Paddling Down Esopus Creek

The company in question in Esopus was Metromedia International Group, Inc. ('Metromedia'), based in Charlotte, NC. Metromedia owns interests in communications and media outlets throughout Eastern Europe.

Esopus Creek Value LP ('Esopus') is a hedge fund and one of the shareholders of Metromedia. Esopus and another hedge fund/shareholder, Black Horse Capital, LP, sued to enjoin Metromedia from executing the agreement in question without the affirmative vote of the majority of the company's common stockholders as required by the Delaware General Corporate Law (that is, in compliance with the applicable state statutory law). The Defendants also included Metromedia's board of directors and several executives, including Mark Hauf, the company's chairman, president and CEO.

So, What Happened?

The facts, while unusual, were not unheard-of. Metromedia was not financially troubled, and in fact, its financial performance had improved considerably in the time leading up to the litigation. On the other hand, however, the company was delinquent in its SEC reporting requirements (Like Metromedia, other companies have been similarly unable to file SEC reports. Examples include Navigant International and United Rentals. For various reasons, these solvent companies were unable to meet their SEC reporting requirement and did not file for bankruptcy).

In early-to-mid 2006, a group of investors sought to purchase Metromedia's key asset, a majority interest in the leading mobile telephone provider in the Republic of Georgia ('Magticom'), at a price the Board considered to be attractive. The would-be sale was considered to be a 'sale of all or substantially all' of Metromedia's assets, and thus the Board was required to seek an affirmative vote of the common stockholders under DGCL ' 271.

The problem was that the Board, relying on the advice of counsel, believed that such a vote was impossible under ' 14(c) of the Securities Exchange Act of 1934, since it bars a registered company delinquent in its reporting obligations from calling a meeting or soliciting proxies from its stockholders. The court noted that the Board did not consider seeking an exemption from the strictures of Section 14(c), which the court felt would be readily available given the SEC's predisposition to use its broad exemptive authority to support important state law principles of corporate governance. Instead, the Board adopted a four-step strategy to sidestep the problem. The strategy called for:

• Executing an agreement providing for the sale of the subsidiary as well as a lock-up agreement with the holders of roughly 80% of the preferred shares;
• Filing a Chapter 11 case;
• Obtaining approval of the sale from the bankruptcy court under ' 363 of the Bankruptcy Code; and
• Confirming a Chapter 11 Plan that would distribute the proceeds of the sale to shareholders.

The plaintiffs sued to enjoin shortly after the announcement of the proposed transaction. Following expedited discovery and the submission of briefs, Metromedia retreated from its position. Rather than argue that the Board be permitted to employ the Bankruptcy Code to effectuate the sale, Metromedia proposed, and the plaintiffs and the court agreed, to an order stipulating to the following:

• The transaction would be subject to a vote of the common stockholders under DGCL Section 271(a);
• The Board would seek exemptive relief from the SEC to permit the company to solicit proxies and to provide stockholders with fulsome disclosure regarding Magticom;
• Irrespective of the company's success in seeking exemptive relief, the company would distribute all information required under Delaware law to ensure that the vote of the common stockholders is informed;
• The company would take all necessary steps to encourage the common stockholders to attend the meeting and vote on the proposed transaction; and
• The court would reserve the right to adjust any terms contained in the order upon application by either party.

Contemporaneously with the entering of the order above, the court issued its opinion explaining its rationale that provided the foundations of the order. It is that decision that has caused all of the hullabaloo.

What This Means

As a threshold matter, Esopus is interesting from a procedural and precedential perspective. Vice Chancellor Lamb fully sets forth his reasoned opinion underlying the order. However, his opinion might be considered solely dicta given the fact that the parties had already agreed to the order, which was inclusive of all that the court sought to achieve. Whether this more unusual backdrop for an opinion of the court mitigates against the precedential strength of the case remains to be seen.

As for the substance of the case, on one level, as the court itself made clear, the question it faced in Esopus was answered in Newcastle Partners, L.P. v. Vesta Insurance Group, Inc., 887 A.2d 975 (Del.Ch.2005) aff'd 906 A.2d 807 (Del.2005). In Newcastle, the Chancery Court held that the right of stockholders to meet for the purpose of choosing directors should not be suspended indefinitely on the basis of the company's inability to comply with federal proxy regulations.

In Esopus, the court similarly held that the right of common stockholders to approve a proposed sale of all or substantially all of the assets of a company under DGCL ' 271 may not be suspended on the basis of the company's inability to comply with federal reporting requirements that barred the company from calling a meeting or soliciting proxies. Both courts believed that the SEC would not interpret or administer federal securities laws in a manner that would interfere with the court from requiring a company to hold such a vote. Citing Newcastle, the Esopus court stated that such an outcome would 'cut directly against the policy of a strong stockholder franchise that underlies the SEC's rules on the distribution of proxy and information statements.'

