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Kevin Walsh is a Member in the firm’s Boston office. His practice focuses on all aspects of bankruptcy and commercial law, workouts, restructurings, and commercial lending transactions, including negotiating and documenting commercial loans and credits. Kevin represents debtors and creditors, including bondholders, trustees, financial institutions, insurers and other entities in out-of-court restructuring and bankruptcy proceedings.  He has significant experience in distressed acquisitions and divestitures, complex commercial transactions, and business litigation.

Exculpation provisions in operating agreements must be carefully crafted in order to protect members, managers, directors and officers for breaches of fiduciary duties. In In re Simplexity, LLC, the Chapter 7 trustee sued the former officers and directors (who were also members and/or managers) for failing to act to preserve going concern value and exposing the debtors to WARN Act claims.  The defendants argued the exculpation language in the operating agreements shielded against breach of fiduciary duty liability.  The Delaware bankruptcy court found that the plain language of the applicable operating agreement did not protect the defendants from liability for breach of fiduciary duty; therefore the members, officers and directors could be liable for damages.

Under Delaware law, charter documents, such as a limited liability company operating agreement, can reduce or eliminate fiduciary duty liability for managers and controlling members of limited liability companies. The intent to reduce or eliminate such liability, however, must be “plain and unambiguous.”  In the absence of plain and unambiguous intent, managers and controlling members owe fiduciary duties.  To ascertain whether such intent was present in the Simplexity case, the court began where it must, with the language of the operating agreements.

If you want exculpation, be explicit.

The relevant provisions of the Simplexity operating agreement (Simplexity Agreement) provided:

Limitation on Liability. No current or former Manager of [Simplexity] shall be personally liable to the Company or the Member for monetary damages for breach of fiduciary duty as a Manager of [Simplexity]…provided, however, that this provision shall not eliminate liability of a Manager (i) for any breach of the Manager’s duty of loyalty to the Company and the Member, (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, or (iii) for any transaction from which the Manager derived an improper personal benefit…

Limitation of Duties; Conflict of Interest To the maximum extent permitted by applicable law, the Company and each Member, Manager, officer and employee of the Company hereby waives any claim or cause of action against any [Parent Company] Person for any breach of any fiduciary duty to the Company or its Members or any of the Company’s Affiliates by any such [Parent Company] Person, including, without limitation, as may result from a conflict of interest between the Company or its Members or any of the Company’s Affiliates and such [Parent Company]Person or otherwise. Each Member acknowledges and agrees that in the event of any such conflict of interest, each such [Parent Company]Person may, in the absence of bad faith, act in the best interests of such [Parent Company]Person, including without limitation its Affiliates, employees, agents and representatives…[S]uch waiver shall not apply to the extent the act or omission was attributable to the Manager’s gross negligence or knowing violation of law as determined by a final judgment, order or decree of a court of competent jurisdiction… .

The similar provisions of the operating agreement for Services, LLC, Simplexity’s subsidiary, provided (Services Agreement):

Exculpation.

(a) No Fiduciary Duties. To fullest extent permitted by law:

(i) notwithstanding any duty otherwise existing at law or in equity, and notwithstanding any other provision of this Agreement, no Indemnified Party shall owe any duty (including fiduciary duties) to the Company, the Member or any other Person that is a party to or is otherwise bound by this Agreement, in connection with any act or failure to act, whether hereunder, thereunder or otherwise; provided, however, that this clause (i) shall not eliminate the implied contractual covenant of good faith and fair dealing, and

(ii) No Indemnified Party shall have any personal liability to the Company, the Member, or any other Person that is a party to or is otherwise bound by this Agreement for monetary damages in connection with any act or failure to act, or breach, whether under this Agreement, the Act or otherwise; provided, however, that this clause (ii) shall not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing.

(b) No Personal Lability. If any provision of [the above-cited sections] is held to be invalid, illegal or unenforceable, the duties and personal liability of any Indemnified Party to the Company, of the Member or any other Person that is a party to or is otherwise bound by this Agreement shall be eliminated to the greatest extent permitted under the Act.

The defendants argued that they had no liability for breaches as to Simplexity because most of the parties to the Services Agreement were also party to the Simplexity Agreements, and therefore, the broad language of the Services Agreement that any “Member or any other Person that is a party to or is otherwise bound by this Agreement” covered Simplexity’s managers in their management of Simplexity.  Thus, they argued that the broad exculpation provisions of the Services Agreement were applicable to the managers of Simplexity.

