1 Bankruptcy Law: What Duty Is Owed in Vicinity of Insolvency? by Glenn E. Siegel, Stephen J. Gordon, and Eric S. O Malley February 19, 2002 This article is reprinted with permission from the February 19, 2002 edition of the New York Law Journal 2002 NLP IP Company. All rights reserved. Further duplication without permission is prohibited.
2 SERVING THE BENCH AND BAR SINCE 1888 Web address: VOLUME 227 NO. 32 TUESDAY, FEBRUARY 19, 2002 What Duty Is Owed in Vicinity of Insolvency? BY GLENN E. SIEGEL, STEPHEN J. GORDON, AND ERIC STEVEN O MALLEY IT HAS BECOME an increasingly common struggle. Public companies issue high-yield debt that starts to trade at a substantial discount when earning expectations are not met. The purchasers of the discounted debt see value in the company but fear management might engage in practices that jeopardize the noteholders investment in an effort to resurrect shareholder value. The company has not breached any covenants under its indenture, but the creditors have a concern that money is running out and default is impending. Must the creditors wait until disaster actually arrives before they can act to protect their interests? Justice Helen E. Freedman of the Supreme Court of New York, County of New York, recently had occasion to consider this question in Fir Tree Partners, L.P. v. MCG Communications, Inc., et al., No (Nov. 7, 2001). In Fir Tree, noteholders asked the court to declare that a corporation s board of directors owed a fiduciary duty to creditors where the company s financial statements strongly suggested that it would soon be insolvent. In a two-page decision, the court dismissed the complaint, finding that the no action clause contained in the applicable indenture precluded the holders of the public debt from taking action with respect to the indenture or the underlying notes. Despite this technical basis for the court s ruling, the litigation raises legal arguments that provide a glimpse at important issues that may arise between troubled companies and their creditors. Community of Interests The plaintiffs in Fir Tree were led by a self-described value oriented investment firm that works in a collaborative manner with management to increase shareholder Glenn E. Siegel is a partner in the New York office of Dechert. Stephen J. Gordon and Eric Steven O Malley are associates in that office. value[.] Fir Tree had purchased $69.9 million of 13 percent Senior Notes issued by defendant MCG Communications, Inc., a/k/a Mpower Holding Corporation (Mpower). The complaint described Mpower as one of the many companies in the telecommunications industry that had prospered substantially during the market boom, but was now en route to bankruptcy after the economic downturn. Fir Tree alleged that although noteholders had yet to suffer a tangible injury, heavy losses would occur unless the court intervened by declaring that the Mpower board of directors owed a duty to the distressed company s creditors rather than to its shareholders. 1 As support for this request for declaratory relief, Fir Tree used an important but infrequently litigated doctrine that imposes a fiduciary duty upon a board of directors of a corporation operating in the vicinity of insolvency. In Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp WL (Del. Ch. Dec. 30, 1991), 2 the Delaware Court of Chancery held that [a]t least where a corporation is operating in the vicinity of insolvency, a board of directors is not merely the agent of the residual risk bearers, but owes its duty to the corporate enterprise[.] Thus, a board must consider the community of interests, including those of the company s creditors. Id. at *43. Using this doctrine, Fir Tree sought a declaratory judgment that (i) Mpower was insolvent or in the vicinity of insolvency and (ii) that Mpower and its directors owed a fiduciary duty to Mpower s creditors, which stands in preference to any duties owed to Mpower s shareholders. The complaint alleged no specific instances of management malfeasance aside from refusing to engage in workout discussions with the plaintiffs, general wasting of assets, and jeopardizing Fir Tree and other creditors recovery of their investments. Nor did Fir Tree allege any breach of any specific financial covenant, apparently because the indenture did not contain any such covenants. 3 Nonetheless, Fir Tree argued that the company was in the vicinity of insolvency because even if Mpower was not already insolvent, it would be in due course. In the face of an auditor s finding that the company was not technically insolvent and had an asserted net worth of $324 million, the plaintiffs offered a technically sophisticated argument based on (i) Mpower s recent financial filings and projections and (ii) analogies to other similarly situated firms that were among the best managed and strongest telecommunications companies but were substantially more pessimistic than Mpower was about the industry s (and hence their own) near-term prospects. Fir Tree argued that Mpower s publicized intent to write off $200 million in goodwill and additional charges proved conclusively that the company, if not already insolvent, would be so within a matter of months. Mpower s motion to dismiss derided the complaint as a mere press release masquerading as a legal document. 