It is not surprising that the court drew such a clear analogy to the Newcastle case. In Newcastle, the issue was the right of stockholders to meet to elect directors. In Esopus, the issue was the right of stockholders to approve a sale of all or substantially all of the assets of the company. In both instances, the result would be the disenfranchisement of stockholders, which the court indicated in both cases would contradict the SEC's own emphasis on stockholders' rights, evident in the SEC's proxy solicitation process. In addition, since the bankruptcy court filing had not yet occurred, there was no question that state laws applied (In bankruptcy, the debtor in possession has the authority to sell all or substantially all of the assets of the estate without shareholder approval. 11 U.S.C. ' 363(b). See In re Entz, 44 B.R. 483, 485 (Bankr.D.Ariz.1984) and its progeny). The more controversial aspect of Esopus involved the Chancery Court's incursion into an area it arguably has no place being ' bankruptcy.

The Bankruptcy Code is clear that a solvent company may avail itself of bankruptcy protections so long as it does so in 'good faith.' While the Esopus court stated that it was not determining whether a Chapter 11 filing would be in good faith, the court nonetheless stated that it would rely on its general equitable authority to intervene where a board action 'offend[s] fundamental notions of equitable conduct.' The court explained that the 'good faith' requirement under the Bankruptcy Code is equitable in nature and based on the policy that the Code ought not encourage the filing of petitions that lack a 'valid organizational purpose.' The court then cited a bankruptcy court's description of the underlying policy of Chapter 11: that it 'was designed to give those teetering on the verge of a fatal financial plummet an opportunity to reorganize on solid ground and try again, not to give profitable enterprises an opportunity to evade' other contractual and state law obligations. Esopus, 2006 WL 3499526 at *8, citing In re SGL Carbon Corp., 200 F.3d 154, 160 (3d Cir.1999) (citing Furness v. Lilienfield, 35 B.R. 1006, 1009 (D.Md.1983)).

The Esopus court recognized that the Board's proposed use of the Bankruptcy Code would legally permit the sale of substantially all of the assets of the company without requiring the vote of a majority of the company's common stockholders. However, the court cited that oft-quoted axiom: 'inequitable action does not become permissible simply because it is legally possible.' The court looked to the underlying spirit of the Bankruptcy Code and relied on Schnell v. Chris Craft Indus., Inc., 285 A.2d 437 (Del. Ch. 1971) and its progeny to argue that the company's proposed transactional structure 'though technically within the letter of the law, works a profound inequity upon the company's common stockholders.' Esopus, 2006 WL 3499526 at *7. Further, the court deemed the contemplated action inequitable, as it would deprive stockholders of their right under DGCL ' 271 to vote on the sale and because it would give the preferred stockholders who did not have the right to vote on such a sale under the company's articles of incorporation and bylaws a right to consent to the company's reorganization plan.

To the extent the Chancery Court is stating what it will do as long as a company has not filed for bankruptcy protection under federal law, we see nothing controversial. And, we think this is all it is saying and, in any event, all it can say on the subject. Some commentators, as suggested above, believe the Chancery Court is signaling a willingness or intent to go further, and get into the 'business' of deciding when a company may or may not file bankruptcy. We give the Chancery Court more credit than this.

Conclusion

To conclude, we believe that Esopus stands for two key take-away's: first, the Delaware Chancery Court will rely on its equitable authority to prevent a solvent company from taking steps to use ' 363 of the Bankruptcy Code to sell all or substantially all of its assets prior to the actual filing of a bankruptcy petition, when such action is taken with the sole purpose of avoiding the stockholder voting requirement under DGCL ' 271. Second, if a solvent company wishes to employ a strategy to take advantage of the Bankruptcy Code and its ability to trump state corporate law with respect to stockholder voting rights, it needs be careful to execute that strategy in a manner that takes Esopus into account. And, while Esopus is a Delaware case, we think it wise to keep in mind that other courts often look to the Delaware Chancery Court for guidance.

Jonathan Friedland is a partner in the Chicago office of Schiff Hardin LLP, where he practices in both the corporate and securities group, and the bankruptcy, workouts, and creditors' rights group. Until recently, he was a partner at Kirkland & Ellis LLP in Chicago. Mazen Asbahi is an associate in the corporate and securities group of Schiff Hardin LLP.

An end-of-year (Nov. 29) Delaware Chancery Court decision, Esopus Creek Value LP v. Hauf, No. 2487-N (Del. Ch. Nov. 29, 2006), is receiving a great deal of attention from corporate transactional and corporate restructuring attorneys alike.

