Turning Off The Lights: Safely Shutting Down An Insolvent Subsidiary

It is not uncommon for a holding company (or private equity fund) to have at least one operating subsidiary (or portfolio company) that is underperforming relative to the other companies it owns. Sometimes problems can be fixed and fortunes reversed. Other times, however, the subsidiary/portfolio company continues to struggle and may eventually become truly distressed and even insolvent. At some point, the strategic decision will be made to discontinue the operating subsidiary's business. When this occurs, strategy must be quickly developed and executed to minimize any ongoing losses and to maximize the recovery for the subsidiary's stakeholders.

Any business strategy should be approached with an informed understanding of the overall legal landscape, as well as the specific risks and potential rewards associated with each of the parent's available options. Likewise, the parent must understand its position in the decision-making process relative to those of the insolvent subsidiary's other obligees ' its creditors.

For example, a troubled company will likely need cash infusions to continue operating. And, because potential lenders are not likely to be lining up to extend financing in such a situation, the parent is probably going to be faced with having to decide whether continuing to fund the subsidiary is worthwhile, or just a case of throwing good money after bad. In this context, of course, making a secured loan is preferable to making an unsecured one. Even a secured loan, however, can later be “recharacterized” by a bankruptcy court and treated as if it was a capital contribution (and thus moving any recovery on account of the loan to the end of the line).

Is the Subsidiary Worth Saving?

In some instances, the proper business strategy may be to try to save the subsidiary. Broken balance sheets can be fixed if there is a sufficient consensus among the parties at the various levels of the company's capital structure. Flawed business models can in many instances be improved.

Restructurings (whether out of court or through chapter 11 bankruptcy, and whether primarily financial or operational) can be time consuming and expensive. Moreover, the ability to restructure successfully depends upon many factors beyond the parent's control. For example, financial institutions may not have the flexibility to be as accommodating as the situation reasonably calls for because of legal restrictions, internal and/or short-term strategic objectives concerning under-performing loans. Also, in the case of a bankruptcy filing, the inherent uncertainty may cause vendors to be hesitant to extend regular credit terms and may cause diminished customer loyalty. Understanding these dynamics is key.

Deciding to 'Cut Bait'

For the reasons described immediately above, the parent may decide not to rehabilitate the subsidiary, but rather dispose of it.

To assist the parent with this decision, we attempt here to do two things. First, we present a very basic framework for spotting and analyzing the key legal drivers involved in deciding how to dispose of a troubled subsidiary. We do this by suggesting that you ask and answer five basic, yet strategic, questions:

• What are the respective fiduciary duties in the situation?
• Can the subsidiary's business be sold as a going-concern?
• Will the business require additional funding in order to accomplish the going-concern sale or wind-down?
• Are there liabilities that the parent will be obligated for after the wind-down?
• What is the parent's litigation exposure relative to the operating subsidiary's insolvency and dissolution?

We then provide a brief overview of the various procedural mechanisms that are available to wind-down an insolvent business and distribute its assets (if any) to creditors and shareholders. These include:

• Dissolution under state law;
• Assignment for the benefit of creditors;
• Chapter 7 liquidation; and
• Chapter 11 liquidation.

For an illustrative summary of each liquidation option as such relates to the above-mentioned key legal drivers, see the chart below.

Key Legal Drivers

Question 1: What Fiduciary Duty Issues Must Be Kept In Mind?

All decisions should be made against the backdrop of an adherence to one's fiduciary duties. A company's directors and officers normally owe all of their three principal fiduciary duties to the company and its owners. These three duties are:

• duty of obedience,
• the duty of care, and
• the duty of loyalty.

The duty of obedience has two aspects. First, directors and officers must act within the scope of authority delegated to them. Second, they cannot permit the company to breach the terms of its applicable governing agreement or applicable law. Directors and officers can be held liable in their personal capacities for tolerating waste, spoliation or misapplication of company property, including the payment of excessive compensation to management.

Next, the duty of care requires that directors and officers act in good faith, in a manner reasonably believed to be in the best interests of the company, and perform their duties as careful and prudent persons would do so under similar circumstances. Directors and officers can be held personally liable for failing to grasp material information or for failing to make reasonable, pertinent inquiries into company affairs. For the reasons discussed in further detail below, in situations where the company is financially distressed, directors and officers must be acutely aware of any action that would benefit the shareholders to the detriment of the company's creditors, such as funding dividends or redemptions of stock, as well as any action that unnecessarily benefits one creditor over another.

Finally, the duty of loyalty requires that directors and officers elevate the company's interests above their own, and that they ensure that the company is not deprived of any advantage to which it is entitled. Not surprisingly, the duty of loyalty requires complete candor and disclosure of all information germane to a proposed transaction.

Understanding the 'Shift' In Fiduciary Duties

The rules regarding fiduciary duties become increasingly more complicated as a company becomes financially troubled. Officers and directors continue to have fiduciary responsibilities, but they are no longer limited to just the company and its owner(s). When a company enters the “zone” of insolvency, its directors and officers begin to owe fiduciary duties to the company's creditors as well. We are speaking here, of course, about the subsidiary. The parent's duties (including those of its directors and officers) do not change merely because one of its subsidiaries has entered the zone of insolvency. The parent, however, must understand the way in which the duties of the subsidiary's directors and officers change.

Inherent Conflict with the Wholly-Owned Insolvent Subsidiary

The directors and officers of an insolvent subsidiary are then required to critically scrutinize actions that could increase the parent's return to the detriment of the subsidiary's creditors. This can be particularly problematic for the director or officer of the wholly-owned subsidiary, who, upon the company's insolvency, finds herself caught in a “Catch 22,” wedged between her newly-acquired fiduciary obligations to creditors and her long-standing loyalties (and perhaps conflicting fiduciary duties) to the parent (which may very well be her primary employer, of which she may also be a director or officer).

Directors and officers' actions are generally judged by the “business judgment” rule in the event someone later sues on account of such actions. Essentially, the business judgment rule is a legal presumption that directors and officers who made a business decision, made that decision in good faith, on an informed basis, and in the honest belief that the action taken was in the best interests of the company. However, the business judgment rule may be rendered inapplicable where the defendant is shown to be improperly “interested” in the transaction, the burden shifts to the defendant to prove the “entire fairness” of the transaction in question.

When making a decision while the subsidiary is at or near insolvency, a director who dually represents a parent's interests will be considered “interested”, thereby losing the protection of the business judgment rule.

The 'Entire Fairness' Test: A Heightened Standard

The Entire Fairness Test places the burden on the interested director to show that the transaction that followed her decision was fair with respect to those to whom the director owed fiduciary obligations. The Entire Fairness Test involves a two-pronged inquiry – first, as to the fair dealing, and second, as to the fair price of the transaction in question. If the director is unable to provide adequate proof to meet this burden, she will be held personally liable for any resulting damages incurred by the company's creditors.

Shifting the Burden of Proof Back to the Challenging Party

One way to avoid subjecting oneself to the entire fairness test is for an interested director or officer to take steps early on to recuse herself from making potentially conflicting decisions. This can be accomplished by placing those decisions in the hands of capable and independent decision-makers.

The interested director can (and probably should) still remain on the board, but additional directors who are not tied to the parent may need to be appointed for purposes of establishing an independent committee to make decisions in matters for which the interested director finds herself in the inevitable 'Catch 22'. Indeed, state laws of incorporation usually provide rules for the creation of such special committees. See, eg, Del. Gen. Corp. Laws '141(c).

