Dysfunctional bankruptcy courts

It is a truth universally acknowledged that a failed business must be in want of a lawsuit.

My own bias in such cases is that investors --especially the institutional sort -- have to be prepared to take their knocks. When they invest in a risky posititon, either they were aware of the risk or they were likely lacking in their due diligence. Either way, I can work up more sympathy for the failed managers than for their vengeful former investors.

The failed managers aren't the only targets of the lawsuits that follow from a typical early 21st century business debacle.

We have these darned "fraudulent conveyance" and "avoidance" lawsuits that help spread trouble. Even the possibility that X now teeters near bankruptcy makes it very risky for anyone to accept money from X, which has a variety of perverse consequences and may have helped lead Bear Stearns to slaughter earlier this year.

Bridgeport Holdings will likely worsen the problems that arise from such situations. All it seems likely to accomplish in the first round of consequence is to drive up D&O liability insurance rates. The second round? the impact of those higher rates? an arbitrary re-allocation of resources toward fields thought to be inherent lewss transparent, and thus less likely to draw lawsuits.

Important bankruptcy precedent

The US bankruptcy court in Delaware issued an opinion in late May that may prove important to financially distressed firms considering a bankruptcy filing.

I'm only finding out about it now, I'm afraid, because the Harvard Law School Corporate Governance Blog has expounded on it.

The precedent is Bridgeport Holdings Inc. Liquidating Trust v. Boyer , a directors' & officers' liability case. The gist of it is that liability may exist for breach of fiduciary duty where D&O authorized a distress sale of most of the debtor company's property prior to the bankruptcy filing.

The decision in May was NOT on the "fraudulent conveyance" claim. Such a claim had been made and had been settled in February 2007 for $25 million. No, the claim this year was against the D&O of the conveying company as individuals.

Also, the decision in May didn't by itself attach any liability to Messrs Boyer et al. It merely said that their motion to dismiss has failed -- the lawsuit goes forward. Still, it is significant.

The judge found that specific factual allegations can make out an actionable case that D&O Defendants breached their fiduciary duty of loyalty and failed to act in good faith by abdicating crucial decision-making to their restructuring advisor, and by sitting on their hands, so to speak: by failing to monitor his execution of the ’sell strategy,’ resulting in an abbreviated and uninformed sale process.

This action can go forward despite two facts that the directors thought, or hoped, would be dispositive in their favor: their are no allegations of self-dealing, i.e. that any of the directors benefitted from their supposed abdication; and the certificate of incorporation contains an exculpation provision, purporting to bar claims for breach of duty of care, gross negligence, lack of good faith, or waste.

I suspect this decision may be bad news from the point of view of our already dysfunctional corporate bankruptcy system, and I'll try to explain why in tomorrow's entry.