Corporate Governance in Chapter 11 and Stockholder Voting Rights Whos in Control

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Jul/Aug 2003

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When a corporation files a voluntary petition for relief under chapter 11, it becomes a debtor-in-possession (<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…).
See 1 U.S.C. §1107(a)</a>. As a DIP, the debtor corporation remains in control of property and management of its
operations. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… U.S.C. §§1107(a), 1108</a>.

A corporation, however, is a legal fiction. As such, a corporation does not manage and operate itself. Instead,
individuals, whether they are titled officers, managers and/or directors, manage and operate a corporation. And,
since officers of the company manage the day-to-day affairs of a company outside of bankruptcy, they manage the
day-to-day affairs of the DIP.

Officers, directors and/or managers, however, are not debtors in bankruptcy and are not the DIP. Nonetheless, a DIP
and a trustee cannot coexist under the provisions of §1107. Consequently, the duties and obligations of a trustee
must vest either in the corporation, the individuals that manage and operate the corporation, or both‹a requirement
that, although at first glance appears simple, creates a complicated web of duties and raises the ultimate issue of
who is in control.

<h3>Duties and Obligations of a Corporate DIP and Its Management in Chapter 11</h3>

Pursuant to §1107(a), a corporate DIP "occupies the shoes of a trustee in every way." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=7… re Mark Hughes, 704 F.2d
820, 822 (5th Cir. 1983)</a>. In fact, a DIP, acting as a trustee, is an officer of the court. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Performance Nutrition
Inc., 239 B.R. 93, 112 (Bankr. N.D. Tex. 1999)</a>. As an officer of the court, the DIP owes the court a duty to act in
the best interest of the bankruptcy estate. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…;; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9… re Intermagnetics Am. Inc., 926 F.2d 912, 917 (9th Cir. 1991)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
re Tri-Cran Inc., 98 B.R. 609, 617 (Bankr. D. Mass. 1989)</a>. Indeed, the concept of allowing the debtor to remain in
possession is "premised upon an assurance that the officers and managing employees can be depended upon to carry
out the fiduciary responsibilities of a trustee." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3… v. Weinstein, 372 U.S. 633, 651 (1963)</a>.

Reliance upon a board of directors accepting the heightened fiduciary obligations of a trustee is necessary because a
corporation is a legal fiction. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3… v. Weinstein, 372 U.S. 633, 644 (1963)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… re Schepps Food Store Inc., 160 B.R.
792, 797 (Bankr. S.D. Tex. 1993)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… re Albion Disposal Inc., 152 B.R. 794, 813 (Bankr. W.D.N.Y. 1993)</a>. Courts
and commentators have recognized that this creates a conflict of interest due to the fact that "on the one hand,
[directors] must act in the best interests of the corporation and stockholders, and on the other hand, [they] must act
in the best interest of the estate, stockholders and creditors, collectively," but have not specifically addressed how to
deal with this conflict. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… re Schepps Food Store Inc., 160 B.R. at 798</a>; Miller, Harvey R., "Corporate Governance
in Chapter 11: The Fiduciary Relationship Between Directors and Stockholders of Solvent and Insolvent
Corporations," <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… Seton Hall L. Rev. 1467 (1993)</a>. Nonetheless, directors must devise a means to deal with the
diverse interests of their different constituencies so that the purposes of the Bankruptcy Code are achieved without
favoritism or breach of fiduciary duties. Nimmer, Raymond T. and Feinberg, Richard B., "Chapter 11 Business
Governance: Fiduciary Duties, Business Judgment, Trustees and Exclusivity," <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=6… Bank. R. Dev. J. 1, 21 (1989)</a>.

Due to the lack of guidance, directors of a corporate debtor find themselves in a quandary as to how to protect all of
the varying interests of the bankruptcy estate and its constituents. And, although creditor constituents must move
the court to change management from the DIP to a chapter 11 trustee, equity interest-holders are not necessarily
under such constraints. This basic premise of state law corporate governance makes the conflicting duties and
obligations even more complicated.

<h3>The Right of Stockholders to Change the Board of Directors During a Chapter 11 Proceeding</h3>

Upon the filing of a chapter 11 petition, and usually due to the events leading up to it, equity interest-holders are
not happy. These equity interest-holders typically blame management for the corporation's downfall, regardless of
other factors. When equity interest-holders become organized, whether right or wrong, they may seek to change the
perceived cause of the bankruptcy: the board of directors and/or management.

In fact, equity interest-holders may seek to replace a board of directors with a board of directors that promises to
consider the interests of equity over the interests of creditors. While some may consider such foolishness the
creation of its own penalty, mainly the appointment of a chapter 11 trustee and/or conversion to chapter 7, that
result overlooks the real parties at risk: creditors of the bankruptcy estate. Thus, there is some question as to
whether equity interest-holders should retain their state law rights regarding the election of directors post-petition.
See, e.g., LoPucki, Lynn M. and Whitford, William C., "Preemptive Cram Down," <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=6… Am. Bankr. L.J. 625
(1991)</a>; LoPucki, Lynn M. and Whitford, William C., "Bargaining over Equity's Share in the Bankruptcy
Reorganization of Large, Publicly Held Companies," <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… U. Pa. L. Rev. 125 (1990)</a>.