When a special committee's process is perceived as reflecting a good faith, informed attempt to approximate aggressive, arm's length bargaining, it will be accorded substantial importance by any reviewing court. In order to withstand scrutiny, however, the special committee must i) be independent and disinterested from the transaction at hand, ii) be composed of members that are fully informed, and iii) have the authority to negotiate at arm's length. In addition, it is crucial that the subsidiary retain separate and independent counsel and other professionals with respect to the action/transaction at question. The key is to be able to prove that decisions were made by truly independent and fully informed decision-makers.

In the event that it is impractical to appoint additional independent directors, it is even more critical that any negotiations be conducted at arm's length. Complete records of such negotiations, as well as board meetings, must be maintained.

Question 2: Can the business be sold as a going-concern?

Where a company can be sold as a going-concern, the sale usually results in a greater return for the company's stakeholders. In such cases, the prospects of a going-concern sale may drive things towards a Chapter 11 filing so that the subsidiary and the purchaser can obtain the associated benefits. Indeed, many purchasers will insist on this. However, deciding to sell the subsidiary as a going-concern does not usually answer the question of how to distribute the proceeds of the sale to the subsidiary's creditors, since such sales are typically structured as asset sales.

Concerns about successor liability and similar doctrines often drive prospective purchasers to insist on consummating a transaction inside of chapter 11. See James H.M. Sprayregen and Jonathan Friedland, The Legal Considerations of Acquiring Distressed Businesses: A Primer, 11 J. Bankruptcy L. & Prac. 1 (Nov.-Dec. 2001) (www.kirkland.com/files/tbl_s14Publications/Document1303/844/friedland.pdf). In chapter 11, a buyer can obtain a court order that cleanses the purchased assets from nearly all of the subsidiary's previous liabilities.

Bankruptcy courts typically require that any offer be subject to higher and better offers, and often require an auction and a formal bidding process. While the sale process is underway, chapter 11 allows the subsidiary to continue to operate in the ordinary course of its business. Thus, the subsidiary's going-concern value can be preserved, while it simultaneously enjoys the other benefits of bankruptcy. Conducting the sale through bankruptcy also obviates a significant amount of the directors' risk of exposure for breach of fiduciary duties, because the entire sale process is subject to bankruptcy court approval.

Question 3: Will the Subsidiary Require Additional Funding In Order to Accomplish the Wind-Down?

A troubled subsidiary is not particularly likely to be generating the free cash flow necessary to keep it afloat while it weighs its options and executes on its chosen course. Consequently, the parent, which may already have a history of funding the subsidiary's operating losses, may be called upon to continue this assistance.

As discussed earlier, this scenario may pose a problem in the event that the subsidiary eventually files for bankruptcy. If recharacterized as equity, the parent's cash infusion will be moved to the back of the proverbial line, and will likely not get paid at all unless all of the subsidiary's other creditors are paid in full.

Where it is necessary for the parent to provide additional funding to its insolvent subsidiary, it is critical to avoid recharacterization of the loan as a capital contribution that the funding arrangement follow the formalities that typically exist between a lender and debtor in a traditional lending relationship. Such formalities include, for example, i) the presence of a fixed maturity date on the loan, ii) the parent's contractual right to enforce payment in the event of default, and iii) the use of proper nomenclature and terms in the funding documents (eg, note, loan, facility, debenture, etc.). For more information on recharacterization and ways to avoid it, see James H.M. Sprayregen & Jonathan Friedland, Doubledowning: Avoid Double Trouble: Structuring Alternatives for Additional Rounds in Troubled Portfolio Companies, J. Private Equity, 45-57 (Fall 2002).

Question 4: Are There Any Liabilities for Which the Parent Will Be Obligated After the Wind-down?

Another factor to consider is the extent to which the subsidiary's creditors can look to the parent or the subsidiary's directors and officers as a source for payment of the subsidiary's unpaid obligations. Moreover, if the subsidiary files for bankruptcy, the automatic stay may only protect the subsidiary itself, and offer no protection for guarantors and principals who are jointly liable with the bankrupt subsidiary. It should come as no surprise that creditors who cannot pursue the subsidiary will usually turn to guarantors or co-obligors as a source for payment.

The most common basis for such sharing of liability is where the parent has guaranteed a particular obligation. Liability for particular obligations can also exist for the parent and/or company directors under state and federal statutes. Thus, when determining when and how to dispose of an insolvent subsidiary, it is wise for the parent to consider these shared liabilities and factor them into the decision-making process.

It is worth noting, however, that under chapter 11, the automatic stay can be extended in certain circumstances to protect non-debtor third-parties, including the parent. Additionally, in certain jurisdictions, the parent may be able to obtain a release from the subsidiary's creditors pursuant to the subsidiary's chapter 11 plan.

Additionally, there are certain potential risk factors that the parent should be aware of no matter which procedural course of action it takes with respect to its subsidiary.

A number of employee-related obligations, for example, such as COBRA and defined benefit pension plan payments under the federal Employee Retirement Income Security Act of 1974 (ERISA) are obligations not only of the subsidiary, but also are liabilities of each member of the subsidiary's “controlled group”. See, 29 U.S.C. '1563 (defining “controlled group” as any one or more corporations or chain of companies connected by equity ownership with a common parent company).

Some statutes specifically provide that a company's directors and officers can be held personally liable for certain unfulfilled obligations, such as unpaid “trust fund” taxes and wages. A subsidiary's directors and officers are often employees of the parent, and, in many cases, may have indemnification rights against the parent and/or may be named insureds under group directors and officers' insurance policies. Therefore, the parent often has a keen interest in avoiding such liability for its subsidiary's directors and officers. The subsidiary's directors and officers will, in any event, have an enlightened self-interest in this regard, which the parent at least ought to understand.

The most common trust fund taxes include payroll withholding, sales and use taxes. Under federal law, personal liability for failure to pay trust fund taxes is imposed in the form of a penalty, equal to 100% of the tax not paid, on any responsible officer who willfully fails to pay the tax. See, 26 U.S.C. '6672(a).

Similarly, a number of states have enacted laws that hold a company's officers and directors personally liable for any unpaid sales and use taxes, and employee wages and benefits under certain circumstances. In such cases, “wages” is usually broadly defined to include more than just an employee's annual salary or weekly pay. In fact, “wages” can include accrued and vested vacation and sick-leave time, separation and other guaranteed pay, pension contributions, employer-paid insurance premiums, severance, expense reimbursements, union dues withheld from the employee's pay by the employer, and any other amounts to be paid pursuant to an agreement with the employee, a third party or fund for the benefit of employees.

Question 5: What Is the Parent's Litigation Exposure?

It is an almost sure bet that some of the subsidiary's creditors will be looking for a proverbial “deep pocket” to cover the subsidiary's unpaid debts. In this regard, a parent can be particularly exposed to threatened litigation because of its unique relationship with the subsidiary, and the multiple hats that it wears in connection with the subsidiary's business operations. Minimizing litigation risk can be a key driver in determining a strategy and tactics.

Bankruptcy Case as Forum for Litigation

Bankruptcy provides an open and ready forum for litigation. Moreover, certain causes of action, such as equitable subordination and recharacterization, are unique to bankruptcy, and could not otherwise be brought in the context of an alternative insolvency proceeding, such as an out-of-court dissolution or assignment.

