February 24, 2005
Equity Committees - Representation of Shareholders in Bankruptcy Cases
Coauthored by Neil B. Glassman
Much has been written lately regarding directors and officers and their fiduciary duties when the company they manage 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) heralded a general awareness that directors owe creditors a fiduciary duty under that scenario. Yet, there has been less discussion regarding equity's lack of representation in a bankruptcy setting when a company enters the “zone of insolvency.” Coincidentally (or perhaps not), in the years following Credit Lyonnais, an increase in bankruptcy filings by large, publicly-traded companies has been accompanied by an increase in the number of equity committees appointed. Equity committees have been appointed in a minimum of 30 cases in 12 jurisdictions in the US since 2000. For example, equity committees were appointed in the bankruptcy cases of Loral Space, Kmart, Mirant Corp., Adelphia Communications Corp., Footstar Inc., Trump Hotel and Casinos, Federal Mogul, Seitel and USG. Could this phenomenon be the logical result of Credit Lyonnais?
The board of directors of a solvent corporation owes fiduciary duties to its shareholders. As a fiduciary, directors have duties of loyalty, candour and care. However, under Credit Lyonnais and subsequent case law, once a board of directors determines that the company may not be able to pay its debts as they become due, directors cease being solely a fiduciary for the shareholders and become a watchdog for all creditors and shareholders. At this moment, equity loses its favoured position in the corporate hierarchy. Moreover, the concerns of shareholders can be easily forgotten if the directors elect to file for protection under Chapter 11 of title 11 of the US Code (the “Code”). The Code has built in protections for secured and unsecured creditors, and these creditors are actively represented in a bankruptcy. Conversely, the appointment of an official committee of equity holders remains less common in a Chapter 11 case. Consequently, the advent of fi duciary duties owing to all creditors may leave equity in the precarious position of not being zealously represented. Since in many bankruptcy cases the interests of shareholders run contrary to those of 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 directly or through an “ad hoc committee” to the Office of the US Trustee (the “UST”). Then, the UST will attempt to determine the level of interest among shareholders.
“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 (with less than satisfactory results). These committees consist of shareholders who are knowledgeable of 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. In fact, given the volume of recent equity committee solicitations, there are a growing number of law firms and financial advisory firms who actively compete to represent such committees. Like professionals for official creditors' committees, 673694-1 professionals for official equity committees are compensated from assets of the bankruptcy estate.
Realising the objective of an appointment of an “official” equity committee requires immediate action by shareholders. One impediment
Much has been written lately regarding directors and officers and their fiduciary duties when the company they manage 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) heralded a general awareness that directors owe creditors a fiduciary duty under that scenario. Yet, there has been less discussion regarding equity's lack of representation in a bankruptcy setting when a company enters the “zone of insolvency.” Coincidentally (or perhaps not), in the years following Credit Lyonnais, an increase in bankruptcy filings by large, publicly-traded companies has been accompanied by an increase in the number of equity committees appointed. Equity committees have been appointed in a minimum of 30 cases in 12 jurisdictions in the US since 2000. For example, equity committees were appointed in the bankruptcy cases of Loral Space, Kmart, Mirant Corp., Adelphia Communications Corp., Footstar Inc., Trump Hotel and Casinos, Federal Mogul, Seitel and USG. Could this phenomenon be the logical result of Credit Lyonnais?
The board of directors of a solvent corporation owes fiduciary duties to its shareholders. As a fiduciary, directors have duties of loyalty, candour and care. However, under Credit Lyonnais and subsequent case law, once a board of directors determines that the company may not be able to pay its debts as they become due, directors cease being solely a fiduciary for the shareholders and become a watchdog for all creditors and shareholders. At this moment, equity loses its favoured position in the corporate hierarchy. Moreover, the concerns of shareholders can be easily forgotten if the directors elect to file for protection under Chapter 11 of title 11 of the US Code (the “Code”). The Code has built in protections for secured and unsecured creditors, and these creditors are actively represented in a bankruptcy. Conversely, the appointment of an official committee of equity holders remains less common in a Chapter 11 case. Consequently, the advent of fi duciary duties owing to all creditors may leave equity in the precarious position of not being zealously represented. Since in many bankruptcy cases the interests of shareholders run contrary to those of 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.
The appointment process
A shareholder's first step in requesting the appointment of an official equity committee is sending a letter directly or through an “ad hoc committee” to the Office of the US Trustee (the “UST”). Then, the UST will attempt to determine the level of interest among shareholders.
“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 (with less than satisfactory results). These committees consist of shareholders who are knowledgeable of 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. In fact, given the volume of recent equity committee solicitations, there are a growing number of law firms and financial advisory firms who actively compete to represent such committees. Like professionals for official creditors' committees, 673694-1 professionals for official equity committees are compensated from assets of the bankruptcy estate.
Realising the objective of an appointment of an “official” equity committee requires immediate action by shareholders. One impediment