The court disagreed and concluded that the Simplexity Agreement controlled the question of liability for management of Simplexity. The plain language of the Simplexity Agreement did not contain a clear intention to exculpate members and managers from fiduciary duty liability (contrast the language in the Services Agreement).  In other words, the Simplexity Agreement did not mitigate fiduciary duties and associated liability to the fullest extent permissible under Delaware law.  Rather, it expressly preserved claims for the breach of the duty of loyalty, gross negligence, and knowing violations of law. Thus, the defendants owed fiduciary duties and therefore could be held liable for their breach.

The take away is clear: Delaware law permits a limited liability company’s top brass to be insulated from fiduciary duty liability, but any such protection requires “plain and unambiguous” language in the charter documents. In the absence of plain and unambiguous language, managers and controlling members owe fiduciary duties, and can be found liable if they breach those duties.  If you want exculpation, be explicit.

As noted in a recent Distressing Matters post, the United States Supreme Court in In re Jevic Holding Corp. held that debtors cannot use structured dismissals to make payments to creditors in violation of ordinary bankruptcy distribution priority rules.  The Jevic dissent complained that the majority avoided the more general question presented—whether a bankruptcy settlement can violate the statutory priority scheme.  The bankruptcy court for the Eastern District of Tennessee has addressed that complaint, holding that priority-altering settlements must be “fair and equitable” and promote a significant Code-related objective.

In In re Fryar, the bankruptcy court reviewed a settlement involving the sale of the debtor’s equity interests in two private ventures.  The IRS had a lien on the debtor’s equity interests.  The settlement proposed using the sale proceeds to pay off a bank lien on certain real estate, rather than using the proceeds to satisfy the IRS.  In exchange for the sale proceeds, the bank would release its lien on the real estate and retain a subordinated deficiency claim.  The IRS would then receive a lien on the now unencumbered real estate.  The bank acknowledged that if the sale proceeds were distributed according to the statutory priorities and the bank merely foreclosed on the real estate, its recovery would be less than half of what it stood to receive under the settlement.

Three unsecured creditors and the United States Trustee objected to the settlement on the basis that it reordered distribution priorities for the benefit of the bank. The bankruptcy court agreed, noting that the settlement allowed the bank to jump “to the head of the line.”  Absent the settlement, the proceeds would have gone first to the IRS to satisfy its lien on the equity, then to the estate for distribution to priority unsecured creditors (e.g., other unpaid tax claims) and finally to general unsecured creditors on a pro rata basis.

The bankruptcy court cited dicta from Jevic while considering the merits of the proposed settlement:

We recognize that Iridium is not the only case in which a court has approved interim distributions that violate ordinary priority rules. But in such instances one can generally find significant Code-related objectives that the priority-violating distributions serve. . . .  In doing so, these courts have usually found that the distributions at issue would “enable a successful reorganization and make even the disfavored creditors better off.” [Citations omitted].

Applying such guidance, the bankruptcy court determined that the settlement was more of a preamble to a conversion or structured dismissal than an anticipated reorganization and that the debtor did not prove that the settlement promoted a significant Code-related objective. Accordingly, the bankruptcy court sustained the objections to the settlement.

The bankruptcy court’s holding essentially establishes a new requirement for acceptance of any priority-altering settlement—post-Jevic, debtors wishing to consummate such settlements must now prove not only that the settlements are “fair and equitable” but also that the settlements promote a significant Code-related objective.  It remains to be seen whether other courts will demand that debtors meet similar standards for priority-altering settlements.

One of the most powerful and oft used devices in bankruptcy is the sale of assets “free and clear” of liens, claims and interests. One issue a buyer at a bankruptcy sale must consider, however, is whether due process has been met with respect to parties whose liens, claims and/or interests are released through such sale.  Indeed, a lack of due process could foil a “free and clear” sale, leaving a buyer with an encumbered purchase and nowhere to turn for recourse.

In In re Olsen, a Wisconsin bankruptcy court considered whether the failure to provide formal notice to a party with a right of first refusal (ROFR) on certain of the debtor’s real estate (Property) voided the court’s “free and clear” sale order. The court held that the sale process did violate due process and that the effective remedy was honoring the ROFR in a subsequent (post bankruptcy) sale of the Property.

