcy trustee personally because the trustee filed a lawsuit against a deep pocket defendant on an overly aggressive theory of liability and optimistic theory of damages. The 7th Circuit implied that a bankruptcy trustee’s litigation judgment takes a scorched earth approach to litigation because it does not concern itself with maintaining relationships with vendors, customers, creditors or commercial trade in general. In short, it intimated, that a bankruptcy trustee’s judgment is not colored by the temperance that other litigants impose upon themselves. Therefore, the court stated that “[j]udges must be vigilant in policing the litigation judgment exercised by trustees in bankruptcy, and in an appropriate case must give consideration to imposing sanctions for the filing of a frivolous suit.”
In addition, Congress passed, and the President signed into law, the Small Business Reorganization Act, which takes effect in February of 2020. The Act does several things to reform bankruptcies for small businesses. But in the context of preference actions, it also now requires a bankruptcy trustee to take into consideration a party’s statutory defenses to such claims. Prior to this act, the bankruptcy trustee could simply look at the debtor’s accounts payable, draw a line 90 days from the filing of the bankruptcy case, and sue everyone who received a payment within that 90-day window. It was a fundamental flaw that saw many defendants scrambling to settle, retaining lawyers, and incurring substantial costs to defend themselves from lawsuits for which they may have had valid defenses.
In summary, bankruptcy trustees are not above the law. The courts and Congress have recently gone to great lengths to curb overly aggressive litigation brought by bankruptcy trustees, to make them more responsible and accountable when bringing such actions. If your company has been the target of an adversary proceeding that crosses the line, you may want to consider reviewing this issue more closely.
This document is intended for informational purposes only and is not legal advice or a substitute for consultation with a licensed legal professional in a particular case or circumstance.