Fiduciary Duties Owed to Subsidiary

More specifically, Scotty's sold several parcels of real estate to certain defendants at less than market rates. Even though they were insiders, Scotty's failed to solicit and consider third-party offers for the purchase of this choice real estate, and failed to seek any independent consideration or review of these insider transactions.

Additionally, Scotty's entered into insider loans with these defendants, whereby they loaned several million dollars to Scotty's at what appeared to be above market interest rate of 11% or greater. All these loans were paid back before the filing.

The defendants, directors and officers moved to dismiss on several grounds, including that the directors of the wholly owned subsidiary owe no duty to the subsidiary corporation, and, thus, they could not have violated their fiduciary duties to Scotty's, Inc. Relying upon Southwest Holdings, L.L.C. v. Kohlberg & Co. (In re Southwest Supermarkets L.L.C.), 315 B.R. 565 (Bankr. D. Ariz. 2004), the defendants argued that Delaware law holds that the directors and officers of a wholly owned subsidiary owe their fiduciary duties solely to the single shareholder and not to the subsidiary corporation itself, even when the corporation becomes insolvent.

The Trustee opposed the motion, arguing that such a duty did exist, and that he was bringing the action on behalf of the parent corporation, the wholly-owned subsidiary, and the creditors of Scotty's.

Court's Decision

The court rejected the defendants' contention, and ruled that Delaware law would recognize that the directors and officers of an insolvent, wholly-owned subsidiary owe fiduciary duties to the subsidiary and its creditors. It distinguished the Southwest Court's decision primarily because of its reliance upon Anadarko Petroleum Corp. v. Panhandle Eastern Corp., 545 A. 2d 1171 (Del. 1998), which arose out of different factual circumstances. In Anadarko, the Delaware Supreme Court considered whether a corporate parent and directors of a wholly owned subsidiary owe fiduciary duties to the prospective stockholders of the subsidiary after the parent declares its intention to spin-off the subsidiary. The Delaware Supreme Court ruled that, before the date of distribution, the interests of the respective stockholders were not sufficient to impose fiduciary obligations on the parent and the subsidiary's directors. But Anadarko did not, as the defendant directors and officers in Scott suggest, eliminate all duties of directors to subsidiary corporations. The Bankruptcy Court also noted that the majority of courts following Anadarko have rejected just such a contention as overbroad. The Scott court cited as one example Judge Allan L. Gropper's decision in In re RSL Comm. Primecall, Inc., ___ B.R. ___, 2003 WL 22989669 (Bankr. S.D. N.Y. 2003), which noted under similar circumstances that Anadarko is distinguishable in part because both the parent company and the subsidiary were solvent:

It would be absurd to hold that the doctrine that directors owe special duties after insolvency is inapplicable when the insolvent company is a subsidiary of another corporation. That is precisely when a director must be most acutely sensitive to the needs of the corporation's separate community of interests, including both the parent shareholder and the corporation's creditors ' There is no basis for the principle propounded by a few of the Defendants that the directors of an insolvent subsidiary can, with impunity, permitted to be plundered for the benefit of its parent corporation. Primecall at *42-44.

Southwest distinguished Primecall by noting that its exception to the Anadarko rule arose in the context of creditor, rather than debtor, claims. Thus, Southwest posits that directors of wholly owned insolvent subsidiaries do not owe any fiduciary duties to the subsidiary corporation, but nevertheless owe fiduciary duties to the subsidiary's creditors. But this misunderstands the concept of fiduciary duty to creditors, according to the Scott court. Under Delaware law, creditors of insolvent corporation are owed fiduciary duties, but these duties are typically derivative of those owed to subsidiary corporation itself. So, if a subsidiary's creditors are said to be owed a fiduciary duty upon insolvency, the subsidiary itself must also be owed such a duty. Thus, Southwest's distinction is without merit.

The Scott court also noted that Southwest failure to recognize this point may in part be attributable to the fact that it was decided without the benefit of Production Resources Group L.L.C. v. NCT Group, Inc., 863 A. 2d 772, 791-92 (Del. Ch. 2004), which clarified that director's fiduciary obligations in the zone of insolvency are still to the corporation itself:

When a firm has reached the point of insolvency, it is settled that under Delaware law, the firm's directors are said to owe fiduciary duties to the company's creditors. This is an uncontroversial proposition and does not completely turn on its head the equitable obligations of the directors to the firm itself. The directors continue to have the task of attempting to maximize the economic value of the firm. That much of their job does not change.

