Commercial Restructuring & Bankruptcy Alert – October, 2009 - Part 1

Contents

• Supreme Court Leaves Open Issue of Third-Party Releases
• NY Decision Dents Special Purpose Entity Shield
• NY Court Protects Litigation Communications Between Bank Counsel and Syndicate Members
• Sixth Circuit: Privately Held Stock Buyout Protected as 'Settlement Payments'
• Delaware Court Clarifies D&O Liability in Zone of Insolvency
• Ninth Circuit Rules in Favor of D&O Insurer
• Insurers Remain on the Hook Despite Bankruptcy Termination Provisions
• Ninth Circuit Joins Eleventh, Holds There Is Federal Common Law of Receivership
• BAP Decision in City of Vallejo Chapter 9 Case Becomes Final
• Delaware Court Modifies Stub Rent Stance
• New York Ruling Extends Tax Exemption in Bankruptcy Sales
• Counsel's Corner

Supreme Court Leaves Open Issue Of Third-Party Releases
By Derek J. Baker

The U.S. Supreme Court has issued a long-awaited decision that many practitioners had hoped would provide insight into the permissible breadth of third-party releases and injunctions often contained in confirmed chapter 11 plans. The high court, however, narrowly resolved the issue presented in Travelers Indem. Co. v. Bailey, 129 S.Ct. 2195 (2009), and left open that ultimate question.

The case stems from the widely influential In re Johns-Manville Corp. bankruptcy case filed in 1982. The In re Johns-Manville Corp. bankruptcy case was the first to address the multitude of current and future asbestos claims pending against a corporation. That case provided the fundamental framework upon which most (if not all) subsequent asbestos cases have been based, and provided a mechanism for the determination and adjudication of current and future asbestos claims through the creation of the Manville Personal Injury Settlement Trust (the "Manville Trust").

Ultimately, the structure created by the Manville Trust was codified in section 524(g) of the Bankruptcy Code; however, at the time, the "channeling injunction" contemplated by the Manville Trust was unprecedented. To resolve In re Johns-Manville Corp., the bankruptcy court ordered (the "1986 Order") that any and all personal injury claims related to the exposure to asbestos and/or asbestos products against Johns-Manville Corp., or any claims that are, could have been, or might be asserted against any Settling Insurer Group related to certain insurance policies, were released, enjoined and ordered to be made solely against the Manville Trust.

The enforceability of the Manville Trust was timely appealed and ultimately affirmed by the U.S. Court of Appeals for the Second Circuit.

Trust Challenge

After many years, various creditors attempted to make claims against The Travelers Indemnity Company (one of the settling insurers under the Manville Trust), asserting that Travelers conspired with insurers and other asbestos manufacturers to hide the dangers of asbestos.

Travelers defended the actions, arguing that the actions were prohibited by the 1986 Order establishing the Manville Trust. Travelers ultimately sought to have the bankruptcy court enjoin the various actions by confirming that the 1986 Order properly included those actions.

After several rounds of mediation, a settlement was reached whereby the bankruptcy court clarified the 1986 Order and held that the claims currently asserted against Travelers were included in the claims to be prohibited pursuant to the channeling injunction in the 1986 Order. In exchange, Travelers made an additional contribution to the Manville Trust.

Certain creditors appealed and the U.S. District Court affirmed. A further appeal to the U.S. Court of Appeals for the Second Circuit reversed, and a petition for certiorari (seeking appeal to the Supreme Court) was granted.

Supreme Court Review

The issue presented and addressed by the Supreme Court was whether the bankruptcy court had the jurisdiction to clarify the 1986 Order, and/or whether the bankruptcy court had jurisdiction to provide that third-party claims (which are not a derivative of claims arising by or through the debtor) could be enjoined pursuant to the 1986 Order. While most practitioners hoped that the court would expound on the latter issue, the Court (in a 7-2 decision) focused exclusively on the right of the bankruptcy court to clarify the 1986 Order.

The Supreme Court held that the bankruptcy court's clarification of the 1986 Order did not "expand" the 1986 Order; rather, the 1986 Order was broadly drafted and the bankruptcy court simply confirmed that it should be broadly construed. Therefore, the Supreme Court held that because the 1986 Order was entered and became final after a direct review, that order became res judicata and could not be collaterally attacked in any separate proceeding.

The Court expressly noted that it did not confirm or deny whether it was proper for the bankruptcy court to enter the injunction for third-party claims in the 1986 Order or the recent clarification. The Court noted only that once the 1986 Order was entered, formally appealed, and upheld on a direct appeal, it could not be collaterally attacked.

In dissent, Justice Stevens (joined by Justice Ginsberg) focused exclusively on the bankruptcy court's jurisdiction. The dissent noted that the insurance policies were significant assets of the Johns-Manville Corp. bankruptcy estate; therefore, the bankruptcy court had the power to channel claims related to the insurance proceeds to the Manville Trust.

The dissent made the distinction that the claims asserted here were claims directly against Travelers for Travelers' separate "bad acts." They were not "claims relating to a policy" that were meant to be channeled under the 1986 Order. Justice Stevens urged the court to hold that the bankruptcy court had no jurisdiction to enter an order prohibiting third-party claims because the claims sought to be enjoined were third-party claims against a non-debtor. In fact, the dissent argued that the 1986 Order was not clear as to whether such third-party claims were included. The dissent noted that if the 1986 Order had been clear, would Travelers have paid additional consideration for the "clarification"?

