Two recent decisions demonstrate the increasing complexity of the Delaware law.
Bugs in the ice cubes
We start with William J. Yung III, a successful hotelier who started modestly in 1972 and in 18 years amassed a portfolio with more than 70 hotels. In 2006, he paid $2.1 billion “in cash” to acquire five casino properties, including the Tropicana in Atlantic City and Las Vegas.
Yung’s magic touch at management did not extend to casinos. Yung had publicly acknowledged that “we have limited experience operating a full scale casino resort.” In May 2008, his casino empire ended up in Chapter 11 proceedings in Delaware Bankruptcy Court.
At the time, Yung was the director, chief executive and 100 percent equity owner of all the operating casinos and of its ultimate 100 percent parent, Tropicana Casino and Resorts, Inc.
Bankruptcy Court Judge Kevin J. Carey’s Nov. 25, 2014, opinion documents Yung’s seeming mismanagement of cost-cutting. Cups and drinks contained insects, bedding was infested with bed bugs and roaches, toilets overflowed, used coffee stirrers festooned hotel rooms, and even the slot machines were “dirty.”
The court created a “litigation trust” to pursue unsecured creditors’ rights, and the trust sued Yung and his holding companies. Trust claims included breach of fiduciary obligations by Yung, breach of contract by the managing companies, and breach of covenants of good faith and fair dealing.
The court expounded over six entertaining pages the deplorable condition of the casinos under Yung’s stewardship, and then cut the legal baby in half.
End-running fiduciary breaches
Applying Delaware law, the court dismissed all breach of fiduciary duty claims because Yung owed all duties to himself personally, as ultimate equity owner. Noting that directors of wholly owned subsidiaries are obligated “only to manage the affairs of the subsidiary in the best interest of the parent and its shareholders,” the judge confirmed that subsidiary directors must act with loyalty to the parent “even if the directors’ actions make the subsidiary less valuable.”
These subsidiaries, so long as solvent, owe duties to the corporate parent and its ultimate owners. Subsidiary creditors cannot complain that management of a subsidiary breached a fiduciary duty to the subsidiary entity. Owners of a solvent subsidiary may mismanage, or may withdraw assets (up to but not past the point of insolvency) through dividends or otherwise. The fact that any mismanagement actions caused insolvency does not matter.
To prove insolvency, such that the duty of subsidiary directors would shift to creditors, the debtor must show either that its liabilities exceeded its assets with no reasonable prospect that the business could successfully continue, or a failure to meet obligations as they fell due.
Skinning the cat
The ruling does reflect sympathy for the plaintiffs. Proving that there is more than one way to skin the cat, the judge refused to dismiss two counts of the complaint against the corporate parent.
Written agreements between the corporate parent and the operating subsidiaries required provision of management services, including the devotion of adequate time to provide services “as are necessary to fulfill the requirements of [debtor subsidiaries].”
The litigation trustees alleged breach of those agreements, bringing financial ruin on the subsidiary casinos. Applying simple Delaware contract law, and finding a breach of contract and resulting damage, the judge let stand the breach of contract claims.
It seems that insects in an alcoholic beverage constituted breach of the management contract.
Further holding that in all contracts there is an implied covenant “of good faith and fair dealing,” and noting that the litigation trustee alleged that the management company “unreasonably benefited Yung’s hotel properties to the detriment of the casino Debtors,” the judge similarly let stand a claim for breach of implied contractual covenants of good faith.
The judge’s reach for remedies from unexpected directions is a cautionary tale for practitioners, when advising corporate owners that they can do whatever they wish with their subsidiaries so long as the line of insolvency has not been crossed.
Investors on boards
The decision of the Delaware Court of Chancery last fall in In re: Nine Systems Corp. looks at the nature of director fiduciary duty from another and troublesome vantage point — that of directors representing venture capital investors who sit on boards of portfolio companies.
Directors representing invested capital have always had a problem in fulfilling their fiduciary duty. They are clearly representatives of particular shareholders, yet there is no exception in the scope of director fiduciary duty that absolves such a director from fulfilling obligations to all shareholders, including the minority (with whose economic interests the venture capital is often adverse).
In a corporate transaction between a company and entities affiliated with a majority of the board, the standard of review of the transaction under Delaware law requires a finding of “entire fairness” to shareholders. (Interested directors do not enjoy protections afforded under the business judgment rule.)
The 2013 Court of Chancery decision in the In re: Trados case had given hope to venture capital directors. Vice Chancellor J. Travis Laster had held in Trados that, although entire fairness required both a fair dealing process and fair pricing, there was no fiduciary breach even absent robust process in cases in which the minority stock prior to the transaction had no value and the pricing of the ultimate transaction actually was fair.
Nine Systems reaches an opposite conclusion, based on a close analysis of the particular facts of that case.
There is no doubt that the actions of the board majority in Nine Systems, representing investors whose securities were favored in a recapitalization, were facially reprehensible: actively excluding from board deliberation the one independent director, accepting what was admittedly a “back of the envelope” valuation offered by one of the VC investors, not disclosing a side deal that allowed certain but not all the investors to opt into the favorable deal, and changing the deal after it was voted and before it was closed in order to further favor the venture capital investors.
After the recap, the company subsequently failed to hold its annual stockholders’ meeting, gave poor communication to stockholders, and did not provide complete information about the revised capital structure.
Emphasizing that the board’s price determination was hampered by the unfairness of the process and by the absence of reliable financial projections, and noting the failure to engage an independent financial advisor, the court found a breach of director fiduciary duty.
As it turned out, the recapitalization in fact succeeded, facilitating certain acquisitions that thereafter saved the company, and led a few years thereafter to a very successful exit.
The court sardonically noted, however, that inside purchasers of the new preferred stock, created by the recapitalization, received almost 2,000 percent return on their money.
Space in this column does not permit a full exposition, which is aptly summarized by Sullivan and Cromwell in “Deal Lawyers” (November/December 2014 issue, at 7 through 11). However, the Nine Systems lesson can be easily articulated: In a self-interested transaction that invokes the “entire fairness standard of review,” even when the minority stock is without any value at the start of the transaction and turns out to have value afterward, and even when the pricing of the transaction proves fair, sometimes the process of board deliberation, when that deliberation is by a board whose majority is interested venture capitalists, can fail to meet the entire fairness standard.
The Nine Systems opinion makes it clear that, notwithstanding Trados, fiduciary boards (including representatives of invested capital) need to address not only price fairness but also robust process in order to meet fiduciary obligations.
As for the minority shareholders, they received no monetary damages, such damages being deemed speculative. In any event, they had their chestnuts pulled out of the fire by the acquisition, which resulted from the recapitalization itself. The shareholders were granted only their attorneys’ fees.
Counsel can gain a better understanding of the Delaware fiduciary standards applicable to all directors by reference to the Dec. 8, 2014, blog at http://blogs.law.harvard.edu/corpgov/2014/12/08/determining-the-likely-standard-of-review-in-delaware-ma-transactions/.
Defining fiduciary duty seems to have become a full-time occupation for lawyers in Delaware. Corporate counsel is well advised to consider each situation holistically and, in the absence of useful bright lines, to proceed in conservative fashion. Then, perhaps, just wait for the lawsuit anyway.
Stephen Honig practices at Duane Morris in Boston.