Specifically, LoPucki and Whitford suggest that giving equity interest-holders a voice in negotiations over a
reorganization plan is far more than the Bankruptcy Code's black-letter priorities would seem to allow. LoPucki and
Whitford suggest an early elimination of equity interests, which would therefore reduce their bargaining leverage.
See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5… v. AEG Capital Corp., 50 F.3d 1493, 1499-1500 (9th Cir. 1995)</a> (citing LoPucki and Whitford). The
Ninth Circuit, however, declined to accept LoPucki and Whitford's suggestions and reasoning. In fact, the Ninth
Circuit noted the many provisions in chapter 11 that give equity interest-holders influence over plan formulation
and the bankruptcy process. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5…; 50 F.3d at 1500</a>. The Ninth Circuit further noted that corporate
governance in bankruptcy remains shaped by relevant state-law corporate governance issues. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5…;, citing Broude,
Richard F., Reorganizations under Chapter 11 of the Bankruptcy Code, §6.06 ("shareholders still have the power
to elect directors of the corporation...").

Although the Ninth Circuit's comments over corporate governance in Jacobson are dicta, they offer insight into the
Ninth Circuit's view of corporate governance in a chapter 11 bankruptcy case. The Second Circuit, on the other
hand, has directly addressed the post-petition rights of equity interest-holders. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8… re Johns-Manville Corp., 801
F.2d 60 (2d Cir. 1986)</a>.

In Johns-Mansville, the Second Circuit reviewed the propriety of an injunction against equity interest-holders
commencing a state court action to force an annual meeting of equity interest-holders. The debtor in
Johns-Mansville feared that at such a meeting the equity interest-holders would elect new directors, thereby
potentially altering the course of its bankruptcy case.

Although the Second Circuit reversed and remanded, thereby dissolving the injunction, it did not find the right to
compel an annual meeting absolute. Instead, the Second Circuit held that, "[a]s a consequence of the shareholders'
right to govern their corporation, a prerogative ordinarily uncompromised by reorganization, 'a bankruptcy court
should not lightly employ its equitable power to block an election of a new board of directors.'" <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…;
801 F.2d at 64</a>; citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5… re Potter Instrument Co., 593 F.2d 470, 475 (2d Cir. 1979)</a>. Thus, the (equity
interest-holders') right to call such a meeting may be impaired only if such attempts are a clear abuse of their state
law rights. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…; 801 F.2d at 64</a>; citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… re J.P. Linahan Inc., 111 F.2d 590, 592 (2d Cir. 1940)</a> ("It
is the court's concern that the management of the business does not pass into the hands of incompetent or
untrustworthy persons... As to such matters, the right of the majority of stockholders to be represented by directors
of their own choice and thus to control corporate policy is paramount and will not be disturbed unless a clear case of
abuse is made out").

"Clear abuse" does not exist merely because equity interest-holders intend to exercise bargaining power, whether by
actually replacing directors or by "bargaining away" their "chip," without replacing the board. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…; 801
F.2d at 65</a>. However, such intent can be a clear abuse under the appropriate circumstances, such as where a
confirmation hearing has already begun and all indications are that the equity interest-holders are acting in bad faith
and are willing to risk any possibility of reorganization. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…; at 66, FN 7</a>.

Similarly, when a debtor corporation is so insolvent that no equity exists, then denial of an equity interest-holder
meeting may be proper because such equity interest-holders are no longer real parties-in-interest.<a href="#1" name="1a">1</a> Id. at 65, FN 6;
see, also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5… Instrument, 593 F.2d at 475</a>. In Potter Instrument, the Second Circuit found the circumstances
appropriate to enjoin a director election because the election could result in unsatisfactory management and would
probably jeopardize both reorganization and the rights of creditors and shareholders‹sounding the death knell to
debtor and shareholder alike. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5… Instrument, 593 F.2d at 475</a>. While the circumstances in Potter Instrument

were unique, it affirms that if equity interest-holders intend to embark on a suicide mission with the intent of
undermining any reorganization plan, regardless of the economic realities, then a clear abuse exists, and preventing
the election of new directors is appropriate. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…; 801 F.2d at 67</a>.

In developing a standard, the Second Circuit did undermine the state law corporate governance rights of equity
interest-holders. However, such reasoning is sound so as to prevent bitter equity interest-holders from spitefully
preventing an otherwise successful reorganization. Due to the application of state law in chapter 11 bankruptcy cases
and the rights of equity interest-holders in choosing the management of their company, such rights should be
carefully tread upon to prevent the complete disregard of such rights.

<h3>Conclusion</h3>

The divergent interests of the debtor, creditors and equity interest-holders make governance of a corporate debtor
perhaps the most stressful experience corporate management will ever face. Management is constantly faced with
accusations of insider dealing, breach of fiduciary duty and plain incompetence, whether any truth to such
allegations actually exists. Nonetheless, their duties persist, and most directors fulfill their duties of loyalty to all
constituents.

The issue of corporate governance and the election of directors during a bankruptcy case remains troublesome on
both sides of the coin. After all, state law still governs the rights and obligations of officers, directors and equity
interest-holders, and such rights should not be lightly diminished. On the other hand, allowing rogue equity
interest-holders intent on destroying the company is simply inequitable due to the interests of other constituents and
the underlying premises of the Bankruptcy Code. As such, directors remain in control until such time as equity
interest-holders say otherwise, and only if the bankruptcy court allows them to say otherwise.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> This reasoning appears flawed, as the Bankruptcy Code does not dictate such a limitation, nor could such a limitation exist because of the potential application to unsecured
creditors in an apparent "no-asset" case. <a href="#1a">Return to article</a>

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Tuesday, July 1, 2003 - 12:00

Bankruptcy Rule

2003