The Financially Troubled Company

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Business Bankruptcy Issues The Financially Troubled Company

Using Chapter 11 Bankruptcy’s Sale Process To Achieve An Exceptional Sale Price

A Difficult Problem. Imagine that your company is facing a government investigation, requiring you to spend hundreds of thousands of dollars in legal fees and costs, while being threatened with substantially more legal expense. That financial burden is simultaneously starving the company of cash needed to grow the business, and cash balances are heading toward zero. Worse yet, the cloud over the company means it cannot raise additional investment or even find a buyer, as potential buyers fear being saddled with the government investigation and any underlying potential claims.

The Strategy. That was the trap confronting our client Cylex Inc., a Maryland-based life sciences company whose diagnostic test kit detects immune function in organ transplant patients, when they asked me for help. After considering alternatives, the strategy we crafted was to use Chapter 11 bankruptcy’s sale process to obtain a bankruptcy court order expressly permitting the buyer to purchase the company’s assets “free and clear” of the government investigation and underlying claims. 

 

The Stalking Horse Bidder. With the legal strategy in place, the next step was negotiating with a strategic buyer the company had identified.  Fortunately, Cylex recognized the need for a solution early enough that we had time to work through the challenges of implementing the strategy.

  • Given that the sale would be under Bankruptcy Code Section 363 – which allows a bankruptcy court to authorize an asset sale free and clear of liens, interests, claims and encumbrances – the buyer knew that its asset purchase agreement would be subject to “higher and better bids.” In effect, as seller, Cylex would have a chance to “shop” the buyer’s purchase agreement to try and find a better deal.
  • The buyer, known as a “stalking horse bidder” in bankruptcy parlance, wanted both a break-up fee (a percentage of the sale price) and an expense reimbursement (for legal and other direct expenses), in the event another bidder emerged and won the bidding. Those amounts also set the floor for a minimum “topping” or overbid price.
  • As is common, the stalking horse bidder also insisted on a no-shop provision until the bankruptcy was filed, meaning that Cylex would have a chance to shop the deal but only for a relatively short period after the bankruptcy was filed.
  • The pre-bankruptcy sale negotiations with the stalking horse bidder were challenging and took months. However, in November 2012, Cylex and the stalking horse bidder executed a formal asset purchase agreement calling for a $6 million purchase price, but also including a long list of closing conditions, an escrow holdback, and other non-economic terms unfavorable to Cylex.

The Bankruptcy Filing.  Cylex filed Chapter 11 bankruptcy in the U.S. Bankruptcy Court for the District of Delaware on December 3, 2012. Among the motions we filed on the first day of the case was one to approve the break-up fee, expense reimbursement, and bidding procedures, and the Bankruptcy Court approved them two weeks later. Given the company’s dwindling cash, the bidding procedures set a deadline of January 18, 2013 for any overbids, an auction on January 22, 2013 (if any overbids were made), and a hearing on approval of the sale on January 23, 2013. The schedule was accelerated to be sure Cylex could get the transaction closed before it ran out of cash.

 

The Sale And Auction Process. The company and its advisors only had about six weeks to shop the stalking horse bid, including over the holidays, but they made the most of the limited time.

  • On the day of the overbid deadline, two new strategic bidders submitted overbids, both in the $6.7 million minimum overbid amount. That set the stage for the auction four days later.
  • The auction made all of the efforts worthwhile. After 16 rounds of bidding, spanning more than 12 hours, the winning bid (from one of the two overbidders) was a stunning $14.425 million, all cash at closing. Through the auction, Cylex had increased the sale proceeds by more than $8 million over the stalking horse bid.
  • When faced with bidding competition at the auction, the stalking horse bidder and each of the overbidders made concession after concession on non-economic terms, dropping closing conditions and the escrow holdback, and agreeing to purchase price adjustments favorable to Cylex.
  • The Bankruptcy Court approved the sale to the winning bidder on January 23, 2013, and entered an order expressly permitting the winning bidder to purchase Cylex’s assets “free and clear” of the government investigation and underlying claims. The sale closed in February.

