What Happens if you Vote for Bankruptcy
from
July/August 2002
by James Burnett
Dennis Klein was fresh out of law school at the University of Virginia when his bosses at Baker & Hostetler sent him to the Bahamas in 1982 to work on a bank failure. It was a complex case, and his role was highly specialized: He mostly spent long hours riffling through file boxes in a dank, bug-infested warehouse in a dodgy section of Freeport.
Klein’s firm represented members of the bank’s board. They were being sued by creditors in an attempt to force a loss-lessening settlement from the bank’s directors and officers. Klein says he can’t remember exactly how the matter was resolved—“It was many years ago,” he explains—but he does recall being intrigued by the idea that board members, and officers, for that matter, could be sued. “At that time, D&O lawsuits just weren’t very common,” he says.
For directors, those good old days are fast fading into memory, and attorneys like Klein are a major reason. Following his assignment in the Caribbean, Klein began to switch sides. He emerged as one of the Federal Deposit Insurance Corp.’s go-to lawyers in its effort to hold board members accountable for cave-ins at various thrifts, including Knox Federal Savings & Loan in Knoxville, Tennessee, and John Sevier Savings & Loan in the Knoxville suburb of Sevierville. Then he went on to bankruptcy cases featuring companies across an array of industries, from health care to technology. Today Klein is a partner in the Washington, D.C., outpost of New York City-based Hughes Hubbard & Reed, and the strategies he has helped develop are becoming an increasingly popular topic among attorneys involved in the current record-breaking run of corporate bankruptcies. When the last entry was added to the 2001 docket, some 257 publicly traded companies had sought Chapter 11 bankruptcy protection, up from 176 in 2000. Their total assets of $258.5 billion were just $27 billion or so short of the gross domestic product of Argentina—which, given the chance, might itself have entered Chapter 11 last December. Chapter 7 bankruptcies, designed for companies that want to shut down completely, were up about 20% in 2001.
The future looks grimmer still, for both liquidations and Chapter 11 filings. Asbestos lawsuits in particular are accelerating, with big payouts looming. And then there is the glut of outstanding junk bonds, which Moody’s Investors Service has put at $574 billion. “In the next 18 months, 25% of those loans are going to either mature or go into default,” says William A. Brandt, president and CEO of Development Specialists, a leading turnaround firm. “And with these junk bonds, maturation is almost as good as default, because nobody can pay them.” It’s impossible to predict how many bankruptcies the bad debt will trigger. But with each additional failure, another set of directors will find themselves in the unfamiliar role of working for creditors, a shift in corporate strategy that requires new rules of governance.
“An often overlooked source of payment to unsecured creditors,” Dennis Klein recently wrote in Washington Business Journal , “is money obtained—through investigations by attorneys in the bankruptcy proceedings—from the personal assets of individual officers who have failed to manage the company properly, and directors who have failed to oversee and supervise management.” In that article, titled “Look to Officers in Dot-Bomb Bankruptcy,” Klein says it is the companies’ directors’ and officers’ insurance policies that most often provide the actual payouts, and he enumerates the “powerful investigatory tools” available to him when he pursues evidence of gross negligence—or just simple ineptitude, which can prove as useful to his cause. He recalled for Corporate Board Member how his review of board-meeting minutes revealed the shockingly lax attendance of one director, who then briskly admitted it under oath in a misguided attempt to free himself from responsibility for the collapse of a mismanaged company. Klein told, too, of the time his gumshoeing uncovered a CEO who spent his days in the office viewing Internet pornography with passwords paid for on his expense account.
“Those are the kind of investigations,” says Klein, “that lead board members and their insurance companies to settle, because it just doesn’t look good.”
Klein considers himself “very reasonable” when deciding whether to advise creditor clients to launch a full-scale investigation of a board. If a bankruptcy shows strong prospects for a successful reorganization, he says, lenders will fare best if the company recovers, so it’s not in their interest to antagonize the board by threatening to sue.
But there are also some bankruptcies—about one in five, in his experience—in which the available assets are so scarce that a potential D&O windfall represents one of the creditors’ few options for getting back any of what they are owed. And when that happens, even the slightest indiscretions by directors become potential causes for action. They include not only obvious mistakes such as paying for porn with company cash, but subtle decisions like taking notes—or not—at the wrong time (see page 11). “Even in the most innocent corporate failures, there are going to be things that in hindsight don’t look that great,” says Glenn E. Siegel, a partner in the corporate recovery and insolvency practice at Philadelphia-based Dechert and chairman of the American Bankruptcy Institute’s public-companies committee. “The hope, if you’re a creditor, is that you bring one of these suits and the insurance company settles for an amount that allows you to recover some of what you’ve lost.”
Adds Sean Gilligan, a corporate-restructure attorney with Pepe & Hazard in Boston: “All of a sudden I’m starting to get a lot more inquiries about this particular topic. People see that someone was successful in suing under a D&O policy, and they say, ‘Wow, that’s great. I’m going to use that approach on my bankruptcy case.’ And then you have a trend.”
