In yet another example of the role that the Delaware Court of Chancery plays as an international arbiter of disputes, on December 15, 2010, the Court of Chancery in Pope Investments LLC v. Benda Pharmaceutical Inc. et al., C.A. No. 5171-VCP, denied, without prejudice, an application for the appointment of a receiver on the grounds that while the plaintiff demonstrated that the defendant Benda Pharmaceutical Inc. was insolvent, the plaintiff failed to show that "special circumstances existed which would warrant the appointment of a receiver.” Read opinion here.
This summary was prepared by Kevin F. Brady and Zhun Lu of Connolly Bove Lodge & Hutz LLP. In keeping with an international theme, it is interesting to note that the defendant Benda is a publicly-traded Delaware corporation with its principal office in Wuhan, China, and one of the co-authors of this summary, Zhun Lu, who was born and raised in Wuhan, China, is now a member of the Delaware Bar.
In 2006, Pope, an investment fund, made an equity investment in Benda, a holding company whose assets are in China. Benda is engaged in research, discovery, and development of pharmaceuticals. It owns or controls various Chinese subsidiaries or joint ventures (Hubei Tongi Benda Ebei Pharmaceutical Co., Ltd., Shenzhen SiBiono GeneYech Co., Ltd., Yidu Benda Chemical Co., Ltd. and Jiangling Benda). Pope initially purchased $4.15 million of Benda common stock in 2006. In 2007, Pope loaned Benda $5.52 million in the form of a convertible note to Benda which gave Benda the option to purchase additional shares upon the loan’s maturity. In an unrelated agreement, Pope received warrants to acquire almost 10 million additional shares. Thus, while Pope only owned a 21% stake in Benda, its beneficial interest was much higher.
Benda suffered financial losses and was not able to repay the note. In 2009, Pope obtained a judgment in a New York court on the over-due note. It then filed an action in the Court of Chancery against Benda and its directors, directly and derivatively, for breaches of fiduciary duty seeking, among other things, the appointment of a receiver to allow Pope to recover the amount of its judgment. While Pope holds an equity interest in Benda, it only asserted a claim for a receiver in its capacity as a creditor.
In supporting the appointment of a receiver, Pope argued that, among other things, (1) Benda was insolvent; and (2) Banda’s director defendants made improper loans to insiders for the purpose of gaining preferred creditor status and failed to repay loans. Thus, Pope argued that Benda’s liquidation would be disorderly and inefficient without a receiver to assume management of Benda’s business affairs.
In opposing the appointment of a receiver, the defendants argued that (1) Benda merely has illiquid assets but was not insolvent, (2) Benda has an ongoing viable business, (3) the parties’ dispute was mainly over the proper course of management (which is not sufficient for a court to appoint a receiver), and (4) there were less drastic remedies than the appointment of receiver available (for example, Pope could use its substantial ownership of the company to change its management or to enforce the judgment in China.)
Section 291 Requirements for Appointing a Receiver
As the Court noted, a receiver is appointed for the protection of the rights of stockholders and creditors when a company has become insolvent. Under 8 Del. C. § 291, the appointment of a receiver is within the sole discretion of the court, upon the application by any creditor or stockholder. However, the appointment is proper “only if the company is insolvent and there exist ‘special circumstances’ where ‘some real beneficial purpose will be served.” In other words, “the court will appoint a receiver only if the company is insolvent and exigent circumstances warrant such relief.” The Court also noted that a company is insolvent (i) if the entity’s liabilities exceed its assets and (ii) if the entity is unable to pay its obligations as they come due in the ordinary course of business. Insolvency is a jurisdictional fact so the proof of insolvency must be clear, convincing, and free from any doubt.
Benda’s most recent financial data showed that its liabilities exceeded its assets by about $18 million. Thus, there was no dispute about the first test. Regarding the second test, however, – the inability to pay obligations as they became due in ordinary course of business, the Court found a working capital deficit in Benda (current assets minus current liabilities) of over $27 million. Thus, Benda did not have enough short-term assets to satisfy its short-tem liabilities. Moreover, Benda could not raise capital by issuing new debt or selling equity interests and therefore, it could not use those mechanisms to pay debts in the ordinary course. Benda argued that there were two ways it could meet the short-terms debts by selling some of its illiquid, long terms assets. However, as the Court noted, its business of research and manufacturing pharmaceuticals was particularly capital intensive requiring large capital investment at the outset and while its total assets exceed its liabilities, many of those assets are relatively illiquid including real estate and equipments used by its subsidiaries in China. Thus, the Court was not persuaded by Benda’s argument and instead found that Benda was insolvent “because it is unable to pay its debts in the ordinary course of business.”
The Court then turned to whether there existed “special circumstances of great exigency when some real beneficial purpose will be served thereby.” Because of “the discretionary and extraordinary nature of relief sought, one factor [the Court] considered important in evaluating Pope’s Application for appointment of a receiver was whether there were other less drastic remedies by which it might achieve its objectives.”
Benda argued that Pope had two possible avenues or less drastic remedies to achieve its goals without a receiver and those were that: (i) Pope could have pursued “its claims through corporate action based on its large equity position;” and (ii) enforce its judgment in China by attaching Benda’s assets. Pope responded by arguing that a receiver was necessary because of various deficiencies in Benda’s corporate practice (such as a failure to nominate a designee to serve on the Benda Board which could have been remedied by filing an action under 8 Del. C. § 225 or the failure of Benda to hold an annual meeting which could have been remedied under 8 Del. C. § 211) and because of the uncertainties in enforcing the judgment in China. The Court, however, was not persuaded.
Pope also argued that several loans made by defendant directors were improper and they undermine the orderly debts repayment. The Court, however, could not make a final decision on the propriety of those loans at this stage of the litigation and thus found that Pope had not shown “a special or exigent circumstance justifying the appointment of a receiver.” But the Court pointed out that other counts in the Complaint, if proven later, “may be sufficient exigent circumstances to lead to the appointment of a receiver.”
Appointment of Receiver Should Serve Beneficial Purpose
The Court further explained “[e]ven if exigent circumstance did exist, the appointment of a receiver is only justified if it would serve a ‘beneficial purpose.’” In this case, Pope asserted two benefits – salvaging the company and ensuring its creditors receive equal treatment. But the Court cautioned that the potential benefits “must be weighed against the likelihood of harm that might occur if an appointment causes the Company’s creditors to panic and trigger an immediate liquidation.” In the end, the Court was not convinced that the creditors have been treated unfairly.
As for Pope’s argument that a receiver would change the management course of Benda and salvage greater value, the Court found (1) a receiver to a Delaware holding company may be “ineffectual” with respect to an operating subsidiary in China, (2) even Pope “tacitly acknowledges Benda has certain attributes which conceivably are valuable,” thus, it would not be proper “to second guess a company’s board of directors’ business judgment[,]” and (3) appointing a receiver may trigger adverse reactions by creditors that poses “a serious risk that … will do more harm than good.”