The United States Bankruptcy Court for the District of Delaware on May 30, 2008, issued a memorandum opinion in which it refused to dismiss claims of breach of fiduciary duty against directors and officers of a company who approved the sale of the company’s assets on the eve of its filing for bankruptcy protection. In issuing its opinion in In re Bridgeport Holdings Inc., the court provided some guidelines for directors and officers, particularly during challenging economic times.
The complaint, filed by a liquidating trust, alleged that the directors and officers of Bridgeport Holdings, doing business as Micro Warehouse, failed to conduct an adequate sale process and abdicated decision-making authority to the company’s restructuring advisor, resulting in the sale of the company’s assets for a grossly low price in September 2003.
According to the complaint, following the collapse of the dot-com market, Micro Warehouse began experiencing financial difficulties. Highly leveraged, the company’s economic woes resulted in its failure to meet covenants in its credit facility, requiring continued renegotiation with its lenders. In August 2003, with its sources of liquidity and trade credit tightening, the directors hired a restructuring advisor and approved an exit strategy.
After the directors decided to proceed with a sale of the company’s assets, one director called upon a long-time acquaintance, the chief executive officer of a competitor, CDW Corporation, to discuss the possibility of a transaction between the two companies. Without an auction or competitive bidding process, the company and CDW quickly agreed to terms and commenced an asset sale for $28 million, or approximately 22 percent of the company’s worth based on an internal valuation. The day after the closing of the deal with CDW – which took approximately two weeks from start to finish according to the plaintiff – Micro Warehouse filed for Chapter 11 bankruptcy.
After confirmation of the company’s bankruptcy plan, the liquidating trust brought a fraudulent conveyance action against CDW to void the sale; the parties settled the proceeding for $25 million, almost doubling the price paid by CDW for the company’s assets.
The liquidating trust sought to recover damages from the directors and certain officers for breach of the fiduciary duties of loyalty, care and good faith. The plaintiff made no allegations of self-dealing, however, and the defendants sought to have the complaint dismissed for failure to state a claim, based solely on the facts alleged in the complaint.
The court denied the defendants’ motion to dismiss the claims for breach of duty of loyalty, rejecting the defendants’ argument that such claims may only be sustained if directors and officers acted out of self-interest or where they lacked independence. The court reiterated its 2006 stance from Stone v. Ritter that a breach of loyalty claim under Delaware law may be rooted in a director’s or officer’s failure to act in good faith and held that the liquidating trust alleged sufficient facts to support a claim that the directors and officers “breached their fiduciary duty of loyalty and failed to act in good faith by abdicating crucial decision-making authority to [the company’s newly appointed restructuring professional] and then failing adequately to monitor his execution of a ‘sell strategy,’ resulting in an abbreviated and uninformed sale process.”
The directors argued that the trust’s claims concerning breach of duty of care must fail because of a provision in Micro Warehouse’s certificate of incorporation that incorporated the exculpatory provision permitted under Delaware corporate law. The court disagreed, stating that “[w]hen a duty of care breach is not the exclusive claim, a court may not dismiss [the duty of care claim] based upon an exculpatory provision.” In reaching this conclusion, the court distinguished an earlier decision by the United States District Court for the District of Delaware in IT Litig. Trust v. D’Aniello (In re IT Group Inc.), holding that duty of care claims cannot be sustained if there is an exculpatory provision in a company’s bylaws. Because the liquidating trust’s claim alleged facts that, if true, were sufficient to support claims for both the breach of the duty of loyalty and lack of good faith, the exculpatory provision was not effective to defeat the trust’s duty of care claim, according to the bankruptcy court.
The defendants also contended that, since there were no allegations of self-dealing, they were protected by the business judgment rule. The court disagreed, stating that the business judgment rule only applies when directors fulfill their duty to inform themselves, prior to making a business decision, of all material information reasonably available to them. If the directors did not fulfill this duty, the court would resort to a review of the business decision based on the “entire fairness” standard, rather than affording the presumption that the business decision was protected by the informed judgment of the directors. Because the liquidating trust’s claim alleged facts that, if true, would indicate that the directors did not inform themselves of all material information reasonably available to them prior to the sale to CDW, the court held that the board was not protected by the business judgment rule. Specifically, the court pointed to the board’s failure to obtain a valuation of the company’s assets or a fairness opinion, and its failure to seek offers from other potential buyers.
While the court in Bridgeport only determined whether the plaintiff alleged facts that, if proven, would support a cause of action, the court’s opinion provides a wakeup call to officers and directors of financially troubled companies. Micro Warehouse was in a troubled industry and having difficulty obtaining necessary credit, the directors engaged a well-regarded financial advisor and there was no self-dealing. Nonetheless, the court found there were sufficient allegations to sustain claims of breach of fiduciary duties of loyalty and care, and that the officers and directors were not entitled to rely on the business judgment rule or on the exculpatory provisions in the charter. Although it dismissed causes of action based on the failure to put the assets up for sale before a liquidity event ensued and failure to hire a turnaround advisor earlier, the court based its dismissal on a statute of limitation, and whether those causes of action may have been sustained otherwise is unclear. The court also noted in more than one place in its decision that the sale price of the assets was $28 million and the settlement on the fraudulent conveyance claim was $25 million. Clearly, the court was influenced by that settlement and regarded it as evidence that the sale price was substantially below market. Whether the court would have made a different decision absent those facts is not clear.
In the current business climate, fiduciaries of financially distressed companies may capitalize on the court’s holding in Bridgeport to support claims against directors and officers – even in the absence of self-dealing. Officers and directors of companies facing difficult economic times must be especially diligent in fulfilling their fiduciary duties and must pay careful attention to documenting the process. Plaintiffs likely will allege that directors and officers were not fully informed on a timely basis, and the timing of the hiring of investment banks, restructuring advisors or other crisis managers may also be a factor in these allegations.
Directors should discuss and evaluate all potential “red flags,” such as credit agreement defaults, liquidity problems or issues with trade creditors, on an ongoing basis, to ensure that they are apprised of the company’s financial status and to determine whether any action should be taken, whether suggested internally or by expert advisors.
If the board determines that a sell strategy is appropriate, it should make decisions to ensure it is receiving the best price for the company’s assets, possibly including hiring an investment banker, obtaining a fairness opinion and seeking serious offers from multiple potential purchasers.
Above all, the directors and officers should document their decision-making process. Creating a clear record that they informed themselves of all material information in a timely manner and made deliberate decisions based on that information will afford directors and officers the most protection against claims for breach of fiduciary duty.