The dilemma

whether to fi le

for bankruptcy

FIDUCIARY DUTIES OF THE

BOARD UPON THE FINANCIAL

DISTRESS OF A COMPANY

HON. MARTIN GLENN

U.S. BANKRUPTCY JUDGE

SOUTHERN DISTRICT OF NEW YORK

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� 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.”

� -Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168,

204 (Del. Ch. 2006).

OPERATING WHILE INSOLVENT

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� 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)

WHEN IS A COMPANY INSOLVENT?

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� 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

DIRECTOR OBLIGATIONS DURING ZONE

OF INSOLVENCY

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� 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

DIRECTOR OBLIGATIONS DURING

INSOLVENCY

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� 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

RISKS FOR DIRECTORS IN THE ZONE OF

INSOLVENCY OR DURING INSOLVENCY

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� 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.

ZONE OF INSOLVENCY CASELAW (1 OF 2)

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� 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)

ZONE OF INSOLVENCY CASELAW (2 OF 2)

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� 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

PROTECTION FOR CREDITORS DURING

ZONE OF INSOLVENCY (1 OF 2)

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� Recognizing a duty to creditors during the zone of insolvency

would “fil l gaps that do not exist.”

� Prod. Prod. Res. Grp., 863 A.2d at 789–90

� “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

PROTECTION FOR CREDITORS DURING

ZONE OF INSOLVENCY (2 OF 2)

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� 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, 293–94 (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 174–75

� The directors are not guarantors of success.

DEEPENING INSOLVENCY CASE LAW

(1 OF 2)

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� 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)

DEEPENING INSOLVENCY CASE LAW

(2 OF 2)

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� 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.

FRAUDULENT CONVEYANCE

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� 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.

ACTUAL AND CONSTRUCTIVE FRAUD

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� 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, of ficers, 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.

ACTUAL FRAUD AND THE

BANKRUPTCY CODE

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� Given the dif ficulty 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;

BADGES OF FRAUD

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� 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.

ACTUAL FRAUD AND THE UFTA

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� 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 l ienor who transferred assets to insider of debtor.

INDICIA OF ACTUAL INTENT TO

DEFRAUD IN THE UFTA

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� 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.

CONSTRUCTIVE FRAUD AND THE

BANKRUPTCY CODE

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� 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.

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CONSTRUCTIVE FRAUD AND THE UFTA

� 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

335993, 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.

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REASONABLY EQUIVALENT VALUE

(1 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).

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REASONABLY EQUIVALENT VALUE

(2 OF 2)

� In re Tronox, 2013 WL 6596696, (Bankr. S.D.N.Y. Dec. 12,

2013): Defendant spun off business with $550 million in

debt, substantial environmental l iabilities, and only $40

million in cash.

� The defendants disclosed the purpose of the spinoff.

� 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.

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RECENT FRAUDULENT CONVEYANCE

CASELAW

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QUESTIONS