Governance during a Chapter 11 case.

• Author: Lieb, Richard
• Position: Includes related articles

Once a corporation becomes a Chapter 11 debtor, new considerations and forces relating to governance come into play.

The advent of mega-Chapter 11 cases during recent years is not surprising. Since the early 1980s, many major corporations faced with massive liabilities have resorted to Chapter 11 of the United States Bankruptcy Code as a means to deal with their business and financial problems, and particularly to contain their massive product liability exposure. Various approaches were tried to harness massive liabilities outside of bankruptcy, but without much success. A principal mechanism devised to address such problems was the simultaneous filing with a court of a "class action" and a concurrent settlement between the company and representatives of the claimant class. This approach, however, received a cool reception from the U.S. Supreme Court in 1997 in the Amchen Products Inc. v. Windsor case, in which the Court struck down what may have been the largest class action settlement in history. (The asbestos exposure case involved a class so large it could have numbered in the hundreds of thousands, and perhaps as large as millions.)

At present, Chapter 11 may be the principal business tool available for the resolution of massive liability problems. These days of easy credit available to fund enormous acquisitions and for other corporate purposes may be a prelude to a host of big corporate bankruptcies such as those filed in recent years, including Johns-Manville Corp., Texaco Inc., A.H. Robins Co. Inc., Eastern Airlines Inc., Continental Air Lines Inc., Federated Department Stores, R.H. Macy's Co. Inc., and LTV Corp., to name a few of the billion-dollar Chapter 11 cases. Corporations and their boards of directors should be ready for new major Chapter 11 cases that could be filed by companies with which they have significant contractual or credit relationships.

The fundamental issue

The use of Chapter 11 by large publicly held corporations has posed a host of new issues and problems for both the debtor corporation and other companies with which it has business relations. The commencement of a Chapter 11 case can also bring to the fore the fundamental issue of governance - whether a new board may be voted into office as a result of efforts by shareholders or an equity committee to obtain greater leverage in the reorganization process. Chapter 11 filings have thus generated substantial tension between the corporation's board of directors and its shareholders.

Among the issues posed by a Chapter 11 filing is whether the debtor corporation's existing board of directors will remain in office and honor the corporation's commitments as best it can, or be voted out of office by the shareholders or an official Chapter 11 equity securityholders' committee. The advent of a new board of directors for a Chapter 11 debtor corporation could pose substantial problems for the creditor body, as well as other entities that have contract and other business relationships with the Chapter 11 debtor corporation. A new board of a Chapter 11 company voted in by the shareholders after a Chapter 11 fixing could delay reorganization while seeking to negotiate a larger share of the reorganization pie for the shareholders than the prior management was willing to negotiate for them.

The allocation of the shares

A central issue for negotiation during the reorganization process often involves the negotiated allocation of the shares of the reorganized company under a plan of reorganization. Existing pre-bankruptcy management may be anxious to come to closure on a plan of reorganization that will allocate a larger share of the new equity to the creditors under a plan that would retain such management in office. By contrast, a new board elected by the shareholders after a Chapter 11 filing may not be supportive of pre-petition management and may seek to retain a larger portion of the reorganized equity for the shareholders. A new board could also challenge existing contracts and security arrangements that the prior management may have been willing to assume and perform as part of the reorganization.

One might have a knee-jerk reaction that the exercise of shareholder voting rights to replace the board should be suspended when the corporation is suffering serious financial or other problems that require it to seek relief under Chapter 11. Some argue that that is the time when there should be no interference with the efforts of management to solve the serious problems faced by the corporation. The law, however, generally does not see it that way.

The shareholders are the owners of the corporation and, as such, should have the opportunity to choose the management to lead the effort to solve the corporation's problems and to retain for the shareholders the largest share of the reorganized equity. That is no less true - and may even be more compelling - when a corporation has found it necessary to take the drastic step of commencing a case for relief under Chapter 11 and to work toward a Chapter 11 plan of reorganization. As concluded by the Supreme Court of the State of New York in ordering an election of directors in 1983 over the opposition of the management of Lionel Corp., a substantial publicly held corporation, while it was in Chapter 11:

At this juncture, it is more important than in less turbulent and more normal times that the shareholders have a voice in the crucial decisions affecting their company's destiny. A period of crisis does not justify officeholders retaining their positions indefinitely. Democracy, whether political or industrial, is capable of dealing with difficulty and crisis, and is not to be suspended on the pretext of exigency. [The Committee of Equity Security Holders v. The Lionel Corp.]

The primacy of the right of shareholders to elect the directors of a Chapter 11 debtor corporation has been a long-established principle that was pronounced over six decades ago in the In re Bush Terminal Co. case, in which the U.S. Court of Appeals for the Second Circuit issued in 1935 the following ruling: "If the right of stockholders to elect a board of directors should not be carefully guarded and protected, the statute giving the debtor a right to be heard or to propose a plan of reorganization could not truly be exercised, for the board of directors is the representative of the stockholders." This fundamental ruling has been followed through the years and was reaffirmed in 1997 in the Marvel Entertainment Chapter 11 case [In re Marvel Entertainment Group Inc., adjudicated in the Delaware District Court].

The general principles of corporate governance are well established. The board of directors constitutes the management of the corporation and selects the officers who carry out its business policies. The directors owe a fiduciary duty to the shareholders. They must act honestly in the interests of the shareholders, not in their own self-interest. The directors are expected to exercise reasonable business judgment. If they do so, the law provides a safe harbor insulating them from personal liability for action or inaction predicated on honest business judgment.

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