Stanwich Clarifies Wagoner Rule In Fraudulent Transfer Cases

In the Second U.S. Circuit, the so-called Wagoner rule deprives a trustee of standing to sue third parties, such as lawyers and investment bankers, if the bankrupt corporation participated with them in defrauding creditors. A recent decision from Connecticut clarifies the limitation of the Wagoner rule when a trustee asserts fraudulent transfer claims.

The case involved Settlement Services Treasury Assignments Inc. (SSTAI), which was sold in 1997 in a leveraged buyout (LBO). However, according to allegations in a lawsuit that followed, the deal rendered the company insolvent and unable to pay its debts, and the company's management had allegedly misappropriated corporate funds and improperly amended key corporate documents. SSTAI spiraled downward and, in 2001, filed for Chapter 11 in Connecticut. The debtor confirmed a plan in 2004, and a liquidating agent was appointed.

In 2002, the unsecured creditors' committee in the case had sued the company's principals and professionals to recover fraudulent transfers made in connection with the LBO. The liquidating agent later succeeded the committee as plaintiff in the action.

Early in the case, the Bankruptcy Court had ruled that the plaintiff lacked standing to assert certain claims because management had participated in the fraud. But earlier this year—13 years after the case began—an appellate judge reversed that decision and held that the plaintiff does have standing to assert fraud-related claims that had been dismissed.

At the heart of the case have been basic concepts of standing that apply when management of a company in bankruptcy has engaged in fraudulent conduct. "Whether a claimant has standing is the threshold question in every federal case, determining the power of the court to entertain the suit." Leasing by Paolo v. Sinatra (In re Cucci), 126 F.3d 380, 387- 88 (2d. Cir. 1997) (quoting Warth v, Seldin, 422 U.S. 490, 498 (1975)).

The doctrine of standing stems from the U.S. Constitution's requirement that federal courts only decide cases or controversies. U.S. Const. art. III, sec. 2., cl. 1. "A plaintiff must allege a personal injury fairly traceable to the defendant's allegedly unlawful conduct and likely to be redressed by the requested relief." Allen v. Wright, 468 U.S. 737, 751 (1984). The U.S. Supreme Court has held that "[a] plaintiff must always have suffered a 'distinct and palpable injury to himself' . . . ." Gladstone Realtors v. Village of Bellwood, 441 U.S. 91, 100 (1979) (quoting Warth v. Seldin, 422 U.S. at 501). In addition, the injury cannot be "abstract," "conjectural," or "hypothetical." City of Los Angeles v. Lyons, 461 U.S. 95, 101-02 (1983). See Ass'n of Data Processing Serv. Orgs. v. Camp, 397 U.S. 464, 472 (1982).

Significantly, the "'case or controversy'...