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Recent Developments The Financially Troubled Company

Directors Of Insolvent Corporations: Duties And Protections

The fiduciary duties that directors owe a Delaware corporation and its shareholders are generally held to expand to include the interests of creditors when the company is insolvent or in the "zone of insolvency."  A hot topic among directors, particularly those serving on boards of troubled companies, is how best to meet their fiduciary duties and avoid the potential for personal liability in these situations. 

One of the most important decisions in recent years on this issue came from the Delaware Court of Chancery, the corporate law court, in November 2004 in a case called Production Resources. Why is the case important?  In short, the Production Resources court interpreted the law in a way that gives directors more protection when they make business judgments for a troubled company. 

First, the Production Resources court rejected a trend among some courts and commentators that had sought to impose on directors of insolvent or potentially insolvent corporations a new set of fiduciary duties, beyond those owed to the corporation, in favor of creditors. That trend started back in 1991 with the Court of Chancery decision in the Credit Lyonnais case — the decision that helped coin the phrase “vicinity” or “zone” of insolvency.  

Second, it held that the common exculpatory provision found in the corporate charter of most Delaware corporations, protecting directors from liability for monetary damages for a breach of the fiduciary duty of care, applies to claims made by creditors as well as by shareholders or the corporation itself.

This analysis discusses the Production Resources decision in more detail. (A pdf of the analysis is available as well.)  A "zone of insolvency" conference last November also produced an interesting discussion reported by Professor Larry Ribstein.  If you want to read the 54-page Production Resources decision itself, click here.

The decision’s ultimate impact will depend on whether other courts (including bankruptcy courts where these issues are often litigated) decide to follow its approach — so stay tuned.

Business Bankruptcy Issues The Financially Troubled Company

Setoffs And Bankruptcy

Many businesses not only sell products or services to another company, they also buy products and services from that company.  If you do business with a customer or vendor and you each end up owing the other money, you may have the right to "set off" the amount the other company owes you against the amount you owe it.  

Setoff. When a complete setoff is made, no cash changes hands but each side’s debt to the other is canceled. In some business relationships, including in the telecommunications industry, these kinds of cross-debts occur frequently and setoffs can be an important part of the payment structure. In others, setoffs only come up if one side fails to pay what it owes.  The term is also used to describe a bank’s right to sweep or set off the amounts owed on a loan against amounts the borrower has on deposit at the bank. 

Recoupment. A related concept called "recoupment" is similar to a setoff but it applies only when the offsetting amount or other defense to payment arises from the same contract or transaction that gives rise to your debt to the other company.

Impact of bankruptcy. The U.S. Bankruptcy Code does not create any setoff rights, but with certain limitations it does recognize the rights that exist under other applicable law.  However, with a bankruptcy filing comes a new risk that is similar to the preference risk that arises when you receive a direct payment before a bankruptcy.

  • If you made a setoff within 90 days before the bankruptcy filing, the debtor company (or its bankruptcy trustee, if one has been appointed) may have a right to sue you to recover the amount of that pre-bankruptcy setoff.  
  • Be sure to maintain detailed records of any setoffs made, along with the amounts each side owed the other during the business relationship. These records can be very helpful to your defense if such a claim is ever brought.

Setoff after bankruptcy. Making a setoff after a bankruptcy is filed — also known as a "post-petition" setoff — is allowed only in narrow circumstances.  Among other technical requirements, the debts have to be mutual between you and the actual debtor (not with one of its subsidiaries, for example) and they have to have arisen before the bankruptcy was filed.  Another very important point to remember is that you cannot make a setoff unless the bankruptcy court first grants you relief from the automatic stay that arises as soon as a company files for bankruptcy.

Get legal advice. This is a complex area of bankruptcy law and neither setoffs nor recoupments should be attempted after a bankruptcy has been filed without the advice of a bankruptcy attorney.  The old adage “Don’t try this at home” definitely applies. 

 

Business Bankruptcy Issues Recent Developments

Texas District Court Holds Part Of New Bankruptcy Law Unconstitutional

In a decision on Wednesday, July 26, 2006, the United States District Court in Dallas ruled that a portion of the new bankruptcy law, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (also known as BAPCPA), unconstitutionally restricts attorneys when they provide legal advice to their clients. 

These provisions were part of BAPCPA’s focus on consumers and the restrictions were aimed at preventing attorneys — who are apparently included within the term "debt relief agency" under BAPCPA — from advising individuals, among other things, to take on more debt if they are contemplating bankruptcy.  The court also held that other related provisions were constitutional, specifically one requiring disclosure of certain specific information to individuals who are considering filing for bankruptcy.

While the decision does not affect businesses directly, it’s important to know when a court holds part of the bankruptcy law unconstitutional.  For those interested in learning more about the decision and the consumer-related provisions involved, I recommend that you read David Rosendorf’s excellent post on the American Bankruptcy Institute’s BAPCPA blog and Steve Jakubowski’s equally informative post on his Bankruptcy Litigation blog.