Going Forward

While the Travelers Indemnity Company decision confirms the Supreme Court's res judicata jurisprudence, it unfortunately does not lend much insight into the issues practitioners hoped to have clarified through the petition for certiorari. The permissible scope of third-party releases and injunctions contained in confirmed chapter 11 plans and confirmation orders continues to be fluid and differs depending on the appellate circuit in which the bankruptcy case is pending.

Ny Decision Dents Special Purpose Entity Shield
By Scott M. Esterbrook

A fundamental component in the commercial mortgage-backed securities ("CMBS") market is the lender's reliance that the loan is made to a "bankruptcy remote" special purpose entity ("SPE"). The loan documents and operating agreements relating to an SPE typically require that the SPE maintain separate existence and contain restrictions that limit the SPE's debt and ensure separateness. This structure protects the lender by keeping the operations and assets of the SPE borrower separate and remote from its affiliates and parent—the goal being to ensure that the SPE's operations and assets are not impacted by a bankruptcy proceeding of its affiliates or parent.

On Aug. 11, the U.S. Bankruptcy Court for the Southern District of New York issued a memorandum opinion in the bankruptcy cases of General Growth Properties, Inc. ("GGP") and its debtor subsidiaries (the "Debtor Subsidiaries") that demonstrates that the SPE structure does not ensure that an SPE borrower will always be able to avoid becoming ensnared in the bankruptcy proceeding of its parent and affiliates. In re Gen. Growth Props., Inc., No. 09-11977, 2009 WL 2448423 (Bankr. S.D.N.Y. Aug. 11, 2009).

Credit Crisis Fallout

GGP is the ultimate parent of approximately 750 of the Debtor Subsidiaries. GGP and its Debtor Subsidiaries ("Debtors") own and manage more than 200 shopping centers throughout the United States. The Debtors had approximately $18.27 billion of debt at the project-level secured by the respective underlying real estate (shopping center properties), each of which is typically owned by an SPE. Some of this debt constituted conventional mortgage debt, but a considerable portion of it represented debt securitized in the CMBS market.

The loans typically were structured with three- to seven-year maturities, low amortization rates, and balloon payments due at maturity. The Debtors' business plan was based on the premise that they would be able to refinance their debt. As the credit crisis spread to commercial real estate finance, the Debtors found themselves unable to refinance. Without the ability to refinance, the Debtors began using operating cash to pay obligations as they became due, and two large project-level loans eventually went into default.

The Debtors ultimately filed voluntary petitions under chapter 11 in April of this year.

Bad Faith Claims Dismissed

In the decision, Judge Gropper denied five motions to dismiss certain of the chapter 11 cases filed by one or more of the Debtor Subsidiaries ("Subject Debtors"). Each of the Subject Debtors was an SPE. Each motion to dismiss was filed by or on behalf of a secured lender ("Movants") with a loan to one or more of the Subject Debtors. The Movants premised the dismissal of the cases on the argument that the Subject Debtors filed their cases in bad faith.

The court began its analysis by explaining that, in the U.S. Court of Appeals for the Second Circuit, to dismiss a bankruptcy petition for bad faith, the court must find both objective futility of the reorganization process and subjective bad faith in filing the petition.

The court rejected the Movants' argument that the Subject Debtors were not in financial distress at the time of the filing and the prospect of liability was too remote to justify their respective chapter 11 filings. Instead, the court ruled that the filings of the Subject Debtors were not premature—the Subject Debtors were in financial distress and needed to be placed into bankruptcy.

The court found no evidence to counter the Debtors' demonstration that the CMBS market was "dead" on the Petition Date and that, while solvent and not facing loan maturity, the Subject Debtors were all in varying degrees of financial distress in April 2009 because the Debtors could not refinance their debt. The court explained that an entity is not required to postpone filing for bankruptcy until it is actually insolvent, and found that the Subject Debtors were justified in iling their respective chapter 11 petitions when they did.

SPE Structure

The court also rejected the Movants' argument that consideration of the financial problems of the Debtors as a whole would violate the purpose of the SPE structure, and that financial distress must be determined separately for each individual entity. The court found that, while the purpose of the SPE structure was intended to insulate the Subject Debtors from the financial problems of its affiliates, GGP and the Debtor Subsidiaries functioned as an integrated operation.

"Movants do not contend that they were unaware that they were extending credit to a company that was part of a much larger group, and that there were benefits as well as possible detriments from this structure," the court noted.

The court addressed the fact that the Subject Debtors' corporate governance required the appointment of independent managers who were not employed or affiliated with GGP. Pursuant to the SPE Operating Agreements, approval from such independent managers was required for certain significant SPE corporate actions, including the filing of a voluntary chapter 11 petition. The court found that the powers and duties granted to the independent directors under the SPE Operating Agreements were limited to those permitted under applicable state law.

Under Delaware law, the SPE's independent managers did not have a duty to their creditors to prevent a bankruptcy filing, regardless of contrary language in the Subject Debtors' Operating Agreements. Instead, the independent managers had a duty to the business and its shareholders, and any argument that the independent managers of an SPE can serve on the board to prevent that entity from filing for bankruptcy was rejected by the court.