During the free-lending late 1990s, corporations borrowed with ease and spent with few restraints. “What you find now,” says Siegel, “is that because of the fundamental tightening of the economy, companies don’t have the access to capital, and they’re filing for bankruptcy because they can’t find someone to take on that risk any longer.” This is one of the factors that forced Kmart to file the largest-ever retailer bankruptcy in late January; already hobbled by a lackluster holiday season, the company, with assets of $17 billion, found banks unwilling to bail it out by floating additional debt or relaxing existing terms. Just days after Kmart’s filing, Global Crossing, a $25.5 billion telecommunications giant, became the fourth outfit in 12 months to flop onto the list of history’s 10 biggest U.S. bankruptcies. The others were Enron, the $14 billion financial-services company Finova Group, and Pacific Gas & Electric, a $21.5 billion flameout.
It is Enron, of course, that has dominated the news of corporate failures. And while the company’s $63 billion bankruptcy is the largest in U.S. history, the speed of its plunge is representative of so many others in the current wave. Lately the preferred way to go bankrupt has been to get there in a hurry. This leaves boards especially vulnerable to charges that they violated their fiduciary duties, which broaden from the protection of shareholders to the protection of creditors as a company slides towards insolvency.
“There’s now not a major insolvency that does not carry significant issues for directors and officers of American companies,” says William Brandt. “Suits against board members are becoming as common as daisies in April. My guess is that in the months to come, there will be no shortage of directors called to answer the question ‘What were you doing, and where has my equity gone?’”
More than ever, bankruptcy has become a corporate strategy—and it is loaded with legal traps trickier than those that bring on shareholder class-action lawsuits. Chapter 11 restructuring, of course, allows a company to keep its doors open. It can also enable top management to hold on to their jobs, often with the bonuses known as “pay to stay” deals. Over the last two years, for example, the top brass at Polaroid, bicycle maker Schwinn-GT, and discount retailer Bradlees have been offered lucrative bonuses to lead their companies to restructuring goals. Shareholders are typically galled by the notion that the executives who bankrupted the company should receive incentives to stick around, but many creditors will not raise the same objections. Creditors prefer “the devil they know to the devil they don’t,” says David A. Skeel Jr., author of Debt’s Dominion: A History of Bankruptcy in America.
The period just before a bankruptcy poses particular dangers for directors. In 1991 William Allen, chancellor of the Delaware Court of Chancery, handed down a ruling that established what is now commonly referred to as the “zone of insolvency.” It had long been clear where directors’ duties lie when their company is operating in the black, and how those responsibilities change once it dips into the red. In Credit Lyonnais v. Pathe Communications , Allen delved into the gray area in between, and came back convinced that directors of an all but (but not yet) bankrupt company were obligated to make decisions based on what would benefit every party with a stake in the company’s long-term performance, not just those who currently held stock. Writing in the November 1992 issue of The Business Lawyer , Gregory V. Varallo and Jesse A. Finkelstein described the implications for board members who find themselves confronting that switch: “Unnatural as it may seem, the board is expected to undergo a radical metamorphosis in its approach to management upon the occurrence of insolvency. Entrepreneurship and risk-taking, the hallmarks of corporate activity prior to insolvency, suddenly expose directors to new potential liabilities.”
It’s easy to see why lawyers involved in today’s bankruptcies—most notably those involving defunct dot-coms—are looking up Credit Lyonnais as their clients work their way through the system. A number of tech companies have been accused of trying to goose revenues for a high-flying IPO by engaging in expansionary strategies so aggressive that there weren’t many assets left to go around when the companies went out of business. In the months to come, creditors of those outfits may seek to recover a portion of their losses by documenting that some of the gambles approved by the directors were undertaken at a time when the lenders were owed a fiduciary duty. Or they may try to push the legal theory further by arguing that a debtor’s cash-burning ways put it into the zone of insolvency from the very moment it opened its doors.
When he founded Living.com with his father in June 1998, Andrew Busey’s ambition was to quickly establish his fledgling firm as the No. 1 furniture retailer on the Web. Eight months later, not long after pumping $5.5 million into the business, a venture capitalist named David Bierne joined Busey on the board of directors. Together they expanded their goals to fit the times: If all went according to plan, Living.com’s stock would go on sale in January 2000—a pace they figured would set a record as the fastest IPO in Internet history.
By its first birthday, Living.com had acquired a discount furniture superstore near High Point, North Carolina, borrowed $8 million from international financier Comdisco, lined up an additional $35 million in venture capital, and booted Busey out of his CEO post. For a six-figure fee, a search firm—which, it so happened, was part-owned by Bierne—tapped Shaun Holliday, a former Guinness executive, to take over, luring him to the company with a stock-option-fattened, seven-figure pay package, plus a spot on the board. Living.com went live on the Internet July 26, 1999.
