Feature - Spotts Fain

Feature
By Jed Donaldson1
Parent Corporations: Mitigating
Risk and Preserving Rights When
a Subsidiary Files for Chapter 11
P
Jed Donaldson
Spotts Fain PC
Richmond, Va.
Jed Donaldson is
an associate in the
Creditors’ Rights,
Bankruptcy and
Insolvency Group
of Spotts Fain PC in
Richmond, Va.
arent corporations face many issues and decisions when a subsidiary is distressed, insolvent and ultimately bankrupt. If that subsidiary files for chapter 11 protection, not only may
the subsidiary/debtor be subject to strict scrutiny by
creditors and the court, but the parent corporation’s
pre-petition acts will be also scrutinized — especially if that parent is solvent — by stakeholders,
creditors and the court. Parent corporations face
risks when a subsidiary files due to the likelihood of
intra-corporate loans and claims, an overlap in officers and directors, and the informational advantage
that a parent, an affiliate or insider2 holds relative to
unaffiliated creditors. Significant risks include (1)
equitable subordination of claims and recharacterization of debt as equity, (2) denial of credit-bidding
rights and (3), to the extent that the parent and subsidiary share officers and directors, the appointment
of a chapter 11 trustee. The law on these theories
provides guidance on how parent corporations may,
through careful pre-petition planning and corporate
governance, avoid litigation and punitive remedies
that would impair a parent’s rights and claims.
The Risk of Equitable Subordination
A parent corporation that holds claims against
its debtor/subsidiary must avoid using informational
advantages to the detriment of unaffiliated creditors.
Under § 510(c), the law on equitable subordination
is well established, and courts may subordinate
claims of a creditor if the following three elements
exist: (1) the claimant has engaged in inequitable
conduct; (2) the misconduct has injured the debtor’s creditors or conferred an unfair advantage on
the claimant; and (3) equitable subordination is not
inconsistent with the Bankruptcy Code.3
Claims arising from transactions between the
debtor and its fiduciaries face rigorous scrutiny. If
the claims are sufficiently challenged, the burden
of proof then shifts to the fiduciary to prove the
good faith and inherent fairness of the transaction.4
1 The author thanks Robert H. Chappell, III of Spotts Fain PC for his comments and suggestions in writing this article.
2 See 11 U.S.C. §§ 101(2) and 101(31) (defining “affiliate” and “insider,” respectively).
3 See, e.g., Benjamin v. Diamond (In re Mobile Steel Co.), 563 F.2d 692, 699-700 (5th
Cir. 1977).
4 Diamond, 563 F.2d 692; Summit Coffee Co. v. Herby’s Foods (In re Herby’s Foods Inc.),
2 F.3d 128, 131 (5th Cir. 1993); see also Shubert v. Lucent Techs. Inc. (In re Winstar
Commc’ns Inc.), 554 F.3d 382, 412 (3d Cir. 2009).
