Young Conaway Bankruptcy Law Update

Tuesday, April 1, 2008 - 01:00

This is a modified version of the original update of YCST Bankruptcy Updates , edited on a rotating basis by members of the Wilmington, Delaware firm's Bankruptcy and Corporate Restructuring Section. The following cases have relevance to in-house counsel dealing with related bankruptcy matters.

U.S. Court Of Appeals For The Third Circuit

Communications with and documents created by the general legal department of a corporate family may not be subject to the attorney-client privilege in a later dispute between a parent and its past subsidiaries

In re Fleming Cos. , 499 F.3d 300 (3d Cir. July 17, 2007) (Ambro, J.)

In litigation between members of a corporate family, a dispute arose over whether certain documents were subject to the attorney-client privilege and, as a result, were not discoverable. The documents at issue were all created by or communications with the corporate family's general legal department while all of the litigants were members of corporate family. However, at the time of the litigation, certain entities were no longer members of the corporate family. Because the dispute implicated the co-client (or joint client) privilege, its exceptions, its scope and a lawyer's ethical obligations, the Court of Appeals embarked on a thorough background discussion of various legal concepts related thereto. After reviewing and clarifying these legal concepts, the Court of Appeals determined that there was insufficient evidence to determine whether the attorney-client privilege applied and to require production of documents to the ex-members of the corporate family. As a result, the case was remanded to the District Court.

U.S. Bankruptcy Court For The District of Delaware

Section 502(b)(6)'s statutory cap on damages resulting from rejection of a lease of non-residential real property applies to all damages, not just damages for unpaid rent and rent reserved

In re Foamex Int'l, Inc. , 368 B.R. 383 (Bankr. D. Del. May 16, 2007) (Gross, J.)

The debtor's landlord filed a proof of claim resulting from the debtor's rejection of a lease. The claim included amounts for unpaid rent, unpaid taxes, and repair obligations. The debtor objected to the claim and asserted that repair obligations were improperly asserted in the landlord's 502(b)(6) claim because they did not satisfy the McSheridan test. Relying on cases that declined to follow McSheridan , the landlord argued that repair and maintenance obligations arose prior to rejection; therefore, the damages were independent of the damages available under (and not capped by) section 502(b)(6).

Relying on McSheridan , the bankruptcy court held that the portion of the claim for repair obligations was not permitted because the obligations did not satisfy the McSheridan test; in particular, the obligations were not fixed, periodic, and regular. In reaching its conclusion, the bankruptcy court recognized that the Third Circuit Court of Appeals' decision in First Bank, N.A. v. FDIC , which adopted the McSheridan test in a non-bankruptcy context, was the Circuit's implicit, if not explicit, approval of the McSheridan rationale and holding, regardless of the context.

Modification of an "ordinary course employee bonus compensation plan" cannot be challenged if the modification is in the ordinary course of business; however, the modification must comply with the Bankruptcy Code, including Section 503(c)

In re Nellson Nutraceutical, Inc. , 369 B.R. 787 (Bankr. D. Del. May 24, 2007) (Sontchi, J.)

During the debtor's bankruptcy, the debtor implemented an "ordinary course employee bonus compensation plan," which applied to various tiers of employees, including senior management. The plan provided for payment of bonuses only if the debtor reached certain EBITDA targets. The debtor did not meet any of the EBITDA targets, and, as a result, no bonuses were paid under the plan.

Thereafter, the debtor modified the plan to provide for payment of bonuses. Based on agreements with creditors and prior representations to the bankruptcy court, the debtor sought approval of the modifications, notwithstanding that the debtor believed court approval was unnecessary because the modifications were in the ordinary course of business. In support of the modifications, the debtor presented evidence of repeated past modifications of prior plans and expert testimony on similar plans in the industry. Guided by this evidence, the court conducted "horizontal and vertical" analyses and determined that the modifications were in the ordinary course of the debtor's business. Thus, so long as the modifications were an exercise of business judgment, they could not be challenged on that basis.

However, the bankruptcy court went further and held that the modifications must also comply with the Bankruptcy Code. Because the plan, prior to and after the modifications, contemplated payments to insiders, the bankruptcy court held that section 503(c) was applicable. In analyzing the plan under section 503(c)(1), the bankruptcy court found that its primary purpose was to motivate employees, including senior management. As a result, the plan did not run afoul of section 503(c)(1). Furthermore, section 503(c)(2) was not implicated because the plan did not contemplate severance payments. Finally, because the modifications were in the ordinary course of business, section 503(c)(3) was not implicated either. Therefore, the modifications were permissible.

