Generally impermissible until 1987, class action proofs of claim have increasingly been used by class creditors to their advantage.
A class proof of claim can be a particularly powerful tool when the class of creditors are current and former employees of the debtor.
Going forward, debtors and non-class creditors will need to watch out for and proactively protect themselves from situations where a class claim could disrupt the confirmability of a plan of reorganization and diminish recoveries to non-class creditors.

In recent years, bankruptcy courts across the country have been dealing with creditors of chapter 11 debtors testing the limits of the applicability of Federal Rules of Civil Procedure 23 (“Rule 23”), as applied by Federal Rule of Bankruptcy Procedure 7023 (“Bankruptcy Rule 7023”) where creditors seek to file “class” proofs of claims. These class proofs of claim pose significant challenges for debtors and other parties-in-interest. They can delay the administration of a bankruptcy case, dilute recoveries, and in some contexts threaten feasibility of a plan. This is especially true, as discussed below, when the putative class is composed of employees who have filed a prepetition class action against the debtor for violations of labor laws, damages for which can enjoy priority status in some circumstances.

Using Rule 23 to file a “class” proof of claim was generally impermissible under the Bankruptcy Act of 1898 and similarly not allowed initially under the Bankruptcy Code. This changed with a landmark Seventh Circuit opinion in 1987, In re American Reserve, 840 F.2d 487 (7th Cir.1988), which began a line of case law allowing creditors to file class proofs of claims in certain circumstances and at the discretion of the bankruptcy court.

History of the Use of Rule 23 in the Bankruptcy Proof of Claim Process
Before American Reserve, bankruptcy courts broadly disfavored the use of class proofs of claim. Under the Bankruptcy Act, class proofs of claim were not permitted at all. In re Computer Learning Centers, Inc., 344 B.R. 79, 85 (Bankr. E.D. Va. 2006). In 1978, the Bankruptcy Code replaced the Bankruptcy Act and, initially, most bankruptcy courts and the first court of appeals that addressed the issue concluded that class proofs of claim were not permissible.1 A common justification for disallowing class proofs of claim is illustrated by the Standard Metals court, which found that section 501(a) of the Bankruptcy Code and Bankruptcy Rule 3001(b) only allow claims to be filed by a “creditor” (but for an exception provided for in section 501(a) allowing for the filing of claims by an indenture trustee). The Standard Metals court ruled that a class is not a “creditor” in that context.

Shortly after American Reserve, two more courts of appeals addressed the issue and, like the American Reserve court, found that a class representative may file a class proof of claim on behalf of a putative class.2  Following these courts’ lead, courts now generally recognize that class proofs of claim may be permitted, but not as a matter of right. The courts have developed a two-step process to determine whether a putative class can utilize the class action tools applied by Bankruptcy Rule 7023: first, the bankruptcy court must determine whether it is beneficial to apply Bankruptcy Rule 7023 to the bankruptcy process, and second, the bankruptcy court must determine whether the requirements of Rule 23 have been satisfied.

Evaluating Use of Rule 23
In evaluating whether it is beneficial to apply Bankruptcy Rule 7023, courts have developed a three-factor framework to help guide the court’s discretion, known as the Musicland 3 factors:

1.  Was the class certified prepetition?

Courts have found that classes certified prepetition are the “best candidates” for a class claim. In re Sacred Heart Hosp. of Norristown, 177 B.R. 16, 22 (Bankr. E.D. Pa. 1995). Courts have also approved class claim for putative classes not certified prepetition,4 but those courts face additional analysis in deciding whether to recognize a claim filed on behalf of a putative class by a putative class representative. In re Craft, 321 B.R. 189, 198 (Bankr. N.D. Tex. 2005).

2.  Did the members of the putative class received notice of the bar date?

Courts take a dim view of debtors who fail to provide notice to their known creditors (including those in a putative or certified class) and will deny a debtor’s objection to a class claim where the debtor failed to provide notice to its known creditors. Chaparral Energy, 571 B.R. at 648. If, however, the debtor clearly provided actual or constructive notice of the bankruptcy case and the bar date to the putative class members, courts have held it “advisable” to deny the implementation of a class claim. Sacred Heart, 177 B.R. at 22.