Interests of the Parent Company

The court ultimately held that, under the circumstances of the Debtors' filings, the interests of the parent companies must be taken into account. The court was careful to note that fundamental rights and interests of the subsidiaries and their creditors were not being sacrificed for the benefit of the parent and its creditors. "The point is that a judgment on an issue as sensitive and fact-specific as whether to file a Chapter 11 petition can be in good faith on consideration of the interests of the group as well as the interests of the individual debtor."

The court then analyzed whether the Subject Debtors exercised subjective good faith. The Movants argued that bad faith was evidenced by the failure of the Subject Debtors to negotiate with their respective lenders prior to the petition date, and the abrupt discharge and replacement of certain independent directors to facilitate a filing.

First, the court noted that the Bankruptcy Code does not require a borrower to negotiate with its lender as a condition to filing a chapter 11 petition. While there may be good reason to negotiate, the court found that failing to negotiate does not mean a chapter 11 case should be deemed to have been filed in bad faith. Because of common restrictions in a CMBS lender's ability to negotiate prior to a default or near default of the loan, the court was skeptical that prepetition discussions would have even been adequate.

Consequently, the court concluded that the failure to negotiate with the Movants was justified and not in bad faith.

The court next found that, while replacement of the independent directors for the purpose of obtaining the necessary authority to file bankruptcy was "admittedly surreptitious," the replacements were not indicative of bad faith. The court supported its finding by noting that the underlying corporate documents of the Subject Debtors permitted a shareholder to appoint new independent directors to the board. Furthermore, as discussed above, the independent managers did not have a duty to keep the Subject Debtors from filing a bankruptcy petition.

Accordingly, the court found that the Subject Debtors exercised subjective good faith in the filing of their chapter 11 petitions.

Going Forward

While this decision clearly indicates that bankruptcy inherently alters some of the rights that lenders negotiate and rely on when lending to an SPE, the court was clear that this decision was not intended to collapse the SPE structure.

The court specifically noted that "[n]othing in this Opinion implies that the assets and liabilities of any of the Subject Debtors could properly be substantively consolidated with those of any other entity."

It therefore remains to be seen whether the historic and accepted use of SPEs and securitizations for property-specific and CMBS financing is in jeopardy.

NY Court Protects Litigation Communications Between Bank Counsel And Syndicate Member
By Derek J. Baker

An important ruling by the federal district court in New York expands on the protection provided to the communications of a bank's attorneys with syndicate members in the context of analyzing litigation strategies. In HSH NordBank AG v. Swerdlow, No. 08-CV-6131, 2009 WL 2223476 (S.D.N.Y. July 24, 2009).

The issue in HSH NordBank was the extent to which the attorney/client privilege (as extended by the common interest doctrine) protected communications by agent bank's counsel to the agent and various members of a lending syndicate.

The case arose following several defaults, after which the agent bank determined to proceed in a breach of guaranty action against various guarantors. During discovery, certain documents were inadvertently disclosed, which revealed communications by counsel for the agent bank to both the agent bank and/or various syndicate bank members. The communications were not directed to the syndicate bank members' counsel; the communications were made directly to the syndicate bank members.

These inadvertent disclosures were sought to be reclaimed pursuant to "claw back" provisions in the protective order entered among the parties, as well as under the applicable rules of civil procedure. After the attempted recovery was unsuccessful, the parties submitted the matter to the court for determination.

Counsel-to-Syndicate Communications

The defendants asserted, among other things, because the communications were directly with the individual syndicate bank members (and not through their respective counsel), that the communications constituted a waiver of the attorney/client privilege; therefore, the common interest doctrine could not apply.

Prior cases suggested that communications among parties represented by separate counsel—and communications among their counsel—would not waive otherwise applicable privileges. In other words, to the extent that an attorney for one party communicated information that would otherwise be subject to the attorney/client privilege, or the attorney work-product privilege, to counsel for another party in a common interest, the communication would not waive the original underlying privilege.

This is the crux of the common interest doctrine.

The defendants asserted that because the communications were to individual bank syndicate members directly (and not to their respective counsel), the common interest doctrine could not apply.

The court ruled that there is no requirement that the communications occur on a counsel-to-counsel basis to justify the application of the common interest doctrine. The court noted that the "common interest doctrine is an exception to the general rule that voluntary disclosure of confidential, privileged material to a third party waives any applicable privilege." Id. at *4.

The communication to all of the lenders addressed the enforcement of the bank groups' rights against the guarantors under the guarantees. The communications were for the purpose of determining the proper enforcement mechanism, and all parties believed that the communications would remain confidential. Further, the underlying loan documents (which were executed by the original borrower) noted that the agent bank's counsel would effectively represent the interest of all the lenders whose interests would be presumed to be identical.

Legal v. Business Interests

Under the common interest doctrine, the common interest must be "legal" in nature and cannot be limited solely to business strategies. The defendants asserted that the interest to be protected was solely a business interest, and therefore the common interest doctrine did not apply.

