Recent Delaware Ruling a Cautionary Tale for Fiduciaries Stewarding Brink-of-Insolvency Corporations

The enduring credit and housing crises, extreme market volatility, and the tightening of U.S. purse strings are pushing more and more corporations to the brink of insolvency and beyond. Corporate fiduciaries stewarding any company that is either insolvent or anywhere near the zone of insolvency must be aware that their actions and inactions will be subjected to heightened scrutiny to ensure that they do not run afoul of established fiduciary duties of loyalty and care. The strictures of those duties in a distressed scenario were the subject of a ruling recently handed down by a Delaware bankruptcy court in In re Bridgeport Holdings, Inc., where the court considered a motion to dismiss litigation commenced by a liquidating trust against a chapter 11 debtor’s former directors, officers, and restructuring professional asserting claims for breach of fiduciary duty and lack of good faith. The bankruptcy court ruled that the complaint alleged sufficient facts to support a claim of breach of duty of loyalty by detailing the directors’ conscious disregard of their duties to the corporation by abdicating all responsibility to the hired restructuring professional and then failing to adequately monitor the restructuring professional’s execution of his own sell strategy, which resulted in an abbreviated and uninformed sale process and the ultimate sale of assets for grossly inadequate consideration.

Fiduciary Duties of Care, Loyalty, and Good Faith

The officers and directors of a corporation owe fiduciary duties of care and loyalty to the corporation. The “duty of care” is defined as the fiduciary duty to exercise the care of ordinarily prudent and diligent persons in like positions under similar circumstances, requiring that a board’s decisions be informed and carefully considered. The duty of loyalty requires a board to act to promote the interests of the corporation without regard for personal gain. In the context of a solvent corporation, these duties of care and loyalty are owed to the corporation’s shareholders and are enforceable by the corporation, either directly or derivatively through the shareholders. When a corporation is insolvent, or is nearing the zone of insolvency, the duties of care and loyalty are owed to the entire corporate enterprise, including creditors, albeit derivatively.

Directors and officers can avail themselves of the “business judgment rule” in defending against such claims. The business judgment rule is a legal presumption that a board’s actions are made on an informed basis, in good faith, and in the best interests of the corporation. This presumption, however, is an imperfect shield. It can be overcome by a showing that a board failed to act with due care, in good faith, or in the best interests of the corporation, after which a challenged transaction is closely scrutinized and the board bears the burden of demonstrating its “entire fairness.”

In discharging their duty of care, directors and officers are entitled to rely in good faith on reports and advice provided by officers of the corporation or outside experts. Many courts have also imputed a good-faith component to the duty of loyalty. While rulings have been murky in defining the contours of the interaction between the duty of loyalty and the attendant requirement of good faith, the Delaware Supreme Court in Stone v. Ritter clarified the issue in 2006 by holding that “the fiduciary duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest.” The duty of loyalty may also be breached in cases where the fiduciary fails to act in good faith. According to the court, “[w]here directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.” The good-faith component of the duty of loyalty figured prominently in the bankruptcy court’s ruling in Bridgeport Holdings.

Bridgeport Holdings

Bridgeport Holdings, Inc. (“Bridgeport”), a Norwalk, Connecticut-based PC and Apple Computer-product catalog company that traded under the name “Micro Warehouse,” filed for chapter 11 protection on September 10, 2003, in Delaware. One day prior to filing for bankruptcy, Bridgeport consummated a sale of substantially all of its U.S. assets, including the bulk of its inventory and nearly all of its intellectual property, to CDW Corporation (“CDW”) for $28 million. CDW’s own discounted cash flow valuation of the assets, however, concluded that the present value of Bridgeport’s U.S. operations was $126 million — more than four times the purchase price.

Falling victim to the bursting of the dot-com bubble and the decrease in consumer demand after the September 11, 2001, terrorist attacks, Bridgeport was forced to renegotiate its credit facility in December 2000 and then again after defaulting on various loan covenants in January 2002. In early June 2003, the company’s secured lenders advised Bridgeport to hire a restructuring advisor. Bridgeport retained a restructuring advisor in August 2003. It also appointed a restructuring professional as chief operating officer (the “CRO”). Within 72 hours of his appointment, the CRO decided to sell Bridgeport’s assets to CDW. The CRO did not commence a competitive bidding process for the assets, nor did he hire investment bankers to explore other opportunities. Neither the CRO nor Bridgeport’s other directors made any substantial effort during the abbreviated due diligence and negotiation period to identify or contact any other potential buyers. In fact, Bridgeport entered into an agreement to negotiate exclusively with CDW and rebuffed any requests for due diligence materials from other potential acquirers thereafter.

The bankruptcy court confirmed Bridgeport’s liquidating chapter 11 plan in 2004. Under the plan, a liquidating trustee succeeded to all estate causes of action. The liquidating trustee sued CDW in 2005, seeking to avoid the pre-bankruptcy sale transaction as a fraudulent conveyance. The litigation was ultimately settled after CDW agreed to pay $25 million to the liquidating trust. The trustee then sued Bridgeport’s officers and directors, alleging that they breached their fiduciary duties in connection with the sale transaction by wholly abdicating their decision-making authority to the CRO, failing to supervise him adequately in his restructuring efforts, and passively acquiescing in the CRO’s decision to sell Bridgeport’s assets on the eve of bankruptcy for a grossly inadequate price. The defendants moved to dismiss, claiming, among other things, that the complaint failed to state a claim for breach of the duty of loyalty.

Bankruptcy judge Peter J. Walsh denied the motion. He clarified that the fiduciary duty of loyalty encapsulates the important component of good faith and that a fiduciary acts in bad faith, breaching the duty of loyalty, when he takes or fails to take any action that demonstrates a faithlessness or lack of true devotion to the interests of the corporation and its shareholders. Applying this standard, he concluded that the complaint adequately stated a claim for breach of the duty of loyalty.

Outlook

Adding to the Third Circuit’s robust jurisprudence on a board’s fiduciary duties of care and loyalty, Judge Walsh’s ruling in Bridgeport is a cautionary tale regarding the heightened scrutiny leveled at corporate fiduciaries of companies skirting the zone of insolvency. The decision, which is fairly detailed in parsing the various forms of fiduciary misconduct, provides a kind of road map for corporate fiduciaries intent upon limiting their potential exposure in distressed situations. Among other things, fiduciaries should: (i) recognize that all actions are likely to be examined and second-guessed; (ii) ensure that all actions are taken with the goal of maximizing the value of the corporation; (iii) avoid interested transactions, preferential treatment of some stakeholders at the expense of others, uninformed approval of transactions, or other actions that could result in forfeiture of the protection of the business judgment rule; (iv) ensure that the board of directors meets regularly and is provided with timely and adequate information concerning any proposed transactions; (v) maintain a constant dialogue with the company’s advisors in connection with any proposed transaction; (vi) implement and adhere to a deliberate (and meticulously documented) decision-making process; (vii) fully disclose all facts material to the decision-making process; (viii) in connection with potential transactions, retain investment bankers and/or other financial professionals, obtain fairness opinions, and solicit competing offers; and (ix) remain well informed and proactive in any restructuring process, recognizing that any abdication of duties without adequate oversight can lead to claims of an absence of good faith.

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In re Bridgeport Holdings, Inc., 388 B.R. 548 (Bankr. D. Del. 2008).

Stone v. Ritter, 911 A.2d 362 (Del. 2006).