Recent Developments

Trade Credit Insurer Predicts Increase In Corporate Insolvencies in 2007

Euler Hermes, a trade credit insurer, predicts that corporate insolvencies in the United States will increase by 8% in 2007, after a predicted decline of 5% for the full year 2006.  By contrast, 2005 saw a 14% increase, in part because companies filed bankruptcy before the new bankruptcy law took effect on October 17, 2005. 

Among the economic reasons given for the anticipated increase in insolvencies next year:

  • The cooling of the U.S. housing market
  • High energy prices, and
  • The lagging effect of the Fed’s tightening of interest rates.

The press release on the report includes an interesting graph showing the changes in the Euler Hermes Global Business Failure Index over the past dozen years.  It also provides information on changes in predicted 2006 and 2007 insolvency rates for more than 30 countries and regions worldwide. 

This new analysis is consistent with the results of last month’s Turnaround Management Association survey, discussed in a post earlier this week. 

Business Bankruptcy Issues

Claims Against Individuals In Bankruptcy: Is Every Debt Discharged?

Usually, businesses have claims against other businesses.  Still, you may occasionally have a claim against an individual and it’s good to know what can happen in that situation. 

The "no asset" case. Unfortunately, most individuals who file bankruptcy, especially those who file the more common Chapter 7 liquidation case, do not have any significant assets that can be sold to pay creditors.  What’s more, the assets they do have — such as IRAs, 401(k) accounts, etc. — are usually exempt from creditors’ claims.  Cases in which no non-exempt assets are available to pay creditors are known as "no asset" cases.  (Bankruptcy lawyers love imaginative names.)  In a no asset case, the bankruptcy court’s notice will actually instruct you not to file a proof of claim unless later notified to do so. 

The "asset" case.  Sometimes there are enough non-exempt assets to produce at least some distribution to unsecured creditors.  While not very common in Chapter 7 cases, it could be that the individual has filed a Chapter 13 "wage-earner" case or a Chapter 11 personal reorganization case and expects to pay creditors some amount over time.  If so, a claims filing deadline known as a "bar date" will be set.  If you file a proof of claim form by the bar date, you may eventually receive a check, although typically this will be months or even years after the bankruptcy was filed.  In most cases involving individuals, the distribution to unsecured creditors is painfully small.

The bankruptcy discharge. In general, when individuals file bankruptcy, they will get discharged, or excused, from their pre-filing debts.  This is especially true in Chapter 7 and 11 cases and also in Chapter 13 cases if the individual debtor makes all of the payments required under his or her plan.  The discharge is part of what is often referred to as the "fresh start" that bankruptcy offers. 

Nondischargeable debts. Although recent changes to the bankruptcy laws have made it harder for individuals to file bankruptcy and get a discharge, many people are still able to do so.  That said, the law does call out certain kinds of debts and makes them "nondischargeable," meaning that they can be excluded from the scope of the bankruptcy discharge. These include debts arising from the debtor’s fraud or other intentional bad acts, including when he or she obtained credit, and also to obligations for alimony, child support, student loans, and many taxes.  (So it’s clear, the concept of a debt being nondischargeable applies only to individuals, not to corporations or other business entities.) 

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Recent Developments

Defaults And Restructurings — Will 2007 See An Increase In Both?

The Turnaround Management Association, an organization of turnaround professionals, has announced the results of its June 2006 credit availability survey.  In short, the survey results show relatively good credit availability now but suggest that there may be increasing defaults in 2007.  

The TMA press release on the survey has a very interesting discussion of the results and a chart graphically shows a comparison of the credit availability results over the last five years.  The full poll results are available here.

While default rates may be relatively low now, 76% of those responding to the TMA survey believe there will be a significant increase in the debt default rate by the end of 2007.  If they’re right, we could be in for a bumpy ride next year.

Business Bankruptcy Issues Recent Developments

Chapter 11 Cases: Using The Internet To Keep Track Of Case Developments

A fairly recent phenomenon, especially in large Chapter 11 bankruptcy cases, is the special website designed to help creditors and others keep track of developments in a particular reorganization case.  Among active cases right now, for example, you can follow the latest activity in the Delphi Chapter 11 case, the Refco bankruptcy, and the Delta Airlines case.  These websites generally have information about the attorneys representing the company and the creditors’ committee, an electronic docket of pleadings filed in the case, access to a proof of claim form, and announcements about major events in the case.  

Many companies in Chapter 11 reserve a section of their corporate website for updates on their reorganization efforts, and they often make pleadings and other documents available there.  Adelphia is just one example.

Regardless of whether a special website has been created, you or your attorney can also obtain access to the pleadings and other documents filed in a Chapter 11 case (and any other type of bankruptcy case) through the relevant bankruptcy court’s PACER system.  Another system, called Case Management/Electronic Case Files or CM/ECF, typically is open only to attorneys and other bankruptcy professionals with a need to file pleadings in a bankruptcy case.  Both services require pre-registration and payment of downloading or other fees where applicable.