According to Living.com’s unsecured creditors’ committee, the downward spiral began the moment the first customers clicked the “buy” button. Thirteen months later the company filed for bankruptcy, leaving behind a balance sheet showing $40 million in loans it couldn’t pay, $3 million in orders it couldn’t fulfill, and overall losses reaching $80 million. Its remaining assets represented an infertile source of recovery; like other failed Internet companies, Living.com found that a roomful of computer hardware might as well be a basket of fruit when it comes to holding its value over time.
Patty Tomasco, an attorney with the Austin, Texas, firm Brown McCarroll, helped Comdisco cut a deal that allowed it to get back one-fifth of the $20 million total it had ultimately loaned Living.com. “You can bet,” she says, “that the trustee will consider a lawsuit” against Living.com’s $5 million D&O policy in an attempt to make additional remuneration available to the unsecured creditors.
The disclosure statement by the unsecured creditors’ committee has set the stage for such a lawsuit. The document alleges that after successfully delivering only 10% of the products it sold during its first three months in operation, Living.com poured money into an advertising campaign that greatly increased the number of orders its badly entangled distribution system was asked to handle. It also contends that Living.com’s employees enjoyed perks that were lavish “even by the standards of the Internet industry,” including a $77,120 relocation bonus for one employee who never actually had to move and occasional rides to school in a company-chartered limousine for Holliday’s children.
The disclosure statement arrives at this conclusion: “Management, all of whom owned stock or stock options, devoted their time and the company’s resources in the headlong and reckless race to become the fastest IPO in Internet history in a vain effort to achieve an exponential rate of return for themselves—at the expense of creditors. . . . The Trustee and the Creditors’ Committee believe that Living.com was operating in the zone of insolvency throughout its existence as it burned through funds from its investors, its lender, and its trade creditors at a phenomenal rate. . . . As a direct and proximate result of the fiduciaries’ breach of their duties, Living.com suffered damages at least in the amount of the unpaid indebtedness of the Company.”
What should directors do if a company is in the zone of insolvency? “The standard that’s been established is that you shouldn’t allow yourself to just waste away when there’s no chance of surviving,” says Tomasco. But just as inaction can expose directors to potential liability, so too can overly aggressive plays. “When a company is in this zone, it’s probably not an appropriate time to make an acquisition,” says Orrin Harrison, a Houston corporate litigator who last year defended Ameritruck directors accused of paying too much for a company that their firm bought before it filed for bankruptcy. “You’ve also got to watch that if you sell an asset, you don’t do so for less than a fair market value,” says Harrison. “Unfortunately, most of the time I’ve been retained after the directors and officers have been sued.”
A board that seeks special legal counsel for its distressed company sooner rather than later preserves more than just the cash it will need to satisfy its creditors; by taking action early, it also increases the corporation’s overall options and the likelihood of a successful reorganization. “When a company is in financial distress, as time goes on, options tend to shrink. Bankruptcy should never be viewed as a last resort, but as a means to a constructive end, and the more sophisticated the board, the more they realize that it can be used as a proactive approach to save their company,” says Jordan Kroop, a Phoenix, Arizona, restructuring attorney who recently co-authored Executive Guide to Corporate Bankruptcy with a pair of his colleagues at Squire Sanders & Dempsey.
Kroop tells of a once-thriving Phoenix manufacturer he represented: After leasing space, hiring workers, and even purchasing the raw materials it needed to enact an ill-advised expansion, the company learned that the financing it expected had fallen through. “Now all of a sudden they were a hugely leveraged company that was not competing well in the market they’d leveraged themselves to get into,” he says. “At that point, they should have realized there was no way they were going to remain healthy without filing for bankruptcy, looking for ways to divest themselves of their struggling division, and reverting to their core business, perhaps using a Chapter 11 process to do so. Instead, for six months or more they kept trying to make it, continually reworking their financing to make ends meet. Each time the bank extended their loan it charged an exorbitant fee, pushing them into a deeper and deeper hole. By the time they came to see us, even their core business would not have been enough to keep them solvent. They wound up filing a Chapter 11 that only lasted a few months before it had to be converted into a Chapter 7. The entire company was shut down, and everyone lost their jobs.”
Attorneys who represent directors say that even when things look as bleak as they did for Kroop’s client, board members have to fight the urge to resign. “If the company is falling off a cliff, you can’t resign halfway down and expect to get out of any liability,” says UCLA law professor Kenneth N. Klee, a member of the National Bankruptcy Conference. Adds turnaround specialist William Brandt: “If there is any time that your risks are lessened, it is after your company enters bankruptcy. You need to stay in control in order to minimize the unhealthy consequences that could still arise.”
As long as board members stick around, the usual guidelines apply. “It’s not that different,” says Harrison, “than what you’d do when your business is solvent.” No decision should be made without due diligence. Procedures must remain in place to ensure that management is well monitored. Detailed records of all proceedings need to be kept.
After all, Dennis Klein may be watching you.
