Global Banking & Finance Review - April 2, 2020
A bankruptcy trust for creditors (including former workers and trade vendors) who lost significant sums of money in the Toys “R” Us Inc. (TRU) bankruptcy sued former Chief Executive Officer David Brandon, several other directors and executives of TRU, and its former private equity owners.[i]The lawsuit accuses Brandon and other TRU executives and board members of, among other things, conspiring to keep suppliers in the dark about TRU’s real financial condition in the months preceding TRU’s collapse. As a result, post-bankruptcy suppliers and other creditors collectively lost $800 million, an additional $1.76 billion in pre-bankruptcy claims were left unpaid, and 31,000 employees lost their jobs, according to the complaint.
The complaint asserts that the company continued to purchase goods from suppliers on credit even after it became clear to directors that financing would evaporate because of a terrible fourth quarter. Between December 2017 and March 14, 2018, TRU supposedly placed $600 million of orders on credit, at the instruction of the company’s board, while assuring suppliers that TRU would emerge from bankruptcy.
Under Delaware law, the duties of directors of a solvent corporation run to the corporation, which is to be managed for the benefit of its shareholders. No fiduciary duties are owed to creditors of a solvent corporation. The general rule is that directors do not owe creditors duties beyond the relevant contractual terms.
When a corporation becomes insolvent, or approaches insolvency, directors of such a firm still do not owe any particular duties to creditors, but continue to owe fiduciary duties to the corporation for the benefit of all of its residual claimants, a category which includes creditors. They do not have a duty to shut down the insolvent firm and liquidate its assets for distribution to creditors – although they may make a business judgment decision that this is indeed the best route to maximize the firm’s value. If the board of an insolvent corporation, acting with due diligence and good faith, pursues a business strategy that it believes will increase the corporation’s value, but that also involves the incurrence of additional debt, it does not become a guarantor of that strategy’s success. That the strategy results in continued insolvency and an even more insolvent entity does not in itself give rise to a cause of action.Disinterested directors therefore continue to be substantially protected from ex post facto second-guessing by courts and other constituencies by the business judgment rule, even if the corporation is insolvent.
Decisions made by officers and directors of corporations typically have not subjected the individuals to personal liability. Even if an officer or director makes what turns out to be a bad business decision, such decision does not render the person liable.
The duty of care that an officer or director must exercise relates to the diligence that the person uses to make decisions. In order to fulfill this duty, it is strongly recommended that an officer or director follow several practices, including the following: (a) regularly attend board and committee meetings; (b) remain informed about the business and affairs of the corporation; (c) rely on information provided by others, such as reports, financial statements, and opinions; and (d) make inquiries about problems that may arise with respect to the corporation.
The responsibilities of the board are separate and distinct from those of management. The board does not manage the company. To inform its decisions, a board relies on materials prepared by management. The “duty of care” requires that directors make decisions with due deliberation. A “duty of care” is violated when a director has committed gross negligence by failing to inform him- or herself fully and in a deliberate manner.
Under the “business judgment rule,” a court will not second-guess a board’s decision if such decision was made (a) on an informed basis, (b) in good faith, and (c) in the honest belief that the action to be taken (or not taken) was in the best interest of the corporation. Directors are given the presumption that the business judgment rule has been satisfied unless the directors are interested/engaging in self-dealing, lack independence, are shown to not be acting in good faith, or reach their decision through a grossly negligent process. Thus, where a board (a) followed a reasonable process under the circumstances, (b) took into account the key relevant facts, and (c) made its decision in “good faith,” the board will generally be insulated from liability related to a particular decision or action it takes. Note that acting in “good faith” requires, among other things, that the board act in advancing the best interests of the corporation, without conflicts of interest, and without demonstrating a disregard for its duties such as by turning a blind eye to issues for which it is responsible.