Additionally, a bankruptcy case can encourage inquiry into, and prosecution of, such potential litigation. At the outset of the case, a formal creditors' committee (in a chapter 11) or chapter 7 trustee is appointed and specifically charged with examining the subsidiary's pre-bankruptcy transactions, including its relationship with its parent. The committee's (or trustee's) primary goal is to obtain (through whatever appropriate means available) the greatest return for their constituents ' the subsidiary's creditors ' of which the parent is likely but one of many. To that end, the creditors' committee (or trustee, an independent fiduciary with no loyalties to management) will use the bankruptcy causes of action to attempt to obtain more funds to distribute to the subsidiary's creditors.

To boot, the fees and costs associated with these activities are typically funded out of the debtor's assets. As a result, there is considerably less inhibition to their prosecutorial efforts, compared to that which would otherwise exist if each creditor was required to front its own legal expenses as they would be outside of bankruptcy.

Typical insolvency-related causes of action include (but are not limited to):

1. Fraudulent Transfer Actions

This cause of action exists both in and out of bankruptcy and takes two separate forms ' Actual Fraud and Constructive Fraud. When either actual or constructive fraud is established, the plaintiff can unwind the transfer and claw back the property for the benefit of the company's creditors.

Actual Fraud requires proof of intent by the transferor to defraud some of its creditors. “Intent” can be established by showing that the company displayed certain indicia, or “badges,” of fraud in connection with the transfer in question. These include, for example, absconding after the transfer, concealing assets and/or the transfer, or making the transfer shortly after being threatened with a large lawsuit.

The other form of fraudulent transfer is Constructive Fraud. Constructive Fraud requires no actual intent to defraud, but only a showing that the company, while insolvent, made a transfer of cash or assets without receiving reasonably equivalent value in exchange.

In the context of the parent-subsidiary relationship, it is therefore important that any transfer from the subsidiary to the parent constitute a bargained-for exchange between the parties as if it were at arm's length. If the subsidiary has recently transferred cash or property, or executed releases in favor of the parent, it is important that the transactional documents adequately reflect that the parent provided reasonably equivalent value in exchange for whatever it received. Otherwise, the parent may more likely find itself a defendant to a fraudulent transfer action. For more information, see Prof. John D. Ayer, Michael Bernstein & Jonathan Friedland, Chapter 11 – “101″: The Trustee's Power to Avoid Fraudulent Transfers, ABI L. J. (May 2004) (www.kirkland.com/files/tbl_s14Publications/Document1303/1336/Friedland_Trustees_Power.pdf).

2. Preference Actions

Preference actions are primarily seen within the context of bankruptcy cases (although some states' assignment for the benefit of creditors' statutes provide for similar causes of action). Essentially, once a company files for bankruptcy, under certain circumstances, payments to creditors made within the 90 days prior to the bankruptcy filing date can be clawed back for the benefit of all of the estate's creditors. For insiders, such as a parent, the applicable look-back period is extended to a full year.

A number of defenses exist for preference actions, including the defense that the payment was received in the ordinary course of business and under ordinary business terms. For more information, see Prof. John D. Ayer, Michael Bernstein & Jonathan Friedland, Chapter 11 – “101″: Preference Avoidance, ABI L. J. (April 2004) (www.kirkland.com/files/tbl_s14Publications/Document1303/1254/Friedland20-%20Preference%20Avoidance.pdf).

3. Equitable Subordination

Under the doctrine of equitable subordination, a creditor's claim can be subordinated to claims of other creditors where the court finds that: i) the claimant engaged in some type of inequitable conduct; and ii) the conduct resulted in injury to the debtor's creditors or conferred an unfair advantage to the claimant.

Where equitable subordination is warranted, courts generally limit the subordination to the extent necessary to remedy the particular harms at issue, sometimes subordinating less than all of the holder's claim or subordinating the claims to only a particular category of the remaining creditor group.

4. Recharacterization

As discussed earlier, a bankruptcy court can recharacterize pre-bankruptcy loans. If recharacterized, a parent's loan will be treated as just another equity investment in its subsidiary. Recharacterization may effectively cause a similar result to that of equitable subordination, but without the need for the plaintiff to show inequitable conduct. In addition, if a court recharacterizes, it will recharacterize the entire amount of the purported loan. Moreover, a compound threat may also arise upon recharacterization of the loan, in that any prior repayments may be recoverable as fraudulent transfers (assuming the subsidiary was insolvent when it made such payments).

5. Deepening Insolvency

One additional cause of action that could be brought against an insolvent subsidiary's parent and/or directors and officers is known as “deepening insolvency”. Recognition and use of deepening insolvency as a separate and distinct tort claim is relatively new and still developing. The trend, however, is to provide injured creditors with an avenue of redress against solvent third parties whose control and decision-making contributed to the continued downward spiral of the company.

Deepening insolvency is founded in the theory that those in control of the insolvent company should be liable to those harmed, where the life of the business was fraudulently or negligently extended, and that resulted in a continued worsening of the business to the detriment of the company's creditors. The increasing popularity of this cause of action should breed caution when employing costly out-of-court turnaround strategies, and, in some circumstances, weighs in favor of filing for bankruptcy protection early to avoid risking liability for any failed attempts to salvage the distressed business.

Procedural Options for Dissolving the Subsidiary

Option 1: State Law Dissolution

Perhaps the simplest option is a straight state law dissolution. The mechanics for affecting this type of dissolution are almost always spelled out in the operating subsidiary's articles of incorporation or operating agreement. In most cases, the applicable wind-down provisions substantially reflect the wind-down provisions of the subsidiary's state of incorporation/formation.

In the case of a wholly-owned subsidiary, the subsidiary's formation documents likely provide that, upon a formal decision to dissolve, the parent may appoint a liquidating trustee to manage the subsidiary's dissolution and distribute its assets. The liquidating trustee is responsible for winding up the subsidiary's remaining business affairs and liquidating any assets in an orderly and expeditious manner.

In many cases, a straight dissolution is a simple, fast and cheap way for an insolvent subsidiary to pay its creditors as much as possible. However, it is not the preferred method where a going-concern sale is feasible or where there may be significant bankruptcy causes of action to pursue for the benefit of the operating subsidiary's stakeholders. Also, this out-of-court option runs the constant risk that the subsidiary's creditors may file an involuntary bankruptcy petition against it.

Unlike a voluntary bankruptcy (where the company itself chooses when and where to file for bankruptcy), an involuntary case is thrust upon the company. Although the company can try to fight the involuntary by seeking an order of dismissal or abstention from the bankruptcy court, the mere filing of an involuntary can be quite damaging. If the court determines that the company belongs in bankruptcy, there is a presumption that the proceedings will be held in the court where the involuntary petition was filed. This deprives the company of the various legal and practical advantages that it might otherwise have obtained if it had the opportunity to choose its own venue for filing.

With respect to the distribution of assets, state law (as reflected in the formation documents and applicable statutes) usually provides that, upon the winding up of the subsidiary, the assets shall be distributed as follows:

• To the subsidiary's creditors in satisfaction of the subsidiary's liabilities;
• To the establishment of a reserve which the liquidating trustee may deem necessary for contingent or unforeseen liabilities; and
• Thereafter, to the shareholders.

In cases where there are insufficient assets to pay all creditors' claims in full, such claims will be paid according to their priority and, among claims of equal priority, ratably to the extent assets are available (much like in bankruptcy). A composition agreement, whereby creditors agree to accept a certain distribution in full satisfaction of their outstanding claims, may be employed in conjunction with a dissolution, or alone. A composition agreement can also contain a provision prohibiting individuals from commencing an involuntary bankruptcy proceeding against the subsidiary. Viewed most simply, a composition agreement is simply a contract between the debtor and a single creditor. Debtors will sometimes send composition agreements to each of their creditors that includes as a precondition to the company's obligation thereunder, that a certain pre-set percentage of the debtor's creditors and claims accept the composition in order for such agreement to be binding (in a manner similar to an exchange offer).

