For the third time in as many years, the Delaware Chancery Court has handed down an important ruling interpreting the interaction between federal bankruptcy law and Delaware corporate law. The thorny question this time was whether a bankruptcy court’s determination that the directors of a corporation acted in good faith when they authorized a chapter 11 filing precluded a subsequent claim that the directors breached their fiduciary duties by doing so. The Delaware Chancery Court concluded that it did, ruling in Nelson v. Emerson that a minority shareholder’s claims for breach of fiduciary duty must be dismissed because a bankruptcy court’s finding that a chapter 11 filing was not made in bad faith “precludes a finding that the Company’s directors violated their fiduciary duties by filing for bankruptcy.”

Background

Repository Technologies, Inc. (“Repository”), marketed, supplied, and maintained customer relationship software pursuant to licensing agreements with its customers. William G. Nelson IV was a minority shareholder in the company, beginning in 1996. Nelson also sat on Repository’s board from 1996 until 2006 and served as the company’s chief executive officer from 2002 to 2004. A majority stake in the company was held by E. James Emerson and Kathleen Emerson, who also served as Repository’s officers and directors.

Nelson extended financing to Repository in 2002 in the form of a line of credit that was ultimately increased to nearly $1.75 million. By the middle of 2004, however, Repository’s balance sheet reflected more than $2.5 million in liabilities compared to no more than $500,000 in assets. Even so, and despite the company’s failure to make any payments on the debt to Nelson, Repository was able to secure additional financing from an unrelated lender in October 2004 in the amount of over $200,000.

Nelson purchased the bank debt in 2006, becoming Repository’s sole secured creditor. Immediately afterward, he sent a letter to Repository’s board demanding that past-due interest payments on Repository’s $2 million in debt (nearly $510,000) be made current within 15 days, failing which he considered an act of default to have occurred. Repository responded by filing for chapter 11 protection in Illinois on April 25, 2006.

Nelson moved to dismiss the chapter 11 case as having been filed in bad faith, contending, among other things, that Repository could not effectuate a chapter 11 plan, that there was a continuing loss to or diminution of the estate during the bankruptcy, and that Repository’s assets and business had been grossly mismanaged. More specifically, Nelson alleged that the Emersons breached their fiduciary duties by “authorizing exorbitant salaries and benefits for themselves when the company was insolvent.” He also claimed that the company filed for chapter 11 protection “with the sole purpose of preventing [Nelson] from potentially exercising his state court rights” and that “evidence of self dealing and mismanagement suggest[s] a filing other than in good faith.” Finally, Nelson contended that the bankruptcy filing was undertaken in bad faith because it risked damaging Repository’s “single most valuable asset”—its reputation among customers in the software community. Repository responded by suing to have Nelson’s secured claims either recharacterized as equity or equitably subordinated.

Consolidating the trials on both matters, the bankruptcy court granted Nelson’s motion to dismiss in February 2007. The ruling, however, was based solely on Repository’s inability to confirm a feasible chapter 11 plan, given the court’s decision to recharacterize only $240,000 of the debt to Nelson as equity. The court explicitly rejected Nelson’s other arguments, stating, among other things, that Nelson had not proved the existence of any continuing loss to or diminution of the estate or any mismanagement, and that “the bankruptcy filing cannot be held to be in bad faith.”

Both Nelson and Repository appealed to the district court, which affirmed the bankruptcy court’s ruling in full. In doing so, the court rejected Nelson’s contention that language in the bankruptcy court’s opinion that “the bankruptcy filing [could] not be held to be in bad faith” should be stricken as dicta. According to the district court, the “language [was] part of the Bankruptcy Court’s holding because Nelson based his dismissal motion on [Repository’s] bad faith.” One month after Repository’s chapter 11 case was dismissed, a receiver was appointed for the company’s assets. The receiver later approved the sale of all of Repository’s assets (including causes of action) to Nelson.

In May 2007, Nelson sued the Emersons in Delaware state court for breach of their fiduciary duties to Repository. According to the complaint, the Emersons breached their fiduciary duties by: (i) paying themselves excessive compensation while Repository was insolvent; and (ii) causing the company to file for chapter 11. The Emersons moved to dismiss the complaint on the grounds of collateral estoppel, arguing that the very same issues raised by Nelson in the complaint had already been adjudicated by the bankruptcy and district courts.

The Chancery Court’s Ruling

The Delaware Chancery Court (in an unpublished opinion) ruled in favor of the Emersons. Nelson claimed that collateral estoppel does not apply because the only issue essential to the district court’s ruling was that Repository could not effectively reorganize, and the rest of the court’s findings were therefore dicta. He also contended that the bad-faith filing issue before the Delaware court was not the same issue determined by the bankruptcy court because the legal standards are different. The Chancery Court rejected both arguments. According to the court, the bankruptcy and district courts specifically addressed Nelson’s bad-faith filing and excessive-compensation claims, and their findings on those issues were both necessary and essential components of their rulings.

The Chancery Court also rejected Nelson’s argument that his claims cannot be precluded because the legal standard employed by the bankruptcy court in determining that Repository’s chapter 11 filing was not made in bad faith is different from the standard used by Delaware courts to evaluate a breach-of-fiduciary-duty claim. It concluded with the following observation:

[T]he directors of a Delaware corporation do not commit a breach of fiduciary duty if they have the corporation file a non-frivolous claim, seeking to recharacterize certain debt to equity in order to protect the interests of the company’s equity holders. In such a circumstance, the non-frivolous, good faith nature of the lawsuit makes filing that lawsuit a decision that is protected by the business judgment rule. To hold that this sort of decision is a basis for director liability if the company loses in Bankruptcy Court would discourage directors from exercising their business judgment by subjecting them to a judicially invented English Rule that makes them personally liable for the winner’s costs and damages simply because of an adverse judgment.