Successful Chapter 11 reorganizations can be very difficult to achieve–especially in certain industries, such as retail. The time within which the debtor must turn things around has been shortened by the Bankruptcy Code’s deadline by which to assume or to reject unexpired leases. Further, in retail cases, secured lenders are very conscious of the required timing of a potential liquidation sale if a successful turnaround cannot be achieved. It is necessary to capture the right season for a sale. The fourth calendar quarter may be best. The third calendar quarter may be worst. Landlords become most aggressive in wanting their stores back in order to fill a “dark hole” for the critical fourth quarter–which means a lead time to retrofit the store for a new tenant. Despite the tools that the Bankruptcy Code provides, it is a race against the clock with impatient lenders and impatient landlords. We are not blaming them.
The creditors’ committee and the Bankruptcy Judge want to facilitate job preservation and also the retention of a customer, but those goals may not be achievable in the face of ongoing operating losses and in the face of lenders and landlords who have witnessed a relatively low success rate in retail Chapter 11 case.
Sears, Forever 21, and TRU are examples of recent “administratively insolvent” cases. In each of these recent cases, the company was left with insufficient funds to satisfy post-petition claims. So vendors that sustained losses prior to the petition date got burned a second time when they were unable to be fully paid on account of goods and services supplied to the debtor after the bankruptcy filing.
Allegations in the TRU complaint include that the board was inattentive to the likelihood of growing administrative insolvency and/or that the board knowingly permitted management to incur additional indebtedness–including continued purchase of new product–when it should not have done so. The TRU complaint also alleges that the board gave direction to obtain additional credit from vendors at a time when the board knew that such credit could not be repaid.
Should the board be liable, and if so, what should the plaintiffs be required to prove?
In each of the Sears, Forever 21, and TRU Chapter 11 cases mentioned above, there was a chief restructuring officer (CRO) retained by the debtor who was accountable to the board. CROs are engaged so that management can focus on turning around the business rather than on the day-to-day handling of the Chapter 11 case. CROs are presumed to know the rules of Chapter 11 – one of which is that a debtor must remain “administratively solvent,” i.e.,maintain sufficient assets to satisfy all obligations incurred from and after the bankruptcy petition is filed. Counsel undoubtedly knows that.
The debtor is not expected to become profitable instantaneously on the petition date. But after a fair opportunity to prove that a turnaround is possible (i.e.,more likely than not to occur based upon current knowledge and reasonable assumptions), the debtor should not be falling increasingly behind on its administrative liabilities beyond the point of no return. That allegedly happened in the TRU case. We have no inside information. The Delaware Chancery Court in a recent case[ii]held that “directors cannot be held liable for continuing to operate an insolvent entity in the good faith belief that they may achieve profitability, even if their decisions ultimately lead to greater losses for creditors.”
Therefore, it would be bad precedent to hold the TRU board liable if the TRU board asked the right questions, received reasonable answers, and relied on management and/or the CRO without a basis on which to disbelieve or distrust management or the CRO. A board is not a guarantor of results promised by management. Board membership of distressed businesses should not be discouraged.
It is appropriate for the board to rely on a CRO and other restructuring professionals to keep the board informed of when the debtor is getting too far out on the limb. That is a principal function of the CRO. The CRO is the bankruptcy business/finance expert who is charged with overseeing the debtor’s business and financial affairs as they relate to compliance with the Bankruptcy Code and Bankruptcy Rules. The CRO is typically part of the interface between management and other professional advisors. It is the task of the CRO to rein in management and to alert the board if the debtor is making purchases beyond its reasonably likely ability to pay, but even in such situations, if making such purchases/incurring such debt is based on the good faith belief that incurrence of such debt in the short term will ultimately maximize value for all creditors (and potentially yield sufficient funds to satisfy such obligations), such actions, if properly informed, could be protected under the business judgment rule. It is the job of the CRO to ensure that unsecured creditors are not unfairly being taken advantage of–including in favor of a debtor’s secured creditors–in order to buy time to get a deal done that does not maximize value for the corporation and all of its creditors. At a minimum, the CRO must ensure that the board is aware when the CRO believes that additional debt is being incurred beyond a company’s ability to repay such debt.
