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Third Circuit – Debtor Lacks Derivative Standing to Pursue Avoidance Claims When There is no Abuse of Discretion by a Trustee

October 2, 2017, PennsylvaniaDebtor-Appellant Linda Merritt filed for Chapter 13 bankruptcy after defending a series of lawsuits by a former business partner, Appellee R&R Capital LLC. During the bankruptcy proceedings, the Debtor proposed to the Trustee several adversary actions intended to avoid certain transfers of assets to R&R and Appellee Cheshire Land Preservation Trust under Sec. 548 of the bankruptcy code. The Trustee decided not to pursue those actions, but the Debtor went ahead and filed two adversary actions on her behalf. The Debtor also compelled the Trustee to substitute, join, or ratify her complaints. The Trustee refused, and the bankruptcy court declined to compel the Trustee. R&R and Cheshire filed motions to dismiss the respective adversary actions filed by the Debtor.

The bankruptcy court dismissed both actions, declining to grant the Debtor derivative standing to pursue the claims and alternatively held that the Debtor had failed to state an avoidance claim. On review, the District Court affirmed. The Third Circuit also affirmed, holding that the Trustee’s decision of not pursuing those actions was not a result of failure to carry out its duties. The Court highlighted that derivative standing is a prudent way for bankruptcy courts to remedy lapses in a trustee’s execution of its fiduciary duty. In the case at bar, there was no such situation. The Trustee had declined to pursue under §548 in light of the Debtor’s unexplained delay in sending the draft complaints to the Trustee for review when the statute of limitations was about to expire, and because the Trustee reasonably believed the avoidance complaints would be unsuccessful. So, the Third Circuit held that the Trustee declined to pursue avoidance actions under §548 owing to justified reasons and did not fail to carry out its duties to initiate an avoidance action directly. Accordingly, the Court concluded that the Debtor was not inappropriately denied derivative standing to pursue her avoidance claims, and dismissal was proper under Federal Rule of Civil Procedure 12(b)(1).

(Merritt v. Cheshire Land Preservation Trust (In re Merritt) (3d Cir. Oct. 2, 2017, Nos. 16-1865, 16-1866) 2017 U.S. App. LEXIS 18953.)