The sixth webinar presentation in the M&A Litigation Series examines claims and other issues arising out of bankruptcy, receivership, or assignments for the benefit of creditors. Rights of creditors when the enterprise is in the “zone of insolvency” are discussed. Section 363 asset sales and the acquisition of assets out of receiverships or assignments also are addressed. On our agenda: -Zone of Insolvency: Creditors’ Standing as Ultimate Beneficiaries of Residual Estate -Fiduciary Duties of Boards of Directors -Business Judgment Rule and Related Standards of Review of Corporate Conduct -Acquiring Assets out of a Bankruptcy via 363 Sales and out of Receiverships and Assignments

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Claims and Related Issues Arising Out of
Bankruptcy or Receivership
Presented by: Chris Ward, Todd Bartels, and Robert Spake

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Agenda
 Fiduciary Duties of Boards of Directors
 Business Judgment Rule and Related Standards of Review of
Corporate Conduct
 Zone of Insolvency: Creditors’ Standing as Ultimate
Beneficiaries of Residual Estate
 Acquiring Assets out of a Bankruptcy via 363 Sales and out of
Receiverships and Assignments

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Fiduciary Duties
 When a corporation is insolvent or
approaching insolvency, fiduciaries will
necessarily look to engage in transactions,
including M&As, to salvage the business or
maximize assets
 Fiduciaries must be especially mindful of their
duties at such times

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Summary of Fiduciary Duties
of a Board of Directors
 The Delaware General Corporation Law (the “DGCL”) creates a board-centric governance
structure in which the directors ultimately are responsible for the management of the
corporation’s business and affairs, subject to their authorization to delegate certain but not all
of those responsibilities to managers and other qualified agents of the corporation.
 In discharging this responsibility, decisional law holds that the directors owe “unyielding”
fiduciary duties: namely, the duties of care and loyalty.
 These duties are owed to the corporation and to its stockholders, the latter as an
undifferentiated whole even where a director is appointed to the board by a particular
stockholder or stockholder contingent.
 “[S]tockholders' best interest must always, within legal limits, be the end.
 Other [corporate] constituencies may be considered only instrumentally to advance that end.”
 Broadly stated, the fiduciary duties owed by directors require that they act prudently, loyally,
and in good faith to maximize the corporation’s value over the long-term for the benefit of its
stockholders.

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Duty of Loyalty
 The duty of loyalty forbids fiduciaries from using “their position
of trust and confidence to further their private interests” or the
interests of others not shared by the corporation’s stockholders
at large.
 It requires, “in essence, ‘[] that the best interest of the
corporation and its shareholders take[] precedence over any
interest possessed by a director . . . and not shared by the
stockholders generally.’”
 Accordingly, a director may not misappropriate assets
entrusted to his or her management and oversight, nor may
she engage in self-interested transactions with the corporation
unless the terms of those transactions are entirely fair.

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Duty of Loyalty - Independence
 The duty of loyalty implicates director “independence” and
“disinterestedness.” As to the former, the duty of loyalty
requires that directors maintain independence in their
deliberations and decision-making:
 Independence means that a director’s decision is based on the
corporate merits of the subject before the board rather than
extraneous considerations or influences.

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Duty of Loyalty - Interested
 A director is interested in a matter under consideration if he or
she “expects to derive a material personal financial [or other]
benefit from the transaction that does not devolve on all
stockholders generally.”
 Where an inside director stands to receive a material change-
in-control payment as the result of a transaction under
consideration, or where she stands to lose her job as an officer
of the corporation if the transaction is not consummated, that
director is deemed to be interested.

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Duty of Loyalty – Good Faith
 The duty of loyalty also encompasses a subsidiary duty of good
faith.
 While difficult to define in absolute terms, a “failure to act in
good faith may be shown, for instance, where the fiduciary
intentionally acts with a purpose other than that of advancing
the best interests of the corporation.”
 The absence of good faith may be shown where directors
“knew that they were making material decisions without
adequate information and without adequate deliberation, and
that they simply did not care if the decision caused the
corporation and its stockholders to suffer injury or loss.”

