Delaying A Bankruptcy For Shareholder Benefit May Benefit The Creditors After All

Delaying A Bankruptcy For Shareholder Benefit May Benefit The Creditors After All

Summary

Equity holders and sponsors be wary - a new arrow may now be available in the quiver of potential causes of action that creditors and trustees can use to maximize their recovery in chapter 11 bankruptcy cases. In a recent decision in the bankruptcy case of Xtreme Power Inc., (Case No. 14-1096-HCM, Adversary No. 16-01004-HCM, Docket No. 70), the United States Bankruptcy Court for the Western District of Texas (the “Bankruptcy Court”) permitted the board to be sued because it delayed a chapter 11 bankruptcy filing to increase the value of the investment portfolio of the company’s controlling shareholder while creditor positions deteriorated.

Estate representatives (typically a creditors’ committee or a trustee) regularly examine the past conduct of a bankrupt debtors’ officers and directors in search of facts demonstrating breaches of directors’ fiduciary duties. This often leads to the prosecution (or threat of prosecution) of causes of action to create a recovery for unsecured creditors. Under Delaware law, directors may be liable for breaching two fiduciary duties to the corporations they manage – the duty of loyalty and the duty of care. The duty of loyalty requires that directors “place the best interests of a corporation above any self-interest held by a director and not shared by all stockholders generally.” Xtreme, page 53. Directors act in violation of their duty of loyalty where the facts show that the individual directors were either self-interested or lacked independence to oppose the consummation of a transaction. In addition, in certain circumstances, inaction, even without an actual transaction, can form the basis for a breach of fiduciary duty claim.

By way of background, in 2006 Xtreme began to design, install and monitor energy storage and power management systems. The company initially experienced rapid growth, leading to valuations in excess of $100 million from 2009-2011. However, sales and the company’s value soon rapidly declined. In November 2012, a minority shareholder formally presented its concerns to the board, and demanded the company start a restructuring process to preserve whatever liquidation value remained through a bankruptcy process. Instead, the debtors’ management delayed filing for bankruptcy protection for over a year, until January 2014, at which point the company already ran out of cash and dramatically decreased in value. Xtreme allegedly made up over 30 percent of the largest shareholder’s investment portfolio and a decrease in the value of Xtreme would correspondingly result in a decrease in the value of this investor’s funds as a whole.

The largest and controlling shareholder was sued for breach of fiduciary duties of loyalty, good faith, and care, and inducing and/or aiding and abetting the directors’ breach of fiduciary duty. The Bankruptcy Court noted that the complaint failed to allege either that the controlling shareholder held more than 50 percent of the outstanding stock (the complaint admitted it held less) or that the controlling shareholder exercised actual control over the business affairs of the company. As such, the claims against the controlling shareholder, which failed to assert actual control but relied on inference, were dismissed.

The directors however, who were sued for breach of fiduciary duties of loyalty, good faith, and care, and gross negligence for purposefully choosing to delay the bankruptcy filing to protect the majority shareholder, did not fare quite so well. All of the claims against the directors were dismissed – except, importantly – for the claim of breach of loyalty.

To make its case for breach of a duty of loyalty, the complaint alleged that the directors placed the needs of the controlling shareholder ahead of those of the debtor company, and pointed to various relationships between the directors and the controlling shareholder to rebut the presumption of loyalty. The Bankruptcy Court highlighted several alleged relationships: the chairman and a second director were both directors of the debtor and managing partners of the controlling shareholder; a third director was both a director of the debtor and a manager for a fund of the controlling shareholder; a fourth director was both a director for the debtor and a director at another company within the controlling shareholder’s portfolio; and a fifth was deemed controlled by the controlling shareholder because the other directors controlled by the controlling shareholder dictated this director’s compensation.

The complaint went on to assert a variety of allegations of wrongdoing focusing on the conduct of the directors designed to increase the time that Xtreme stayed out of bankruptcy to increase or preserve the value in the controlling shareholder’s various funds.

The Bankruptcy Court found these allegations sufficient to assert a plausible claim for breach of the duty of loyalty. The claims preserved by the Bankruptcy Court in Xtreme strike a familiar chord with the “deepening insolvency” cases often dismissed or rejected by Delaware courts. See, e.g., RSH Liquidating Trust v. Magnacca, 553 B.R. 298, 313-14 (Bankr. N.D. Tex. 2016) (interpreting Delaware law). However, the claims in those cases were couched as breaches of the duty of care, good faith, or as an independent duty. Here, the Bankruptcy Court in Xtreme allowed claims based on a fact pattern of “deepening insolvency” or waiting too long to file for bankruptcy protection while value erodes, to proceed as a breach of the duty of loyalty. This provides the potential for a revitalization of these claims in cases going forward, and thus, a new potential avenue of recovery for unsecured claimants in chapter 11 bankruptcy cases and a new caution for equity sponsors and their appointed board members.

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