Restructuring

Contributed by Doron P. Kenter.

“So make your life a little easier; When you get the chance, just take; Control”
– Janet Jackson

We know that a corporate parent cannot use its control over its subsidiary to deplete it of value and render the entity insolvent.  Veil-piercing and claims to recover fraudulent transfers or for breach of fiduciary duty (among others) can remedy such wrongful acts.  But can a subsidiary corporation wrongfully manipulate its parent?  If so, what is the remedy?
In Burtch v. Owlstone, Inc. (In re Advance Nanotech, Inc.), the United States Bankruptcy Court for the District of Delaware concluded that yes, children can control their parents, and yes, they can owe “upstream” fiduciary duties to their shareholders.  Consequently, the parties controlling a transaction should take particular care in ensuring that they are aware to whom exactly they owe their duties and that the various parties to any transaction are all at appropriate arm’s length.
The facts in Owlstone are important.  AVNA was an investment vehicle for several early stage companies, including Owlstone, Inc.  Until 2007, AVNA owned approximately 60% of Owlstone’s stock.  Then, in 2007 and 2008, AVNA issued notes secured by its Owlstone stock, the proceeds of which were downstreamed to Owlstone in the form of equity and debt, making AVNA the owner of 83.1% of Owlstone’s stock and holder of $2.64 million of Owlstone debt.  Also in 2008, AVNA fired its own executives and hired Brett Bader and Thomas Finn, Owlstone’s CEO and CFO (respectively), to run AVNA.
Not long after these transactions, as both AVNA and Owlstone were facing liquidity problems, the AVNA board tasked Bader and Finn with developing and implementing a strategy to raise funds for the cash-strapped entities.  In the meantime, Ingalls & Snyder, LLC (“I&S”) provided AVNA with bridge loans aggregating $1.3 million.  AVNA explored several restructuring options, including a conversion of the senior secured noteholders’ debt to equity and the issuance of new stock, but neither of these initiatives materialized.  Finally, in November 2009, Owlstone issued additional stock to resolve its liquidity problems.  Even though Owlstone noted in the stock offering that it would use a portion of the new funds to pay off the remaining intercompany debt owed to AVNA in cash, it instead satisfied the intercompany debt by assuming certain of AVNA’s obligations, including the I&S bridge loan and certain “deferred compensation” claims, including Bader’s, but not the claims of AVNA’s senior secured noteholders.
As a result of these transactions, AVNA ended up owning just 37.98% of Owlstone’s stock (down from 81.3%), while Owlstone assumed I&S’s and Bader’s claims against AVNA (indeed, Bader and Finn resigned from AVNA and continued their employment with Owlstone).  A group of senior secured noteholders then commenced an involuntary bankruptcy proceeding against AVNA, and AVNA’s chapter 7 trustee brought an action against, among others, Owlstone, I&S, Bader, and Finn, alleging claims for breach of fiduciary duty, aiding and abetting breach of fiduciary duty, and equitable subordination of Owlstone’s claims against AVNA – all relating to the underlying allegation that the defendants had reduced AVNA to a minority shareholder of Owlstone and assumed less than all of AVNA’s obligations, rendering AVNA insolvent, while keeping I&S and Bader safe by making Owlstone itself liable for those debts.
In ruling on the defendants’ motions to dismiss the trustee’s action, Judge Walrath recognized the principle under Delaware law that, as a general rule, no fiduciary relationship exists between a debtor and a creditor.  However, citing to a 1983 decision from the United States Bankruptcy Court for the Eastern District of New York, the court also noted that a creditor is, in fact, a fiduciary of the debtor when it “exercises such control over the decision-making processes of the debtor as amounts to a domination of its will.”  Accordingly, if any of the defendants had actually controlled AVNA, a fiduciary duty existed and could have been breached.
Turning specifically to the claims against Owlstone, the court again began by recognizing that under Delaware law, corporations generally do not owe duties to their shareholders, which would seem to suggest that Owlstone would not owe any duties to its shareholder – i.e., AVNA.  However, the court concluded that Owlstone did, in fact, owe fiduciary duties to AVNA because – at least on the facts as alleged – it had actually controlled AVNA’s decision-making with respect to the transactions that allegedly rendered AVNA insolvent.  And even though one would generally assume that “subsidiaries are subject to the direction and control of their parent entities,” the court rejected that assumption, in light of the control that Owlstone, acting through Bader and Finn, had allegedly exercised over AVNA.
Importantly, the court noted that AVNA’s board’s decision to accept or reject the options put before it did not necessarily mean that AVNA acted of its own volition and outside of Owlstone’s control.  Instead, the court concluded that the complaint had adequately alleged that Owlstone had controlled AVNA and its board because the fundraising process was exclusively assigned to Bader and Finn, who had allegedly (i) controlled the options that were put before the board; (ii) misled the board regarding the application of the proceeds of the new stock issuance; and (iii) “switched sides” and acted in Owlstone’s favor, rather than AVNA’s.  This last factor was particularly pronounced in light of the benefits that Bader and Finn stood to realize from their proposed transaction by continuing their employment with Owlstone (and, at least in Bader’s case, by ensuring payment in full of $600,000 in deferred compensation).
Accordingly, the court concluded that the trustee had adequately pled that Owlstone, acting through Bader and Finn, had controlled AVNA and rendered it insolvent.  Notwithstanding the fact that AVNA was Owlstone’s majority shareholder at the time, and had an apparently independent board of directors charged with acting in AVNA’s best interests, the court allowed the claims against Owlstone, Bader, and Finn to proceed.  Even though it remains to be seen whether the trustee will be able to demonstrate that the defendants actually exercised this control over AVNA and its board in furtherance of their scheme to deplete AVNA’s assets, Judge Walrath’s decision is a stern warning to corporate actors throughout an enterprise to respect corporate separateness and to be keenly aware of where their duties lie and in whose interests they should be sure to act.