Conclusion. Cylex, now known as Immunology Partners Inc., faced an extremely challenging set of problems caused by the government investigation, in turn triggered by a False Claims Act qui tam complaint. Although the government later declined to intervene in the qui tam case, that decision came too late for the company to have non-bankruptcy options.  As mentioned in the press release on the sale, despite the legal issues and financial distress it faced, the company was ultimately able to sell its assets for 2.6 times revenue, a multiple typically reserved for healthy companies in its industry. It never could have achieved that sale price, or perhaps any price, without a bankruptcy sale process given the cloud of the government investigation.  Chapter 11 bankruptcy may be considered a last resort, but there are times when it is simply the best way to address a company’s financial and legal problems.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Summer 2012 Edition Of Bankruptcy Resource Now Available

The Summer 2012 edition of the Absolute Priority newsletter, published by the Bankruptcy & Restructuring group at Cooley LLP, of which I am a member, has now been released. The newsletter gives updates on current developments and trends in the bankruptcy and workout area. Follow the links in this sentence to access a copy of the newsletter. You can also subscribe to the blog to learn when future editions of the Absolute Priority newsletter are published, as well as to get updates on other bankruptcy and insolvency topics.

The latest edition of Absolute Priority covers a range of cutting edge topics, including:

  • Decisions from courts in Delaware and California interpreting the Supreme Court’s 2011 Stern v. Marshall decision and its impact on the ability of bankruptcy courts to enter final judgments in fraudulent transfer and other cases;
  • The Section 546(e) defense to fraudulent transfer claims; and
  • Issues involving the recharacterization of a non-insider’s loans as equity.

This edition also reports on some of our recent representations, including our work for official committees of unsecured creditors in Chapter 11 cases involving major retailers and others. Recent committee cases include Ritz Camera & Image, Blockbuster, Orchard Brands, Wave 2 Wave Communications, Signature Styles, Urban Brands, and Mervyn’s Holdings, among others.

I hope you find the latest edition of Absolute Priority to be of interest.

Business Bankruptcy Issues The Financially Troubled Company

Forced Into Bankruptcy: The Involuntary Bankruptcy Process

When a company is facing financial distress, the question often comes up whether creditors can "force" the company into bankruptcy. Although the answer is more complicated than it may seem, this post aims to sort out what being "forced into bankruptcy" really means (hint: there are two different ways this can happen) and why it matters to companies and creditors.

Forced But Voluntary Bankruptcy. When a company is "forced" into bankruptcy, often what actually has happened is that the company filed a voluntary bankruptcy petition under Chapter 11 (reorganization) or Chapter 7 (liquidation) of the U.S. Bankruptcy Code in response to creditor actions. For example, a secured lender may have declared a default under its loan documents and commenced foreclosure proceedings, or an unsecured creditor may have filed a lawsuit or obtained a judgment against the company. In response, the company filed bankruptcy.

While it may be fair to describe the company as having been "forced" into bankruptcy, technically the company’s board of directors made a voluntary decision to file bankruptcy given the company’s financial circumstances or creditor actions. The distinction is important because a voluntary bankruptcy filing puts the company in bankruptcy immediately, making it subject to the Bankruptcy Code’s provisions and the bankruptcy court’s supervision. In contrast, the other kind of bankruptcy — an involuntary bankruptcy filing — does not. 

A Truly Involuntary Bankruptcy. This begs the question: if the company does not consent, can creditors literally force a company into bankruptcy anyway? The answer is yes, under certain circumstances, and subject to meeting the requirements for filing an involuntary bankruptcy petition. The major requirements, discussed below, are found in Section 303 of the Bankruptcy Code.

  • Required number of creditors. The Bankruptcy Code specifies the minimum number of creditors and amount of their claims: 
    • If a company has 12 or more creditors, an involuntary bankruptcy petition requires (a) three or more creditors whose claims are not contingent as to liability or subject to a bona fide dispute as to either liability or amount to file the petition, and (b) those qualifying claims must total, in the aggregate, at least $14,425 if unsecured or $14,425 more than the value of any liens securing those claims if any are secured.
    • If the company has fewer than 12 creditors, it only takes one qualifying creditor to file an involuntary petition.
    • Additional creditors can join the petition later, and if only one creditor files and it turns out that the company has more than 12 creditors, the bankruptcy court will give other creditors an opportunity to join.
    • The $14,425 amount is adjusted every three years, with the next adjustment due in April 2013.
  • Generally Not Paying Debts. If the company timely objects to the involuntary filing, for the company to be placed in bankruptcy, the company also must: 
    • generally not be paying its debts as they become due unless those debts are subject to a bona fide dispute as to liability or amount, or
    • have had a custodian appointed within the past 120 days to take possession or control of substantially all of its assets.
  • Choosing The Chapter. In the involuntary petition, the petitioning creditors must designate which bankruptcy chapter (Chapter 7 or 11) into which they seek to force the company.