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Duty of Loyalty – Bad Faith
The Delaware Supreme Court has articulated three
categories of fiduciary misconduct that are “candidates
for the ‘bad faith’ pejorative label.” They are:
– conduct undertaken with an actual intent to harm the
corporation;
– action undertaken with a lack of due care rising to gross
negligence but without malevolent intent; and
– intentional dereliction of duty reflecting a conscious
disregard for one’s responsibilities.

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Duty of Care
 The duty of care requires directors to “use that amount of care which ordinarily
careful and prudent [individuals] would use in similar circumstances.”
 This in turn requires that directors “consider all material information reasonably
available in making business decisions.”
 While there is no fixed process by which directors discharge their duty of care, the
time spent in the deliberative process and the information and experts relied on are
among the factors considered when directorial action is challenged in court.
 Generally, directors should obtain and consider pertinent information; solicit and
consider the advice of experts where necessary; ask questions of management and
others, and test assumptions where appropriate; fully understand the terms of
important transactions; engage in candid discussion; stay apprised of the
corporation’s financial and operational performance and monitor internal controls;
monitor the performance of management; and probe conditions that may (for
example) signal a failure of internal controls or compliance with applicable law.

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Duty of Care
 Breaches of the duty of care typically are not found
where directors merely fail to follow best practices
 Rather, breaches of fiduciary duty are found where
there has been conduct that is grossly negligent or
directors have acted with reckless indifference to
stockholder concerns

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LLC Fiduciary Duties
 The Delaware Limited Liability Company Act (the “LLC Act”) does not provide
expressly that managers of Delaware limited liability companies (“LLCs”) owe the
common law fiduciary duties of care and loyalty owed by directors and officers of
Delaware corporations.
 The LLC Act expressly does provide that fiduciary duties may be eliminated or
restricted in the operating agreement:
“To the extent that, at law or in equity, a member or manager or other person has duties
(including fiduciary duties) to a limited liability company or to another member or manager
or to another person that is a party to or is otherwise bound by a limited liability company
agreement, the member’s or manager’s or other person’s duties may be expanded or
restricted or eliminated by provisions in the limited liability company agreement ....”
 The LLC Act also permits the LLC agreement to exculpate managers for liability for
breaches of duties, including fiduciary duties.

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Standards of Review
 Standards of review differ from fiduciary duties
(or standards of conduct)
 The standard of review is the test applied to
evaluate whether a standard of conduct has
been met.

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Standards of Review
 Three Standards of Review
– Business Judgment Rule (default)
– Enhanced Scrutiny (intermediate)
– Entire Fairness (heightened)

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Standards of Review
 Business Judgment Rule
– Default standard of review
– Presumes that directors act on an informed basis
and with the honest belief that their decisions are
in the best interests of the corporation.

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Standards of Review
 Enhanced Scrutiny
– Intermediate standard of review
– Applies to certain types of transactions, including mergers
and acquisitions
– Directors must show that they acted reasonably to obtain
the best value reasonably available under the
circumstances, including no transaction at all

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Standards of Review
 Entire Fairness
– Heightened standard of review
– Applies when a director is interested or not independent
– Directors must show that the challenged act or transaction
was entirely fair
– Fairness has two basic aspects: fair dealing and fair price

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Standards of Review
 § 102(b)(7) – Exculpatory Provision
– Eliminates or limits personal liability for monetary
damage arising from breaches of the duty of care

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Fiduciary Conduct - Best Practices
 Entire fairness review is triggered by grossly negligent process, and in failing to
consider material facts when making the decision. Brehm v. Eisner, 746 A.2d 244,
264 n.66 (Del. 2000) Examples of proper care by fiduciaries:
(1) engaged in a “multi-year process;”
(2) formed a “Special Committee of outside directors to negotiate the sale,”
(3)“reviewed strategic alternatives,” “and recommendations to Board;”
(4) “independently selected and retained legal” “advisors,”
(5) “independently selected and retained” “financial advisors,” and
(6) “fairness opinions ..supported by a number of financial analyses.”
In re CompuCom Sys., Inc. S’holders Litig., 2005 WL 2481325, at *7 (Del. Ch.
Sept. 29, 2005).