4 Mpower asserted that, since it continued to meet its contractual obligations, the plaintiffs could not seek an involuntary bankruptcy. Accordingly, Mpower charged that Fir Tree was instead attempting to create an unprecedented, quasi-bankruptcy, quasi-receivership that would allow disgruntled (though as yet unharmed) creditors to execute a coup of the board of directors. The motion was supported by two primary arguments: first, a contractual argument that the no action clause in the indenture 5 expressly prohibited the noteholders lawsuit, and second, that the complaint failed to state an actionable claim. The complaint, in Mpower s view, gave no hint of what it might possibly mean by the vicinity of insolvency, nor of what standards a court might apply in making such a vague determination[,] and therefore sought a constitutionally impermissible advisory opinion. Also, according to the defendants, shifting the directors fiduciary duty from shareholders to creditors was improper absent actual corporate insolvency or a bankruptcy filing. Judge Freedman ruled solely on the basis of Mpower s first grounds for dismissal, holding that the no action clause in Fir Tree s indenture deprived noteholders of their cause of action. The plaintiffs had argued the no action clause did not bar the litigation
3 NEW YORK LAW JOURNAL Monday, February 19, 2002 because the complaint only sought a declaration of respective rights rather than an enforcement of rights and was therefore not a remedy under or with respect to the indenture. 6 The court rejected this contention, dismissing the complaint on the grounds that any rights Fir Tree held were created by the indenture, such that any suit thereon would be with respect to that agreement and were therefore barred by the no action clause. On Nov. 13, 2001, Fir Tree filed a notice of appeal. A Question of Duty Without any explicit financial covenants and obstructed by a broad no action clause precluding suits under and with respect to both the notes and the indenture, the Fir Tree plaintiffs were in a difficult position. The court s ruling was technically correct based on the papers before it. However, one should keep in mind that the court did not rule that the board owed no duty to the creditors. It only found that the no action clause precluded the bondholders from seeking a declaration of that duty in the absence of a default under the indenture. It does not appear, therefore, that the Fir Tree plaintiffs are precluded from bringing an action in the event that Mpower defaults under the bonds and cannot pay its creditors. This would be small consolation if an earlier suit would have avoided a loss of value, however. On the other hand, the creditors would still have to prove that the directors acted in violation of their duty to the creditors, i.e., that the company was insolvent or in the vicinity of insolvency when the directors acted in a way that harmed creditors. The court did not reach Mpower s second argument regarding the vicinity of insolvency doctrine. Currently, the general rule followed by most states is that directors do not owe creditors any duty beyond the terms of the company s contract except in special circumstances, such as fraud, violation of a statute, or (most importantly to this article) insolvency. In New York, the pertinent rule, known as the trust fund doctrine, is that once a company is insolvent, the officers and directors stand in the position of trustees, holding the assets in trust for the creditors benefit. See Credit Agricole Indosuez v. Rossiyskiy Kredit Bank, 708 N.Y.S.2d 25, 31 (N.Y. 2000). The unshakable problem is that by what standard is the vicinity of insolvency determined, and who will decide? 7 A company s assets could exceed its liabilities (legal insolvency) but nonetheless meet its interest obligations (equitable solvency), claiming all the while that it must be given a chance to recover (at least until the principal comes due). Prior to 1991, courts typically required a clear showing that a corporation was in default before its directors owed a fiduciary duty to creditors. Then came the Delaware case of Credit Lyonnais. In Credit Lyonnais, a director and majority shareholder attempted to retain control of a distressed billion-dollar entertainment company. The company s primary creditor had conditioned a loan of working capital on an agreement that the director cede control to a board of the creditor s choosing. When the owner-director refused to relinquish control, the creditors were forced into court to seek enforcement of their agreement. The court found that the director had breached his covenant of good faith and fair dealing, and held that because the corporate enterprise was in danger of becoming insolvent, the creditor-bank was entitled to keep its own managers in place. Otherwise, the court found the owner-director might be inclined to sell off assets at fire-sale prices to further his own interest at the creditors expense. In an oft-cited footnote, the court illustrated how the directors incentives shift as a once solvent corporation approaches insolvency because the benefits of risk-taking behavior will vary greatly for owners as opposed to creditors: directors will recognize that in managing the business affairs of a solvent corporation in the vicinity of insolvency, circumstances may arise when the right (both efficient and fair) course to follow for the corporation may diverge from the choice that the stockholders (or the creditors, or the employees, or any single group interested in the corporation) would make if given the opportunity to act. Credit Lyonnais, 1991 WL , at *34, n. 55. The decision s import lies with the notion that there is a middle ground between solvency, where the board s primary duty is to maximize shareholder value, and insolvency, where the board s primary duty is to ensure obligations to creditors are met to the best extent possible. In this middle ground, the board s primary obligation is to return the enterprise to long-term solvency, even to the short-term detriment of shareholders, so that both shareholders and creditors might benefit