Thus, the court concluded, the more natural reading of Delaware law is that upon insolvency, directors of a wholly owned subsidiary owe fiduciary duties to the subsidiary and its creditors.

Conclusion

While the Scott's decision makes compelling legal sense, it adds a level of uncertainty to the duties of directors and officers acting within the zone of insolvency. To cite but one example, the Bankruptcy Court in In re Century Electronics Mfg., Inc., ____ B.R. ___, 2006, WL 1999216 (Bankr. D. Mass. 2006), relied upon the Scott decision to assert that the actions of directors and officers of a parent company, who also sat on the board of the subsidiary, could give rise to breach of fiduciary duty claims in two states ' Delaware, where the parent corporation was formed, and Massachusetts, where the subsidiary was incorporated. Is it possible at all, then, to serve on the board of a parent and a sub in the zone of insolvency? Based on Scott's, it would certainly be a very fine line to walk.

Editor's Note: In what may prove to be a major development on this issue, on August 10, the Delaware Court of Chancery considered the question of deepening insolvency in Trenwick America Litigation Trust v. Ernst & Young LLP, et al., C.A. No. 157-1. Holding there is no claim for deepening insolvency under Delaware law, Vice Chancellor Leo E. Strine stated that 'put simply, under Delaware law, 'deepening insolvency' is no more of a cause of action when a firm is insolvent than a cause of action for 'shallowing profitability' would be when a firm is solvent.' A full analysis of this decision will appear in an upcoming issue.

Luis Salazar is a shareholder at Greenberg Traurig and a member of its National Business Reorganization and Bankruptcy Department. He is based in the firm's Miami office and can be reached at [email protected].

On June 23, 2006, the jurisdiction that invented the 'zone of insolvency' delivered its latest lesson on the fiduciary duties of directors and officers of insolvent companies. The Delaware Bankruptcy Court, in In re Scott Acquisition Corp., ___ B.R. at ____, 2006 WL 1731277 (Bankr. D.Del. 2006), ruled that directors and officers of insolvent subsidiary companies owe fiduciary duties to both its creditors and the subsidiary itself. Before this, leading cases on this issue held that fiduciary duties were owed only to creditors and the single-shareholder, parent companies. Though the decision stands on some firm legal ground, it is sure to create more uncertainty and doubt in the boardroom.

Background

Scott Acquisition Corp. and Scotty's, Inc., its wholly owed subsidiary, were retailers of building materials and home improvement products for the do-it-yourself home-improvement market. Scotty's and its subsidiary filed for bankruptcy protection on Sept. 10, 2004; their case was later converted to Chapter 7, and a Trustee was appointed. The court's opinion arises out of the Trustee's lawsuit against the officers and directors of Scotty's, Inc., the subsidiary. In his complaint, the Trustee alleged that the directors and officers breached their duties of loyalty and care in connection with Scotty's pre-bankruptcy workout with its lenders.

More specifically, Scotty's sold several parcels of real estate to certain defendants at less than market rates. Even though they were insiders, Scotty's failed to solicit and consider third-party offers for the purchase of this choice real estate, and failed to seek any independent consideration or review of these insider transactions.

Additionally, Scotty's entered into insider loans with these defendants, whereby they loaned several million dollars to Scotty's at what appeared to be above market interest rate of 11% or greater. All these loans were paid back before the filing.

The defendants, directors and officers moved to dismiss on several grounds, including that the directors of the wholly owned subsidiary owe no duty to the subsidiary corporation, and, thus, they could not have violated their fiduciary duties to Scotty's, Inc. Relying upon Southwest Holdings, L.L.C. v. Kohlberg & Co. (In re Southwest Supermarkets L.L.C.), 315 B.R. 565 (Bankr. D. Ariz. 2004), the defendants argued that Delaware law holds that the directors and officers of a wholly owned subsidiary owe their fiduciary duties solely to the single shareholder and not to the subsidiary corporation itself, even when the corporation becomes insolvent.

The Trustee opposed the motion, arguing that such a duty did exist, and that he was bringing the action on behalf of the parent corporation, the wholly-owned subsidiary, and the creditors of Scotty's.

