Creditors’ Rights Against Officers and Directors

BY BILL SIEGEL

Directors of corporations or managers of limited liability companies (LLC) owe a fiduciary duty to the corporation or LLC. The enforceability of 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 or members who bring a “derivative action” to sue on the company’s behalf. A shareholder or member may only launch or maintain a derivative proceeding if they held that status at the time of the act or omission, or obtained that status by operation of law through someone who held shareholder or member status at the time of the act or omission complained of. The shareholder or member must fairly and adequately represent the interests of the company 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, bankruptcy law, and other creditors’ rights laws. When the company becomes insolvent, creditors’ rights often supersede shareholders and members. Indeed, creditors may bring breach of fidu- ciary duty claims through derivative claims when the company is deemed insolvent. See Aurelius Capital Master, Ltd. v. Acosta (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 for 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 prepetition payment of (i) debtor-in-possession financing approved by the bankruptcy court, (ii) executive bonuses, and (iii) advisory fees.

After discovery, the defendant officers and directors moved for summary judgment to dismiss the Trust’s claims. The court granted the motion regarding the debtor-inpossession financing because that financing had been approved by order of the bank ruptcy court (the DIP Order). Notably, the DIP Order 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 to dismiss claims related to their authorization of bonus payments. Prior to the bankruptcy petition filing, the defendant officers and directors approved retention bonuses to executives and managementlevel employees. After the bankruptcy filing, the bankruptcy court approved a reduction of the bonuses. Yet, the bankruptcy court denied this part of the summary judgment motion because the bonuses were paid prepetition 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. A fact issue also remained as to whether the officers and directors violated a fiduciary duty.

On the pre-petition advisory fees, the court also found that the evidence submitted by the Trust’s expert was sufficient to create a fact issue.

The Takeaway

Courts are likely to focus on the language of prior orders as controlling

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in later proceedings. In the Toys-R-Us bankruptcy, the language in the DIP Order protected the officers and directors. However, such post-petition orders will not protect officers and directors from pre-petition activities unless specifically addressed. A “comfort order” simply referring to such actions (e.g., 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, it is troubling that the bankruptcy court’s ruling in the Toys-R-Us case supported a breach of fiduciary duty finding, as such fees are generally approved and paid pre-petition, and the retention of these advisors is approved by the bankruptcy court. HN Bill Siegel is a Shareholder at Cowles & Thompson, P.C. and can be reached at bsiegel@cowlesthompson.com.