CHAPTER 13 A SELECTION OF ETHICS ISSUES IN BANKRUPTCY CASES1
| Jurisdiction | United States |
(Feb 2010)
A SELECTION OF ETHICS ISSUES IN BANKRUPTCY CASES1
David Thoman 3
William S. Boyd School of Law
University of Nevada
Las Vegas, Nevada
Nancy B. Rapoport is the Gordon Silver Professor at the William S. Boyd School of Law, University of Nevada, Las Vegas. After receiving her B.A., summa cum laude, from Rice University in 1982 and her J.D. from Stanford Law School in 1985, she clerked for the Honorable Joseph T. Sneed on the United States Court of Appeals for the Ninth Circuit and then practiced law (primarily bankruptcy law) with Morrison & Foerster in San Francisco from 1986-1991. She started her academic career at The* Ohio State University College of Law in 1991, and she moved from Assistant Professor to Associate Professor with tenure in 1995 to Associate Dean for Student Affairs (1996) and Professor (1998) (just as she left Ohio State to become Dean and Professor of Law at the University of Nebraska College of Law). She served as Dean of the University of Nebraska College of Law from 1998-2000. She then served as Dean and Professor of Law at the University of Houston Law Center from July 2000-May 2006 and as Professor of Law from June 2006-June 2007, when she left to join the faculty at Boyd. Her specialties are bankruptcy ethics, ethics in governance, and the depiction of lawyers in popular culture. She has taught Contracts, Sales (Article 2), Bankruptcy, Chapter 11 Reorganization, Legal Writing, Contract Drafting, Corporate Scandals, and Professional Responsibility. Among her published works is ENRON: CORPORATE FIASCOS AND THEIR IMPLICATIONS (Foundation Press 2004) (co-edited with Professor Bala G. Dharan of Rice University). The second edition, ENRON AND OTHER CORPORATE FIASCOS: THE CORPORATE SCANDAL READER (Nancy B. Rapoport, Jeffrey D. Van Niel & Bala G. Dharan, eds.; Foundation Press 2d ed. 2009), addresses the question of why we never seem to learn from prior scandals. Soon out will be the LAW SCHOOL SURVIVAL MANUAL, co-authored with Jeffrey D. Van Niel (Aspen Publishers 2009). She is admitted to the bars of the states of California, Ohio, Nebraska, Texas, and Nevada and of the United States Supreme Court. In 2001, she was elected to membership in the American Law Institute, and in 2002, she received a Distinguished Alumna Award from Rice University. She is a Fellow of the American Bar Foundation and a Fellow of the American College of Bankruptcy. In 2009, the Association of Media and Entertainment Counsel presented her with the Public Service Counsel Award at the 4th Annual Counsel of the Year Awards. She has also appeared in the Academy Award®-nominated movie, Enron: The Smartest Guys in the Room (Magnolia Pictures 2005) (as herself). Although the movie garnered her a listing in www.imdb.com, she still hasn't been able to join the Screen Actors Guild. In her spare time, she competes, pro-am, in American Rhythm and American Smooth ballroom dancing with her teacher, Sergei Shapoval. The best way to reach her is to call her on her cell phone.
As more and more companies seem to find themselves in financial distress, it's important for everyone who finds himself occasionally involved in a bankruptcy case (or a situation that might end up in bankruptcy) to be aware of certain ethics issues.
I. Fiduciary duties of insolvent companies.
Corporations are statutory persons, and they are organized so that the owners (the shareholders) are distinct from the managers (the directors). It is axiomatic that a corporation is organized to maximize the benefit to its owners, the shareholders. The day-to-day managers of the corporation--the officers--report to the board of directors, which is charged with setting the broad direction for the corporation's business plan. The board of directors reports to the shareholders themselves. When a corporation contemplates filing for protection under the Bankruptcy Code, its board of directors must use its business judgment to determine whether filing for bankruptcy protection is in the corporation's best interests.