To bolster the validity of the out-of-court dissolution process, the subsidiary may want to consider setting up an informal creditors' committee prior to attempting the dissolution. In such a scenario, the subsidiary (if capable) would typically fund the informal committee's expenses to the extent such expenses are limited to the legal costs associated with reviewing certain transactional documents and the proposed dissolution scheme. This 'ad hoc' committee can provide a means by which the creditors' collective voice can be represented from the outset of the proceeding, while, simultaneously, allowing both parent and subsidiary to have a say in which creditors and which law firm represent that collective interest. In the event that the wind-down is ever challenged as unfair to creditors, the legitimacy of the process can be validated by the ongoing and established presence of a creditor constituency and retained counsel.

Option 2: Assignment for the Benefit of Creditors

Another popular dissolution alternative is an assignment for the benefit of creditors. A vast majority of states provide for this alternative to a federal bankruptcy filing, either by statute, common law, or both.

An assignment for the benefit of creditors is a voluntary insolvency process, in which the insolvent company (aka, the “debtor” or “assignor”), usually by way of a formal state filing, assigns all its property to a designated assignee for liquidation. The assignee then liquidates the property and distributes the assets to the company's creditors in accordance with certain procedures and priorities.

The process itself varies from state to state. Less favorable schemes treat the process much like a probate estate. Other states offer a more streamlined process. In addition, a number of states do not require that the assignee be local or domiciled within the state.

Upon liquidation, claims are paid in substantially the same priority as such would be paid pursuant to the applicable provisions of the U.S. Bankruptcy Code. Instead of the Bankruptcy Code, however, the priority scheme is usually enumerated by state law and/or in a composition agreement, which is formulated by the assignor and assignee (subject to certain specific statutory mandates with respect to the priority of claims).

Similar to a trustee in bankruptcy, an assignee has standing to prosecute and defend claims on behalf of and against the debtor/assignor. Included among these claims are state law versions of preference and fraudulent transfer avoidance actions.

Decreased Threat of an Involuntary Bankruptcy

One additional advantage of an assignment over a straight dissolution is that, although creditors may still file an involuntary bankruptcy petition against the debtor, a bankruptcy court is more likely to abstain from exercising jurisdiction where there is a pre-existing assignment for the benefit of creditors in process.

Option 3: Chapter 7 Liquidation

Chapter 7 of the Bankruptcy Code provides a formal procedure for the orderly liquidation of the subsidiary's assets and the ultimate payment of creditors' claims in the order of priority set forth in the Bankruptcy Code. Upon the filing of a Chapter 7 petition, a trustee is appointed by the United States Trustee and charged with marshalling all of the subsidiary's assets, liquidating the estate and eventually distributing the proceeds of the liquidation to its creditors.

Unlike a straight dissolution or assignment for the benefit of creditors, neither the parent nor the subsidiary has the ability to choose the person or firm who will serve as the trustee in a Chapter 7 bankruptcy. Moreover Chapter 7 proceedings are presided over by a federal bankruptcy judge and are governed by a detailed, and often cumbersome federal statute and series of complex rules. Together, these factors result in a total loss of control over the liquidation process.

Therefore, to the extent there is concern that the parent and subsidiary's pre-bankruptcy actions may be inappropriately challenged (and there often is), Chapter 7 may not be preferable as it will empower and fund a trustee, who is more likely to bring such challenges. On the other hand, Chapter 7 does provide perhaps the clearest means by which the parent and subsidiary's management can effectively wash their hands of any future management obligations to the subsidiary and its wind-down process. Indeed, among other things, the federal bankruptcy code provides a uniform, multi-state level of statutory authority and jurisdiction over assets. Assignment laws are much less clear and uniform. In addition, the relevant insolvency professionals (including the presiding judge) are more apt to be experienced with the workings of the various tenets of the Bankruptcy Code as such pertain to an insolvent subsidiary's particular circumstances.

Option 4: Chapter 11 Liquidation

A key benefit of chapter 11 over chapter 7 and the other alternatives discussed above is that chapter 11 permits the subsidiary (aka, the “debtor in possession” or “DIP”) to remain in control of the process. Throughout the chapter 11 process, however, the DIP's decisions remain subject to bankruptcy court approval, and review by the Office of the United States Trustee and committee (if any). Chapter 11 is a complex and expensive wind-down alternative. However, as discussed above, its advantages include providing a method by which a purchaser can receive perhaps the cleanest title in the transferred assets.

Benefits of Chapter 11

While the DIP is busy assessing its liabilities and formulating and confirming its chapter 11 plan, it enjoys the benefit of the automatic stay of the Bankruptcy Code. The automatic stay effectively prohibits the subsidiary's creditors from engaging in any type of collection activity against the estate (other than filing a proof of claim) during the pending bankruptcy case. Indeed, the automatic stay is one of the primary benefits of bankruptcy as it is intended to give the DIP “breathing space” in which it can focus on its chapter 11 plan without the pressures associated with creditors' collection activity.

Additionally, the chapter 11 process provides for protection for post-bankruptcy financing, whereby the lender (which is, in some cases, the parent) can obtain a bankruptcy court order approving the terms of the post-bankruptcy financing agreement (aka, DIP Loan). By obtaining this approval, the lender obtains full assurance that its loan will not be recharacterized or otherwise subordinated to the DIP's other creditors.

Another potential benefit of chapter 11 is the ability, in certain jurisdictions, to obtain broad releases from the subsidiary and its creditors for the parent and/or its directors and officers. These releases can be incorporated as part of the chapter 11 plan. In order for releases to be permitted, however, the released parties must provide some form of consideration in exchange for the release from liability. For directors and officers, it is possible that, depending upon the jurisdication, the consideration requirement may be met through their continued service to the subsidiary during the pending bankruptcy case. The parent, however, would likely need to concede some or all of its claims against the subsidiary or propose some other means by which it can offer the subsidiary additional value in exchange for a release.

Conclusion

When confronted with an underperforming or insolvent subsidiary, it is important for the parent to initially identify its most critical objectives and expectations with respect to its subsidiary. In some cases, an analysis of these objectives may result in a determination that the subsidiary, though struggling, is worth saving. In other cases, the parent may want nothing more than to wash its hands of the subsidiary and limit any additional liability that may arise as a result of the subsidiary's insolvency.

In the latter scenario, it is important to remember that there are a number of procedural alternatives (and combinations of alternatives) that can be used to wind-down the insolvent company. When making the selection, it is important to consider the range of liabilities that may remain or arise in the context of any insolvency, and which procedural vehicle can best limit such liabilities for the parent, subsidiary and their respective directors and officers.

Although an insolvent subsidiary's creditors are entitled to the company's (and its directors and officers') fiduciary obligations, directors and officers can, under certain circumstances, still meet their fiduciary obligations to such creditors yet also take steps to maximize recovery for the principal equityholder as well. A prudent parent, however, may decide to hedge its position by installing an independent board of directors who are charged with making those decisions that could detrimentally affect the interests of the subsidiary's creditors. Nonetheless, in any case, it is important for the parent to remain cognizant of the various liabilities that may arise on the frontier of insolvency and consider such risks when determining when and how to dispose of its insolvent subsidiary.

