Brad B. Erens, Scott J. Friedman & Kelly M. Mayerfeld, Bankrupt Subsidiaries: the Challenges to the Parent of Legal Separation

• Publication year: 2011

BANKRUPT SUBSIDIARIES: THE CHALLENGES TO THE PARENT OF LEGAL SEPARATION

Brad B. Erens^*Scott J. Friedman^**Kelly M. Mayerfeld^***

The financial distress of a subsidiary can be a difficult event for its parent company. When the subsidiary faces the prospect of a bankruptcy filing, the parent likely will need to address many more issues than simply its lost investment in the subsidiary. Unpaid creditors of the subsidiary instinctively may look to the parent as a target to recover on their claims under any number of legal theories, including piercing the corporate veil, breach of fiduciary duty, and deepening insolvency. The parent also may find that it has exposure to the subsidiary's creditors under various state and federal statutes, or under contracts among the parties. In addition, untangling the affairs of the parent and subsidiary, if the latter is going to reorganize under chapter 11 and be owned by its creditors, can be difficult. All of these issues may, in fact, lead to financial challenges for the parent itself. Parent companies thus are well advised to consider their potential exposure to a subsidiary's creditors not only once the subsidiary actually faces financial distress, but well in advance as a matter of prudent corporate planning. If a subsidiary ultimately is forced to file for chapter 11, however, the bankruptcy laws do provide unique procedures to resolve any existing or potential litigation between the parent and the subsidiary's creditors and to permit the parent to obtain a clean break from the subsidiary's financial problems.

INTRODUCTION ................................................................................................ 68

I. FIRST RECOGNITION: THE PARENT NEED NOT BE LIABLE TO HAVE

A PROBLEM ........................................................................................... 69

II. RING-FENCING THE PARENT: UNDERSTANDING POTENTIAL

LIABILITY TO A SUBSIDIARY'S CREDITORS .......................................... 73

A. Contractual Analysis .................................................................... 74

1. Cross-Defaults ........................................................................ 75

2. Credit Exposure to the Subsidiary .......................................... 77 a. Preference Law ................................................................ 78 b. Equitable Subordination .................................................. 81 c. Recharacterization as Equity ........................................... 83 d. Equitable Disallowance ................................................... 86

B. Analysis of Joint Programs: Employee Benefit Plans .................. 87

1. Welfare Plans ......................................................................... 88

2. Qualified Pension and Retirement Benefit Plans ................... 90

3. Non-Qualified Plans ............................................................... 94

C. Analysis of Joint Programs: Insurance Programs ....................... 94

D. Analysis of Joint Programs: Tax Programs ............................... 101

E. Statutory Control Group Liability .............................................. 107

1. Federal Securities Laws ....................................................... 107

2. CERCLA ............................................................................... 109

3. ERISA ................................................................................... 110

4. National Labor Relations Act ............................................... 111

F. Common Law Liabilities ............................................................. 113

1. In General ............................................................................ 113

2. Veil-Piercing, Alter Ego, and Other Theories ...................... 113

3. Breach of Fiduciary Duty ..................................................... 118

4. Deepening Insolvency ........................................................... 122

III. PREPARATIONS FOR A SUBSIDIARY CHAPTER 11 ................................ 127

A. Accounting and Reporting Issues ............................................... 127

B. Separation of Cash Management Systems .................................. 131

C. Protecting Privileged Communications ...................................... 132

IV. IMPLEMENTING A SETTLEMENT THROUGH CHAPTER 11 .................... 134

A. Advantages and Costs of a Settlement Through Chapter 11 ...... 135

B. Releases Under a Chapter 11 Plan ............................................ 137

1. Estate Releases ..................................................................... 137

2. Third-Party Releases ............................................................ 138

a. The Bankruptcy Court Does Not Have Jurisdiction to

Grant the Releases ......................................................... 142

b. The Bankruptcy Court Lacks the Power to Release ...... 143

c. Classification and Unfair Discrimination Arguments ... 145

CONCLUSION .................................................................................................. 146

INTRODUCTION

Corporations increasingly operate a variety of businesses through a complex structure of corporate subsidiaries. Even if wholly-owned, these subsidiaries, at least in part, may have their own separate management, creditors, business plans, facilities, and strategies. In fact, while a subsidiary often will operate in the same general industry as the other companies owned by the parent, the subsidiary's business may be very different than the parent's core business. The parent's business may be foreign, while the subsidiary's business is domestic. The parent generally may operate manufacturing businesses, while the subsidiary is a distributor. The parent may be heavily regulated, while the subsidiary operates an unregulated business. Or the parent and subsidiary may simply have very different products or services.

When the subsidiary does not operate in the same line of business as the parent, the parent may tend to view the subsidiary more as an investment rather than an integral part of its core business, and management of the parent and subsidiary may not have a close working relationship. However, these two aspects of the relationship between the parent and the subsidiary may render the parent unprepared for the challenges that arise when the subsidiary becomes financially distressed. The parent will focus often on whether to continue infusing capital into a failing and insolvent subsidiary, or whether future investment in the subsidiary cannot be justified. The calculus tends to be a decision as to whether expending new funds will save a prior investment, which, absent new capital, will almost surely be lost. When the decision is made that the parent cannot justify providing new capital to a failing subsidiary, often the bankruptcy of that subsidiary is a likely result.

The parent that believes that its troubles are limited to the loss of its investment in the subsidiary may be seriously mistaken, however. Not having had a close relationship with the subsidiary, and perhaps not being fully aware of the legal and operational problems the subsidiary soon will face, the parent may underestimate the legal and operational complexity typically associated with a parent's attempt to separate itself from a subsidiary that has filed, or will soon file, for bankruptcy protection. In fact, many of these problems, if not properly addressed, may have materially adverse consequences for the parent's own business.

Additionally, similar issues often exist for private equity funds owning a large number of portfolio companies. Unlike a publicly traded parent of a corporate family, the private equity fund likely will not have integrated operations or intercompany transactions with the distressed subsidiary, nor will it have extensive contractual relationships with the subsidiary, other than to evidence the private equity fund's equity ownership and any debt financing. However, as the parent of the distressed subsidiary and the party controlling its board of directors, the private equity fund remains a potential target for the subsidiary's unpaid creditors. It also may have statutory liability to the subsidiary's creditors in certain circumstances, such as where a state or federal statute imposes liability on any member of a corporate group.

The purpose of this Article is to identify the difficult issues that a parent faces, both inside and outside a bankruptcy proceeding, when one of its subsidiaries faces serious financial distress. The Article also discusses some of the courses of action that a parent may take in this situation. The proper course of action for any parent, however, typically is based on the particular facts and circumstances of the situation in which it finds itself and is not susceptible to a rigid formulation. Furthermore, some of the decisions that a parent must make require difficult legal and business judgments. It is very difficult to determine meaningfully whether these decisions are "right" or "wrong" not only before, but even after the decisions have been made and implemented. The key for the parent, instead, is to identify the relevant issues as early as possible. Otherwise, the parent may be in a chronically defensive posture and risk that the problems of its subsidiary will become serious problems of its own.

A parent company also should consider the issues identified and discussed in this Article as a matter of prudent corporate planning well before a subsidiary faces any financial distress. In establishing subsidiaries as large or potentially independent enterprises, the parent should at all times consider what exposure the parent itself may have to the subsidiary and its creditors if that enterprise does not succeed. Once financial distress occurs, it simply may be too late to extract the parent from potential liability to the subsidiary's creditors if the parent has not adequately planned for...