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August 14, 2018 in 75-1.1 Exemptions by

When do Creditors of a Bankrupt Corporation Lack Standing to Bring an Unfair and Deceptive Trade Practice Claim?

Lawsuits and collection actions against a corporation are automatically stayed when the corporation files for bankruptcy, generally speaking. In order to avoid the automatic stay, creditors may bring claims against the directors and/or officers of the bankrupt corporation rather than against the corporation itself.

Depending on the nature of the claim, however, individual creditors may lack standing to sue the officers and directors of a bankrupt corporation. Certain claims may instead belong to the trustee appointed to oversee the disposition of the assets and liabilities of the bankrupt company.

In Associated Hardwoods, Inc. v. Lail, the North Carolina Business Court ruled that, at least in some circumstances, individual creditors lack standing to bring a claim under N.C. Gen. Stat. § 75-1.1 that is premised on the alleged wrongdoing of the officers and directors of a bankrupt corporation.

An allegedly wrongful asset sale

Over the span of many years, Associated Hardwoods supplied lumber to Quaker Furniture Company.  Associated Hardwoods permitted Quaker to pay for orders after delivery and otherwise did not demand security to fill Quaker’s orders.

In 2016, Quaker became unable to pay its bills. Allegedly without informing Associated Hardwoods about its financial difficulties, Quaker continued to place orders with Associated Hardwoods, even after Quaker became insolvent. Associated Hardwoods claimed that Quaker failed to pay for over $100,000.00 in lumber orders.

Quaker sold its assets to another company, McNeil & Partners.  Associated Hardwoods alleged that Quaker had net assets worth in excess of $1 million at the time of the sale.  Associated Hardwoods also alleged that those assets could have been liquidated and that the proceeds could have gone to pay Associated Hardwoods and other unsecured creditors.

Instead, the officers and directors of Quaker sold Quaker’s assets for allegedly less than fair value. The sale of Quaker’s assets allegedly yielded no proceeds that could be distributed to Associated Hardwoods.

Associated Hardwoods sues the directors and officers of Quaker

After the asset sale, Quaker filed for bankruptcy. Initially, Quaker sought to reorganize in a chapter 11 proceeding. Eventually, Quaker’s bankruptcy was converted to a chapter 7 liquidation proceeding and a bankruptcy trustee was appointed to wind up Quaker’s business.

Quaker’s bankruptcy proceeding stayed any state court proceeding to collect against Quaker directly. Instead of suing Quaker, Associated Hardwoods sued the officers and directors of Quaker.

Associated Hardwoods brought claims for breach of fiduciary duty, constructive fraud, and violation of section 75-1.1 against Quaker’s former directors and officers. Associated Hardwoods alleged that the directors and officers owed a duty to Associated Hardwoods. Quaker’s directors and officers allegedly breached that duty when they approved the asset sale to McNeil for a price that did not provide for a dividend to unsecured creditors.

Associated Hardwoods brought its lawsuit in North Carolina Superior Court, and the case made its way to the Business Court. In the Business Court, the officers and directors moved to dismiss all the claims against them.  The primary argument of the officers and directors was that Associated Hardwoods lacked standing to sue because the claims that Associated Hardwoods asserted against them belonged to the bankruptcy trustee.

The Business Court agreed that Associated Hardwoods lacked standing. The Court dismissed all of the claims against the officers and directors, including the 75-1.1 claim.

Associated Hardwoods lacks standing to pursue its 75-1.1 and related claims

In dismissing the claims against the officers and directors, the Business Court indicated that whether Associated Hardwoods had standing depended on if the claims became property of Quaker’s bankruptcy estate when Quaker filed for bankruptcy.

When a corporation files for bankruptcy, claims that belong to the bankrupt corporation usually become property of the estate. The corporation’s claims can only be prosecuted by the bankruptcy trustee, by and large. A claim that is personal to a creditor, however, does not become property of the bankruptcy estate. Whether a claim is personal to the creditor or belongs to the corporation depends on state law.

The Court recognized that constructive fraud and breach of fiduciary duty claims under North Carolina law generally belong to the corporation rather than any particular creditor. A recognized exception exists, however, for causes of action “founded on injuries peculiar or personal to an individual creditor.”

Associated Hardwoods argued that the injuries caused by Quaker’s alleged breach of fiduciary duty injuries were particular to Associated Hardwoods because it was the only lumber supplier to Quaker. The Court disagreed that the breach of Associated Hardwoods’ supply agreement sufficiently created an injury unique to Associated Hardwoods.

The Business Court cited the claims history in the bankruptcy itself and noted that several unsecured creditors besides Associated Hardwoods had filed proofs of claim in Quaker’s bankruptcy. The Court determined that the alleged injury was not unique to Associated Hardwoods. As a result, the breach of fiduciary duty and constructive fraud claims belonged to the bankruptcy trustee to prosecute on behalf of all of the creditors of the bankruptcy estate.

With respect to the 75-1.1 claim, the Court ruled that Associated Hardwoods also lacked standing because the claim was based on the same factual predicate as the breach of fiduciary duty and constructive fraud claim.

Creditor standing: a potential trap for the unwary

The standing defense that the directors and officers successfully asserted to defeat the 75-1.1 claim is not self-apparent. The defense’s validity requires a fact-specific assessment of the claims and potential claims involved in the corporation’s bankruptcy. When evaluating 75-1.1 claims that implicate bankrupt entities, analysis by competent bankruptcy counsel is essential, even if the bankrupt entity is not directly a party to the claim itself.

Author: George Sanderson