3.  Will class certification adversely affect the administration of the estate?

In evaluating this factor, courts look at the timing of the motion for certification and whether a plan has been negotiated, voted on, or confirmed. The longer a putative class waits to move for certification, the more likely it is that a court will find the delay in resolving the certification issue will interfere with the administration of the estate. See In re Woodward & Lothrop Holdings, Inc., 205 B.R. 365, 370 (Bankr. S.D.N.Y. 1997). Likewise, a court is more likely to deny the assertion of a class claim when the debtor has already submitted a plan for creditor vote or is already before the court for confirmation. Sacred Heart, 177 B.R. at 22.

In applying these factors, courts have found that “no one factor is dispositive; a factor may take on more or less importance in any given case.” Chaparral Energy, 571 B.R. at 646. The Musicland court found that the first two considerations are “critical,” stating that the putative members of an uncertified class who received actual notice of the bar date but did not file timely claims are the least favored candidates for class action treatment. Musicland, 362 B.R. at 655.

If a bankruptcy court exercises its discretion to apply Bankruptcy Rule 7023, it then must determine whether the claimant has satisfied the four elements of Rule 23(a) and one of the subsections of Rule 23(b). If a class was certified prepetition, the bankruptcy court is still obligated to decide, de novo whether the putative class has satisfied the elements of Rule 23. See, e.g., In re Pac. Sunwear of California, Inc., 2016 WL 3564484, at *7 (Bankr. D. Del. June 22, 2016). To satisfy Rule 23(a), the proposed class representative must establish all the following:

1.  numerosity – that the class is so large that joinder of all members is impracticable;

2.  commonality – questions of law or fact that are common to the class;

3.  typicality – the putative class representative’s claims and defenses are typical of the class; and

4.  adequacy of representation – the class representative will fairly and adequately protect the interests of the class.

Then, to satisfy Rule 23(b), the proposed class representative must establish one of the following:

1.  that prosecution of separate actions risks either inconsistent adjudications which would establish incompatible standards of conduct for the defendant or would as a practical matter be dispositive of the interests of others;

2.  that defendants have acted or refused to act on grounds generally applicable to the class; or

3.  that there are common questions of law or fact that predominate over any individual class member’s questions and that a class action is superior to other methods of adjudication.

The class representative bears the burden of proving the requisite elements of Rule 23. Stirman v. Exxon Corporation, 280 F.3d 554, 562 (5th Cir. 2002). The Supreme Court has found that to satisfy the burden of proof, the movant must not merely plead the existence of the requirements but prove them. Wal-Mart Stores, Incorporated v. Dukes, 131 S. Ct. 2541, 2551 (2011). The courts must perform a “rigorous” analysis to determine whether the Rule 23(a) prerequisites have been satisfied. Id.

Bankruptcy Rule 7023 Application in Action: In re Pac. Sunwear of California, Inc.
In PacSun, several prepetition class action lawsuits were filed against PacSun entities alleging violations of California labor laws relating to wages and hours. In re Pac. Sunwear of California, Inc., 2016 WL 3564484. One class consisting of employees who worked for the PacSun entities over a 10-year period was certified by a California state court two months before the PacSun petition date. After the PacSun entities filed for bankruptcy, the debtors chose to only notify employees who had worked for the company within two years preceding the petition date and failed to notify the entire class. During the bankruptcy, the class representative sought relief from the bankruptcy court to file a class proof of claim on behalf of her class constituents.

The PacSun court utilized the two-step process described above, first applying the Musicland factors to the request to apply Rule 23. The court quickly moved through the first two factors, noting that the class had been certified prepetition and that the PacSun debtors failed to provide adequate notice to class members who had not worked for the debtors during the preceding two years. In weighing the third factor (effect of certification on the bankruptcy), the court noted that the bar date had not yet passed, and the claims administration process was in its initial stages. This caused the court to hold that applying Bankruptcy Rule 7023 would not hinder, but rather would promote, efficiency by resolving thousands of individual claims in a single class claim.

