Delaware Supreme Court: No ‘Insolvency Exception’ for Asset Sales

Delaware corporate law has no “insolvency exception” allowing a corporation’s board of directors to dispose of all or substantially all the assets without shareholder approval, the Delaware Supreme Court held in reversing the Delaware Court of Chancery.

The June 15 opinion is important for Delaware corporations on the brink of bankruptcy. The opinion means that an insolvent corporation cannot give a deed in lieu of foreclosure to secured lenders without shareholder approval. The opinion may also mean that a Delaware corporation’s initiation of an assignment for the benefit of creditors requires shareholder approval.

Here’s an unanswered question: Does the opinion prevent a Delaware corporation from negotiating and signing up documents for a prepackaged chapter 11 plan without shareholder approval?

The Insolvent Startup

The development-stage company had been in business for more than 10 years but was still not generating income. The two largest secured creditors had liens on all assets and were calling defaults and initiating foreclosure proceedings.

A special committee of the board was formed to negotiate a workout. The committee was given power to bind the company to a disposition of the assets to solve its financial problems.

Without shareholder approval, the committee negotiated a deal where the assets would be transferred to a new corporation primarily owned and controlled by the two secured lenders, in return for extinguishing the secured debt. Existing shareholders were slated to have a slice of the new company’s equity.

The company’s executives (who did not control the special committee) owned a controlling stock position. They objected to the transaction, which looked like a glorified deed in lieu of foreclosure. The dispute ended up in the Chancery Court of Delaware.

The vice chancellor upheld the workout agreement, believing that Delaware had an “insolvency exception” allowing the board to dispose of the assets without stockholder approval.

As part of a broader strategy to stop the transaction, the corporate officers had filed a chapter 11 petition, which the bankruptcy court dismissed as a bad faith filing.

The executives appealed the decision by the vice chancellor to the Delaware Supreme Court. En banc, the Court reversed in a 54-page opinion by Justice Karen L. Valihura, who had been a partner with Skadden Arps Slate Meagher & Flom LLC before her appointment to the Court in 2014.

The opinion covers myriad corporate law issues and bears reading in full text by lawyers involved in major corporate restructurings. Our readers may wish to consider whether other states with similar corporate laws would follow Delaware.

Section 271 of the Delaware General Corporation Law

The Court’s primary focus on was Section 271(a) of the DGCL, which provides, in pertinent part:

     Every corporation may at any meeting of its board of directors . . . sell, lease or exchange all or substantially all of its property and
     assets . . . , as its board of directors . . . deems expedient and for the best interests of the corporation, when and as authorized by a
     resolution adopted by the holders of a majority of the outstanding stock of the corporation entitled to vote thereon . . . .

Although not identical to Section 271(a), the corporation’s charter contained a similar provision calling for shareholder approval.

The vice chancellor believed that Delaware courts had adopted a common law “insolvency exception” allowing the board to dispose of all or substantially all of the assets, without shareholder approval, if the corporation was insolvent. Justice Valihura disagreed.

Justice Valihura held “that a common law insolvency exception, if one existed in Delaware, did not survive the enactment of Section 271 and its predecessor.” In other words, she said, “we clarify that a common law insolvency exception, if one existed in Delaware, did not survive the enactment of Section 271 and its predecessor.”

Regarding corporate law in states around the country, Justice Valihura said that the belief of the vice chancellor was based on caselaw and treatises between 1926 and 1948, “with no case cited after 1948 upholding such an exception.”

Justice Valihura found 15 states that recognized the board-only insolvency exception “from the late 1800’s to the early 1900’s.” However, she found “no Delaware case [that] expressly addresses or adopts the board-only insolvency exception.”

Justice Valihura based her conclusion on “the plain language of Section 271, which contains no exceptions and is not ambiguous.” She said that the holding was “consistent with our policy of seeking to promote stability and predictability in our corporate laws, and with recognition that Delaware is a contractarian state.”

The Court reversed the decision by the vice chancellor and remanded for further proceedings.

Observations

The decision means at least two things for Delaware companies on the brink of bankruptcy: (1) They may not transfer all of the assets to creditors outside of court protection without shareholder approval; and (2) assuming they represent a “[sale], lease or exchange [of] all or substantially all of its property and assets,” assignments for the benefit of creditors require shareholder approval.

Regarding ABCs, former ABI president Geoff Berman told us:

     The Delaware Supreme Court decision answered the question [of] whether shareholder approval was required to ratify a company’s
     Board resolution on addressing options for distressed or “failing” businesses. This includes companies looking to make an
     assignment for the benefit of creditors.

Mr. Berman is senior managing director of Development Specialists Inc. He specializes in assignments for the benefit of creditors and post-confirmation estate management, and wrote ABI’s treatise on ABCs, available at store.abi.org.