In order to maximize the going concern value of its grain facility business, the debtor sought to sell substantially all of its assets in conjunction with its plan of reorganization. Archer-Daniels-Midland (Purchaser) purchased the assets, including the Property.  Subsequent to the conclusion of the bankruptcy case, the Purchaser sold the Property to a third party.  Country Visions Cooperative (Objector), the holder of the ROFR, sued the Purchaser in state court and asserted its ROFR.  The Purchaser countered by moving to reopen the bankruptcy case to enforce the confirmation order and bar the Objector’s state court proceeding.

In upholding the ROFR, the bankruptcy court found three important undisputed facts: (i) the Objector was not listed as a creditor of the debtor, and did not receive formal notice of the bankruptcy case, (ii) the Objector never received formal notice that the Property was to be sold free and clear of the ROFR, and (iii) the Objector never received the contractual notice that the Property was being sold as required by the ROFR.

Notably, the Objector did receive informal notice of the bankruptcy case and may have even learned about the sale shortly before closing. However, such notice was not “notice reasonably calculated, under all the circumstances, to apprise interested parties of the pendency of the action and afford them an opportunity to present their objections”—as due process requires.  Thus, the bankruptcy court concluded that the Objector did not receive sufficient notice before its ROFR was purportedly extinguished.

The Purchaser argued that notwithstanding the faulty notice, the court should enforce the confirmation order to strip the ROFR because the Purchaser was a bona fide purchaser that acquired the Property in good faith under section 363(m) of the Bankruptcy Code. The court rejected this argument, explaining that a bona fide purchaser cannot have notice of a prior adverse claim.

Here, the Purchaser did have prior notice of the ROFR (even if the notice was constructive) because the ROFR was properly recorded. The Purchaser also had received an email indicating that someone had a ROFR on the Property.  The court explained that the Purchaser easily could have commissioned a title report and ensured that all parties in interest received due notice.   The court acknowledged that the debtor should have properly noticed all parties in interest, including the Objector, but also found that the Purchaser could not “cloak itself with the mantle of a bona fide purchaser when it ignored information suggesting the [Objector’s] rights were not addressed in the sale.”  Thus, the court approved the Objector’s request to enforce its ROFR in the Purchaser’s post-bankruptcy sale of the Property.

In sum, a buyer in bankruptcy should consider independently ensuring that all parties with purported liens, claims or interests in the sale assets receive proper notice of the sale; hoping that the debtor provides proper notice may not be sufficient.  A little effort up front can save time, money and aggravation in the end.

A recent opinion issued by the United States District Court for the Northern District of Illinois reminds us that corporate veil-piercing liability is not exclusive to shareholders. Anyone who is in control of and misuses the corporate structure can be found liable for the obligations of the corporation.  The facts of this case, however, did not support personal liability for veil-piecing.

In Seamans v. Hoffman, et al., the court was asked to find a former owner (Tauriac) of a debt collection agency personally liable for a violation of the Fair Debt Collection Practice Act (FDCPA).  Tauriac had recently sold the business but remained in control of the business bank account in order to reconcile and appropriately allocate between the pre- and post-sale receivables—the pre-sale receivables were owed to Tauriac per the terms of the sale transaction.

During this reconciliation period, the company attempted to collect a debt from an individual who had gone through a bankruptcy proceeding in which the debt was discharged. The individual, alleging violations of the FDCPA, sued and obtained a default judgment against the company and Tauriac.  Tauriac got the default judgment overturned and pursued the merits of her defense.

As an initial matter, the court recognized that under normal circumstances, “officers and shareholders of a debt collection [company] generally cannot be held liable for violations of the FDCPA.” An exception exists, however, if there is a basis to pierce the corporate veil.  Thus, if an individual exerts sufficient control and dominance over the entity and misuses the corporate structure, personal liability may be found.

Here, apart from the control Tauriac had over the business bank account pursuant to the terms of the sale agreement, she did not exhibit any other indicia of control or dominance over the corporation: she did not manage employees, she did not manage collection efforts, she did not interact, post-sale, with the company (other than with respect to the bank account), there was no evidence that she comingled her assets with those of the company, or otherwise used corporate assets to pay her expenses. In short, she did not disregard the corporate entity to use it as a mere instrumentality for personal gain.  Absent these indicia of control or evidence of personal use, there can be no personal liability for corporate obligations under a veil-piercing theory.

