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Partnership Equity Impairment Claims Belong to Estate

Authors: Francis J. Lawall and John L. Schweder II

9/09/2015
Partnership Equity Impairment Claims Belong to Estate

Reprinted with permission from the September 4, 2015 edition of The Legal Intelligencer. © 2015 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. (ALMReprints.com, 877.257.3382).

In many bankruptcy proceedings, one of the more significant (and sometimes only) assets left to satisfy creditor claims consists of causes of action by the debtor against third parties. These claims come in many varieties including fraudulent conveyance, breach of fiduciary duty and malpractice, as well as a host of others. The question of whether such claims can be asserted directly by creditors or are derivative—and thus can only be asserted by the debtor or its assignee—is often contentious. This distinction has obvious importance as it controls who will be the beneficiary of any recovery.

In the continuing saga of In re SemCrude, No. 14-1204, the U.S. Court of Appeals for the Third Circuit recently addressed the derivative claim issue in the context of harm alleged by certain limited partners arising out of the company's former president and CEO's breach of fiduciary duty, negligence, misrepresentation, and fraud. In reversing the lower court's denial of a motion to enjoin the state court proceedings, the Third Circuit found that such claims were not "in addition to" the losses sustained by the company, and thus were derivative rather than direct.

By way of brief background, Thomas L. Kivisto co-founded SemCrude in 2000 and served as its president and CEO until 2008. SemCrude provided transportation, storage, distribution, and other oil-and-gas services to crude oil producers and refiners across North America. By 2006, SemCrude held assets worth almost $14 billion. In 2008, SemCrude voluntarily commenced Chapter 11 proceedings. Kivisto blamed SemCrude's collapse on market factors, rising oil prices, and tight supply. The limited partners, however, alleged that Kivisto engaged in egregious self-dealing, related-party transactions, commingling personal and corporate funds, and making wildly speculative trades. The limited partners were not the first to make these allegations.

In 2009, SemCrude's litigation trust, which was formed as part of the debtor's confirmed Chapter 11 plan, commenced an adversary proceeding asserting 30 claims against Kivisto on behalf of the bankruptcy estate related to breach of fiduciary duty, breach of contract, fraudulent transfer, and unjust enrichment. Following mediation, the parties reached a $30 million settlement and executed mutual releases of all claims. The U.S. Bankruptcy Court for the District of Delaware approved the settlement in 2010.

One month later, the limited partners filed their state court action in Oklahoma, alleging that their injuries were separate and distinct from the harm suffered by SemCrude. Specifically, they alleged that Kivisto made misrepresentations to the limited partners at formal and informal meetings that induced them to invest millions of dollars in SemCrude. The limited partners identified a specific 2006 country club luncheon where Kivisto was alleged to have made several statements clearly intended to induce them to make these capital contributions. The limited partners sought to distinguish themselves from the litigation trust by alleging that they, unlike other limited partners, were not "insiders," and that Kivisto made representations directly to them and no one else. Accordingly, the limited partners argued that they had been separately harmed.

Kivisto quickly moved to enjoin the state court action, which the bankruptcy court granted. On appeal, the U.S. District Court for the District of Delaware reversed, ruling that the bankruptcy court did not properly consider the limited partners' claims that they had been separately harmed, and finding that there was a sufficient basis to make that determination. On remand, the bankruptcy court denied the motion to enjoin. On direct appeal, the Third Circuit reversed the bankruptcy court's order, ruling that the limited partners' claims were in fact derivative and barred by the litigation trust's settlement and release.

The Third Circuit recognized that "'the derivative injury rule holds that a shareholder ... may not sue for personal injuries that result directly from injuries to the corporation,'" citing In re Kaplan, 143 (F.3d 807, 811-12 (3d Cir. 1998). Under applicable Oklahoma law, however, the derivative injury rule "does not apply when a shareholder alleges that he or she 'sustained a loss in addition to the loss sustained by the corporation,'" citing Dobry v. Yukon Electric, 290 P.2d 135, 138 (Okla. 1955). The court further noted that "where the alleged loss stems from management's wrong to the corporation that incidentally affects the shareholder's stock and affects all shareholders alike, the rights are derivative." If a plaintiff suffers no loss in addition to the losses sustained by the corporation, the action cannot be maintained as a direct claim even if the wrongful acts were done with the specific intent of injuring certain individuals. Finding that these principles extended to limited partnerships, the Third Circuit determined that the limited partners' claims were "masked claims for a diminution in value of their limited partnership units as a result of Kivisto's management." The injury alleged resulted from the exact same wrongful conduct asserted by the litigation trust. Try as they may to distinguish themselves, the Third Circuit ultimately found that the limited partners' losses only differed in amount, not in kind.

In furtherance of its analysis, the court noted that even if the limited partners had been uniquely harmed, they still could not bring direct claims because they had no right to recover the losses they asserted. Specifically, any recovery would be considered equity in SemCrude's estate, which belonged to the litigation trust: "SemCrude, not the [limited partners], had the right to pursue an action to recover from Kivisto's fraudulent conduct toward SemCrude and its equity holders collectively. SemCrude, not the [limited partners] in their individual capacities, was defrauded by Kivisto's misrepresentations and omissions and injured by his alleged misconduct." Stated simply, the misconduct alleged by the limited partners did not injure them directly, but instead injured them indirectly only as a result of their ownership interest in SemCrude.

The Third Circuit's opinion in SemCrude provides helpful guidance to litigators trying to distinguish derivative and direct claims. The issue persists in both bankruptcy cases and general commercial litigation. Limited partners and shareholders often file state court actions asserting claims that do not belong to them individually, but rather, they allege conduct, which if proven, caused harm to the partnership or corporation and the equity holders collectively. The harm claimed to be separate and distinct from, or "in addition to," the harm to the partnership or corporation is often mischaracterized and overstated. Litigators must be vigilant in challenging claims asserted as direct claims when in fact they are derivative because the difference significantly impacts all phases of the litigation, from agreeing to settle or apportioning a judgment. Failing to challenge improperly asserted direct claims could actually prolong litigation and increase costs. The key questions to ask, as derived from SemCrude, should include at a minimum: (1) does the alleged loss stem from conduct that affects the company and individuals alike; (2) does the claimant have a right to recover the losses it asserts; and (3) is the claimant's injury an indirect result of owning an interest in the partnership or corporation. The answers to these questions could help guide a litigation strategy for seeking dismissal of improperly alleged derivative claims, or enjoining an improperly filed state court action.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

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