Bill Siegel was invited to write an article for the Bankruptcy spotlight in the May 2023 edition of the Dallas Bar Association’s Headnotes publication. We are sharing the article here, with permission from the DBA.
Directors of corporations or managers of limited liability companies (“LLC”) owe a fiduciary duty to the corporation or LLC (the “Company”). The right and priority to enforce this duty depends on the Company’s solvency.
Solvency, Rights, and Derivative Claims
When a Company is solvent, the fiduciary duties of officers, directors, and managers may be enforced by the Company shareholders/members who bring a “derivative action” to sue on the Company’s behalf because they are the ultimate beneficiaries of the Company’s growth and increased value. A shareholder or member may only launch or maintain a derivative proceeding if they held that status at the time of the act/omission, OR obtained that status by operation of law through someone who held shareholder/member status at the time of the act/omission complained of. The shareholder/member must fairly and adequately represent the interests of the corporation/LLC in enforcing the rights of that entity.
Unlike direct claims, derivative claims are brought on behalf of the particular entity and not directly for the benefit of the particular shareholder or member. These rights arise from Texas Business Organizations Code sections 21.552 (regarding corporation shareholders) and 101.452 (regarding LLC members).
The rights of creditors of a solvent corporation or LLC arise under contract, fraudulent transfer law, other creditors’ rights laws, and bankruptcy law. When the Company becomes insolvent, these rights increase because creditors supersede shareholders/members in terms of injuries sustained.
Creditors may thus bring breach of fiduciary duty claims through derivative claims when the Company is deemed insolvent. See Aurelius Capital Master, Ltd. v. Acosta, No. 3: 3-CV-1173-P, 2014 WL 10505127, at *5 (N.D. Tex. Jan. 28, 2014).
The Toys-R-Us Bankruptcy
The paradigm seems to change once bankruptcy is filed. Chapter 7 trustees or trusts created pursuant to a bankruptcy plan of reorganization can step into the shoes of shareholders and creditors and file claims against officers and directors based on breaches of fiduciary duty.
The recent Toys-R-Us bankruptcy is instructive. Under the Bankruptcy Plan, a liquidation trust (the “Trust”) was created and became the successor-in-interest to the Debtor and permitted to pursue claims against the Debtor’s directors and officers.
The Trust filed suit against certain officers and directors for breach of fiduciary duties relating to the authorization of pre-petition payment of (i) advisory fees pre-petition and (ii) executive bonuses, plus debtor-in-possession financing approved by the bankruptcy court (collectively, the “Fiduciary Duty Claims”).
After discovery, the Defendant officers and directors filed a motion for summary judgment. The court granted the motion regarding the debtor-in-possession financing because it had been approved by order of the bankruptcy court (the “DIP Order”). Notably, it stated that the terms of the financing “were fair and reasonable…[and] reflect the DIP Loan Parties’ exercise of prudent business judgment consistent with their fiduciary duties.” Further, the DIP Order provided that its terms were “binding upon all parties in interest in these Chapter 11 cases, including…any…fiduciary appointed as a legal representative of any of the Debtors.”
The Defendant officers and directors were less successful regarding bonus payments. Prior to the bankruptcy petition filing, the Defendant officers and directors approved retention bonuses to executives and management-level employees. After the bankruptcy filing, the bankruptcy court approved reduction of the bonuses. Yet, the bankruptcy court denied this portion of the motion because the bonuses were paid pre-petition and thus were not directly approved via a post-petition order. Further, the order that was entered approving the re-negotiated bonuses preserved the rights of the Committee of Unsecured Creditors to pursue claims against the defendant officers and directors. Finally, the court found that evidence was sufficient (if proven at trial) to establish a breach of fiduciary duty.
On the pre-petition advisory fees, the court found the evidence submitted by the Trust’s expert sufficient to create a fact issue.
Courts are likely to focus on the language of prior orders as controlling in later proceedings. Thus, the language in the DIP Order protected the officers and directors. However, such post-petition orders won’t protect officers and directors from pre-petition activities unless specifically addressed. A “comfort order” simply referring to such actions (i.e., the retention bonuses) is insufficient.
When serving as an officer and director of a distressed entity likely to file bankruptcy, it makes sense to negotiate debtor-in-possession loans for approval post-petition by the bankruptcy court, and it is appropriate to negotiate retention bonuses — but not pay them until and unless approved by the bankruptcy court. Regarding advisory fees, the bankruptcy court ruling is troubling regarding a fiduciary duty, as such fees are generally approved and paid pre-petition, then the retention of these advisors is approved by the bankruptcy court. Further, instead of suing the officers and director for breach of fiduciary duty, an action can be asserted against these advisors in the form of a claw back.