[IMGCAP(1)]

It is not uncommon for a holding company (or private equity fund) to have at least one operating subsidiary (or portfolio company) that is underperforming relative to the other companies it owns. Sometimes problems can be fixed and fortunes reversed. Other times, however, the subsidiary/portfolio company continues to struggle and may eventually become truly distressed and even insolvent. At some point, the strategic decision will be made to discontinue the operating subsidiary's business. When this occurs, strategy must be quickly developed and executed to minimize any ongoing losses and to maximize the recovery for the subsidiary's stakeholders.

Any business strategy should be approached with an informed understanding of the overall legal landscape, as well as the specific risks and potential rewards associated with each of the parent's available options. Likewise, the parent must understand its position in the decision-making process relative to those of the insolvent subsidiary's other obligees ' its creditors.

For example, a troubled company will likely need cash infusions to continue operating. And, because potential lenders are not likely to be lining up to extend financing in such a situation, the parent is probably going to be faced with having to decide whether continuing to fund the subsidiary is worthwhile, or just a case of throwing good money after bad. In this context, of course, making a secured loan is preferable to making an unsecured one. Even a secured loan, however, can later be “recharacterized” by a bankruptcy court and treated as if it was a capital contribution (and thus moving any recovery on account of the loan to the end of the line).

Is the Subsidiary Worth Saving?

In some instances, the proper business strategy may be to try to save the subsidiary. Broken balance sheets can be fixed if there is a sufficient consensus among the parties at the various levels of the company's capital structure. Flawed business models can in many instances be improved.

Restructurings (whether out of court or through chapter 11 bankruptcy, and whether primarily financial or operational) can be time consuming and expensive. Moreover, the ability to restructure successfully depends upon many factors beyond the parent's control. For example, financial institutions may not have the flexibility to be as accommodating as the situation reasonably calls for because of legal restrictions, internal and/or short-term strategic objectives concerning under-performing loans. Also, in the case of a bankruptcy filing, the inherent uncertainty may cause vendors to be hesitant to extend regular credit terms and may cause diminished customer loyalty. Understanding these dynamics is key.

Deciding to 'Cut Bait'

For the reasons described immediately above, the parent may decide not to rehabilitate the subsidiary, but rather dispose of it.

To assist the parent with this decision, we attempt here to do two things. First, we present a very basic framework for spotting and analyzing the key legal drivers involved in deciding how to dispose of a troubled subsidiary. We do this by suggesting that you ask and answer five basic, yet strategic, questions:

• What are the respective fiduciary duties in the situation?
• Can the subsidiary's business be sold as a going-concern?
• Will the business require additional funding in order to accomplish the going-concern sale or wind-down?
• Are there liabilities that the parent will be obligated for after the wind-down?
• What is the parent's litigation exposure relative to the operating subsidiary's insolvency and dissolution?

We then provide a brief overview of the various procedural mechanisms that are available to wind-down an insolvent business and distribute its assets (if any) to creditors and shareholders. These include:

• Dissolution under state law;
• Assignment for the benefit of creditors;
• Chapter 7 liquidation; and
• Chapter 11 liquidation.

For an illustrative summary of each liquidation option as such relates to the above-mentioned key legal drivers, see the chart below.

Key Legal Drivers

Question 1: What Fiduciary Duty Issues Must Be Kept In Mind?

All decisions should be made against the backdrop of an adherence to one's fiduciary duties. A company's directors and officers normally owe all of their three principal fiduciary duties to the company and its owners. These three duties are:

• duty of obedience,
• the duty of care, and
• the duty of loyalty.

The duty of obedience has two aspects. First, directors and officers must act within the scope of authority delegated to them. Second, they cannot permit the company to breach the terms of its applicable governing agreement or applicable law. Directors and officers can be held liable in their personal capacities for tolerating waste, spoliation or misapplication of company property, including the payment of excessive compensation to management.

Next, the duty of care requires that directors and officers act in good faith, in a manner reasonably believed to be in the best interests of the company, and perform their duties as careful and prudent persons would do so under similar circumstances. Directors and officers can be held personally liable for failing to grasp material information or for failing to make reasonable, pertinent inquiries into company affairs. For the reasons discussed in further detail below, in situations where the company is financially distressed, directors and officers must be acutely aware of any action that would benefit the shareholders to the detriment of the company's creditors, such as funding dividends or redemptions of stock, as well as any action that unnecessarily benefits one creditor over another.

Finally, the duty of loyalty requires that directors and officers elevate the company's interests above their own, and that they ensure that the company is not deprived of any advantage to which it is entitled. Not surprisingly, the duty of loyalty requires complete candor and disclosure of all information germane to a proposed transaction.

Understanding the 'Shift' In Fiduciary Duties

The rules regarding fiduciary duties become increasingly more complicated as a company becomes financially troubled. Officers and directors continue to have fiduciary responsibilities, but they are no longer limited to just the company and its owner(s). When a company enters the “zone” of insolvency, its directors and officers begin to owe fiduciary duties to the company's creditors as well. We are speaking here, of course, about the subsidiary. The parent's duties (including those of its directors and officers) do not change merely because one of its subsidiaries has entered the zone of insolvency. The parent, however, must understand the way in which the duties of the subsidiary's directors and officers change.

Inherent Conflict with the Wholly-Owned Insolvent Subsidiary

The directors and officers of an insolvent subsidiary are then required to critically scrutinize actions that could increase the parent's return to the detriment of the subsidiary's creditors. This can be particularly problematic for the director or officer of the wholly-owned subsidiary, who, upon the company's insolvency, finds herself caught in a “Catch 22,” wedged between her newly-acquired fiduciary obligations to creditors and her long-standing loyalties (and perhaps conflicting fiduciary duties) to the parent (which may very well be her primary employer, of which she may also be a director or officer).

Directors and officers' actions are generally judged by the “business judgment” rule in the event someone later sues on account of such actions. Essentially, the business judgment rule is a legal presumption that directors and officers who made a business decision, made that decision in good faith, on an informed basis, and in the honest belief that the action taken was in the best interests of the company. However, the business judgment rule may be rendered inapplicable where the defendant is shown to be improperly “interested” in the transaction, the burden shifts to the defendant to prove the “entire fairness” of the transaction in question.

When making a decision while the subsidiary is at or near insolvency, a director who dually represents a parent's interests will be considered “interested”, thereby losing the protection of the business judgment rule.

The 'Entire Fairness' Test: A Heightened Standard

The Entire Fairness Test places the burden on the interested director to show that the transaction that followed her decision was fair with respect to those to whom the director owed fiduciary obligations. The Entire Fairness Test involves a two-pronged inquiry – first, as to the fair dealing, and second, as to the fair price of the transaction in question. If the director is unable to provide adequate proof to meet this burden, she will be held personally liable for any resulting damages incurred by the company's creditors.

Shifting the Burden of Proof Back to the Challenging Party

One way to avoid subjecting oneself to the entire fairness test is for an interested director or officer to take steps early on to recuse herself from making potentially conflicting decisions. This can be accomplished by placing those decisions in the hands of capable and independent decision-makers.

The interested director can (and probably should) still remain on the board, but additional directors who are not tied to the parent may need to be appointed for purposes of establishing an independent committee to make decisions in matters for which the interested director finds herself in the inevitable 'Catch 22'. Indeed, state laws of incorporation usually provide rules for the creation of such special committees. See, eg, Del. Gen. Corp. Laws '141(c).