The court did note that only communications made in the course of an ongoing common legal enterprise, and which were intended to further that enterprise, would be protected. This is the case, however, regardless of whether actual litigation is pending. The court ruled that because the communications in the current case related to the analysis of the enforcement of rights grounded in contract (i.e., the guaranty), the communications involved the pursuit of legal rights and remedies.

While the analysis of the legal rights may overlap with the bank group's business interests, the common interest was not solely for business interest—it had a legal facet.

Communications involving the analysis of syndicate issues and pursuit of legal strategies by agents' counsel to all of the bank syndicate members must be protected. This case is further security for members of bank syndicates to ensure the free-flow of information and strategy concerning the exercise of rights and remedies with agent's counsel.

The court's conclusion that the communications were protected (and did not require the conduit of an individual syndicate member's counsel and could be direct to syndicate bank members), reinforces current business practices, and should help the ongoing free-flow of information as syndicate lenders evaluate how to proceed in connection with their syndicate borrowers.

While the opinion is not a panacea for exchange of information among bank members (i.e., the common interest doctrine only applies to communications that otherwise have an underlying privileged nature), it does help to ensure that attorneys and their clients can continue to have the honest dialogue and frank analysis with members of the bank syndicate that the attorney/client privilege is meant to foster.

Sixth Circuit: Privately Held Stock Buyout Protected As 'Settlement Payments'
By Stephen T. Bobo

In a decision with potentially broad implications, the U.S. Court of Appeals for the Sixth Circuit recently determined that payments made to former shareholders of a privately held company in a leveraged buyout transaction are protected as "settlement payments" pursuant to section 546(e) of the Bankruptcy Code.

In QSI Holdings, Inc. v. Alford (In re: QSI Holdings, Inc.), Adv. No. 08-1176, 2009 WL 1905237 (6th Cir. July 6, 2009), the court found that the payments to shareholders could not be recovered in a subsequent bankruptcy proceeding because they constituted "settlement payments" under the plain language of section 546(e), and that this provision was not limited to transactions involving publicly traded securities, but also extended to privately held securities transactions.

The case arose from the leveraged buyout of Quality Stores, Inc. ("QSI"), a privately held company, through a merger with Central Tractor Farm and Country, Inc. Under the transaction, QSI's 170 shareholders were paid in either cash or stock in the surviving entity, with the total value exchanged exceeding $200 million. The transactions were accomplished through HSBC Bank USA acting as exchange agent to collect the stock from individual shareholders, and distribute cash payments or new stock to them in return.

Some of QSI's stock had been held in an Employee Stock Ownership Trust ("ESOT"). For these shares, the settlement process also involved the ESOT trustee, LaSalle Bank.

Post-Merger Bankruptcy

Two years after the merger, the surviving entity, which had changed its name to Quality Stores, Inc., fell on hard times. Creditors filed an involuntary bankruptcy against it in late 2001, and QSI ended up in a chapter 11 proceeding. In its capacity as debtor in possession, QSI thereafter filed a fraudulent conveyance action against the former shareholders alleging that the stock tendered for cash payments represented less than reasonably equivalent value in return, and that the LBO transaction left the company with unreasonably small capital and caused it to incur debts greater than its ability to pay.

In response, the former shareholders filed a motion for summary judgment on the basis that the cash they received constituted "settlement payments" made by a financial institution, and were therefore exempt from avoidance.

The bankruptcy court agreed, concluding that these payments fell within the section 546(e) exemption. On appeal, the district court affirmed the bankruptcy court's decision.

The debtor further appealed to the Sixth Circuit, contending that this exemption is limited to transactions involving publicly traded securities. It argued that Congress did not intend for the exemption to extend to transactions involving a leveraged buyout of privately held stock, because this type of payment is not "commonly used in the securities trade," as defined in section 741(8) of the Bankruptcy Code.

The debtor contended that the court should follow more the restrictive views of certain other courts construing the scope of this exemption.

'Settlement Payment'

The Sixth Circuit rejected these arguments and joined a number of other courts that recognize that the definition of "settlement payment" is extremely broad, although somewhat circular. The court focused on the final phrase in the section 741(8) definition: the payment must be one "commonly used in the securities trade." Id. at 549. It rejected the debtor's suggestion that the lower courts had failed to consider whether the buyout of QSI contained the hallmarks of a payment made in the securities trade.

The court's brief review of the legislative history revealed that the purpose of section 741(8) was to ensure expanded protection that would include "margin and settlement payments to and from brokers, clearing organizations, and financial institutions. Again, Congress's purpose was to 'minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries.'" Id. at 549-50, quoting from Kaiser Steel Corp. v. Charles Schwab & Co., Inc., 913 F.2d 846, 849 (9th Cir. 1990).

Although the Kaiser Steel court had ruled upon a buyout of publicly-traded securities, the court nonetheless concluded that "the transfer of consideration in an LBO is consistent with the way 'settlement' is defined in the securities industry." Id. at 550.

The Sixth Circuit determined that the logic of the Kaiser Steel decision extends to privately held securities. It relied upon the recent decision in Contemporary Indus. Corp. v. Frost, 564 F. 3d 981 (8th Cir. 2009), in which the Eighth Circuit faced the same issue and found there was no indication of any intent to exclude such payments from the definition of "settlement payments" merely because the stock was privately held. The Eighth Circuit interpreted the phrase "commonly used in the securities trade" as "a catchall phrase intended to underscore the breadth of the § 546(e) exemption." Id. at 986.