Court's Decision

The court rejected the defendants' contention, and ruled that Delaware law would recognize that the directors and officers of an insolvent, wholly-owned subsidiary owe fiduciary duties to the subsidiary and its creditors. It distinguished the Southwest Court's decision primarily because of its reliance upon Anadarko Petroleum Corp. v. Panhandle Eastern Corp. , 545 A. 2d 1171 (Del. 1998), which arose out of different factual circumstances. In Anadarko, the Delaware Supreme Court considered whether a corporate parent and directors of a wholly owned subsidiary owe fiduciary duties to the prospective stockholders of the subsidiary after the parent declares its intention to spin-off the subsidiary. The Delaware Supreme Court ruled that, before the date of distribution, the interests of the respective stockholders were not sufficient to impose fiduciary obligations on the parent and the subsidiary's directors. But Anadarko did not, as the defendant directors and officers in Scott suggest, eliminate all duties of directors to subsidiary corporations. The Bankruptcy Court also noted that the majority of courts following Anadarko have rejected just such a contention as overbroad. The Scott court cited as one example Judge Allan L. Gropper's decision in In re RSL Comm. Primecall, Inc., ___ B.R. ___, 2003 WL 22989669 (Bankr. S.D. N.Y. 2003), which noted under similar circumstances that Anadarko is distinguishable in part because both the parent company and the subsidiary were solvent:

It would be absurd to hold that the doctrine that directors owe special duties after insolvency is inapplicable when the insolvent company is a subsidiary of another corporation. That is precisely when a director must be most acutely sensitive to the needs of the corporation's separate community of interests, including both the parent shareholder and the corporation's creditors ' There is no basis for the principle propounded by a few of the Defendants that the directors of an insolvent subsidiary can, with impunity, permitted to be plundered for the benefit of its parent corporation. Primecall at *42-44.

Southwest distinguished Primecall by noting that its exception to the Anadarko rule arose in the context of creditor, rather than debtor, claims. Thus, Southwest posits that directors of wholly owned insolvent subsidiaries do not owe any fiduciary duties to the subsidiary corporation, but nevertheless owe fiduciary duties to the subsidiary's creditors. But this misunderstands the concept of fiduciary duty to creditors, according to the Scott court. Under Delaware law, creditors of insolvent corporation are owed fiduciary duties, but these duties are typically derivative of those owed to subsidiary corporation itself. So, if a subsidiary's creditors are said to be owed a fiduciary duty upon insolvency, the subsidiary itself must also be owed such a duty. Thus, Southwest's distinction is without merit.

The Scott court also noted that Southwest failure to recognize this point may in part be attributable to the fact that it was decided without the benefit of Production Resources Group L.L.C. v. NCT Group, Inc. , 863 A. 2d 772, 791-92 (Del. Ch. 2004), which clarified that director's fiduciary obligations in the zone of insolvency are still to the corporation itself:

When a firm has reached the point of insolvency, it is settled that under Delaware law, the firm's directors are said to owe fiduciary duties to the company's creditors. This is an uncontroversial proposition and does not completely turn on its head the equitable obligations of the directors to the firm itself. The directors continue to have the task of attempting to maximize the economic value of the firm. That much of their job does not change.

Thus, the court concluded, the more natural reading of Delaware law is that upon insolvency, directors of a wholly owned subsidiary owe fiduciary duties to the subsidiary and its creditors.

Conclusion

While the Scott's decision makes compelling legal sense, it adds a level of uncertainty to the duties of directors and officers acting within the zone of insolvency. To cite but one example, the Bankruptcy Court in In re Century Electronics Mfg., Inc., ____ B.R. ___, 2006, WL 1999216 (Bankr. D. Mass. 2006), relied upon the Scott decision to assert that the actions of directors and officers of a parent company, who also sat on the board of the subsidiary, could give rise to breach of fiduciary duty claims in two states ' Delaware, where the parent corporation was formed, and Massachusetts, where the subsidiary was incorporated. Is it possible at all, then, to serve on the board of a parent and a sub in the zone of insolvency? Based on Scott's, it would certainly be a very fine line to walk.

Editor's Note: In what may prove to be a major development on this issue, on August 10, the Delaware Court of Chancery considered the question of deepening insolvency in Trenwick America Litigation Trust v. Ernst & Young LLP, et al., C.A. No. 157-1. Holding there is no claim for deepening insolvency under Delaware law, Vice Chancellor Leo E. Strine stated that 'put simply, under Delaware law, 'deepening insolvency' is no more of a cause of action when a firm is insolvent than a cause of action for 'shallowing profitability' would be when a firm is solvent.' A full analysis of this decision will appear in an upcoming issue.

Luis Salazar is a shareholder at Greenberg Traurig and a member of its National Business Reorganization and Bankruptcy Department. He is based in the firm's Miami office and can be reached at [email protected].