How Is An Involuntary Different? When an involuntary petition is filed, the automatic stay of bankruptcy kicks in immediately to prevent creditor actions, but that’s where the similarities with voluntary bankruptcy end.

  • Unlike a voluntary bankruptcy filing, when an involuntary bankruptcy petition is filed, a company is not immediately placed into bankruptcy and the company may continue to operate its business and use, acquire, or dispose of its property as if an involuntary bankruptcy case had not been filed.
  • Instead, an involuntary bankruptcy petition functions more like a complaint asking the court to declare that the company should be put into bankruptcy. Like a complaint, the involuntary petition must be served together with a summons.
  • Although the bankruptcy court has the authority to appoint an interim trustee or order other restrictions on the company, those do not automatically apply, have to be sought by motion, and may be denied by the bankruptcy court.
  • The company can consent to the involuntary bankruptcy filing. When an involuntary Chapter 7 filing is made, the company can also respond with its own voluntary Chapter 11 filing and take control over the case as a debtor in possession.
  • To contest an involuntary petition, the company must do so within the time allotted by the Federal Rules of Bankruptcy Procedure, currently 21 days after service of the summons. Typically that involves filing an answer or a motion to dismiss.
  • Litigation over whether the requirements discussed above have been met, and thus whether the company should be put in bankruptcy, can involve various pleadings, document and deposition discovery, status conferences, motions for summary judgment, and/or an evidentiary hearing or trial. 
  • If the bankruptcy court ultimately rules in favor of the petitioning creditors, an "order for relief" is entered and the company is officially placed into bankruptcy. At that point, the company is subject to the Bankruptcy Code’s provisions and supervision by the bankruptcy court.

What If The Involuntary Fails? Filing an involuntary bankruptcy petition against a company is, of course, serious business, and the consequences of failing are equally serious.

  • Once filed, an involuntary petition cannot be dismissed without a notice and an opportunity for a hearing, even if the petitioning creditors and the company agree.
  • If the involuntary petition is dismissed, the petitioning creditors can be liable for costs and attorney’s fees of the company.
  • If the bankruptcy court determines that the involuntary petition was filed in bad faith, the petitioning creditors can be liable as well for damages caused by the involuntary filing and even for punitive damages.

When Do Creditors Typically File An Involuntary? The prospect of creditor liability for costs, attorney’s fees, damages, and possibly punitive damages makes involuntary petitions one of the lesser-used creditor tools. Involuntary bankruptcy is most often used when unsecured creditors suspect fraud on the part of a company, such as when a Ponzi scheme is discovered, or for some other extraordinary reason. Otherwise, creditors will typically pursue collection of their own claims directly, including through litigation in state or federal court. That might end up "forcing" the company into bankruptcy, but technically it would be a bankruptcy of the voluntary kind.

Recent Developments The Financially Troubled Company

Delaware Supreme Court Affirms Ruling Protecting Managers Of Insolvent LLCs

Creditor Derivative Claims Against Fiduciaries Of Insolvent Corporate Entities. In a 2007 decision in North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 930 A.2d 92 (Del. 2007), the Delaware Supreme Court held that directors of an insolvent Delaware corporation could be sued derivatively by creditors for breaches of fiduciary duty. For a discussion of the case, you may find this earlier post of interest: "Delaware Supreme Court Addresses, For The First Time, Whether Creditors Can Sue Directors For Breach Of Fiduciary Duty When The Corporation Is Insolvent Or In The Zone Of Insolvency." 

What About LLCs? The Gheewalla decision clarified that creditors of a Delaware corporation that is insolvent (but not one only in the "zone of insolvency") can assert derivative claims against the corporation’s directors. That led many to wonder whether the same ruling would be extended to managers of Delaware limited liability companies ("LLCs"), the LLC equivalent of a corporation’s directors. 

The Chancery Court’s Decision. In November 2010, the Delaware Chancery Court answered the question, somewhat surprisingly, with a decisive "no." In CML V, LLC v. Bax, 6 A.3d 238 (Del.Ch. 2010), the Chancery Court held that creditors could not bring derivative actions for breach of fiduciary duty against managers of insolvent LLCs, chiefly because the relevant Delaware LLC Act provision limited standing to bring such suits only to LLC members and their assignees. For a discussion of the Chancery Court decision, follow the link to a November 2010 post on the blog entitled "New Ruling Finds Important Protection For Managers Of Insolvent Delaware LLCs."