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Fiduciary Conduct – Best Practices
 Breaches of the duty of care typically are not found where
directors merely fail to follow best practices
 Breaches of fiduciary duty are found where there has been
conduct that is grossly negligent or directors have acted,
– with reckless indifference to stockholder concerns, or
– in a manner that is completely irrational relative to their decision-
making process.

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Fiduciary Conduct – Best Practices
Examples of grossly negligent conduct:
(1) ratification or implementation of a deal “after a very brief consideration by the
board,”
(2) the “board had only three independent members out of six” and “failed to appoint
a special committee of independent directors to evaluate the Agreement,”
(3) “acted without any independent advice as to legality,” and
(4) “acted without any independent advice as to” “valuation” – there is “a reasonable
possibility that the plaintiff may prevail.”
Kosseff v. Ciocia, et al., 2006 WL 2337593, at *7-8 (Del. Ch. Aug. 3, 2006).

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The Origins of the Zone
of Insolvency
 Zone of Insolvency – first referenced in a
footnote
 Credit Lyonnais Bank Nederland, N.V. v. Pathe
Communications Corp., 1991 WL 277613, at
*34 n.55 (Del. Ch. Dec. 30, 1991)

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The Origins of the Zone
of Insolvency
 Over several decades practitioners litigated
when and how the zone of insolvency affected
existing fiduciary duties.

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Current Status of the Zone
of Insolvency
 Do director duties change if a corporation is
solvent, nearly insolvent, or insolvent?
 No.
– See N. Am. Catholic Educ. Programming Found.,
Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007) and
Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P.,
906 A.2d 168, 175 (Del. Ch. 2006)

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Current Status of the Zone
of Insolvency
 Does standing to bring derivative claims
change based on a corporation’s solvency?
 Yes.
– N. Am. Catholic Educ. Programming Found., Inc. v.
Gheewalla, 930 A.2d 92, 101-03 (Del. 2007)

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Current Status of the Zone
of Insolvency
 Do creditors have standing to bring direct
breach of fiduciary duty claims whether a
corporation is solvent, nearly insolvent, or
insolvent?
 No.
– N. Am. Catholic Educ. Programming Found., Inc. v.
Gheewalla, 930 A.2d 92, 101-03 (Del. 2007)

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Current Status of the Zone
of Insolvency
 Standing granted vs. a shifting of duties

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Current Status of the Zone
of Insolvency
 Is “deepening insolvency” a cause of action in
Delaware?
 No.
– Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P.,
906 A.2d 168, 174 (Del. Ch. 2006)

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Current Status of the Zone
of Insolvency
 When does a corporation become insolvent?
 There are multiple approaches, and it is often
difficult to pinpoint the exact moment in time
when a corporation becomes insolvent.

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Corporate Fiduciary Liability in the Zone of
Insolvency to Creditors in Other States
 No uniform approach exists – depends upon
the jurisdiction
 Nearly all courts find directors breached their
duties when they are engaged in self-dealing

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Corporate Fiduciary Liability in the Zone of
Insolvency to Creditors in Other States
 California has the trust-fund doctrine - “duty to
avoid actions that divert, dissipate, or unduly
risk corporate assets that might otherwise be
used to pay creditor claims.”
 8th Circuit - you need self-dealing or
preferential treatment of creditors for liability
to insolvent corporation
 Colorado – a director found liable for sitting
idly by while a self-dealing transaction occurs