In Esopus, the Delaware Chancery Court prevented a financially sound company that was prohibited by federal securities law from holding a shareholder vote, because it failed to meet its reporting requirements, from executing an agreement outside of bankruptcy to sell substantially all of its assets under Section 363 of the Bankruptcy Code without first obtaining common stockholder approval as required under Section 271(a) of the Delaware General Company Law ('DGCL').

Who Was At the Party?

The company in question in Esopus was Metromedia International Group, Inc. ('Metromedia'), based in Charlotte, NC. Metromedia owns interests in communications and media outlets throughout Eastern Europe.

Esopus Creek Value LP ('Esopus') is a hedge fund and one of the shareholders of Metromedia. Esopus and another hedge fund/shareholder, Black Horse Capital, LP, sued to enjoin Metromedia from executing the agreement in question without the affirmative vote of the majority of the company's common stockholders as required by the Delaware General Corporate Law (that is, in compliance with the applicable state statutory law). The Defendants also included Metromedia's board of directors and several executives, including Mark Hauf, the company's chairman, president and CEO.

So, What Happened?

The facts, while unusual, were not unheard-of. Metromedia was not financially troubled, and in fact, its financial performance had improved considerably in the time leading up to the litigation. On the other hand, however, the company was delinquent in its SEC reporting requirements (Like Metromedia, other companies have been similarly unable to file SEC reports. Examples include Navigant International and United Rentals. For various reasons, these solvent companies were unable to meet their SEC reporting requirement and did not file for bankruptcy).

In early-to-mid 2006, a group of investors sought to purchase Metromedia's key asset, a majority interest in the leading mobile telephone provider in the Republic of Georgia ('Magticom'), at a price the Board considered to be attractive. The would-be sale was considered to be a 'sale of all or substantially all' of Metromedia's assets, and thus the Board was required to seek an affirmative vote of the common stockholders under DGCL ' 271.

The problem was that the Board, relying on the advice of counsel, believed that such a vote was impossible under ' 14(c) of the Securities Exchange Act of 1934, since it bars a registered company delinquent in its reporting obligations from calling a meeting or soliciting proxies from its stockholders. The court noted that the Board did not consider seeking an exemption from the strictures of Section 14(c), which the court felt would be readily available given the SEC's predisposition to use its broad exemptive authority to support important state law principles of corporate governance. Instead, the Board adopted a four-step strategy to sidestep the problem. The strategy called for:

• Executing an agreement providing for the sale of the subsidiary as well as a lock-up agreement with the holders of roughly 80% of the preferred shares;
• Filing a Chapter 11 case;
• Obtaining approval of the sale from the bankruptcy court under ' 363 of the Bankruptcy Code; and
• Confirming a Chapter 11 Plan that would distribute the proceeds of the sale to shareholders.

The plaintiffs sued to enjoin shortly after the announcement of the proposed transaction. Following expedited discovery and the submission of briefs, Metromedia retreated from its position. Rather than argue that the Board be permitted to employ the Bankruptcy Code to effectuate the sale, Metromedia proposed, and the plaintiffs and the court agreed, to an order stipulating to the following:

• The transaction would be subject to a vote of the common stockholders under DGCL Section 271(a);
• The Board would seek exemptive relief from the SEC to permit the company to solicit proxies and to provide stockholders with fulsome disclosure regarding Magticom;
• Irrespective of the company's success in seeking exemptive relief, the company would distribute all information required under Delaware law to ensure that the vote of the common stockholders is informed;
• The company would take all necessary steps to encourage the common stockholders to attend the meeting and vote on the proposed transaction; and
• The court would reserve the right to adjust any terms contained in the order upon application by either party.

Contemporaneously with the entering of the order above, the court issued its opinion explaining its rationale that provided the foundations of the order. It is that decision that has caused all of the hullabaloo.

What This Means

As a threshold matter, Esopus is interesting from a procedural and precedential perspective. Vice Chancellor Lamb fully sets forth his reasoned opinion underlying the order. However, his opinion might be considered solely dicta given the fact that the parties had already agreed to the order, which was inclusive of all that the court sought to achieve. Whether this more unusual backdrop for an opinion of the court mitigates against the precedential strength of the case remains to be seen.

As for the substance of the case, on one level, as the court itself made clear, the question it faced in Esopus was answered in Newcastle Partners, L.P. v. Vesta Insurance Group, Inc. , 887 A.2d 975 (Del.Ch.2005) aff'd 906 A.2d 807 (Del.2005). In Newcastle, the Chancery Court held that the right of stockholders to meet for the purpose of choosing directors should not be suspended indefinitely on the basis of the company's inability to comply with federal proxy regulations.