in the long run. Directors are encouraged to act conservatively, in a way that preserves assets with the hope that the enterprise can be kept out of liquidation. This entails avoiding making high-risk, high-return decisions that would mostly benefit shareholders who have little to lose if a nearly insolvent company is liquidated. The more traditional method for balancing the promotion of the long-term viability of corporations with shareholder rights and the rights of creditors is through financial covenants and no action clauses, which typically require suits to be instituted by a minimum number of noteholders. In the case of public subordinated debt, there are frequently no financial covenants to protect holders (although cross-defaults to senior debt may in some circumstances serve the same purpose). However, taking action to protect creditor rights can be cumbersome under no action clauses, especially if there are a large number of creditors or the minimum for commencement of suit is unusually high. Section 6.06(x) of the Fir Tree indenture, for example, required a majority of holders of the principal amount of the notes to institute an action. 8 The problem, therefore, is that while the vicinity of insolvency doctrine could be a superior alternative for protecting creditors of distressed companies, the no action clause can render it useless when it is most needed. Defining Standards New York courts are not generally reluctant to protect creditors rights. See, e.g., Clarkson Company Ltd. v. Shaheen, 660 F.2d 506, 512 (2nd Cir. 1981) (rejecting the argument that a fiduciary duty on behalf of creditors arises only when it becomes clear that the enterprise is entering liquidation because it flies in the face of the New York policy to preserve the assets of insolvent corporations for the creditors ). Moreover, the influential Delaware Court of Chancery has held that, under the vicinity of insolvency doctrine, it is not necessary for a party to institute formal bankruptcy or receivership proceedings in order for the corporation to be found insolvent for purposes of changing fiduciary obligations. See Geyer v. Ingersoll Publication Company, 621 A.2d 784, 789 (Del. Ch. 1992). Following this reasoning, a court should offer creditors some pre-emptive protection to deter directors who knowingly risk plunging distressed corporations into insolvency or further into the vicinity of insolvency by entering into imprudent transactions. 9 In the absence of provisions in the indenture, and because directors are unlikely to acknowledge that their corporation is in the vicinity of insolvency, the only effective means of giving the doctrine weight is by court declaration assuming the plaintiffs can show that default is imminent and to a reasonable certainty, inescapable. All too slowly, courts are defining the standards necessary to make the doctrine
4 NEW YORK LAW JOURNAL Monday, February 19, 2002 effective. Delaware has recently held that plaintiffs must show more than metaphysical doubt as to whether an auditor s assessment was accurate in stating that an enterprise was solvent. See LaSalle National Bank v. Perlman, 83 F.Supp.2d 279, 291 (D. Del. 2000). A Florida court, interpreting Delaware law, suggested that directors of a solvent enterprise who propose transactions knowing they will render the corporation insolvent, stand in a fiduciary relationship to creditors. See In re Shultz, 208 B.R. 723, 729 (M.D. Fla. 1997). More recently, a New York court applying Delaware law found sufficient evidence to sustain an argument that a corporation was in the vicinity of insolvency where its audited financial statements showed a negative shareholder equity of $29.6 million and a projection of more than double that the following year. See Pereira v. Cogan, 2001 WL , at *9 (S.D.N.Y. 2001). Other courts considering similar arguments have been less helpful. In Credit Agricole Indosuez v. Rossiyskiy Kredit Bank, 708 N.Y.S.2d 25, 31 (N.Y. 2000), for example, the court held that, at least for purposes of seeking temporary injunctive relief (to prevent a troubled company from stripping its assets before a judgment was imposed), the trust fund doctrine merely imposed liability on directors for dissipating assets in post-default actions brought by trustees, receivers, or judgment creditors. The Credit Agricole court might have found that the Fir Tree complaint was premature because no defaults had occurred and the plaintiffs did not cite an imminent, specific board action that might potentially affect their rights. On the other hand, the same court might appreciate the logic of extending director liability to include acts which caused a default in the first place. Lessons of Fir Tree The Fir Tree plaintiffs had bad facts. The indenture s no action provision was unusually broad, such that the plaintiffs might have had better luck attacking the clause itself rather than arguing that it did not apply. Or they might have argued that only suits brought for breach of a specific financial covenant would be under, or with respect to, the indenture, thereby circumventing the no action clause. However, this argument is complicated by the Mpower indenture s lack of explicit financial covenants. It might still have been argued that the indenture creates some rights (specifically in the covenants), and these are the rights addressed by the no action clause, but a suit seeking to declare a fiduciary duty based on the common law theory of vicinity of insolvency is based on rights external to, and independent of, the indenture. In other ways, the facts were good, but the plaintiffs may have asked the court to extend the law beyond the current doctrine. Specifically, Fir Tree sought a declaration preferring creditors interests over that of the shareholders. While a creditor s interest may be preferred once a debtor has defaulted on its debt, if the enterprise is merely in the vicinity of insolvency, the best the plaintiffs could In the absence of provisions in the indenture, and because directors are unlikely to acknowledge that their corporation is in the vicinity of insolvency, the only effective means of giving the doctrine weight is by court declaration assuming the plaintiffs can show that default is imminent and to a reasonable certainty, inescapable have hoped for was a duty by the directors to act both for their benefit and for the shareholders. 