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Jurisdictions Recognizing Creditor Suits
Once Corporation Becomes Insolvent
 States following Delaware - New York, Connecticut, Illinois,
New Hampshire, New Jersey, Tennessee, Louisiana
 California and Texas - require more than mere insolvency to
permit creditor suits for breach of fiduciary duties
 California for example would require evidence, as well of
director self-dealing or preferential treatment of creditors
 Texas holds creditors don’t have standing to sue for breach of
fiduciary duty outside the narrow exception under the trust
fund doctrine

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Jurisdictions Recognizing Creditor Suits
Once Corporation Becomes Insolvent
 Missouri and North Carolina - require more
than insolvency
 Missouri - clearly going out of business or
incapable of doing business
 North Carolina - duty when there is a winding
up or dissolution of a corporation

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Jurisdictions Recognizing Creditor Suits When
Corporation is In the Zone of Insolvency
 Not all jurisdictions follow Delaware regarding
creditor suits against directors
 Florida, Arizona and Vermont
 Directors owe fiduciary duties to creditors
when a corporation in the zone of insolvency

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Other Jurisdictions’ View on
Deepening Insolvency
 Deepening insolvency - “an injury to the Debtor’s
corporate property from the fraudulent expansion of
corporate debt and prolongation of corporate life”
See Official Committee of Unsecured Creditors vs. R.F.
Lafferty & Co., 267 F.3d 340 (3rd Cir. 2001)
 Some courts permit such claims
 Deepening insolvency is recognized in 3rd Circuit as a
cause of action
 Delaware state courts do not recognize the tort of
deepening insolvency

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Other Jurisdictions’ View on
Deepening Insolvency
 Some courts treat deepening insolvency as a measure
of damages, not as an independent tort cause of
action
 But some courts have rejected deepening insolvency
both as an independent cause of action and as a
theory of damages
 In re: SI Restructuring, Inc., 532 F.3d 355 (5th Cir. 2008)
and Torch Liquidating Trust v. Stockstill, 561 F.3d 377
(5th Cir. 2009). See also Fehribach v. Ernst & Young,
LLP, 493 F.3d 905 (7th Cir. 2007) and In re: Greater Se.
Cmty. Hosp. Corp., 333 B.R. 506 (Bankr. D.D.C. 2005)

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Why Distressed M&A Is Different
 The usual suspects are – seller, seller’s management team,
seller’s equity holders
 Now, add the unusual suspects – secured lender, suppliers,
landlords, customers, government, employees
 The compressed time frame – capturing the half-life of a
company
 The need for interim funding
 The lack of a seller post-closing to make good on reps,
warranties, and covenants
 The need to manage risk tolerance carefully (“If you can’t stand
the heat, then . . . “)

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The Three (Well, Four) Ways
To Buy a Company
 Equity Sale
 Merger
 Asset Sale
 [Debt Sale – i.e., the “loan to own” scenario,
which turns into one of the other 3]

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Best Practices For the
Distressed Deal
 Special purpose entity (SPE) buyer
 Consider valuation opinion if available
 Handicap the Liabilities:
– Build the unknowns into purchase price (i.e., price
for uncertainty and risk – the used car value
dilemma)
– Diligence, diligence, diligence (but quickly)
– Hold-Back on Purchase Price/Post-Closing
Indemnity if possible
– Consider Cleansing Methods

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Risk v. Reward – The Risks?
 The potential for an unwind
 The problem of liens
 The problem of title
 The problem of successor liability
 The problem of tax successor liability
 The problem of individual liability of seller’s
management and shareholders

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Options For Cleansing the Sale
 When no Cleansing Method Necessary, Handle
Carefully as a Private Sale
 When a Cleansing Method is Necessary, Here
are the Options:
– Short Sale with the Secured Lender
– Foreclosure Sale – Real estate, or UCC Article 9
(friendly, unfriendly, etc.)
– Receivership Sale
– Bankruptcy 363 Sale – Chapter 7 or 11

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Section 363 Bankruptcy Sales –
Pros
1. Simplicity and speed.
2. Avoid corporate law requirements to obtain
majority shareholder approval.
3. Sell property free and clear of all liens, claims
and other interests.
4. Assume and assign contracts and leases.
5. Good faith purchaser finding
6. Blessed by court (successor liability, etc.)