When a special committee's process is perceived as reflecting a good faith, informed attempt to approximate aggressive, arm's length bargaining, it will be accorded substantial importance by any reviewing court. In order to withstand scrutiny, however, the special committee must i) be independent and disinterested from the transaction at hand, ii) be composed of members that are fully informed, and iii) have the authority to negotiate at arm's length. In addition, it is crucial that the subsidiary retain separate and independent counsel and other professionals with respect to the action/transaction at question. The key is to be able to prove that decisions were made by truly independent and fully informed decision-makers.

In the event that it is impractical to appoint additional independent directors, it is even more critical that any negotiations be conducted at arm's length. Complete records of such negotiations, as well as board meetings, must be maintained.

Question 2: Can the business be sold as a going-concern?

Where a company can be sold as a going-concern, the sale usually results in a greater return for the company's stakeholders. In such cases, the prospects of a going-concern sale may drive things towards a Chapter 11 filing so that the subsidiary and the purchaser can obtain the associated benefits. Indeed, many purchasers will insist on this. However, deciding to sell the subsidiary as a going-concern does not usually answer the question of how to distribute the proceeds of the sale to the subsidiary's creditors, since such sales are typically structured as asset sales.

Concerns about successor liability and similar doctrines often drive prospective purchasers to insist on consummating a transaction inside of chapter 11. See James H.M. Sprayregen and Jonathan Friedland, The Legal Considerations of Acquiring Distressed Businesses: A Primer, 11 J. Bankruptcy L. & Prac. 1 (Nov.-Dec. 2001) (www.kirkland.com/files/tbl_s14Publications/Document1303/844/friedland.pdf). In chapter 11, a buyer can obtain a court order that cleanses the purchased assets from nearly all of the subsidiary's previous liabilities.

Bankruptcy courts typically require that any offer be subject to higher and better offers, and often require an auction and a formal bidding process. While the sale process is underway, chapter 11 allows the subsidiary to continue to operate in the ordinary course of its business. Thus, the subsidiary's going-concern value can be preserved, while it simultaneously enjoys the other benefits of bankruptcy. Conducting the sale through bankruptcy also obviates a significant amount of the directors' risk of exposure for breach of fiduciary duties, because the entire sale process is subject to bankruptcy court approval.

Question 3: Will the Subsidiary Require Additional Funding In Order to Accomplish the Wind-Down?

A troubled subsidiary is not particularly likely to be generating the free cash flow necessary to keep it afloat while it weighs its options and executes on its chosen course. Consequently, the parent, which may already have a history of funding the subsidiary's operating losses, may be called upon to continue this assistance.

As discussed earlier, this scenario may pose a problem in the event that the subsidiary eventually files for bankruptcy. If recharacterized as equity, the parent's cash infusion will be moved to the back of the proverbial line, and will likely not get paid at all unless all of the subsidiary's other creditors are paid in full.

Where it is necessary for the parent to provide additional funding to its insolvent subsidiary, it is critical to avoid recharacterization of the loan as a capital contribution that the funding arrangement follow the formalities that typically exist between a lender and debtor in a traditional lending relationship. Such formalities include, for example, i) the presence of a fixed maturity date on the loan, ii) the parent's contractual right to enforce payment in the event of default, and iii) the use of proper nomenclature and terms in the funding documents (eg, note, loan, facility, debenture, etc.). For more information on recharacterization and ways to avoid it, see James H.M. Sprayregen & Jonathan Friedland, Doubledowning: Avoid Double Trouble: Structuring Alternatives for Additional Rounds in Troubled Portfolio Companies, J. Private Equity, 45-57 (Fall 2002).

Question 4: Are There Any Liabilities for Which the Parent Will Be Obligated After the Wind-down?

Another factor to consider is the extent to which the subsidiary's creditors can look to the parent or the subsidiary's directors and officers as a source for payment of the subsidiary's unpaid obligations. Moreover, if the subsidiary files for bankruptcy, the automatic stay may only protect the subsidiary itself, and offer no protection for guarantors and principals who are jointly liable with the bankrupt subsidiary. It should come as no surprise that creditors who cannot pursue the subsidiary will usually turn to guarantors or co-obligors as a source for payment.

The most common basis for such sharing of liability is where the parent has guaranteed a particular obligation. Liability for particular obligations can also exist for the parent and/or company directors under state and federal statutes. Thus, when determining when and how to dispose of an insolvent subsidiary, it is wise for the parent to consider these shared liabilities and factor them into the decision-making process.

It is worth noting, however, that under chapter 11, the automatic stay can be extended in certain circumstances to protect non-debtor third-parties, including the parent. Additionally, in certain jurisdictions, the parent may be able to obtain a release from the subsidiary's creditors pursuant to the subsidiary's chapter 11 plan.

Additionally, there are certain potential risk factors that the parent should be aware of no matter which procedural course of action it takes with respect to its subsidiary.

A number of employee-related obligations, for example, such as COBRA and defined benefit pension plan payments under the federal Employee Retirement Income Security Act of 1974 (ERISA) are obligations not only of the subsidiary, but also are liabilities of each member of the subsidiary's “controlled group”. See, 29 U.S.C. '1563 (defining “controlled group” as any one or more corporations or chain of companies connected by equity ownership with a common parent company).

Some statutes specifically provide that a company's directors and officers can be held personally liable for certain unfulfilled obligations, such as unpaid “trust fund” taxes and wages. A subsidiary's directors and officers are often employees of the parent, and, in many cases, may have indemnification rights against the parent and/or may be named insureds under group directors and officers' insurance policies. Therefore, the parent often has a keen interest in avoiding such liability for its subsidiary's directors and officers. The subsidiary's directors and officers will, in any event, have an enlightened self-interest in this regard, which the parent at least ought to understand.

The most common trust fund taxes include payroll withholding, sales and use taxes. Under federal law, personal liability for failure to pay trust fund taxes is imposed in the form of a penalty, equal to 100% of the tax not paid, on any responsible officer who willfully fails to pay the tax. See, 26 U.S.C. '6672(a).

Similarly, a number of states have enacted laws that hold a company's officers and directors personally liable for any unpaid sales and use taxes, and employee wages and benefits under certain circumstances. In such cases, “wages” is usually broadly defined to include more than just an employee's annual salary or weekly pay. In fact, “wages” can include accrued and vested vacation and sick-leave time, separation and other guaranteed pay, pension contributions, employer-paid insurance premiums, severance, expense reimbursements, union dues withheld from the employee's pay by the employer, and any other amounts to be paid pursuant to an agreement with the employee, a third party or fund for the benefit of employees.

Question 5: What Is the Parent's Litigation Exposure?

It is an almost sure bet that some of the subsidiary's creditors will be looking for a proverbial “deep pocket” to cover the subsidiary's unpaid debts. In this regard, a parent can be particularly exposed to threatened litigation because of its unique relationship with the subsidiary, and the multiple hats that it wears in connection with the subsidiary's business operations. Minimizing litigation risk can be a key driver in determining a strategy and tactics.

Bankruptcy Case as Forum for Litigation

Bankruptcy provides an open and ready forum for litigation. Moreover, certain causes of action, such as equitable subordination and recharacterization, are unique to bankruptcy, and could not otherwise be brought in the context of an alternative insolvency proceeding, such as an out-of-court dissolution or assignment.