10 If the plaintiffs sought an aggressive extension of the law, then the defendants were equally aggressive in overstating the consequences of granting the requested relief. While the creditors were able to evict a director in Credit Lyonnais, it was done pursuant to written agreement. No such coup confronted Mpower. Moreover, although the focus of the duty may shift (or expand), at least one jurisdiction has found that the fiduciary obligation imposed still requires only that the directors act in an informed manner and in a good faith effort to maximize the corporation s long-term wealth-creating capacity. In re Ben Franklin Retail Stores, Inc., v. Kendig, 225 B.R. 646 (N.D. Ill. 1998), opinion amended and superceded on other grounds by Ben Franklin Retail Stores, Inc. v. Kendig, et al., 2000 WL (N.D.Ill. Jan. 12, 2000). If courts follow this logic, even if the company is in the vicinity of insolvency and the duty is to the corporate enterprise, so long as directors act on an informed basis, in good faith, and in the honest belief that their actions will serve the long-term welfare of the corporation, the directors will not be in breach of their fiduciary duties. (1) This strategy was not without risk since the court could have ruled that the company was not in the vicinity of insolvency and no duty was owed to creditors at all. (2) Although this case was brought in New York, Mpower is a Delaware corporation and Credit Lyonnais was the applicable standard. While New York courts have acknowledged the existence of the doctrine, it has yet to be tested with a New York corporation or under New York law. See, e.g., Management Technologies, Inc. v. Morris, 961 F.Supp. 640, 645 n.8 (S.D.N.Y. 1997) (holding that under English law, directors of corporations in perilous financial circumstances may owe a duty to creditors while also noting that Delaware, which may have the most fully developed body of corporate governance law, recognizes the vicinity of insolvency doctrine). (3) The Mpower indenture did contain a cross-default provision. Such provision could not help the Fir Tree plaintiffs, however, as the indenture created an event of default with respect to senior debt only where either there was a payment default on such senior debt or such debt was accelerated. Presumably, if Mpower was not delinquent to its subordinated bondholders, it would also be current in its obligations to its senior debtholders. (4) Fir Tree Partners, L.P. v. MCG Communications, Inc., et al., No (Nov. 7, 2001) (Reply Memorandum of Law in Further Support of Defendants Motion to Dismiss). (5) The clause in question provided in relevant part: [n]o holder of any note shall have any right to institute any proceeding with respect to this indenture or the Notes or any remedy thereunder (6) Such clauses have been avoided in other cases but only in special circumstances. In Envirodyne Industries, Inc., 174 B.R. at 993, for example, a court relied on a provision of the Trust Indenture Act of 1939, codified at 15 U.S.C. 77ppp(b), specifically protecting the rights of bondholders to seek recovery of delinquent principal or interest. (7) By New York statute, insolvency arises once the present fair salable value of his assets is less than the amount that will be required to pay his future liability of his existing debts as they become absolute and matured. New York Debtor and Creditor Law 271. See also, e.g., Geyer v. Ingersoll Publication Company, 621 A.2d 784, (Del.Ch. 1992) (In Delaware an enterprise is insolvent when it has liabilities in excess of a reasonable market value of assets held. ) (citing Harff v. Kerkorian, 324 A.2d 215, 222 (Del.Ch. 1974) (citations omitted)). (8) It should not be forgotten that the Indenture Trustee does have the power to take action under the indenture, but is highly unlikely to act without a default and indemnification. (9) See Steven L. Schwarcz, Rethinking a Corporation s Obligations to Creditors, 17 Cardozo L. Rev. 647, 671 (1996) ( It is not the corporation s closeness to insolvency that is relevant, but rather whether, under the circumstances, a corporation s contemplated action would cause insolvency, meaning that insolvency is one of the reasonably expected outcomes. ). (10) See Equity-Linked Investors, L.P. v. Adams, 705 A.2d 1040, 1042 n.2 (Del. Ch. 1997). In Equity-Linked, Chancellor Allen, the same judge who decided Credit Lyonnais, explained his earlier decision that when a corporation operates in the vicinity of insolvency an independent board may consider impacts upon all corporate constituencies in exercising its good faith business judgement for the benefit of the corporation (emphasis added). Some commentators suggest that the permissive language means that the rule does not create an affirmative right on behalf of creditors but rather a defense for board members against shareholders. See Andrew D. Shaffer, Corporate Fiduciary- Insolvent: The Fiduciary Relationship Your Corporate Law Professor (Should Have) Warned You About, 8 Am. Bankr. Inst. L. Rev. 479, 517 (2000).