December 3, 2006
Equity Committees: A Consequence of the "Zone of Insolvency"
Coauthored by Neil B. Glassman
A good deal has been written lately regarding directors and officers and their fiduciary duties when a company enters the “zone of insolvency”. Chancellor Allen’s footnote in Credit Lyonnais Bank Nederland N.V. v. Pathe Communications, 1991 WL 277613 (Del. Ch. 1991), heightened awareness that directors owe all creditors a fiduciary duty under that scenario, yet what has not been discussed is equity’s need for representation after a company enters the “zone of insolvency.” There has been a surprising number of official committee of equity security-holders appointed in recent years.1 This phenomenon may be attributed, at least in part, to Credit Lyonnais and the subsequent decisions.
By definition, the board of directors is a warrior for shareholders. However, since Credit Lyonnais, once a board determines that the company may not be able to pay its debts as they come due, the board ceases being a warrior for the shareholders and becomes a watchdog for all creditors. At this moment shareholders lose their favored position in the corporate structure. For all intents and purposes, any lingering concerns of shareholders can be easily forgotten if the board elects to file for protection under chapter 11. The Bankruptcy Code has built-in protections for secured and unsecured creditors, and these creditors are actively represented in a bankruptcy case. However, prior to Credit Lyonnais, shareholders were typically left out of the equation. The creation of a quasifiduciary duty to all creditors in the “zone of insolvency” left shareholders in the precarious position of not being zealously represented upon the filing of a bankruptcy petition. As a result, official equity committees can become the warrior the board once was. Since in many bankruptcy cases the interests of shareholders run contrary to those of other creditors, inevitably there will be disagreements regarding valuations of a company’s assets and its chances of survival. The appointment of an equity committee certainly changes the dynamics of these struggles.
A shareholder’s first step in requesting the appointment of an official equity committee is sending a letter to the Office of the U.S. Trustee petitioning the Trustee to solicit interest among shareholders to serve on an official equity committee. “Ad hoc” or informal committees often will already have been formed before such a request, so that equity’s concerns may have already been brought to the attention of management or debtor’s counsel (usually with lessthansatisfactory results). These committees consist of shareholders who are knowledgeable about the company’s condition and, typically, disenchanted with the attention given to their interests or management’s general intentions regarding equity. These informal committees invariably are represented by counsel.
Time is not necessarily on the share-holder’s side when seeking the appointment of an official equity committee. One impediment in the process will be a cool reception or even opposition by the debtor. One way to expedite the process is to seek support from counsel to the Securities & Exchange Commission (SEC). With SEC support of an official equity committee, the U.S. Trustee may be more receptive to the idea. Otherwise, filing a motion with the court may be the only other option in a fastmoving case.
Under §1102(a)(2) of the Code, upon request of a party in interest, the court may order the appointment of a committee of equity security-holders if necessary to assure “adequate representation” of equity securityholders. 11 U.S.C. §1102. Section 1102 does not define what constitutes “adequate representation.”
To make that determination, court
A good deal has been written lately regarding directors and officers and their fiduciary duties when a company enters the “zone of insolvency”. Chancellor Allen’s footnote in Credit Lyonnais Bank Nederland N.V. v. Pathe Communications, 1991 WL 277613 (Del. Ch. 1991), heightened awareness that directors owe all creditors a fiduciary duty under that scenario, yet what has not been discussed is equity’s need for representation after a company enters the “zone of insolvency.” There has been a surprising number of official committee of equity security-holders appointed in recent years.1 This phenomenon may be attributed, at least in part, to Credit Lyonnais and the subsequent decisions.
By definition, the board of directors is a warrior for shareholders. However, since Credit Lyonnais, once a board determines that the company may not be able to pay its debts as they come due, the board ceases being a warrior for the shareholders and becomes a watchdog for all creditors. At this moment shareholders lose their favored position in the corporate structure. For all intents and purposes, any lingering concerns of shareholders can be easily forgotten if the board elects to file for protection under chapter 11. The Bankruptcy Code has built-in protections for secured and unsecured creditors, and these creditors are actively represented in a bankruptcy case. However, prior to Credit Lyonnais, shareholders were typically left out of the equation. The creation of a quasifiduciary duty to all creditors in the “zone of insolvency” left shareholders in the precarious position of not being zealously represented upon the filing of a bankruptcy petition. As a result, official equity committees can become the warrior the board once was. Since in many bankruptcy cases the interests of shareholders run contrary to those of other creditors, inevitably there will be disagreements regarding valuations of a company’s assets and its chances of survival. The appointment of an equity committee certainly changes the dynamics of these struggles.
Process for Appointment of Equity Committee
A shareholder’s first step in requesting the appointment of an official equity committee is sending a letter to the Office of the U.S. Trustee petitioning the Trustee to solicit interest among shareholders to serve on an official equity committee. “Ad hoc” or informal committees often will already have been formed before such a request, so that equity’s concerns may have already been brought to the attention of management or debtor’s counsel (usually with lessthansatisfactory results). These committees consist of shareholders who are knowledgeable about the company’s condition and, typically, disenchanted with the attention given to their interests or management’s general intentions regarding equity. These informal committees invariably are represented by counsel.
Time is not necessarily on the share-holder’s side when seeking the appointment of an official equity committee. One impediment in the process will be a cool reception or even opposition by the debtor. One way to expedite the process is to seek support from counsel to the Securities & Exchange Commission (SEC). With SEC support of an official equity committee, the U.S. Trustee may be more receptive to the idea. Otherwise, filing a motion with the court may be the only other option in a fastmoving case.
Applicable Legal Standard
Under §1102(a)(2) of the Code, upon request of a party in interest, the court may order the appointment of a committee of equity security-holders if necessary to assure “adequate representation” of equity securityholders. 11 U.S.C. §1102. Section 1102 does not define what constitutes “adequate representation.”
To make that determination, court