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.
Sensing the downturn in its business, Ultimate Escapes entered into merger talks with a major competitor, Club Holdings, and other potential suitors. As Ultimate Escapes’ liquidity crisis worsened, Tousignant and Keith loaned funds to cover mortgage payments for vacation properties and interest payments to the senior lender. Ultimate Escapes asked Club Holdings to help cover the remaining $115,000 shortfall, which included payroll obligations, in exchange for an agreement to transfer 30 members to Club Holdings (the “August Agreement”). To implement the 30-member migration, Ultimate Escapes agreed to waive any claims it might have against Club Holdings for soliciting the members.
After entering into the August Agreement, Club Holdings discovered that Ultimate Escapes was talking to other potential merger partners. Club Holdings decided to solicit the entire membership of Ultimate Escapes, which prompted the bankruptcy filing. The bankruptcy Trustee brought suit against Tousignant and Keith for breach of fiduciary duty, arguing that they were grossly negligent in entering into the August Agreement, motivated by their own self-interests rather than the best interests of Ultimate Escapes, and that the August Agreement was an irrational waste of corporate assets—giving away the “crown jewels” (i.e., the members through the solicitation by Club Holdings) for $115,000.
Standard of Review
Given the alleged breaches of duty, the Trustee sought to apply a heightened level of scrutiny, other than the business judgment standard, to the fiduciaries’ actions. Under applicable Delaware law, the District Court noted that the correct standard of review depended on whether the fiduciary (i) was disinterested and independent, for which the “business judgment” standard would apply, (ii) faced potential conflicts because of decisional dynamics present in a particular recurring and recognizable situation, for which the “enhanced scrutiny” standard would apply, or (iii) confronted actual conflict such that the decision-making fiduciary was not disinterested, for which the “entire fairness” standard would apply. The District Court went on to recognize that Delaware’s default standard of review is business judgment, under which a court will not second guess a decision as long as it has any rational business purpose.
Duty of Care
Delaware law requires directors of a corporation to use care which ordinary careful and prudent people would use in similar circumstances and consider all information reasonably available when making decisions. Directors meeting this standard are protected from liability for honest mistakes.
The Trustee argued that Tousignant breached the duty of care because he was grossly negligent in failing to adequately inform himself of the provisions of the August Agreement, failing to seek the advice or approval of the outside Board members or other financial or legal professionals, and failing to prudently manage Ultimate Escapes’ business operations.
The District Court relied on the finding of the Bankruptcy Court that Tousignant pursued other business alternatives, kept his Board and other officers of the company updated about the poor financial state of the company, and was directly involved (as authorized by the Board) in negotiating the August Agreement, which represented the only viable solution at the time to the liquidity crisis facing the company while it explored merger opportunities. Thus, the District Court agreed with the Bankruptcy Court that no breach of the duty of care had occurred.
Duty of Loyalty
The duty of loyalty in Delaware requires that a fiduciary act with undivided and unselfish loyalty to the corporation, that they not appear on both sides of a transaction, nor derive any personal financial benefit as opposed to a benefit which devolves to the corporation or all stockholders generally.
The Trustee alleged a breach of the duty of loyalty because Tousignant and Keith were self-interested under the August Agreement because both stood to gain in several ways (if the merger happened), including (i) repayment of personal loans they made to Ultimate Escapes, (ii) relief from the personal guarantees of the senior secured debt, (iii) avoidance of personal liability for missed payroll obligations, and (iv) preservation of their jobs, compensation, and executive titles.
Again, the District Court gave credence to the Bankruptcy Court’s findings that neither fiduciary acted in his own self-interest or was to receive any benefit not available to all stockholders. The District Court recognized that all such interests (fiduciary and corporate) were aligned and that the Board had determined that pursuing the merger with Club Holdings (and the August Agreement as a precondition) was in the best interests of the shareholders. The record reflected that avoiding personal liability for missed payroll was not a motivating factor to Tousignant. Rather, he pushed to get payroll met to avoid the reputational damage (and the negative effect on merger talks) missing payroll would have caused. Further, the District Court noted that there was nothing in the trial record that indicated the fiduciaries would be released from their personal guarantees if a merger were consummated.
In a further effort to have the District Court apply the enhanced scrutiny standard, the Trustee alleged that the fiduciaries had committed corporate waste by selling the membership list for $115,000 pursuant to the August Agreement. The District Court agreed that the August Agreement was merely an interim agreement that provided for a limited solicitation of members (30ish versus all members) in connection with the financing consideration Club Holdings was providing in contemplation of a possible merger. The August Agreement did not effectuate a change of control or constitute a merger agreement, final stage transaction or other specific, recurring, and readily identifiable situation where a court would ordinarily apply the enhanced scrutiny standard of review.
In sum, the District Court reaffirmed general Delaware law that bad decisions by fiduciaries will not be seconded guessed as long as the fiduciaries act on information relevant to the circumstances and do not place their interests ahead of those of the company.