In Esopus, the court similarly held that the right of common stockholders to approve a proposed sale of all or substantially all of the assets of a company under DGCL ' 271 may not be suspended on the basis of the company's inability to comply with federal reporting requirements that barred the company from calling a meeting or soliciting proxies. Both courts believed that the SEC would not interpret or administer federal securities laws in a manner that would interfere with the court from requiring a company to hold such a vote. Citing Newcastle, the Esopus court stated that such an outcome would 'cut directly against the policy of a strong stockholder franchise that underlies the SEC's rules on the distribution of proxy and information statements.'

It is not surprising that the court drew such a clear analogy to the Newcastle case. In Newcastle, the issue was the right of stockholders to meet to elect directors. In Esopus, the issue was the right of stockholders to approve a sale of all or substantially all of the assets of the company. In both instances, the result would be the disenfranchisement of stockholders, which the court indicated in both cases would contradict the SEC's own emphasis on stockholders' rights, evident in the SEC's proxy solicitation process. In addition, since the bankruptcy court filing had not yet occurred, there was no question that state laws applied (In bankruptcy, the debtor in possession has the authority to sell all or substantially all of the assets of the estate without shareholder approval. 11 U.S.C. ' 363(b). See In re Entz, 44 B.R. 483, 485 (Bankr.D.Ariz.1984) and its progeny). The more controversial aspect of Esopus involved the Chancery Court's incursion into an area it arguably has no place being ' bankruptcy.

The Bankruptcy Code is clear that a solvent company may avail itself of bankruptcy protections so long as it does so in 'good faith.' While the Esopus court stated that it was not determining whether a Chapter 11 filing would be in good faith, the court nonetheless stated that it would rely on its general equitable authority to intervene where a board action 'offend[s] fundamental notions of equitable conduct.' The court explained that the 'good faith' requirement under the Bankruptcy Code is equitable in nature and based on the policy that the Code ought not encourage the filing of petitions that lack a 'valid organizational purpose.' The court then cited a bankruptcy court's description of the underlying policy of Chapter 11: that it 'was designed to give those teetering on the verge of a fatal financial plummet an opportunity to reorganize on solid ground and try again, not to give profitable enterprises an opportunity to evade' other contractual and state law obligations. Esopus , 2006 WL 3499526 at *8, citing In re SGL Carbon Corp ., 200 F.3d 154, 160 (3d Cir.1999) (citing Furness v. Lilienfield , 35 B.R. 1006, 1009 (D.Md.1983)).

The Esopus court recognized that the Board's proposed use of the Bankruptcy Code would legally permit the sale of substantially all of the assets of the company without requiring the vote of a majority of the company's common stockholders. However, the court cited that oft-quoted axiom: 'inequitable action does not become permissible simply because it is legally possible.' The court looked to the underlying spirit of the Bankruptcy Code and relied on Schnell v. Chris Craft Indus., Inc. , 285 A.2d 437 (Del. Ch. 1971) and its progeny to argue that the company's proposed transactional structure 'though technically within the letter of the law, works a profound inequity upon the company's common stockholders.' Esopus, 2006 WL 3499526 at *7. Further, the court deemed the contemplated action inequitable, as it would deprive stockholders of their right under DGCL ' 271 to vote on the sale and because it would give the preferred stockholders who did not have the right to vote on such a sale under the company's articles of incorporation and bylaws a right to consent to the company's reorganization plan.

To the extent the Chancery Court is stating what it will do as long as a company has not filed for bankruptcy protection under federal law, we see nothing controversial. And, we think this is all it is saying and, in any event, all it can say on the subject. Some commentators, as suggested above, believe the Chancery Court is signaling a willingness or intent to go further, and get into the 'business' of deciding when a company may or may not file bankruptcy. We give the Chancery Court more credit than this.

Conclusion

To conclude, we believe that Esopus stands for two key take-away's: first, the Delaware Chancery Court will rely on its equitable authority to prevent a solvent company from taking steps to use ' 363 of the Bankruptcy Code to sell all or substantially all of its assets prior to the actual filing of a bankruptcy petition, when such action is taken with the sole purpose of avoiding the stockholder voting requirement under DGCL ' 271. Second, if a solvent company wishes to employ a strategy to take advantage of the Bankruptcy Code and its ability to trump state corporate law with respect to stockholder voting rights, it needs be careful to execute that strategy in a manner that takes Esopus into account. And, while Esopus is a Delaware case, we think it wise to keep in mind that other courts often look to the Delaware Chancery Court for guidance.

Jonathan Friedland is a partner in the Chicago office of Schiff Hardin LLP, where he practices in both the corporate and securities group, and the bankruptcy, workouts, and creditors' rights group. Until recently, he was a partner at Kirkland & Ellis LLP in Chicago. Mazen Asbahi is an associate in the corporate and securities group of Schiff Hardin LLP.