FIDUCIARY DUTIES OF THE BOARD UPON THE FINANCIAL DISTRESS OF A COMPANY The dilemma whether to file for bankruptcy

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1 FIDUCIARY DUTIES OF THE BOARD UPON THE FINANCIAL DISTRESS OF A COMPANY The dilemma whether to file for bankruptcy HON. MARTIN GLENN U.S. BANKRUPTCY JUDGE SOUTHERN DISTRICT OF NEW YORK 1

2 OPERATING WHILE INSOLVENT In the United States, companies may continue to operate while insolvent. Directors can rescue the company from insolvency or generate more value before a liquidation. In a representative case, a Delaware court found that Delaware law imposes no absolute obligation on the board of a company that is unable to pay its bills to cease operations and to liquidate. Even when the company is insolvent, the board may pursue, in good faith, strategies to maximize the value of the firm. -TrenwickAm. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 204 (Del. Ch. 2006). 2

3 WHEN IS A COMPANY INSOLVENT? One formulation: An entity is insolvent when it has liabilities in excess of a reasonable market value of assets held. Geyer v. Ingersoll Publ ns Co., 621 A.2d 784 (Del. Ch. 1992). Another court explained that demonstrating insolvency requires showing: Insufficient assets to cover liabilities and no reasonable prospect that the business can be successfully continued in the face of that deficiency; or Inability to meet maturing obligations as they fall due in the ordinary course. -N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 98 (Del. 2007) 3

4 DIRECTOR OBLIGATIONS DURING ZONE OF INSOLVENCY When operating in the zone of insolvency, directors must exercise business judgment in the best interests of the company for the benefit of its shareholder owners. -Gheewalla, 930 A.2d at 101 No fiduciary duty owed to creditors Directors must: Comply with fiduciary duties Pursue plausible and prudent strategies to maximize the firm s value -Prod. Res. Grp., 863 A.2d at 790 Companies in the zone of insolvency need: Effective and proactive leadership The ability to negotiate with creditors in good faith -Gheewalla, 930 A.2d at 100 4

5 DIRECTOR OBLIGATIONS DURING INSOLVENCY When a firm is insolvent, directors: Owe fiduciary duties to the company s creditors; and Must continue attempting to maximize the economic value of the firm -Prod. Res. Grp. L.L.C. v. NCT Grp., Inc., 863 A.2d 791 (Del. Ch. 2004) Insolvency does not suddenly turn directors into mere collection agents. -Trenwick, 906 A.2d at 195 n.75 Directors of insolvent corporations must retain the freedom to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation. -Gheewalla, 930 A.2d at 103 5

6 RISKS FOR DIRECTORS IN THE ZONE OF INSOLVENCY OR DURING INSOLVENCY Liability for conduct during the zone of insolvency: Derivative shareholder claims for breach of fiduciary duty Fraudulent transfer claims Breach of contractual covenant claims Liability for deepening a company s insolvency: Recognized in some jurisdictions, but not in others Ordinary breach of fiduciary duty claims available where independent deepening insolvency claim is not recognized 6

7 ZONE OF INSOLVENCY CASELAW (1 OF 2) No special duties to creditors owed during zone of insolvency Even when a company is operating in the zone of insolvency, the directors fiduciary duties are owed to the company and the shareholders. A pre-insolvency duty of care to creditors could distort incentive structures for corporate managers and ensure that a company remains the zone of insolvency not escape from that zone due to litigation costs. 7

8 ZONE OF INSOLVENCY CASELAW (2 OF 2) Unless the company is insolvent, directors should undertake business activities for the benefit of the residual risk-bearers, the owners of the firm s equity capital. Burtch v. Huston (In re USDigital, Inc.), 443 B.R. 22, 42 (Bankr. D. Del. 2011) Creating a special duty to creditors during the zone of insolvency would impede a company s ability to recruit qualified directors, generate capital, and serve their general wealth-maximizing function. -RSL Comm s PLC v. Bildirici, 649 F. Supp. 2d 184, 206 (S.D.N.Y. 2009) 8

9 PROTECTION FOR CREDITORS DURING ZONE OF INSOLVENCY (1 OF 2) Contractual agreements: Strong covenants Liens on assets Fraud and fraudulent conveyance law Implied covenants of good faith and fair dealing Bankruptcy law General commercial law 9

10 PROTECTION FOR CREDITORS DURING ZONE OF INSOLVENCY (2 OF 2) Recognizing a duty to creditors during the zone of insolvency would fill gaps that do not exist. Prod. Prod. Res. Grp., 863 A.2d at Creditors are presumed to be able to protect themselves through the contractual agreements governing their relationship with firms. In addition... the law of fraudulent conveyance also exists to protect creditors. In re USDigital, 443 B.R. at 42 10

11 DEEPENING INSOLVENCY CASE LAW (1 OF 2) Allowed in certain jurisdictions with a showing of fraud. The Third Circuit defines it as an injury to... corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life.... A claim of negligence cannot sustain a deepening insolvency cause of action. In re Lemington Home for the Aged, 659 F.3d 282, (3d Cir. 2011) Rejected in Delaware Even during insolvency, directors may take risks that could result in the company being painted in a deeper hue of red. With the prospect of profit often comes the potential for defeat. -Trenwick, 906 A.2d at The directors are not guarantors of success. 11

12 DEEPENING INSOLVENCY CASE LAW (2 OF 2) Delaware found a separate tort unnecessary: Both state law and federal law provide a panoply of remedies in order to protect creditors injured by a wrongful conveyance, including avoidance, attachment, injunctions, appointment of a receiver, and virtually any other relief the circumstances may require. Trenwick, 906 A.2d at 199. The court found no difference between deepening insolvency and lessening profitability, which is not a tort absent violation of a fiduciary duty. The D.C. bankruptcy court also rejected a separate cause of action because it is duplicative of a breach of fiduciary duty claim. Alberts v. Tuft (In re Greater Southeast Cmty. Hosp. Corp.), 333 B.R. 506 (Bankr. D.D.C. 2005) 12