The Delaware Supreme Court Decision. The decision was appealed to the Delaware Supreme Court. On September 2, 2011, the Delaware Supreme Court issued an opinion analyzing the Delaware LLC Act and affirming the Chancery Court’s decision. A copy of the Delaware Supreme Court’s opinion is available through this link.

  • The Delaware Supreme Court held that the literal terms of the Delaware LLC Act, specifically 6 Del. C. section 18-1002, limits standing to bring derivative claims only to LLC members and their assignees because the LLC Act provides that only they are "proper plaintiffs." The Delaware Supreme Court held that this statute was unambiguous and expressly limits standing only to LLC members and their assignees. The creditor plaintiff argued that it was "absurd" for the result to be different as between a corporation and LLC, but the Delaware Supreme Court held that the Delaware General Assembly "was well suited to make that policy choice and we must honor that choice." 
  • The plaintiff also claimed that by limiting standing, the statute violated the Delaware Constitution’s prohibition against curtailing the Chancery Court’s jurisdiction to less than the general equity jurisdiction of the High Court of Chancery of Great Britain as it existed in 1792, when Delaware ratified its first constitution. The Delaware Supreme Court rejected the argument holding that, among other reasons, Delaware limited liability companies, unlike corporations, came into existence only in 1992 and therefore did not exist in 1792. In addition, the LLC statute was properly able to both grant and limit derivative standing.

Creditor Options. Recognizing that this standing provision could limit creditor remedies in the event of insolvency, the Delaware Supreme Court discussed one remedial option available to creditors. In footnote 20 of the opinion, the Court stated:

Admittedly, this approach is not the only option the General Assembly had, and we make no normative comment on the General Assembly’s policy choice. Our only purpose here is to explain that limiting derivative standing to members and assignees in a contractual entity like an LLC is not absurd because other interest holders–like creditors–have other options–as, for example, negotiating automatic assignment of membership interests upon insolvency clauses into the credit agreement and requiring the members and governing board to amend the LLC agreement accordingly.

Key Observations. As the Delaware Supreme Court noted, certain creditors may require that the LLC agreement be amended to provide for automatic assignment of membership interests to the creditors upon insolvency. If so, those creditors would then have standing to bring derivative claims. However, absent such provisions, under the Delaware Supreme Court’s decision:

  • Managers of a Delaware LLC will not be subject to derivative claims by creditors if the entity becomes insolvent, although it is far less certain that the standing statute would preclude a bankruptcy trustee from bringing claims on behalf of the LLC itself;
  • An insolvent LLC’s creditors will not have derivative standing to bring potential D&O type claims; and
  • These creditors will be limited to contractual remedies against the LLC to protect themselves. 

Although Delaware LLCs and corporations share many common features, this new Delaware Supreme Court decision makes clear that the automatic derivative standing of creditors upon insolvency is one important distinction.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Spring 2011 Edition Of Bankruptcy Resource Now Available

The Spring 2011 edition of the Absolute Priority newsletter, published by the Cooley LLP Bankruptcy & Restructuring group, of which I am a member, has just been released. The newsletter gives updates on current developments and trends in the bankruptcy and workout area. Follow the links in this sentence to access a copy of the newsletter. You can also subscribe to the blog to learn when future editions of the Absolute Priority newsletter are published, as well as to get updates on other bankruptcy and insolvency topics.

The latest edition of Absolute Priority covers a range of cutting edge topics, including:

  • Recent case law on third-party releases in bankruptcy plans;
  • Treatment of make-whole and no-call provisions in bankruptcy;
  • Breach of fiduciary duty claims against managers of insolvent Delaware LLCs; and
  • Ordinary course of business defense to preferences.

This edition also reports on some of our recent representations, including the successful Chapter 11 reorganization of our client, retailer Crabtree & Evelyn, Ltd., and our work for official committees of unsecured creditors in Chapter 11 bankruptcy cases involving major retailers and others. Recent committee cases include Blockbuster, Orchard Brands, Ultimate Electronics, Claim Jumper Restaurants, OTC Holdings, Urban Brands, Mervyn’s Holdings, Sierra Snowboard, Trade Secrets, Mt. Diablo YMCA, and Pacific Metro, among others.

I hope you find the latest edition of Absolute Priority to be of interest.