The take-away from this case is that there could be situations where a non-shareholder is held liable under a veil-piercing theory, if control, dominance and misuse are present.

Shareholders who received nearly $8 billion from the Tribune Company leveraged buyout (LBO) do not have to give back that money as a constructive fraudulent transfer. Although the possibility remains that the creditors can recover this money through the pending intentional fraudulent transfer claims, which are much more difficult to prove, the Second Circuit recently held that the Bankruptcy Code preempts creditors from recovering under state constructive fraud theories when shareholders receive distributions under securities contracts effectuated through financial institutions.

Continue Reading TRANQUIL WATERS ONCE AGAIN IN THE SAFE HARBOR: Bankruptcy Safe Harbor Protects Shareholders From State Constructive Fraud Claims

A recent bankruptcy court decision from the influential Southern District of New York permitted a debtor to reject executory contracts with midstream gathers as an exercise of sound business judgment. In In re Sabine Oil & Gas Corporation, the court issued an advisory ruling in which it determined that certain provisions of the rejected contracts were not covenants that ran with the land, and thus could be rejected thereby relieving the debtor of a financial hardship.

Continue Reading Oil, Gas and Mineral Companies Take Note: Agreements Purporting to “Run with the Land” may be Rejected in Bankruptcy

In the Ultimate Escapes bankruptcy case, the U.S. District Court for the District of Delaware recently held that the “business judgment rule” may protect fiduciaries who negotiate and enter into unconventional financing agreements in an attempt to save the company. In short, a failed business strategy by itself does not lead to liability for breach of fiduciary duty.

Before the Great Recession, Ultimate Escapes was a luxury destination club providing members with access to high-end vacations. Membership involved a high one-time initiation fee and annual membership dues.

Prior to the bankruptcy, James Tousignant served as President, CEO, and a member of the Board. Richard Keith served as Chairman of the Board. Ultimate Escapes owed its senior lender approximately $90 million secured by all assets of the company. Tousignant and Keith had personally guaranteed the loan.

Continue Reading DIRECTORS AND OFFICERS’ ULTIMATE ESCAPE FROM PERSONAL LIABILITY

Lending credence to the old adage “if it’s too good to be true, then it probably is,” the Seventh Circuit Court of Appeals recently held that a secured lender was on inquiry notice of possible fraud by its borrower in impermissibly pledging customers’ assets to secure loans. And the penalty was steep—the Court determined the pledge to be a fraudulent transfer to the lender and the lender’s failure to act upon inquiry notice destroyed the lender’s good faith defense. As a result, the lender’s $300 million secured claim was reduced to a near-worthless general unsecured claim.  Continue Reading Turning A Blind Eye Cost Lender Hundreds Of Millions Of Dollars; Inquiry Notice Spoils Lender’s Good Faith Defense In Fraudulent Transfer Case

Many of us have endured the nightmare of a disastrous home renovation or at least enjoyed Tom Hanks in The Money Pit (How long? Two weeks, of course). Well imagine spending half a million dollars, not for a new and improved home, but rather chasing your contractor for paid, but never completed, work.

That is exactly what happened to one homeowner, said the Delaware Chancery Court in Doberstein v. G-P Indus., Inc. In October 2012, Doberstein contracted with a building company on a significant home renovation project. Despite paying over $300,000, the project saw little progress over the next 14 months. When the company promised to complete the project in the next few weeks and asked for additional funds, Doberstein handed over an additional $150,000. Shortly thereafter, the company abandoned the project and ceased doing business, citing an inability to continue because of financial troubles. Continue Reading Piercing The Corporate Veil Takes More Than Just Fraud By The Individual

At first glance, Stanziale v. MILK072011, looks like someone suing over a bad expiration date and conjures up images of Ron Burgundy proclaiming “Milk was a bad choice.” But in actuality Stanziale is much more interesting: it answers whether one can breach their fiduciary duty by exposing an employer to a claim under the aptly-named WARN Act, which requires employers to tip off their workers to a possible job loss.

Continue Reading A WARNing to Directors and Officers — Failure to Give Proper WARN Act Notice May Breach Your Fiduciary Duty