Chancery Rejects Claims that Directors Breached Fiduciary Duties to Creditors by Company Filing for Chapter 11 Bankruptcy; Excessive Compensation Claims Also Rejected

Nelson v. Emerson, 2008 WL 1961150 (Del. Ch., May 6, 2008), read opinion here. This Chancery Court decision provides a cornucopia of useful  and important statements of Delaware law for those lawyers whose practice overlaps corporate governance and creditors’ rights, including bankruptcy proceedings. Although one could appropriately write a lengthy article about this case, the constraints of time and paying-clients compel me to highlight just a few key points from the opinion, with copious quotations from the court’s decision.

The essential claims made were that the directors and majority stockholders of a company breached their fiduciary duties to the only secured creditor by causing the company to file for bankruptcy and by paying themselves "excessive compensation" during the time that the creditor was insolvent, both before and after the bankruptcy.

In sum, the court determined that Nelson, the creditor/plaintiff,  had made the same arguments before, and they were rejected in the bankruptcy court. Or, as the court expressed it: "The problem with Nelson’s claims is that he is seeking a second chance to win the same game." The court nonetheless explained its reasoning in great detail. Along the way, there are several statements of Delaware law that are eminently quotable and worth "having handy for future reference", such as the following quote:

Nelson also argues that the bad faith standard used
in bankruptcy law is not the same as the standards
used to determine breaches of fiduciary duty under
Delaware law. In making that argument, Nelson
misunderstands the applicable Delaware law. It is
settled Delaware law that an insolvent company is
not required to turn off the lights and liquidate when
that company’s directors believe that continuing
operations will maximize the value of the company.
Federal bankruptcy law shares this belief and
provides procedures that enable an insolvent
company to continue its operations while at the same
time balancing the interests of the affected corporate
constituencies.

Here is another money quote:

The directors of an insolvent company who, in good faith, undertake a strategy to benefit the company’s equity holders cannot be held liable just because the strategy failed. The Bankruptcy Court has already determined that Repository’s bankruptcy filing was a non-frivolous strategy and that it was partially successful. That precludes any finding that the Emersons breached their fiduciary duties by causing the Company to undertake that strategy.

Even if Nelson was not precluded from bringing his claims due to the prior rulings of the bankrupcty court, the Chancery Court explained why he still had an uphill battle ahead of him in order to prevail on his claims:

Alternatively, I note that even if Nelson were not precluded from making his fiduciary duty claim, his pleadings fail to state a claim that the Emersons breached their fiduciary duties. Repository’s charter contains a § 102(b)(7) clause that exculpates its directors from liability for breaches of their duty of care. Nelson must, therefore, plead facts supporting a viable claim for a breach of the duty of loyalty to survive the Emersons’ motion to dismiss. Nelson’s assertion that the Emersons caused Repository to pay them excessive compensation while the Company was insolvent does not support a duty of loyalty
claim because the complaint neither quantifies the amount of the allegedly excessive compensation nor describes which directors approved that compensation or suggests that those unknown directors were not independent. Likewise, Nelson’s contention that the Emersons caused Repository to file for bankruptcy in bad faith for the purpose of
frustrating Nelson’s efforts to collect the debt owed to him by Repository does not support a duty of loyalty claim.

At footnote 13 and accompanying text, the Chancery Court discusses two causes of action that may be familiar to bankruptcy lawyers, but are not commonly seen in Chancery Court opinions. Namely, "recharacterization of loans from debt to equity" and "equitable subordination". These were claims that the company pursued against the creditor in response to the creditor’s efforts to have the bankruptcy dismissed–which he was successful in doing, but not  because of the mismanagement basis and the bad faith reasons he wanted the court to rely on.

The Chancery Court extensively discusses each of the elements of the doctrine of collateral estoppel and applies them to the facts to explain why that doctrine bars the claims presented in this case.

Here are a few other instructive quotes that reiterate important statements of Delaware law and that, I suggest, are of great interest to business litigators:

It is settled Delaware law that “[e]ven when the company is insolvent, the board may pursue, in good faith, strategies to maximize the value of the firm.”FN54  Filing a Chapter 11 bankruptcy petition is a federally-sanctioned strategy for maximizing the value of an insolvent company.FN55  Here, after a full trial, the Bankruptcy Court determined that
Repository used that strategy in good faith.FN56 Directors of a Delaware corporation do not commit a breach of fiduciary duty against the corporation if they, in good faith, seek to benefit the equity holders by bringing a bankruptcy, in order to recharacterize certain debt as equity.FN57  So long as that action is not frivolous, such an exercise of business judgment to advance the interests of the equity holders is not a breach of fiduciary duty simply because the directors do not achieve ultimate success.FN58

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FN54.Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 204 (Del. Ch.2006), aff’d, 931 A.2d 438 (Del.2007).

FN55. See, e.g., Trenwick, 906 A.2d at 204 (“Chapter 11 of the Bankruptcy Code expresses a societal recognition that an insolvent corporation’s creditors (and society as a whole) may benefit if the corporation continues to conduct operations in the hope of turning things around.”); Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772, 793 n. 66 (Del. Ch.2004) (“[I]n most instances when a firm is insolvent but believes itself to have a
prospect for viability, the firm will seek out the protections of the Bankruptcy Code and
attempt to restructure its affairs through the well-articulated body of federal law specifically designed for that purpose.”); see also Trenwick, 906 A.2d at 204 n. 103 (citing numerous federal decisions explaining the purpose of federal bankruptcy protection and the discretion afforded to directors in deciding whether to take advantage of the bankruptcy process).

