Delaware Bankruptcy Court Expounds on Directors’ Duties in Financially Distressed Situations

June 30, 2008

On May 30, 2008, the United States Bankruptcy Court for the District of Delaware issued a memorandum opinion in which it refused to dismiss breach of fiduciary duty claims against corporate directors who approved the sale of a financially distressed company’s assets on the eve of bankruptcy.[1]  The Court’s opinion sheds light on directors’ duties, and what they can and should do to protect themselves from liability, in such situations. 

In Bridgeport, a bankruptcy liquidating trust filed a complaint against the officers and directors of the debtor, traded as "Micro Warehouse," alleging that they breached their duties to the company, its shareholders and its creditors in connection with a sale of the company’s assets.  The complaint alleged that Micro Warehouse began experiencing financial difficulty in 2000.  After several years of declining financial performance, in early August 2003, the company concluded that its best option was to execute a sell strategy.  At that point, one of the directors called upon an acquaintance at another company, CDW Corporation ("CDW"), to talk about purchasing Micro Warehouse. 

In late August 2003, the company formally retained a restructuring advisor and appointed him to the position of Chief Operating Officer.  Within 72 hours of commencing work, the restructuring advisor determined to sell the company’s assets.  However, instead of hiring an investment bank and commencing a competitive bidding process, the complaint alleged that the restructuring advisor immediately continued the sale process with CDW and reached a handshake deal with CDW on September 2, 2003.  During this time, the restructuring advisor made contact with only one other potential acquiror, but provided it with limited due diligence materials.  On September 9, 2003, Micro Warehouse sold to CDW a substantial portion of its North American assets.  The next day, Micro Warehouse filed for chapter 11 bankruptcy protection. 

The liquidating trust sought to recover damages from the officer and director defendants for breaches of the fiduciary duties of loyalty, care and good faith as a result of:  (1) failing to put the assets up for sale earlier, (2) failing to hire a restructuring professional earlier in 2003, (3) abdicating all responsibility to the restructuring professional after he was hired, and (4) acquiescing in the decision to sell the assets quickly, immediately before filing a chapter 11 petition, rather than in a court-supervised sale under the Bankruptcy Code. 

The complaint made no allegations of self-dealing.  As a result, the defendants argued that the breach of duty of loyalty claim must fail.  The Court disagreed, pointing out that the Delaware Supreme Court had recently clarified that a claim for breach of loyalty may be premised on a failure to act in good faith.  The Court concluded that the liquidating trust had alleged sufficient facts to support a claim that the officer and director defendants breached the duty of loyalty and acted in bad faith by consciously disregarding, or abdicating, their duties to the company.  Specifically, the Court said, "the allegations support the claim that the D&O Defendants breached their fiduciary duty of loyalty and failed to act in good faith by abdicating crucial decision-making to [the restructuring advisor], and then failing adequately to monitor his execution of the ‘sell strategy,’ resulting in an abbreviated and uninformed sale process; and approving the sale to CDW for grossly inadequate consideration."[2] 

The defendants argued that the breach of duty of care claim must fail because of the exculpation provision in Micro Warehouse’s certificate of incorporation and the business judgment rule.  The Court again disagreed, noting that "'[w]hen a duty of care breach is not the exclusive claim, a court may not dismiss [the duty of care claim] based upon an exculpatory provision.’"[3]  Therefore, because the liquidating trust had alleged facts supporting a claim for breach of the duty of loyalty as well as lack of good faith, the exculpatory provision was not cause to dismiss the duty of care claim. 

With respect to the business judgment rule, the Court said that to invoke its protections "’directors have a duty to inform themselves, prior to making a business decision, of all material information reasonably available to them.’"[4]  If directors fail to do so, then a court will scrutinize the challenged transaction under the "entire fairness" standard of review.  The complaint had alleged that the director and officer defendants had approved an uninformed fire sale of the company’s assets because they had not hired an investment banker to shop the deal or value the assets, they had not obtained a fairness opinion, and they failed to seek offers from other purchasers.  As a result, the defendants lost the protection of the business judgment rule.

Plaintiffs will certainly seize upon the Bridgeport decision to press their claims against the directors and officers of financially distressed companies.  In particular, plaintiffs will be sure to allege any facts they can to support the inference that officers and directors abdicated their responsibilities and failed to inform themselves of material facts before making decisions.  By doing so, under Bridgeport, plaintiffs will hope to make out claims for breach of the duty of loyalty even in the absence of any self-dealing.  In turn, by making out such claims, plaintiffs will argue that exculpatory provisions and the business judgment rule will not act to defeat claims for breach of the duty of care.

To limit such claims, directors and officers of financially distressed companies should:

• assume all actions will be scrutinized and second guessed;
• avoid actions that could cause loss of protection of business judgment rule (e.g., conflicts of interest or conflicting loyalties; insider issues; preferential treatment of certain stakeholders, failing to keep informed);
• act with care after obtaining all necessary information (directors, members and managers can rely in good faith on reports prepared by officers or outside experts);
• obtain adequate professional and expert advice on a timely basis;
• in consultation with the company’s advisors, establish and follow a deliberate decision-making process;
• document the decision-making process;
• disclose all material facts;
• in connection with potential transactions, hire investment bankers, obtain fairness opinions and/or seek offers from potential purchasers;
• do not freeze up—no decision is a decision and will likely lead to an argument that duties were abdicated.