Proceeds of A D&O policy are not property of the estate where the debtor's ability and need to seek coverage under the policy is speculative or hypothetical

Miller v. McDonald (In re World Health Alternatives, Inc.) , 369 B.R. 805 (Bankr. D. Del. Jun. 8, 2007) (Gross, J.)

In securities litigation pending elsewhere, the debtor's former officers and directors entered into and sought approval of a settlement. Proceeds from the debtor's directors' and officers' policy would be used to fund the settlement. Before the settlement was approved, the chapter 7 trustee moved for a preliminary injunction to enjoin the former officers and directors from entering into the settlement and funding it with proceeds from the policy.

The trustee argued that because the debtor was covered by the policy, the proceeds of the policy were property of the estate. However, the bankruptcy court disagreed and followed the Allied Digital (Del.) and Adelphia Communs. (S.D.N.Y.) decisions. The bankruptcy court held that although the debtor was covered for indemnification obligations under a portion of the policy, the debtor's indemnification obligations had not been triggered and were speculative and hypothetical. Thus, the proceeds of the policy were not property of the estate, and the preliminary injunction was denied.

A corporate officer's claim for advancement of fees and indemnification was not subject to disallowance under section 502(e)(1)(B) of the Bankruptcy Code

In re RNI Wind Down Corp. , 369 B.R. 174 (Bankr. D. Del. Jul. 9, 2007) (Sontchi, J.)

Pursuant to the debtor's articles of incorporation, a former officer of the debtor filed a claim for indemnification and advancement of his defense costs incurred in a civil SEC lawsuit. The plan administrator filed an objection that sought to disallow the claim, pursuant to section 502(e)(1)(B) of the Bankruptcy Code, as a contingent claim for reimbursement of debt. The bankruptcy court held that the plan administrator failed to satisfy its burden under section 502(e)(1)(B) of the Bankruptcy Code, which requires proof that the claim is (i) contingent claim (ii) for reimbursement of a debt (iii) for which the debtor and the claimant are co-liable. Taking the elements out of order, the court first found that the claim was for indemnification, and accordingly, the second element was satisfied. With respect to the remaining elements - the first and third elements - the court held that the elements were not satisfied. Specifically, the court held that the claim was not contingent because the officer's right to pre-indemnification advancement of fees and expenses presently existed. Furthermore, although the amount of the claim was unknown, the claim was not contingent; instead, it was unliquidated. Finally, because there was no risk of the debtor having to make a double payment, the third element was not satisfied. Accordingly, the claim objection was overruled.

Delaware Supreme Court

A creditor may not bring a direct claim for breach of fiduciary duty against a corporation's board of directors, regardless of whether the corporation is insolvent or in the "zone of insolvency"

N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla , 930 A.2d 92, 2007 Del. LEXIS 227 (Del. May 18, 2007) (Holland, J.)

A creditor of a Delaware corporation sued the corporation's directors for alleged breaches of fiduciary duties. Rather than sue the directors derivatively, the creditor filed direct claims against the directors because the company was insolvent or in the "zone of insolvency." The directors moved to dismiss the complaint, and the Chancery Court granted the motion. The Supreme Court affirmed.

In affirming dismissal of the complaint, the Supreme Court held that Delaware law does not recognize direct breach of fiduciary duty claims for creditors of an insolvent company or a company in the zone of insolvency. The Court further held that directors' fiduciary duties do not change in the zone of insolvency. Thus, directors "must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment ." However, once a corporation becomes insolvent, creditors take the place of shareholders and may maintain derivative breach of fiduciary duty claims against the corporation's directors.

Michael R. Nestor and Joel A. Waite are Partners, and Ian S. Fredericks is an Associate in Young Conaway Stargatt & Taylor's Bankruptcy and Corporate Restructuring Section. Based in Wilmington, Delaware, the firm has one of the largest bankruptcy practices in the region. Young Conaway provides clients and colleagues with quarterly summaries of relevant bankruptcy law cases. To receive the quarterly update from Young Conaway, please contact one of the editors.

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