FN56. Nelson’s argument that good faith in bankruptcy law only considers objective
factors whereas good faith in Delaware fiduciary duty law considers subjective
intent is misguided. The very decision that Nelson cites to support that proposition
explains that in determining whether the debtor filed for bankruptcy in bad faith a court “may consider any factors which evidence an intent to abuse the judicial process and the purposes of the reorganization provisions.”In re McCormick Road Associates, 127 B.R. at 413 (quoting In re Phoenix Piccadilly Ltd., 849 F.2d 1393, 1394 (11th Cir.1988) (emphasis
added); see also id. at 415 (“[O]nce a court has properly found that the debtor has failed
to satisfy the court’s objective good faith inquiry-i.e., whether reorganization is the
proper course of action in a particular debtor’s case-it may properly dismiss the debtor’s petition without considering the debtor’s subjective good faith. In other words, a finding of subjective bad faith-i.e., intentional abuse of the bankruptcy laws-is not a necessary prerequisite to dismissal for bad faith filing.”) (internal quotation and citations omitted). Moreover, the use of objective factors as a proxy for subjective intent makes sense. See Production Resources, 863 A.2d at 793 n. 85 (“Because it is impossible for non-divine judges to peer into the hearts and souls of directors, this court has recognized the importance of considering relevant circumstantial facts that bear on scienter, which include the substance and effects of the defendants’ conduct.”). The reality is that Nelson
received a trial on, among other issues, whether Repository’s bankruptcy filing was
made in subjective bad faith. That he failed to prevail on that contention does not mean
his argument was not fairly considered.

FN57.See Gheewalla, 930 A.2d at 103 (explaining that its rationale for not recognizing direct fiduciary duty claims by creditors was that “[d]irectors of insolvent corporations must retain the freedom to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation”) (citing Production Resources, 863 A.2d. at 797).

FN58 See id.(“Recognizing that directors of an insolvent corporation owe direct fiduciary duties to creditors, would create uncertainty for directors who have a fiduciary duty to exercise their business judgment in the best interest of the insolvent corporation.”).

Regarding the claim that the defendant directors paid themselves "excessive compensation", the court’s opinion provides a tutorial about the necessary elements of that claim:

To state a claim for excessive compensation, a plaintiff “must either plead facts from which it may reasonably be inferred that the board or the relevant committee that awarded the compensation lacked independence (e.g., was dominated or controlled by the individual receiving the compensation), in which event proof of such allegations would cast upon the
officer the burden to prove that the compensation paid was objectively reasonable in the circumstances or plead facts from which it may reasonably be inferred that the board, while independent, nevertheless lacked good faith (i.e., lacked an actual intention to advance corporate welfare) in making the award.”FN60

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FN60.Gagliardi v. TriFoods Intern., Inc., 683 A.2d 1049, 1051 (Del. Ch.1996).

The court went on to example why Nelson woefully fell short of these prerequisites. For example, the court observed that:

Second and even more fatally to Nelson’s claim, his complaint provides no information about the amount or specific instances of the alleged excessive compensation.FN64  By no facts, I mean none that quantify what compensation the Emersons received and when, much less any that support an inference that the non-pled amounts exceeded what was
rational and proper. As explained above, Nelson has no excuse for the lack information about the alleged excessive compensation. Therefore, “[i]n the absence of [pled] facts casting a legitimate shadow over the exercise of business judgment reflected in
compensation decisions,” this claim must be dismissed.” FN65

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FN64.See id. ¶ 2 (alleging that the Emersons enriched “themselves and members of their
family through the payment of exorbitant salaries, benefits and expenses); id. ¶ 13
(alleging that “Mrs. Emerson received excessive commissions in that commissions
were paid for customer service, rather than sales activities); id. ¶ 14 (alleging that the
Emersons “both dined frequently at [Repository's] expense, charging meals to
the company American Express Card”); id. ¶ 20 (alleging that the “continued payment of
excessive salaries and commissions further diminished [Repository's] cash reserves”).
Nelson’s contention that amounts and specifics are not necessary because the
payment of “any compensation during insolvency was exorbitant” is absurd and
illustrates why conclusory pleading that compensation is “excessive” has been held
to be not sufficient to state a claim. Nelson Ans. Br. at 18 n. 9 (emphasis in original).

FN65.Gagliardi, 683 A.2d at 1051.

UPDATE: Here is an insightul analysis of the case from a bankruptcy expert’s perspective by Steve Jakubowski on his Bankruptcy Litigation Blog.

Supplement: Although it is not directly on point, a somewhat related recent decision I came across in the current issue of the ABA/BNA Lawyers’ Manual on Professional Conduct, might be worth a "see generally" type of closing footnote. The Virginia Supreme Court on April 18 ruled in the case of McNally v. Rae , (VA, No. 070522), that an attorney has no duty to warn an adversary that the attorney’s client is considering a filing for bankruptcy. The Virginia Supreme Court in this case reversed a trial court’s imposition of attorneys’ fees on an attorney for the costs of trial preparation due to the attorney not announcing to his opponent until the day that trial started that his client, the defendant, had filed bankruptcy the night before, though the client had been contemplating it for some time. Part of the reasoning would be that the client had a right to file bankruptcy, and requiring an attorney to disclose his client’s deliberations prior to making the decision would have a chilling impact on the attorney/client relationship.