A prudent board of a company in Chapter 11 bankruptcy should require of management, and especially of the CRO and other bankruptcy/restructuring professionals, regular reporting, including but not limited to the following:
- Accrued post-petition liabilities to vendors, employees, taxes, etc.
- Accrued post-petition professional fees (net of “carve outs” from the secured lenders)
- Outstanding purchase orders for goods not yet received
- Goods in transit/awaiting acceptance by the debtor
- Rolling payments to vendors versus accrual of additional liabilities–is the net number increasing?
- Projections of further expense reductions to improve cash flow
- Projections of income and expenses on an accrual basis, excluding Chapter 11-related expenses
- Projections of cash flow, including Chapter 11-related expenses
- Actual to projected results of cash flow and of operations
- YOY results
- Outstanding and future quarterly Chapter 11 operating fees owed to the United States Trustee (which fees are now assessed at 1% of quarterly disbursements for all amounts disbursed greater than $1 million (capped at $250,000 per quarter).
- Outstanding liabilities for “20 day” Section 503(b)(9) claims.
It is the job of the board to challenge the reasonableness of assumptions underlying projections. The board should obtain the input of the CRO and other bankruptcy professionals/advisors as to whether management is realistic or overly optimistic. The CRO and other bankruptcy professionals/advisors have the most credibility, on which the board should rely in this regard.
What are the limits to be established by the board on unpaid/unpayable administrative claims? It should not be zero. Businesses do not turn around immediately upon commencement of a Chapter 11 case. But the board should, after consultation with the CRO and management, inquire of management what will be the guardrails not to be breached absent extraordinary (positive) circumstances or a good faith belief that doing so will maximize the value of the corporation for the benefit of all stakeholders, including creditors.
Assuming that a board has abided by the protocol described above, it should be insulated from liability for administrative insolvency – unless the board knowingly or unreasonably permitted or directed unreasonable excesses. If the board asked the right questions, received the right reporting, and reasonably relied on the CRO and management, the board should not be liable. And, when it comes to “reasonableness,” the board should not be second-guessed by Monday morning quarterbacks unless the board’s reliance was reckless or evidenced self-dealing or other personal gain, the antithesis of maximizing value for the company and all of its residual stakeholders.
[i]See Bloomberg News, Toys ‘R’ Us Creditors Sue Directors and Private-Equity Owners, available at https://www.bloomberg.com/news/articles/2020-03-13/toys-r-us-creditors-sue-directors-and-private-equity-owners.
[ii]Quadrant Structured Prods. Co. v. Vertin, 115 A.3d 535, 547 (Del. Ch. 2015).
For an excellent treatment of the topic, see:
- Columbia Law School Millstein Center for Global Markets and Corporate Ownership, Fiduciary Duties of Corporate Directors in Uncertain Times, Ellen J. Odoner, Stephen A. Radin, Lyuba A. Goltser, and Andrew E. Blumberg (August 2017).
- Thomson Reuters Practical Law Bankruptcy, Crucial Steps to Be Taken by the Board of Directors of Financially Troubled Companies (2016).
- Westlaw Journal Bankruptcy, Nearing the End Zone: Developments in the ‘Zone of Insolvency’ (2016).
- ABI Journal, The Fiduciary Duties of Directors of Troubled Companies, Marshall S. Huebner and Darren S. Klein (Feb. 2015).
- In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, the court summarized the duties of directors of solvent corporations. 930 A.2d 92, 99 (Del. 2007). These duties were further clarified and explained by the Delaware Chancery Court in Quadrant Structured Prods. Co. v. Vertin, 115 A.3d 535, 547 (Del. Ch. 2015).
Reprinted with permission from the April 2, 2020, issue of Global Banking & Finance Review. © 2020 GBAF Publications Ltd. All Rights Reserved. Further duplication without permission is prohibited.