The Sixth Circuit adopted this conclusion reached by the Eight Circuit. Id. at 550.

Public and Private Markets

The QSI court acknowledged that other courts have reached a different conclusion on the issue because of their focus on a perceived purpose of section 546(e) to protect publicly traded securities from market volatility resulting from a bankruptcy, citing In re Norstan Apparel Shops, Inc., 367 B.R. 68 (Bankr. E.D.N.Y. 2007).

Norstan arose from the leveraged buyout of all of the company stock, which was owned directly and indirectly by the two principal officers. The proceeds of the loans made to finance the stock purchase flowed directly from the lender to the shareholders, rather than to the company. Id. at 73.

The Sixth Circuit distinguished the Norstan case on the basis that it "involved the two sole shareholders of a closely held Subchapter S corporation, did not implicate public securities markets, and lacked many of the indicia of transactions 'commonly used in the securities trade.'"

By contrast, the QSI situation involved "a transaction with the characteristics of a common leveraged buyout involving the merger of nearly equal companies, ....[t]he value of the securities at issue is substantial and there is no reason to think that unwinding that settlement would have any less of an impact on financial markets than publicly traded securities." Therefore, the Sixth Circuit concluded that nothing in the text of section 546(e) precluded its application to settlement payments involving privately held securities. Id. at 550.

Limits to 'Settlement Payments' Exception

The debtor also contended that an element of section 546(e) had not been satisfied because there had been no "transfer ... made by or to a ... financial institution." The debtor argued that the intermediary bank never had dominion or control over the funds but instead had acted merely as a conduit, relying on a decision by the Eleventh Circuit in In re Munford, Inc., 98 F.3d 604, 610 (11th Cir. 1996). According to this argument, the bank could not have received a transfer of the debtor's property if it never had a beneficial interest in either the funds or the shares exchanged for those funds.

The Sixth Circuit rejected this position, following instead decisions from several other circuit courts that have found that the plain language of section 546(e) does not require a "financial institution" to have a "beneficial interest" in the transferred funds, relying on In re Resorts Int'l, Inc., 181 F.3d 505, 516 (3d Cir. 1999), and Contemporary Indus., 564 F.3d 986-87. According to the Sixth Circuit, the role played by HSBC Bank in the QSI buyout was sufficient to satisfy the requirement that the transfer was made to a financial institution. Id. at 551.

The Sixth Circuit's analysis and careful use of language suggests limits to the "settlement payments" exception through the use of an intermediary financial institution in buyout transactions.

In particular, its contrast between the Norstan Apparel decision and the QSI situation provides insight. In the view of the Sixth Circuit, Norstan Apparel merely involved the two sole shareholders of a Subchapter S corporation (who were paid directly by the LBO lender and not through a separate intermediary). The transaction lacked "many of the indicia of transactions commonly used in the securities trade."

QSI's buyout, on the other hand, involved 170 shareholders who received more than $200 million in cash and stock through HSBC Bank USA. In the view of the Sixth Circuit, this transaction "had the characteristics of a common leveraged buyout" and involved "the merger of nearly equal companies." The potential impact of unwinding the settlement payments would be comparable to a transaction involving publicly traded securities.

The wording of the actual QSI holding—that nothing in the text of section 546(e) precludes its application to settlement payments involving privately held securities—also suggests that not all buyout transactions involving an intermediary financial institution may be entitled to this exemption. Transactions that do not share much in common with transactions "commonly used in the securities trade" or that lack the characteristics of a common leveraged buyout may not be able to rely on such protection under section 546(e).

For example, a small buyout transaction where the use of a financial institution as exchange agent appears to have been unnecessary except to gain the protections of section 546(e), could fall into what the district court below referred to as "exceptional circumstances" and not be entitled to the exemption. Another example of exceptional circumstances would clearly be the exception contained in section 546(e) for transactions sought to be avoided under section 548(a)(1)(A), that is, for transactions involving actual fraud.

Going Forward

The QSI decision represents increasing legal support for protection of payments for sales of stock in either a public or a private company appropriately made through a financial institution where no fraud was present. This protection extends to constructive fraudulent conveyance and preference theories.

The use of a financial institution as an exchange agent or other similar intermediary to facilitate the buyout of a corporation's stock where justified by the needs of the transaction, and having the indicia of transactions "commonly used in the securities trade," would appear to insulate the payments from avoidance should the corporation later end up in a bankruptcy proceeding.

Delaware Court Clarifies D&O Liability In Zone Of Insolvency
By Amy M. Tonti

In an area of the law that continues to be active, the federal bankruptcy court in Delaware has once again issued a detailed ruling on the actions of directors and officers leading up to a company's insolvency. Among the notable conclusions are: (1) failure to conduct due diligence before obtaining a loan may support a claim for breach of duty of care; and (2) there is no cause of action for "improvident lending" in Delaware or New Jersey. Official Comm. of Unsecured Creditors of Fedders N. Am., Inc. v. Goldman Sachs Credit Partners L.P. (In re Fedders N. Am., Inc.), 405 B.R. 527 (Bankr. D. Del. 2009).