Additionally, a bankruptcy case can encourage inquiry into, and prosecution of, such potential litigation. At the outset of the case, a formal creditors' committee (in a chapter 11) or chapter 7 trustee is appointed and specifically charged with examining the subsidiary's pre-bankruptcy transactions, including its relationship with its parent. The committee's (or trustee's) primary goal is to obtain (through whatever appropriate means available) the greatest return for their constituents ' the subsidiary's creditors ' of which the parent is likely but one of many. To that end, the creditors' committee (or trustee, an independent fiduciary with no loyalties to management) will use the bankruptcy causes of action to attempt to obtain more funds to distribute to the subsidiary's creditors.

To boot, the fees and costs associated with these activities are typically funded out of the debtor's assets. As a result, there is considerably less inhibition to their prosecutorial efforts, compared to that which would otherwise exist if each creditor was required to front its own legal expenses as they would be outside of bankruptcy.

Typical insolvency-related causes of action include (but are not limited to):

1. Fraudulent Transfer Actions

This cause of action exists both in and out of bankruptcy and takes two separate forms ' Actual Fraud and Constructive Fraud. When either actual or constructive fraud is established, the plaintiff can unwind the transfer and claw back the property for the benefit of the company's creditors.

Actual Fraud requires proof of intent by the transferor to defraud some of its creditors. “Intent” can be established by showing that the company displayed certain indicia, or “badges,” of fraud in connection with the transfer in question. These include, for example, absconding after the transfer, concealing assets and/or the transfer, or making the transfer shortly after being threatened with a large lawsuit.

The other form of fraudulent transfer is Constructive Fraud. Constructive Fraud requires no actual intent to defraud, but only a showing that the company, while insolvent, made a transfer of cash or assets without receiving reasonably equivalent value in exchange.

In the context of the parent-subsidiary relationship, it is therefore important that any transfer from the subsidiary to the parent constitute a bargained-for exchange between the parties as if it were at arm's length. If the subsidiary has recently transferred cash or property, or executed releases in favor of the parent, it is important that the transactional documents adequately reflect that the parent provided reasonably equivalent value in exchange for whatever it received. Otherwise, the parent may more likely find itself a defendant to a fraudulent transfer action. For more information, see Prof. John D. Ayer, Michael Bernstein & Jonathan Friedland, Chapter 11 – “101″: The Trustee's Power to Avoid Fraudulent Transfers, ABI L. J. (May 2004) (www.kirkland.com/files/tbl_s14Publications/Document1303/1336/Friedland_Trustees_Power.pdf).

2. Preference Actions

Preference actions are primarily seen within the context of bankruptcy cases (although some states' assignment for the benefit of creditors' statutes provide for similar causes of action). Essentially, once a company files for bankruptcy, under certain circumstances, payments to creditors made within the 90 days prior to the bankruptcy filing date can be clawed back for the benefit of all of the estate's creditors. For insiders, such as a parent, the applicable look-back period is extended to a full year.

A number of defenses exist for preference actions, including the defense that the payment was received in the ordinary course of business and under ordinary business terms. For more information, see Prof. John D. Ayer, Michael Bernstein & Jonathan Friedland, Chapter 11 – “101″: Preference Avoidance, ABI L. J. (April 2004) (www.kirkland.com/files/tbl_s14Publications/Document1303/1254/Friedland20-%20Preference%20Avoidance.pdf).

3. Equitable Subordination

Under the doctrine of equitable subordination, a creditor's claim can be subordinated to claims of other creditors where the court finds that: i) the claimant engaged in some type of inequitable conduct; and ii) the conduct resulted in injury to the debtor's creditors or conferred an unfair advantage to the claimant.

Where equitable subordination is warranted, courts generally limit the subordination to the extent necessary to remedy the particular harms at issue, sometimes subordinating less than all of the holder's claim or subordinating the claims to only a particular category of the remaining creditor group.

4. Recharacterization

As discussed earlier, a bankruptcy court can recharacterize pre-bankruptcy loans. If recharacterized, a parent's loan will be treated as just another equity investment in its subsidiary. Recharacterization may effectively cause a similar result to that of equitable subordination, but without the need for the plaintiff to show inequitable conduct. In addition, if a court recharacterizes, it will recharacterize the entire amount of the purported loan. Moreover, a compound threat may also arise upon recharacterization of the loan, in that any prior repayments may be recoverable as fraudulent transfers (assuming the subsidiary was insolvent when it made such payments).

5. Deepening Insolvency

One additional cause of action that could be brought against an insolvent subsidiary's parent and/or directors and officers is known as “deepening insolvency”. Recognition and use of deepening insolvency as a separate and distinct tort claim is relatively new and still developing. The trend, however, is to provide injured creditors with an avenue of redress against solvent third parties whose control and decision-making contributed to the continued downward spiral of the company.

Deepening insolvency is founded in the theory that those in control of the insolvent company should be liable to those harmed, where the life of the business was fraudulently or negligently extended, and that resulted in a continued worsening of the business to the detriment of the company's creditors. The increasing popularity of this cause of action should breed caution when employing costly out-of-court turnaround strategies, and, in some circumstances, weighs in favor of filing for bankruptcy protection early to avoid risking liability for any failed attempts to salvage the distressed business.

Procedural Options for Dissolving the Subsidiary

Option 1: State Law Dissolution

Perhaps the simplest option is a straight state law dissolution. The mechanics for affecting this type of dissolution are almost always spelled out in the operating subsidiary's articles of incorporation or operating agreement. In most cases, the applicable wind-down provisions substantially reflect the wind-down provisions of the subsidiary's state of incorporation/formation.

In the case of a wholly-owned subsidiary, the subsidiary's formation documents likely provide that, upon a formal decision to dissolve, the parent may appoint a liquidating trustee to manage the subsidiary's dissolution and distribute its assets. The liquidating trustee is responsible for winding up the subsidiary's remaining business affairs and liquidating any assets in an orderly and expeditious manner.

In many cases, a straight dissolution is a simple, fast and cheap way for an insolvent subsidiary to pay its creditors as much as possible. However, it is not the preferred method where a going-concern sale is feasible or where there may be significant bankruptcy causes of action to pursue for the benefit of the operating subsidiary's stakeholders. Also, this out-of-court option runs the constant risk that the subsidiary's creditors may file an involuntary bankruptcy petition against it.

Unlike a voluntary bankruptcy (where the company itself chooses when and where to file for bankruptcy), an involuntary case is thrust upon the company. Although the company can try to fight the involuntary by seeking an order of dismissal or abstention from the bankruptcy court, the mere filing of an involuntary can be quite damaging. If the court determines that the company belongs in bankruptcy, there is a presumption that the proceedings will be held in the court where the involuntary petition was filed. This deprives the company of the various legal and practical advantages that it might otherwise have obtained if it had the opportunity to choose its own venue for filing.

With respect to the distribution of assets, state law (as reflected in the formation documents and applicable statutes) usually provides that, upon the winding up of the subsidiary, the assets shall be distributed as follows:

• To the subsidiary's creditors in satisfaction of the subsidiary's liabilities;
• To the establishment of a reserve which the liquidating trustee may deem necessary for contingent or unforeseen liabilities; and
• Thereafter, to the shareholders.

In cases where there are insufficient assets to pay all creditors' claims in full, such claims will be paid according to their priority and, among claims of equal priority, ratably to the extent assets are available (much like in bankruptcy). A composition agreement, whereby creditors agree to accept a certain distribution in full satisfaction of their outstanding claims, may be employed in conjunction with a dissolution, or alone. A composition agreement can also contain a provision prohibiting individuals from commencing an involuntary bankruptcy proceeding against the subsidiary. Viewed most simply, a composition agreement is simply a contract between the debtor and a single creditor. Debtors will sometimes send composition agreements to each of their creditors that includes as a precondition to the company's obligation thereunder, that a certain pre-set percentage of the debtor's creditors and claims accept the composition in order for such agreement to be binding (in a manner similar to an exchange offer).

