Avoiding an Out-of-Court Restructuring May Breach Fiduciary Duties

Dechert LLP
Contact

Dechert LLP

[co-author: Owen Haney]*

Key Takeaways

  • A Delaware Bankruptcy Court denied a motion to dismiss breach of fiduciary duty claim against a Debtors’ former directors who failed to pursue out-of-court restructuring because lenders would not indemnify the directors.
  • Resisting out-of-court restructuring to preserve speculative value in the reorganized company may violate fiduciary obligations.
  • The risk is even greater for directors who put the cart before the horse, seeking personal indemnification when their company is on the brink.

Introduction

Under Delaware law, the board of directors of an insolvent company has wide latitude to pursue good-faith strategies to maximize the value of the firm. Trenwick Am. Litig. Tr. v. Ernst & Young, L.L.P., 906 A.2d 168, 204 (Del. Ch. 2006) (“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.”) And the business judgment rule safeguards the board’s decision to file for bankruptcy, pursue an out-of-court restructuring, or continue operations despite insolvency. In re RSL COM PRIMECALL, Inc., 2003 WL 22989669, at *8 (Bankr. S.D.N.Y. Dec. 11, 2003) (“It has never been the law in the United States that directors are not afforded significant discretion as to whether an insolvent company can ‘work out’ its problems or should file a bankruptcy petition.")

The Case of SportCo

Not withstanding the above principles, a Delaware Bankruptcy Court recently determined that the former directors of SportCo Holdings, Inc. (“SportCo”), may have breached their duty of loyalty by putting their own interests ahead of the Debtors’ interests in failing to negotiate an out-of-court restructuring. In re SportCo Holdings, Inc., 2021 WL 4823513 (Bankr. D. Del. Oct. 14, 2021).

In 2017, the directors and officers of SportCo (the “Directors”) determined that the company may have breached its obligations to their first and second lien lenders as the result of an unprofitable acquisition. A SportCo director notified lenders, initially seeking forbearance. The director reported back to the Board, however, that the lenders would consider waiving some principal and interest owed in exchange for a majority equity interest in the company. In late 2018, SportCo exchanged a term sheet with the lenders for a proposed restructuring. Following internal discussions, however, SportCo distributed an amended term sheet that included indemnification provisions and releases of personal liability for its Directors. The lenders objected to the releases, but SportCo refused to engage in any restructuring that did not indemnify the Directors for personal liability. Negotiations halted, SportCo defaulted on its loans, and SportCo and its affiliates filed for bankruptcy the next year.

A liquidation trust was formed pursuant to the plan of reorganization, and the Trustee sued the Directors alleging, inter alia, that the Directors breached their fiduciary duties of care and loyalty for failing to enter into an out of court restructuring. The directors moved to dismiss the claims, and Judge Stickles for the United States Bankruptcy Court of Delaware granted the motion as to the breach of the duty of care but denied the motion as to the breach of the duty of loyalty.

On the duty of care claim, Judge Stickles determined that the Directors’ actions in the face of insolvency did not amount to a breach. Turning to the duty of loyalty, the Directors argued that seeking individual releases did not place their self-interests above the interests for which they act as fiduciaries. The Directors asserted that negotiating releases would save the reorganized company the expense of indemnifying the Directors in connection with any litigation that would arise following a change-of-control restructuring.

The Court disagreed, holding that any benefit that would accrue to the reorganized company by way of the releases was “partly factual question” that the Court could not resolve on the pleadings. After drawing all inferences in favor of the trustee/plaintiff, Judge Stickles found that the Complaint contained sufficient allegations to infer that the directors breached their duty of loyalty by failing to restructure out of court.

Directors Be Aware

While SportCo could eventually be resolved in the Directors’ favor on the merits (assuming the parties don’t settle), directors should take the SportCo opinion to heart. Corporate directors must tread carefully during restructuring negotiations to avoid the appearance of putting one’s own interest before that of the company. Resisting out-of-court restructuring to preserve speculative value in the reorganized company which also accrues to the personal benefit of the directors, may violate their fiduciary obligations.

*Law Clerk

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Dechert LLP | Attorney Advertising

Written by:

Dechert LLP
Contact
more
less

Dechert LLP on:

Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
- hide
- hide

This website uses cookies to improve user experience, track anonymous site usage, store authorization tokens and permit sharing on social media networks. By continuing to browse this website you accept the use of cookies. Click here to read more about how we use cookies.