History: In a June 14, 2017, bankruptcy blog titled “Six Degrees of Separation: Use of Bankruptcy Rule 2004 Examination in Connection with Third-Party Litigation“, we reported on what appeared to be a case of first impression that arose in a case pending before United States Bankruptcy Judge Stuart Bernstein in the United States Bankruptcy Court for the Southern District of New York. In the Chapter 11 case of In Re: Sun Edison Inc., et al., 16-109292(SMB), a dispute had arisen as to whether a debtor (“Sun Edison” or “Debtors”) and a related but non- debtor entity, TerraForm LLC (“TERP”) were entitled to Bankruptcy Rule 2004 discovery with respect to a pending state court litigation between TERP and a non-debtor third party plaintiff (“Plaintiff”). The Debtors and TERP argued that the outcome of that litigation may have an effect on the value of a significant asset of the bankruptcy estate of the Debtors, being the Debtors’ equity interests in TERP. In that earlier blog we noted that the Court at oral argument had stated: “You know, every piece of information and fact out there is within six degrees of separation of a Debtors’ assets and financial affairs. The question is where do you draw the line?” 4/2017 Transcript of Hearing, In Re: Sun Edison Inc., et al., Case No. 16-10992-SMB, page 30, lines 6-11.
The Decision: As of the date of our earlier blog, the question posed by the Court remained unanswered. On June 16, 2017, however, the Court ruled in its fairly lengthy 16 page “Memorandum Decision and Order Denying Motion for a Rule 2004 Examination”. In re Sunedison, Inc., 572 B.R. 482 (Bankr. S.D.N.Y. 2017) (the “Decision”). First, Judge Bernstein reiterated his ruling from the bench at the hearing denying TERP’s request for Rule 2004 discovery based on the “pending proceeding” rule. Decision at 490. Under that rule, Judge Bernstein noted that once an adversary proceeding or contested matter is commenced, discovery should be pursued under the Federal Rules of Civil Procedure and not by Rule 2004, and that the principle also applies to pending state court litigation (in which the state court discovery rules would be applied). Id.
Turning next to the Debtors, the Court noted that the pending proceeding rule did not apply because the Debtors were not a party to the state court litigation. The Court then stated that the Debtors would be entitled to Rule 2004 discovery if they could establish cause. Id. But beyond this, Judge Bernstein noted, “[r]elevance, however, is not enough; the Debtors must show that they need the discovery for some appropriate purpose, or that the failure to get the discovery will result in hardship or injustice.” Id. Judge Bernstein ruled that the Debtors’ essential argument that that cause exists because the outcome of the state court action will have a material effect on the value of an important asset (the TERP shares) did not withstand scrutiny under the facts of this case. Id. at 491.
Judge Bernstein noted that this was not a circumstance in which a debtor was seeking pre-litigation discovery for a legitimate and supportable basis, such as into claims that it owns, or examining into whether to take control of a subsidiary in order to sell or liquidate its assets. Id. The Court opined that “Rule 2004 does not reach so far as to allow a debtor to take discovery from participants in third-party litigation involving claims it does not own or defenses it will not assert simply because the outcome may affect the value of an asset the debtor does own.” Id. Judge Bernstein noted further that he had requested supplemental briefing on this point, but the Debtors were unable to cite any authority to support their use of Rule 2004 to discover the merits of claims asserted in third party litigation against a subsidiary in order to value its stock ownership. Id. Furthermore, Judge Bernstein stated that the Debtors failed to support their assertions that they needed the discovery to finalize a chapter 11 plan, ensure accurate disclosure, reassure lenders and secure exit financing, and confirm and implement a Plan. Id. [Note: With the benefit of the passage of time, it is now known that the Debtors were able, without the Rule 2004 discovery it sought, to procure replacement debtor in possession financing, obtain approval of their disclosure statement, confirm a plan and have the plan go effective.]
In addition, Judge Bernstein stated in his decision that the specific circumstances of the joint Rule 2004 request gave the Court pause. More specifically, it appeared to Judge Bernstein that with the Debtors and TERP being “united in interest regarding the desired outcome of the [state court action between TERP and the Plaintiff], what was actually occurring was an effort by the Debtors to use Rule 2004 to help TERP get the discovery that should be sought by TERP in the [state court action].” Id. at 492.
Judge Bernstein concluded that the Debtors “failed to show any necessity for the Rule 2004 discovery, or that they will suffer injustice or hardship if they don’t get it.” Id.
So, while a Rule 2004 examination itself may be broad, designed to assist the trustee in revealing the nature and extent of the estate, ascertaining assets, and discovering whether any wrongdoing has occurred, there does not appear to be any clearly definable answer to the question of how many degrees of separation may exist before moving beyond examination pursuant to Bankruptcy Rule 2004. It appears that the elements of “cause” that a debtor must satisfy will be guided by the specific facts underlying the discovery it seeks, and an unsupported general assertion of need, or of adverse effect in the absence of such examination, will be a degree too far.