13 FRAUDULENT CONVEYANCE Creditors may be protected through fraudulent conveyance causes of action. Transfers made or obligations incurred by a company may be avoided if the transfer or incurrence was either actually or constructively fraudulent. In a bankruptcy case, fraudulent transfer claims may be brought under: Section 548 of the Bankruptcy Code, codifying federal fraudulent conveyance law, and Section 544 of the Bankruptcy Code, enabling a debtor s estate to invoke state fraudulent transfer laws. 13

14 ACTUAL AND CONSTRUCTIVE FRAUD Actual fraud requires a showing of intent to: Hinder; Delay; or Defraud Constructive fraud requires a showing that: The transferor did not receive reasonably equivalent value for the transfer; and At the time of the transfer the transferor was suffering from one or more statutorily-defined forms of financial distress. 14

15 ACTUAL FRAUD AND THE BANKRUPTCY CODE Not required to prove insolvency to avoid a transaction as an intentional fraudulent transfer For corporate debtors, courts examine knowledge and intent of debtor s directors, officers, and other agents. Courts impute the fraud of an officer to a corporation when the officer commits the fraud: In the course of employment; and For the benefit of the corporation. 15

16 BADGES OF FRAUD Given the difficulty in proving actual intent to commit fraud, courts consider badges of fraud. Lack, or inadequacy, of consideration; Close relationship between parties; Retention of possession, benefit, or use of property; Financial condition of transferor before and after transaction; Debtor conduct worsening company s financial condition after company already incurred debt, financial difficulties, or creditor lawsuits; General chronology of events and transactions; Transfer of substantially all of debtor s property; Debtor insolvency; 16

17 ACTUAL FRAUD AND THE UFTA Most U.S. states apply the Uniform Fraudulent Transfers Act, which enables creditors to reach assets a debtor has transferred to keep them from being used to satisfy a debt. The UFTA provides a cause of action for transferring or incurring obligations with actual intent to hinder, delay, or defraud. 17

18 INDICIA OF ACTUAL INTENT TO DEFRAUD IN THE UFTA Transfer or obligation was to an insider; Debtor retained possession or control of property after transfer; Transfer or obligation was concealed; Debtor had been sued or threatened with suit before transfer was made or obligation was incurred; Transfer involved substantially all the debtor s assets; Debtor absconded; Debtor removed or concealed assets; Value of consideration was not reasonably equivalent to value of asset transferred or amount of obligation incurred; Debtor was insolvent or became insolvent shortly after transfer or the obligation; Transfer shortly before or after substantial debt incurred; and Debtor transferred essential assets of business to lienor who transferred assets to insider of debtor. 18

19 CONSTRUCTIVE FRAUD AND THE BANKRUPTCY CODE A bankruptcy trustee may avoid a transfer or obligation incurred within two years of the petition date if: The debtor received less than reasonably equivalent value in exchange for transfer or obligation; and The debtor: Was insolvent on date of transfer or obligation or became insolvent as result of transfer or obligation; Was left with unreasonably small capital to carry on business or a contemplated transaction; Intended to incur, or believed it would incur, debts beyond ability to pay; or Made transfer to or for benefit of an insider under an employment contract and not in ordinary course of business. 19

20 CONSTRUCTIVE FRAUD AND THE UFTA Transfers are fraudulent as to both present and future creditors if the debtor did not receive reasonably equivalent value in exchange, and the debtor: Was engaged or was about to engage in a transaction for which the remaining assets of the debtor were unreasonably small; or Intended to incur, or believed (or reasonably should have believed) that it would incur, debts beyond its ability to pay as they became due. Transfers are fraudulent as to present creditors if the debtor did not receive reasonably equivalent value in exchange and: Transfer or obligation was made while debtor was insolvent or where debtor became insolvent as a result; or Transfer was made to an insider for an antecedent debt, debtor was insolvent at that time, and insider had reason to believe debtor was insolvent. 20

21 REASONABLY EQUIVALENT VALUE (1 OF 2) Reason for concern about value: [A]ny significant disparity between the value received and the obligation assumed... will have significantly harmed the innocent creditor. Liquidation Trust v. Daimler AG (In re Old Carco LLC), 2013 WL , at *1 (2d Cir. Jan. 30, 2013) Typically a question of fact depending on case specific circumstances. May consider direct and indirect benefits of transaction, so long as indirect benefits are concrete and quantifiable. Courts look to the value at the time of the transaction. 21

22 REASONABLY EQUIVALENT VALUE (2 OF 2) Courts consider: Whether value of what was transferred is equal to value of what was received; Market value of what was transferred and received; Whether transaction took place at arm s length; and Transferee s good faith. Leonard v. Mylex Corp. (In re Northgate Computer Sys., Inc.), 240 B.R. 328, 365 (Bankr. D. Minn. 1999). 22

23 RECENT FRAUDULENT CONVEYANCE CASELAW In re Tronox, 2013 WL , (Bankr. S.D.N.Y. Dec. 12, 2013): Defendant spun off business with $550 million in debt, substantial environmental liabilities, and only $40 million in cash. The defendants disclosed the purpose of the spinof f. Even where a debtor s motives are known to the creditors, the court may find a fraudulent conveyance if the debtor intended to hinder or delay the creditors. The court rejected the idea that the defendants were merely managing liabilities. Defendants left the liabilities attached to a fraction of assets. 23

24 QUESTIONS 24

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