58 September 2013
Common themes that arise in the context of equitable subordination are (1) a fiduciary of the debtor
misuses its position to the disadvantage of other
creditors, (2) a third party controls the debtor to
the disadvantage of other creditors and (3) a third
party defrauds other creditors.5 If a debtor is an
instrumentality of its parent and subject to control,
then, where the parent acts inequitably to injure
other creditors, courts may subordinate that parent’s claim. Loans from insiders to distressed corporations, however, will not ipso facto be subordinated or recharacterized as equity because courts
are reluctant to punish an insider that makes efforts
to revive a struggling corporation.6
A 1998 Third Circuit case highlights how misuse of insider information by a creditor that also has
representation on a debtor’s board of directors may
lead to equitable subordination. In Citicorp Venture
Capital Ltd. v. Unsecured Creditors’ Committee,7
the Third Circuit affirmed the equitable subordination of claims acquired post-petition by Citicorp
Venture Capital (CVC), an entity that pre-petition
had acquired a 28 percent interest in the debtor’s
corporate parent and that also had representation on
each of the parent’s, debtors and two of the debtor’s
subsidiaries’ boards. Within seven months after the
petition date, CVC acquired a 40 percent interest in
the debtor’s note obligations. CVC then objected to
the proposed plan that it had supported pre-petition,
instead proposing its own plan to purchase the debtor’s assets. CVC acquired the interest by spending
$10.5 million for claims with a face value of $60.8
million. CVC’s claims, purchased post-petition, (1)
were not disclosed to other creditors, (2) utilized
confidential information and (3) were purchased
for profit in derogation of its fiduciary duties. CVC
diluted the voting rights of pre-petition creditors
to wrest control and assets away from those creditors, giving it the ability to influence negotiations
and oppose the pre-petition plan that it had earlier
supported. Also, CVC’s actions created a conflict
of interest that prevented it from making decisions
as the debtor’s fiduciary in issue exacerbated by its
profit motive. “[T]he opportunity to purchase the
5 See In re U.S. Abatement Corp., 39 F.3d 556, 561 (5th Cir. 1994).
6 Rego Crescent Corp. v. Tymon (In re Rego Crescent Corp.), 23 B.R. 958 (Bankr.
E.D.N.Y. 1982).
7 160 F.3d 982 (3d Cir. 1998).
ABI Journal
notes was a corporate opportunity of which CVC could not
avail itself, consistent with its fiduciary duty, without giving
the corporation and its creditors notice and an opportunity
to participate.”8 The bankruptcy court applied a per se rule
that when an insider purchases a claim of a debtor without
disclosure of the purchase to the debtor and its creditors, that
claim will be allowed only to the extent of the amount paid,
and recovery on the claim will be limited to the percentage
distribution provided in the plan, as applied to the allowed
claim. While the Third Circuit affirmed the district court,
it neither expressly approved nor rejected that remedy, but
held that remand was appropriate in order to allow for further
factual findings.9 A parent corporation should be mindful of
conflicts of interest and its use of inside information in order
to mitigate the risk of equitable subordination.
Preserving Credit-Bid Rights
To the extent that the parent seeks to purchase the subsidiary/debtor’s assets, the parent may credit-bid10 its secured
claim for those assets.11 Insiders, such as a parent, that act in
bad faith may lose their credit-bid rights, and while § 363(m)
protects good-faith purchasers of assets at a § 363 sale, good
faith is absent where there exists “fraud, collusion between
the purchaser and other bidders or trustee, or an attempt to
take grossly unfair advantage of other bidders.”12 An assetpurchaser that is an insider of the debtor with an informational
advantage that fails to disclose relevant facts while pursuing
an acquisition of the debtor may evince a lack of good faith.
On the other hand, creditors that exercise restraint while
possessing insider information mitigate the risk of jeopardizing their credit-bidding rights. The U.S. Bankruptcy
Court for the District of Delaware evaluated alleged badfaith conduct by a creditor with significant inside information that purchased a debtor’s assets in Official Committee of
Unsecured Creditors v. Tennenbaum.13
The debtor, Radnor Holdings Corp., obtained pre-petition financing from Tennenbaum Capital Partners (TCP).
TCP’s loans were secured by substantially all of Radnor’s
assets, and TCP designated one member and one observer
to Radnor’s board of directors but exercised no other rights
that had been granted in an investor rights agreement. The
initial loans were debt obligations with fixed maturity dates,
fixed interest payments, default provisions and other covenants, which later proved to be a beneficial defense to the
unsecured creditors’ committee’s allegations that TCP’s debt
should be recharacterized as equity.14 In early 2006, when it
was approaching insolvency, Radnor requested $23.5 million
8 Id. at 987.
9 Id. at 990. If a court equitably subordinates an insider’s claims, the insider’s credit-bid may then be
capped at the amount that it paid for the claim, rather than the full amount of the debt that it acquired at
a discount. For example, if a buyer acquired $15 million in debt for $8 million and did so through inequitable conduct, then the buyer’s credit-bid could be reduced to $8 million from $15 million.