To bolster the validity of the out-of-court dissolution process, the subsidiary may want to consider setting up an informal creditors' committee prior to attempting the dissolution. In such a scenario, the subsidiary (if capable) would typically fund the informal committee's expenses to the extent such expenses are limited to the legal costs associated with reviewing certain transactional documents and the proposed dissolution scheme. This 'ad hoc' committee can provide a means by which the creditors' collective voice can be represented from the outset of the proceeding, while, simultaneously, allowing both parent and subsidiary to have a say in which creditors and which law firm represent that collective interest. In the event that the wind-down is ever challenged as unfair to creditors, the legitimacy of the process can be validated by the ongoing and established presence of a creditor constituency and retained counsel.

Option 2: Assignment for the Benefit of Creditors

Another popular dissolution alternative is an assignment for the benefit of creditors. A vast majority of states provide for this alternative to a federal bankruptcy filing, either by statute, common law, or both.

An assignment for the benefit of creditors is a voluntary insolvency process, in which the insolvent company (aka, the “debtor” or “assignor”), usually by way of a formal state filing, assigns all its property to a designated assignee for liquidation. The assignee then liquidates the property and distributes the assets to the company's creditors in accordance with certain procedures and priorities.

The process itself varies from state to state. Less favorable schemes treat the process much like a probate estate. Other states offer a more streamlined process. In addition, a number of states do not require that the assignee be local or domiciled within the state.

Upon liquidation, claims are paid in substantially the same priority as such would be paid pursuant to the applicable provisions of the U.S. Bankruptcy Code. Instead of the Bankruptcy Code, however, the priority scheme is usually enumerated by state law and/or in a composition agreement, which is formulated by the assignor and assignee (subject to certain specific statutory mandates with respect to the priority of claims).

Similar to a trustee in bankruptcy, an assignee has standing to prosecute and defend claims on behalf of and against the debtor/assignor. Included among these claims are state law versions of preference and fraudulent transfer avoidance actions.

Decreased Threat of an Involuntary Bankruptcy

One additional advantage of an assignment over a straight dissolution is that, although creditors may still file an involuntary bankruptcy petition against the debtor, a bankruptcy court is more likely to abstain from exercising jurisdiction where there is a pre-existing assignment for the benefit of creditors in process.

Option 3: Chapter 7 Liquidation

Chapter 7 of the Bankruptcy Code provides a formal procedure for the orderly liquidation of the subsidiary's assets and the ultimate payment of creditors' claims in the order of priority set forth in the Bankruptcy Code. Upon the filing of a Chapter 7 petition, a trustee is appointed by the United States Trustee and charged with marshalling all of the subsidiary's assets, liquidating the estate and eventually distributing the proceeds of the liquidation to its creditors.

Unlike a straight dissolution or assignment for the benefit of creditors, neither the parent nor the subsidiary has the ability to choose the person or firm who will serve as the trustee in a Chapter 7 bankruptcy. Moreover Chapter 7 proceedings are presided over by a federal bankruptcy judge and are governed by a detailed, and often cumbersome federal statute and series of complex rules. Together, these factors result in a total loss of control over the liquidation process.

Therefore, to the extent there is concern that the parent and subsidiary's pre-bankruptcy actions may be inappropriately challenged (and there often is), Chapter 7 may not be preferable as it will empower and fund a trustee, who is more likely to bring such challenges. On the other hand, Chapter 7 does provide perhaps the clearest means by which the parent and subsidiary's management can effectively wash their hands of any future management obligations to the subsidiary and its wind-down process. Indeed, among other things, the federal bankruptcy code provides a uniform, multi-state level of statutory authority and jurisdiction over assets. Assignment laws are much less clear and uniform. In addition, the relevant insolvency professionals (including the presiding judge) are more apt to be experienced with the workings of the various tenets of the Bankruptcy Code as such pertain to an insolvent subsidiary's particular circumstances.

Option 4: Chapter 11 Liquidation

A key benefit of chapter 11 over chapter 7 and the other alternatives discussed above is that chapter 11 permits the subsidiary (aka, the “debtor in possession” or “DIP”) to remain in control of the process. Throughout the chapter 11 process, however, the DIP's decisions remain subject to bankruptcy court approval, and review by the Office of the United States Trustee and committee (if any). Chapter 11 is a complex and expensive wind-down alternative. However, as discussed above, its advantages include providing a method by which a purchaser can receive perhaps the cleanest title in the transferred assets.

Benefits of Chapter 11

While the DIP is busy assessing its liabilities and formulating and confirming its chapter 11 plan, it enjoys the benefit of the automatic stay of the Bankruptcy Code. The automatic stay effectively prohibits the subsidiary's creditors from engaging in any type of collection activity against the estate (other than filing a proof of claim) during the pending bankruptcy case. Indeed, the automatic stay is one of the primary benefits of bankruptcy as it is intended to give the DIP “breathing space” in which it can focus on its chapter 11 plan without the pressures associated with creditors' collection activity.

Additionally, the chapter 11 process provides for protection for post-bankruptcy financing, whereby the lender (which is, in some cases, the parent) can obtain a bankruptcy court order approving the terms of the post-bankruptcy financing agreement (aka, DIP Loan). By obtaining this approval, the lender obtains full assurance that its loan will not be recharacterized or otherwise subordinated to the DIP's other creditors.

Another potential benefit of chapter 11 is the ability, in certain jurisdictions, to obtain broad releases from the subsidiary and its creditors for the parent and/or its directors and officers. These releases can be incorporated as part of the chapter 11 plan. In order for releases to be permitted, however, the released parties must provide some form of consideration in exchange for the release from liability. For directors and officers, it is possible that, depending upon the jurisdication, the consideration requirement may be met through their continued service to the subsidiary during the pending bankruptcy case. The parent, however, would likely need to concede some or all of its claims against the subsidiary or propose some other means by which it can offer the subsidiary additional value in exchange for a release.

Conclusion

When confronted with an underperforming or insolvent subsidiary, it is important for the parent to initially identify its most critical objectives and expectations with respect to its subsidiary. In some cases, an analysis of these objectives may result in a determination that the subsidiary, though struggling, is worth saving. In other cases, the parent may want nothing more than to wash its hands of the subsidiary and limit any additional liability that may arise as a result of the subsidiary's insolvency.

In the latter scenario, it is important to remember that there are a number of procedural alternatives (and combinations of alternatives) that can be used to wind-down the insolvent company. When making the selection, it is important to consider the range of liabilities that may remain or arise in the context of any insolvency, and which procedural vehicle can best limit such liabilities for the parent, subsidiary and their respective directors and officers.

Although an insolvent subsidiary's creditors are entitled to the company's (and its directors and officers') fiduciary obligations, directors and officers can, under certain circumstances, still meet their fiduciary obligations to such creditors yet also take steps to maximize recovery for the principal equityholder as well. A prudent parent, however, may decide to hedge its position by installing an independent board of directors who are charged with making those decisions that could detrimentally affect the interests of the subsidiary's creditors. Nonetheless, in any case, it is important for the parent to remain cognizant of the various liabilities that may arise on the frontier of insolvency and consider such risks when determining when and how to dispose of its insolvent subsidiary.

[IMGCAP(1)]