Traditionally, the board of directors is charged with fulfilling two fiduciary duties to the owners of the corporation: the duties of loyalty4 and due care.5 (Courts sometimes discuss an
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explicit duty of good faith, but this duty can also be subsumed within the duty of due care.6 ) Various state codes and corporate bylaws may provide exculpatory language that provides more protection to directors regarding their fiduciary duties.7 The actions of the directors on the board are measured by the business judgment rule,8 and as long as their actions are reasonable under the circumstances, courts will not second-guess those actions. Therefore, for a corporation to contemplate filing for bankruptcy protection, it must be the board's business judgment that bankruptcy is a reasonable choice under the circumstances.9
What makes the board's decision somewhat more difficult is the possibility that the business itself might be insolvent or might become insolvent. A corporation that is completely and utterly insolvent has no residual value left for the shareholders; in that sense, the
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shareholders no longer "own" the corporation, and bankruptcy may help to transition the official ownership of the corporation from the shareholders to the unsecured creditors (or to other eventual owners under a confirmed plan of reorganization).10 But insolvency, unlike pregnancy, is not always an all-or-nothing proposition: instead, it can be quite nuanced and can ebb and flow, depending on the corporation's circumstances, and on how those circumstances are calculated. Therefore, the directors can be put in the precarious position of having to guess to whom their traditional duties are owed as they consider whether to file for bankruptcy protection.
A good way to think about the business judgment rule is as a link between the duty of due care and the reasonable risks that directors should take in running a corporation, in order to provide a reasonable return to the shareholders. The business judgment rule has two rationales: to encourage people to serve as directors by protecting them from a myriad of lawsuits second-guessing all of their business decisions, and to allow them to take the types of business risks that might result in larger profits (and thus larger dividends to shareholders).11
Therefore, even the sort of behavior that might temporarily worsen a corporation's financial condition (e.g., borrowing more funds than might usually be prudent) in order to fund an experimental venture that could pay off would not necessarily be actionable, as long as the directors obtained relevant information, educated themselves about the possible risks and rewards, and operated in the best interests of the corporation.12
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As Professor Daniel Bogart has suggested, the standards for operating the company in a chapter 11 case are fairly similar to the standards for running it outside chapter 11: "The 'beneficiaries' include creditors, the eventual reorganized debtor and any other parties in interest. These fiduciary obligations arise generally from trust law, and include the duties of care, loyalty and impartiality."13 Professor Bogart goes on to point out, however, that for most of the business decisions that the management of the DIP will make during the chapter 11 case, the more generous protection of the business judgment rule standard of care falls away, replaced by a reasonableness standard.14
Not surprisingly, directors inside chapter 11 would do well to avoid the same pitfalls that they should avoid outside chapter 11. They should avoid conflicts of interest, first by disclosing to the Bankruptcy Court any connections that they personally have in connection with transactions being contemplated by the DIP, and second by recusing themselves from having any decision-making role in consummating any transactions in which they might personally benefit. They should make sure that their decisions in running the company are well-reasoned, made after gathering sufficient information for a reasonably prudent person to be able to make an informed decision. Just as they would do outside chapter 11, directors should operate the corporation in
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the best interests of the corporation, which in turn has been interpreted as in the best interests of the ultimate owners of the corporation--the shareholders. The difference is that, inside bankruptcy, the DIP operates the corporation for the benefit of the bankruptcy estate, which will be divvied up pursuant to a plan of reorganization (if one is confirmed) as a way of paying the creditors of the estate. If there are sufficient funds to pay all of the creditors in full (a rare situation), then current equity holders will still own the company after the bankruptcy is over; if, as is more common, there is not enough money to pay all of the creditors in full, then the equity interests are cancelled, and the unsecured creditors, in effect, become the new owners of the company as part of the plan of reorganization. The important thing for directors to remember is that their standards of behavior should not change; it is to whom they may report that could change, not how they should behave.
Zone of insolvency cases: an update.
In Trenwick America v. Ernst & Young, L.L.P.15 the Delaware Chancery Court dismissed the concept of deepening insolvency, with its "stentorious academic ring,"16 out of hand, explaining
...... Delaware law does not recognize this catchy term as a cause of action, because catchy though the term may be, it does not express a coherent concept. Even when a firm is insolvent, its directors may, in the
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