D&O Duties

The Delaware Supreme Court has long held that directors and officers of a Delaware corporation owe the corporation and its shareholders the duty of care, the duty of loyalty, and the duty to act in good faith. A breach of the duty of care cannot be proved unless there is a showing of gross negligence. To the extent that the decision made by the directors or officers was an informed decision, made in the good-faith pursuit of a legitimate corporate interest, the directors and officers are protected by the "business judgment rule."

The Delaware Supreme Court also has held that the fact that a company is insolvent does not mean that the company's officers and directors "cannot choose to continue the firm's operations in the hope that they can expand the inadequate pie such that the firm's creditors get a greater recovery." Trenwick American Litig. Trust v. Billett, 931 A.2d 438 (Del. 2007). See CR&B Alert, "Delaware High Court Affirms Deepening Insolvency Ruling," (November 2007) p. 1.

The above principles recently were applied in In re Fedders North America, Inc., an adversary proceeding wherein a creditors' committee was granted derivative standing to challenge the actions of the debtors' pre-petition lenders, and former officers and directors. The committee asserted claims for, inter alia, breach of fiduciary duty, aiding and abetting breach of fiduciary duty, fraudulent transfer, aiding and abetting fraudulent transfer, improvident lending, tortuous interference with contractual relations, and tortuous interference with prospective business advantage (the "Complaint").

Fedders had been a successful business for many years. Between 1996 and 2006, Salvatore Giordano, Jr. became the executive chairman and embarked on new product lines, and moved much of its operations overseas, financed by the incurrence of substantial debt. By February 2007, Fedders was in default of its obligations with its lenders, which led to an inability to access new cash. By March 2007, Fedders obtained new financing with new lenders ("Lenders") that paid off the old debt, and increased its debt by 20 percent.

By May 2007, Fedders was in default of certain covenants pertaining to its earnings under the new loans. A chapter 11 was filed in August 2007, the operating companies were sold, and a plan of liquidation was filed.

Creditor's Complaint

The creditor's complaint was met with a motion to dismiss by the Lenders and the former officers and directors (collectively, the "Defendants"). The Third Circuit has summarized the pleading standard created by Federal Rules of Civil Procedure, Rule 8 and Rule 12(b)(6) as follows:

In re Fedders, at 537, citing Phillips v. County of Allegheny, 515 F.3d 244, 234 (3d Cir. 2008).

Delaware law requires that a plaintiff plead facts supporting an inference that officers and directors committed a cognizable breach of duty. Fedders summarizes the applicable law as follows:

• Duty of Care: A plaintiff cannot prove a breach of duty of care without showing gross negligence, which generally requires directors and officers to fail to inform themselves fully and in a deliberate manner.
• Duty of Loyalty: The duty of loyalty mandates that the best interest of the corporation and the shareholders take precedent over any interest possessed by a director, officer or controlling shareholder, and not shared by the stockholders generally.
• Duty to Act in Good Faith: The duty to act in good faith is a subsidiary element of the duty of loyalty. The Delaware Supreme Court has identified three examples of conduct that may establish a failure to act in good faith: intentional acts with a purpose other than that of advancing the best interest of the corporation; acts with the intent to violate applicable positive law; or intentional failure to act in the face of a known duty to act demonstrating a conscious disregard for the director's duties.

Court's Findings

Having reviewed the applicable law, the bankruptcy court made a number of key findings in Fedders with respect to the Defendants' Motion to Dismiss the Complaint, as summarized below.

Breach of Fiduciary Duty – Directors

Simply alleging that a corporation was insolvent and took on more debt is not enough to plead a breach of fiduciary duty.

The fact that officers and directors continued to work and take compensation, standing alone, is not sufficient to plead a breach of fiduciary duty.

Because the directors approved the new loan without due diligence—Fedders never obtained a financial assessment verifying that it would be able to comply with the covenants contained in the financing agreements—the Complaint pleaded sufficient facts to support a claim for breach of duty of care with respect to the loan.

Aiding and Abetting Breach of Fiduciary Duty—Lenders

Because the court found a claim for breach of duty of care with respect to the loan, the court held that the Complaint pleaded sufficient facts to support a claim for aiding and abetting a breach of fiduciary duty of care asserted against the Lenders.

The court acknowledged that the claim against the directors for breach of duty of care with respect to the loan would be dismissed because the Fedders' certificate of incorporation exculpates them from monetary liability. Nonetheless, the court determined that the exculpation of the directors does not necessarily prevent the Lenders from being liable for aiding and abetting the directors' breach of duty of care.

Fraudulent Conveyance: Actual Fraud

Change of Control provisions that would have given several directors large severance payments were not sufficient to support a cause of action for fraudulent conveyance because a change of control never occurred, and hence the payments were never made.

Revisions to Giordano's employment agreement that resulted in a potential release of a $6 million no-interest loan he had taken from Fedders was sufficiently pleaded to state a claim for a fraudulent transfer against Giordano.

Fraudulent Transfer – Constructive Fraud

Because the new loan was drawn down when made—i.e., consideration was received—the Complaint did not state a claim for constructive fraud against the Lenders.

The Complaint did state a claim against Giordano wherein it alleged that Fedders received less than reasonably equivalent value from Giordano in exchange for an interest-free loan, and that Fedders made the transfer to or for the benefit of an insider not in the normal course of business.