10“At a sale under subsection (b) of this section of property that is subject to a lien that secures an allowed
claim, unless the court for cause orders otherwise, the holder of such claim may bid at such sale, and
if the holder of such claim purchases such property, such holder may offset such claim against the purchase price of such property.” 11 U.S.C. § 363(k).
11Credit-bidding is a right that is more certain since RadLAX. RadLAX Gateway Hotel LLC v. Amalgamated
Bank, 132 S. Ct. 2065 (2012).
12Tompkins v. Frey (In re Bel Air Assocs. Ltd.), 706 F.2d 301, 304-05 n.11 (10th Cir. 1983).
13Official Committee of Unsecured Creditors v. Tennenbaum Capital Partners LLC (In re Radnor Holdings
Corp.), 353 B.R. 820 (Bankr. D. Del. 2006); see also In re Medical Software Solutions, 286 B.R. 431
(Bankr. D. Utah 2002).
14Radnor, 353 B.R. at 830. Demands for recharacterization often accompany demands for equitable subordination. See, e.g., Cohen v. KB Mezzanine Fund II LP (In re SubMicron Sys. Corp.), 291 B.R. 314 (D. Del.
2003); see also Roth Steel Tube Co. v. Comm’r of Internal Revenue, 800 F.2d 625 (6th Cir. 1986) (stating
factors that may justify recharacterization).
ABI Journal from TCP, which TCP provided. TCP and Radnor executed
a side letter, which included loan covenants that afforded
to TCP the right to appoint a majority of the Radnor board
upon default. TCP, in light of a subsequent default, never
exercised that right. Radnor filed for bankruptcy by August
2006, and shortly after the petition date, Radnor reached an
asset-purchase agreement with TCP.15
The unsecured creditors’ committee filed a complaint
seeking equitable subordination, alleging breaches of fiduciary duty, which the court ultimately dismissed. No evidence existed that TCP used insider information improperly
or that TCP had access to information that other bidders did
not. Also, Radnor’s chief restructuring officer testified that
the sale process was full and fair with no favorable treatment
extended to TCP. While TCP could have exerted pressure
over Radnor, the court found that it exercised restraint.16
Further, the court overruled an objection to TCP acting
as the stalking-horse bidder. The court entered an explicit
bidding-procedures order that became the law of the case.
The court held that the order granted TCP the right to creditbid under § 363(k) the entire amount of its allowed claim.
The order specifically named TCP as the stalking-horse bidder.17 The unsecured creditors’ committee could not collaterally attack that order, which the court held to be in the best
interests of the estate.
There was no evidence that TCP’s board representative
voted in favor of outside financial interests (i.e., TCP), rather
than voting in the best interests of Radnor. “[T]here is no
per se breach of fiduciary duty for an insider making a bid to
purchase a company or its assets. Were it otherwise, every
management-led leveraged buyout would be a per se breach
of fiduciary duty.”18 Further, the unsecured creditors’ committee was comprised mainly of pre-petition noteholders,
95 percent of whom approved the 2006 loan. Their earlier
acquiescence, under Delaware law, precluded them from
later attacking the transaction.19 Such acquiescence, however,
will provide a parent with greater protection if there is full
and fair disclosure of that pre-petition transaction. In addition
to the restrained use of inside information and some measure of forbearance, a parent will benefit from a well-drafted
bidding-procedures order if it wishes to acquire the assets of
its debtor/subsidiary through a § 363 sale.
Appointment of a Chapter 11 Trustee
Appointment of a trustee is a critical concern due to conflicts of interest where there exists an overlap in officers and
directors between a parent and subsidiary.20 If a trustee is
appointed for the debtor in possession (DIP), then along with
added cost and expense, the parent’s mission and goals may
be frustrated. Either of two findings justify the appointment of
a trustee under § 1104. The first, “cause,” includes fraud, dishonesty, incompetence or gross mismanagement of the debtor
by current management.21 The second, the “best-interests-of15Id. at 834.