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Section 363 Bankruptcy Sales –
Cons
1. Sale process can be somewhat time
consuming and costly.
2. Bankruptcy risk – damage to business/asset
3. Subject to higher and better offers
4. Stalking horse/auction process
5. Credit bids

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Other Options
 Foreclosure – Friendly or Adverse
 Assignment for the Benefit of Creditors
 Receivership – Federal or State

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Comparison of Certain Available
Distressed Sale Alternatives
Topic Chapter 11 Chapter 7 Receiver Assignment
Procedures Detailed Code, rules and US Trustee involvement No formal court rules Streamlined; with or
without court (State
specific)
Company Involvement May still operate as DIP
and attend 341 hearing
Must attend 341 hearing None or TBD Debtor consensual
conveyance of the property;
ongoing role limited/TBD
Publicity Public forum with all pleadings and financial results
available to the media and public
Fewer reporting
requirements but pleadings
available
Publicity minimized; public
filings are limited (subject to
specific State laws)
Court Federal Federal Federal or State State (if applicable)
Oversight US Trustee
Judge, Committees
US Trustee
Judge
Judge Depends on State, Judge or
creditors

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Comparison of Certain Available
Distressed Sale Alternatives
Topic Chapter 11 Chapter 7 Receiver Assignment
Financing the Process DIP Lending provisions
attract capital, process to
use cash collateral
Asset Sale Proceeds Potentially financed by
Senior Creditor; no process
to secure use of cash
Asset Sale Proceeds, use of
secured creditor’s collateral
Process Costs Expensive; cost benefit
analysis should be
undertaken
Could be less expensive;
but asset values could =
liquidation value or less
Less Expensive Potentially least Expensive
Cost Drivers Committee Counsel and
FA
US Trustee
Rigorous Court Process
No Committee
No US Trustee
No Committee
No US Trustee Fewer
reporting requirements
No Committee
No US Trustee
Potentially no supervision.
Speed of ability to liquidate
assets
Time Detailed Code, rules and US Trustee involvement=slow
with statutory delays
Federal or State; no formal
court rules=fast
State; streamlined with no
court process=fast

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Comparison of Certain Available
Distressed Sale Alternatives
Topic Chapter 11 Chapter 7 Receiver Assignment
Flexibility of the Process Specific Law; Federal
Jurisdiction
Vague and Open; State
laws vary, could be
Federal
Vague and Open;
dependent on State law
Sales are “as-is, where-is”
so up to buyer to be clear as
to liens on purchased assets
Assignment or Rejection of
Contracts/Leases
Yes - landlord claim limited pursuant to
502(b)(6)
No (opportunity with
Receiver Order and Court
approval)
No
Ability to Position Operating
Asset for Best Value
Use Code to restructure
operations
NA Operating Receiver; limited
ability
Limited
Creditor Composition/ Impact
on Forum
Best Option for complex
capital structure/multi
state
NA Best Option for creditor
concentration; single State
TBD; the less other
interested parties the better
Other Considerations Ability to pursue claims and causes of actions or other
Code based creditor recovery strategies
No Federal; State Law may
have basis
State law specific

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Contact Information
Christopher A. Ward
Shareholder | Practice Co-Chair
Wilmington, DE
302.252.0922
cward@polsinelli.com
Todd H. Bartels
Shareholder
Kansas City, MO
816.572.4418
tbartels@polsinelli.com
Robert V. Spake, Jr.
Associate
Kansas City, MO
816.395.0600
rspake@polsinelli.com

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Thank you, and we hope you will join us for our
next webinar on August 16, 2016:
Successor and Alter-Ego Liability

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