Aiding and Abetting Fraudulent Transfers

The plaintiff did not have standing to bring a state law cause of action for aiding and abetting a fraudulent transfer in the bankruptcy proceeding. Furthermore, there is no federal cause of action for aiding and abetting a fraudulent transfer.

Improvident Lending

No Delaware or New Jersey (jurisdictions of applicable law) has recognized a cause of action for "improvident lending," so the court considered whether the Delaware and/or New Jersey Supreme Court would recognize such as cause of action. After reviewing decisions from other courts, the federal bankruptcy court in Delaware concluded that a cause of action for improvident lending does not exist.

The court concluded that other remedies exist to address the issues involved (e.g., aiding and abetting a breach of fiduciary duty, lender liability premised on contractual rights, and common law fraud and fraudulent transfers), and any attempt to create a new remedy of "improvident lending" would be wholly duplicative.

Going Forward

Particularly in the current economic climate, businesses and their counsel should be acutely aware of the developing law surrounding D&O liability for corporations experiencing financial difficulties.

A regular review of the principles involved in Trenwick, and its progeny, which now includes Fedders, is essential in advising companies teetering on insolvency, and their officers, directors and lenders. The principles involved in this line of cases also are important in contemplating actions to seek recovery for the losses suffered as a result of such insolvency.

Ninth Circuit Rules In Favor Of D&O Insurer
By Claudia Z. Springer

The U.S. Court of Appeals for the Ninth Circuit has held that a creditor trustee could not recover claims under a Director & Officer insurance policy because of the policy's "insured v. insured" exclusion. Biltmore Assocs., LLC v. Twin City Fire Ins. Co., Ad. No. 07-16036, 2009 US App. LEXIS 15322 (9th Cir. July 10, 2009).

The case is an important one because creditors of a bankrupt company often investigate the pre-petition actions of current and former officers and directors to determine whether their conduct may have caused or worsened the company's poor financial condition. Officers and directors, in turn, aware of this potential exposure and risk, customarily insist that the company employing them indemnify them from most claims, other than claims arising from intentional misdeeds or gross negligence. Hence, companies typically obtain Director and Officer (D&O) liability coverage to pay the costs associated with defending claims brought against their directors and officers, and any judgments awarded on account of such claims.

In Biltmore Associates, the Ninth Circuit dismissed a claim brought in the chapter 11 case of Visitalk, an Arizona corporation, against various insurance companies (the "Insurers") that provided different layers of D&O liability coverage to Visitalk and its former officers and directors.

The claims initially were brought by Visitalk, an insured under the D&O liability policies and then were assigned by Visitalk to a creditor trust, established for the benefit of Visitalk's creditors. The trustee of the creditor trust, Biltmore Associates ("Biltmore"), continued to prosecute the claims after the assignment.

Insured v. Insured Exclusion

The D&O policies at issued named Visitalk as well as the directors and officers as insured parties. The policies promised to pay covered claims brought by third parties, and specifically excluded claims brought "by or on behalf of" an insured party. This exclusion is known as the insured v. insured exclusion, and essentially bars one insured under a policy from recovering thereunder by bringing a claim arising from the wrongful actions of another insured. The D&O policies at issue contained some exceptions to the insured vs. insured exclusion, none of which the court found applicable to the facts of this case.

After the Insurers refused to cover claims initially brought against the former officers and directors by Visitalk, because of the D&O policies' insured v. insured exclusion, Visitalk assigned the claims to the creditor trust, and Biltmore, as trustee, stepped into Visitalk's shoes. The Insurers posited that the fact that the claims had been assigned to the creditor trust and then were being pursued by Biltmore had no bearing on the continuing effect of the insured v. insured exclusion.

The court agreed with the insurers, finding that the insured v. insured exclusion continued to bar the claims being pursued by the creditor trust because the underlying claim still was being "brought or maintained on behalf of an Insured in any capacity," and thus was excluded from coverage.

According to the Ninth Circuit, a cause of action for mismanagement of a company belongs to the corporation that was mismanaged. It can be pursued derivatively by shareholders and creditors, but it belongs to the corporation. Coverage for such claims, however, is excluded if the company sues the directors and officers as it did in this case. Changing plaintiffs does not serve to breathe new life into the plaintiff's right to recover under the policies.

Open Question

As the assignee of the company's claims, Biltmore can have no greater right than the party from whom the claim was assigned.

The court noted the anomaly that Biltmore had to step into Insured's shoes to have any basis for coverage under the policy, and then step out again to recover thereunder because of the insured v. insured exclusion. According to the court, this alone justified the dismissal of the claims. The court did not buy the argument made by Biltmore that the pre-petition debtor differed from the debtor-in-possession, and therefore it could be an insured under the policy but also a plaintiff when it became a debtor-in-possession.

The court did leave open the question of whether a chapter 11 or chapter 7 trustee would have been able to overcome the insured v. insured defense to coverage had it been the plaintiff in this case.