Recent Developments The Financially Troubled Company

New Ruling Finds Important Protection For Managers Of Insolvent Delaware LLCs

Derivative Claims Against Directors Of An Insolvent Delaware Corporation. With its 2007 decision in North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 930 A.2d 92 (Del. 2007), the Delaware Supreme Court held that directors of an insolvent Delaware corporation could be sued derivatively by creditors for breaches of fiduciary duty. To read that decision, click on the case name in the prior sentence. For a discussion of the case, you may find this earlier post of interest: "Delaware Supreme Court Addresses, For The First Time, Whether Creditors Can Sue Directors For Breach Of Fiduciary Duty When The Corporation Is Insolvent Or In The Zone Of Insolvency."

What About LLCs? The Gheewalla decision clarified that creditors of a Delaware corporation that is insolvent (but not one only in the "zone of insolvency") can assert derivative claims against the corporation’s directors, but a question remained: Would that same ruling extend to managers of Delaware limited liability companies, the LLC equivalent of a corporation’s directors. Although a number of commentators and some court decisions assumed that it would, a recent Delaware Chancery Court decision has answered the question, somewhat surprisingly, with a decisive "no."

New Chancery Court Ruling. In the new decision, CML V, LLC v. Bax, C.A. No. 5373-VCL (Del.Ch. Nov. 3, 2010), the Delaware Chancery Court undertook an extensive analysis of the Delaware LLC Act and also examined the issue more broadly.

  • The Court held that under the literal terms of the Delaware LLC Act, specifically 6 Del. C. section 18-1002, only LLC members and their assignees have standing to bring derivative claims because the LLC Act provides that only they are "proper plaintiffs." The LLC Act does not give an insolvent LLC’s creditors standing to bring derivative claims. The situation is different for creditors of insolvent corporations because the governing Delaware corporation statutes do not impose exclusive derivative standing provisions.
  • Although the Chancery Court acknowledged that arguments could be made for allowing creditors to bring derivative actions against managers of an insolvent LLC, the Court saw no reason to set aside the literal reading of the LLC Act’s standing provision. The Court also noted that the Delaware Limited Partnership Act has a similar exclusive standing provision.

For a full discussion of the decision, including a link to the opinion itself, be sure to read Francis G.X. Pileggi’s excellent post entitled "Chancery Bars Derivative Claim of Creditor Against Insolvent LLC, Based on LLC Act."  

Impact On An Insolvent LLC’s Creditors. So where does this new decision leave creditors of an insolvent Delaware LLC?

  • Under the Chancery Court decision, unlike directors of a Delaware corporation, managers of a Delaware LLC are not be subject to derivative claims by creditors if the entity becomes insolvent. 
  • If the decision is followed by other courts — specifically including bankruptcy courts where claims involving managers of bankrupt LLCs may more often be litigated — then an insolvent LLC’s creditors will not have access to potential D&O type claims. Instead, those creditors will have to rely on contractual remedies against the LLC to protect themselves. 

Stay Tuned. As noted, the bankruptcy court is often the forum where insolvency-related matters are litigated. Should these claims be pursued outside of the Chancery Court, it will be interesting to see how other courts interpret the Delaware LLC Act’s provisions. 

Recent Developments The Financially Troubled Company

California Court of Appeal Provides Guidance For Directors Of Financially Distressed California Corporations

As I have reported over the past several years, Delaware courts, including the Delaware Supreme Court, have addressed the nature of a director’s fiduciary duties when a Delaware corporation is insolvent or in the "zone of insolvency," most notably with the 2007 decision in North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 930 A.2d 92 (Del. 2007). To read that decision, click on the case name in the prior sentence. For a discussion of that case, you may find this earlier post of interest: "Delaware Supreme Court Addresses, For The First Time, Whether Creditors Can Sue Directors For Breach Of Fiduciary Duty When The Corporation Is Insolvent Or In The Zone Of Insolvency."

California courts, however, did not have occasion to consider fiduciary duty issues involving directors of financially distressed California corporations until recently. In a decision called Berg & Berg Enterprises, LLC v. Boyle, the California Court of Appeal for the Sixth Appellate District has provided directors of California corporations facing potential insolvency with meaningful guidance on the scope of their fiduciary duties, including the application of California’s "trust fund doctrine." 

It will be interesting to see whether other California courts, perhaps eventually including the California Supreme Court, will have opportunity in the months and years ahead to consider these important issues to directors and officers.