The PacSun court then advanced to the second step—whether the putative class had established the relevant factors of Rule 23. The court found that the putative class satisfied three of the four elements of Rule 23(a) with respect to all unnamed class members: numerosity, commonality and typicality. In examining the fourth element of Rule 23(a) (adequacy of representation), the court found that an intra-class conflict between class members who were just general unsecured creditors, and those who held wage and hour claims entitled to wage priority or administrative status. Bankruptcy Code section 507(a)(4) provides priority for wages (up to a cap of $12,850) earned within 180 days before the date of the petition date. The court addressed this conflict by finding adequacy of representation as to class members holding general unsecured claims, but not as to those with priority or administrative claims. After finding that Rule 23(b) was satisfied, the PacSun court certified as a class the employees who worked for the PacSun entities for the period up through the 181st day prior to the filing of the bankruptcy petition. This resolved the court’s concern as to the adequacy of representation for the employees who held priority or administrative claims.

While bankruptcy courts generally acknowledge that class proofs of claim are permissible, they have created a rather rigorous threshold that a putative class claimant must overcome. A number of courts have discussed the difficulties that a putative class claimant faces. One court noted “bankruptcy significantly changes the balance of factors to be considered in determining whether to allow a class action and … class certification may be ‘less desirable in bankruptcy than in ordinary civil litigation.’” Ephedra Prods., 329 B.R. at 5 (quoting American Reserve, 840 F.2d 493). Another found that “the inherent simplicity of the bankruptcy process tends to make class action treatment not superior … because an individual claimant would only need to fill out and return a proof of claim form.” In re Motors Liquidation Co., 447 B.R. 150, 164 (Bankr. S.D.N.Y. 2011).

As discussed above, the application of Rule 23 to the proof of claim process is particularly significant in cases where the putative class claimants are current and former employees of the debtor. These types of class action claims are frequently brought against companies outside of the bankruptcy context and therefore may be more likely to have been certified prepetition. The classes can be quite large, which can lead to a significant claim against a debtor’s estate. Employee related claims also add an additional wrinkle, as seen in PacSun, due of the statutory priority for wage claims accruing within 180 days of the petition date. This creates a risk of priority claim so enormous that it could threaten the feasibility of confirming a reorganization plan.

Creditors who find themselves in a situation where they may want to file a class proof of claim need to be aware of the hurdles that they face within a bankruptcy case. Entities in financial distress who are contemplating seeking relief in bankruptcy need to be aware of their exposure to employee class actions not only before bankruptcy, but also in the bankruptcy proof of claim process as well. Other creditors should be concerned about being diluted by a class claim, as well as by the in-terrorem effect of a class claim with a large potential damage recovery but uncertain prospects on the merits.

1.  See, e.g., In re Standard Metals Corp., 817 F.2d 625, 630 (10th Cir. 1987); In re Texaco, Inc., 81 B.R. 820, 825–826 (Bankr. S.D.N.Y. 1988); In re Allegheny Int’l, Inc., 94 B.R. 877, 881 (Bankr. W.D. Pa. 1988); In re Baldwin-United Corp., 52 B.R. 146, 149 (Bankr. S.D. Ohio 1985); In re Computer Devices, Inc., 51 B.R. 471, 474-476 (Bankr. D. Miss. 1985); In re Grocerland Coop., Inc., 32 B.R. 427, 435 (Bankr. N.D. Ill. 1983).

2.  Reid v. White Motor Corp., 886 F.2d 1462, 1472 (6th Cir. 1989); In re Charter Co., 876 F.2d 866, 873 (11th Cir. 1989).

3.  In re Musicland Holding Corp., 362 B.R. 644, 654 (Bankr. S.D.N.Y. 2007).

4.  See, e.g., In re Chaparral Energy, Inc., 571 B.R. 642 (Bankr. D. Del. May 24, 2017); In re Kaiser Group Int’l, Inc., 278 B.R. 58, 62 (Bankr. D. Del. 2002); In re MF Global Inc., 512 B.R. 757, 763 (Bankr. S.D.N.Y. 2014).