Insurers Remain On The Hook Despite Bankruptcy Termination Provisions
By Han J. Ahn

The U.S. Bankruptcy Court for the Southern District of New York recently prohibited insurers from terminating debtors' insurance contracts based on so-called "cesser" clauses, which provided for the automatic termination of insurance coverage upon the commencement of proceedings under any bankruptcy or insolvency law. LaMonica v. N. of Eng. Protecting & Indem. Ass'n Ltd. (In re Probulk Inc.), 407 B.R. 56 (Bankr. S.D.N.Y. 2009).

Probulk involved the procedurally consolidated chapter 7 bankruptcy cases of 73 debtors, each of which owned, operated or managed one or more ocean-going reefers, dry bulk ships, tankers, containers or freezer vessels. Upon the filing of the debtors' bankruptcy cases, the two relevant insurers—the UK P&I Club and the North of England Protecting and Indemnity Association Limited (collectively, the "Clubs")—sought to cancel the debtors' outstanding insurance contracts.

In response, the Trustee commenced an adversary proceeding seeking a preliminary injunction against the Clubs to prevent them from terminating outstanding insurance or, to the extent necessary, to require the Clubs to restore coverage that existed prior to the filing of the debtors' bankruptcy petitions.

In their defense, the Clubs contended that the Trustee failed to establish two prongs necessary for a party to obtain a preliminary injunction: (1) irreparable injury if preliminary relief is not granted; and (2) a probability of success on the merits.

Cesser Clause

With respect to the second prong, probability of success on the merits, the Clubs pointed to a certain "cesser" clause contained in the relevant contracts. This clause provided that insurance coverage would automatically terminate in the event that a member of the Clubs (the insured debtors) commenced proceedings under any bankruptcy laws. The Clubs claimed that this clause resulted in termination of coverage as soon as the debtors' boards authorized a bankruptcy filing.

The court, however, warned that "[t]he Bankruptcy Code is not so easily evaded."

The court noted that "[t]here is no question that in the circumstances at bar [the debtors'] insurance rights constituted property of the debtors." In turn, the court looked to section 541(c)(1)(B) of the Bankruptcy Code, which provides, with exceptions inapplicable here, that an interest of the debtor in property becomes property of the estate:

11 U.S.C. § 541(c)(1)(B).

The court concluded there was "no question that the debtors' insurance rights continued notwithstanding the Clubs' attempt to deem them terminated as a consequence of the resolutions of the boards of directors of the debtors authorizing a bankruptcy filing...." The court again emphasized that section 541(c) explicitly applies "not withstanding any provision in ... applicable nonbankruptcy law." Thus, the court stated, "the fact that the provisions of the Clubs' contracts are authorized under U.K. law or that the contracts are governed by U.K. law is not determinative."

Furthermore, the court noted that any questions as to the scope of section 541(c)(1) in these cases were addressed by the provisions of 28 U.S.C. § 1334(e)(1), which give the district court, and by referral, the bankruptcy court, exclusive jurisdiction "of all the property, wherever located, of the debtor as of the commencement of such case, and of property of the estate." With no issue regarding subject matter jurisdiction, the court reasoned "[t]he fact that the debtors' world-wide insurance rights became property of the estate makes applicable § 362(a)(3) of the Bankruptcy Code, creating an automatic stay in bankruptcy ...."

As the court explained, the automatic stay "prevents a party to a contract from terminating the contract or taking action to deem the contract terminated after the bankruptcy case has commenced without seeking relief from the stay, and it is obviously applicable to insurance contracts."¹

Based on the foregoing, the court found that the Trustee had demonstrated that he had "a clear probability of success on the merits in seeking a preliminary injunction against the Clubs' purported termination of the debtors' insurance" and that application of the "cesser" clause would constitute a violation of the automatic stay.

Irreparable Injury

The court disposed of the issue of irreparable injury swiftly, finding that the Trustee was relieved of having to prove irreparable injury in order to obtain a preliminary injunction. As the court explained, "[i]t has been held that a debtor need not prove irreparable injury if the requested injunction is necessary in order to preserve the jurisdiction of the Bankruptcy Court, especially if the automatic stay is at issue."

In any event, the court found that the record contained sufficient evidence that termination of insurance would create irreparable injury under the facts of this case: "Without insurance [the Trustee] would have to abandon the vessels, some of them in mid-voyage, resulting in the possibility of loss of cargo and loss of the vessels themselves. He has stated without contradiction that he has attempted unsuccessfully to obtain other insurance for the vessels."

Finally, the court dealt with the Clubs' contention that they simply were not subject to the personal jurisdiction of the bankruptcy court. The court rejected this argument, noting that the Clubs stood "mute" and provided no support for their contention.

The court concluded the Trustee had sufficiently established that the termination of the debtors' insurance because of their bankruptcy filings would have an immediate, substantial, direct and foreseeable impact on U.S. debtors, which sections 541(c)(1)(B) and 362(a) were designed to prevent. The court reasoned that termination of insurance would "subvert the interest of the United States in administering bankruptcy proceedings of domestic corporations in one forum."

Thus, the court held that the "Trustee of these domestic corporations in U.S. bankruptcy proceedings has therefore made out a prima facie case that personal jurisdiction exists over insurers that provided such corporations with world-wide P & I [maritime operations] cover."

Footnote

^{1.The court served a reminder that "the burden is on the Clubs to move for relief from the stay and establish both the relevance and validity of their contentions."}

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This article is presented for informational purposes only and is not intended to constitute legal advice.