16Id. at 841.
17Id. at 846.
18Id. at 845 (internal citations omitted).
19Id. at 847.
20See, e.g., In re Microwave Prods. of Am. Inc., 102 B.R. 659, 672 (Bankr. W.D. Tenn. 1989).
21See In re Cajun Elec. Power Cooperative Inc., 191 B.R. 659, 661 (Bankr. M.D. La. 1995).
continued on page 78
September 2013 59
Mitigating Risk and Preserving Rights When a Subsidiary Files for Chapter 11
from page 59
creditors” test, is a flexible standard under which courts consider (1) the debtor’s trustworthiness; (2) the DIP’s past and
present performance and its rehabilitation prospects; (3) the
confidence, or lack thereof, of the creditors in the debtor’s
current management; and (4) a cost-benefit analysis.22
Two cases from the utility industry — in which producers
of electricity often form member cooperatives where each
member has board representation on the cooperative — highlight some of the pitfalls of relationships between subsidiaries and parents. In In re Cajun Elec. Power Cooperative,23
each member had two representatives on the debtor’s board.
The court appointed a trustee due to the existence of conflicts of interest among the debtor, its members — akin to
corporate parents — and creditors. The debtor failed to collect monies owed to it by its members and failed to provide
its members with information about a sale of its assets while
also favoring the interests of certain members at the expense
of creditors, which warranted appointment of a trustee.24
In In re Colorado-Ute Elec. Assoc’n Inc.,25 the debtor was
an electric company with 14 members. Pre-petition, there
had been significant turnover on the debtor’s board. The new
replacement directors lacked the industry experience and
expertise to retain skilled outside advisers. Colorado-Ute’s
creditors filed an uncontested involuntary bankruptcy against
it. The creditors contended “that the board and members
[were] divided due to parochial interests and that there [was]
an inherent conflict of interest or gridlock on the board due to
22See In re The 1031 Tax Group LLC, 374 B.R. 78, 91 (Bankr. S.D.N.Y. 2007).
23191 B.R. 659 (Bankr. M.D. La. 1995).
24Id. at 662 (“Under the facts of this case, it is impossible for the [DIP] to act as a fiduciary for the estate at
the same time as it acts as a fiduciary for its members and customers.”).
25120 B.R. 164 (Bankr. D. Colo. 1990).
the Colorado-Ute directors wearing hats as both board members and creditor representatives of the co-op members.”26 The
debtor failed to collect debts due from members and implemented some of the recommendations of an outside auditor,
but it still needed a trustee because “no new board members ...
have brought the skills and expertise suggested by [the auditor].”27 Unlike the conflicted board, an outside trustee would
serve as a “fiduciary of the estate [and] be mindful of his
or her duties to all constituents, and will not be controlled
or stymied by one particular group.”28 The allegiance of the
debtor/subsidiary’s directors is crucial, and a majority of disinterested directors serving on the debtor’s board is one factor
that helps to preclude appointment of a trustee.
Takeaway and Conclusion
These theories are not the only hazards for a careless or
self-dealing parent corporation that faces a distressed subsidiary. Substantive consolidation is another potential but
remote concern, as are veil-piercing-type claims.29 Each case,
however, is fact-specific and requires careful review of the
parent’s and subsidiary’s bylaws and articles of incorporation at an early stage, as those documents may define the
parties’ relationship and the level of the parent’s control, and
may even require an amendment to best address an insolvent
subsidiary. While there is always risk for a parent, especially
a solvent one, deliberate and diligent planning will serve it
well when faced with a distressed subsidiary. abi
26Id. at 171.
27Id.
28Id. at 177.
29See generally In re Owens Corning, 419 F.3d 195 (3d Cir. 2005).
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American Bankruptcy Institute.
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78 September 2013
ABI Journal