Restructuring

Contributed by Adam Lavine
Hoku, a publicly-owned Delaware corporation, filed for bankruptcy with just $8 million in assets compared to a relatively staggering $1.3 billion in liabilities, much of which was funded debt.  In light of this significant insolvency, Hoku’s chapter 7 trustee brought various breach of fiduciary claims against Hoku’s board of directors, including one akin to a claim for “deepening insolvency.”  As the case of Hopkins v. Nakamoto (In re Hoku Corp.), Adv. Case No. 15-08183 (Bankr. D. Idaho Aug. 2, 2016) proves, the prohibition on deepening insolvency claims under Delaware law remains alive and well, even in the face of incredible balance sheet insolvency.  The Hoku decision also presents a helpful primer on certain other defenses available to directors when faced with breach of fiduciary duty claims under Delaware law.

Background
Hoku had issued hundreds of millions of dollars in debt so that its wholly-owned subsidiary could construct a polysilicon manufacturing plant.  The subsidiary obtained additional financing by contracting with several customers to prepay for the purchase of polysilicon after construction of the plant was completed.
Within two years, Hoku faced significant cost overruns related to the project and was in need of additional financing.  It therefore entered into a transaction with Tianwei, the parent of one of its prepay customers.  Pursuant to the transaction, Tainwei (i) caused the prepay customer to forgive approximately $50 million in debt and (ii) committed to use its assets as collateral so that Hoku could obtain an additional $50 million in financing from third-party sources.  In exchange, Tianwei acquired a 60% ownership interest in Hoku and the right to appoint a majority of its board of directors.
The plant’s cost overruns continued, and in the years that followed, Hoku borrowed an additional $339 million from several lenders.  The venture ultimately failed, in part due to a precipitous drop in the price of polysilicon: $475 per kilogram in February 2008, to less than $16 per kilogram in December 2012.
The Breach of Fiduciary Duty Claims
Hoku’s chapter 7 trustee brought breach of fiduciary duty claims under Delaware law against Hoku’s board of directors, targeting the actions taken by the board after Tianwei had appointed a majority of its members.  It argued that the directors breached their duty of loyalty by:
(i) entering into “excessively favorable” polysilicon supply agreements with Tainwei;
(ii) incurring hundreds of millions of dollars of debt to construct the plant, even after the market for polysilicon crashed; and
(iii) placing the interests of Hoku’s subsidiary ahead of Hoku by paying the subsidiary’s creditors.
The court dismissed the claims with prejudice, holding that the trustee had failed to allege sufficient facts to rebut the application of the business judgment rule.  Specifically, the court found that the trustee had failed to sufficiently allege facts establishing that “board members were either interested in the outcome of the transaction or lacked the independence to consider whether the transaction was in the best interest of [the] company.”
The Court’s Analysis
The court first addressed the allegation that Hoku’s directors violated their duty of loyalty by approving excessively favorable agreements with Tianwei at a time when a majority of the board was allegedly employed by or closely tied to Tianwei.   The court noted that, “it is well-settled that a director’s appointment at the behest of a controlling shareholder does suffice to establish a lack of independence” and that “the existence of some financial ties between the interested party and the director, without more, is not disqualifying.”  The court then held that the trustee failed to allege that a majority of the board lacked independence because all it pled was that two directors were employed by Tianwei and that the other Tianwei-appointed directors had “strong ties” to Tianwei.  According to the court, the allegations concerning “strong ties” were conclusory statements that could not form the basis for a finding of a lack of independence.
Next, the court considered the allegations concerning the board’s decisions to incur hundreds of millions in debt to complete its manufacturing plant after the polysilicon market had crashed.  The court treated these allegations as akin to a claim for “deepening insolvency” for which there is no independent cause of action under Delaware law.  The court faithfully applied this doctrine of Delaware law, notwithstanding the incredible depth of Hoku’s insolvency.  According to the court, there was clearly a rational basis to incur additional debt, as the completion and operation of the polysilicon plant was Hoku’s only hope of continuing as a going concern.
To escape Delaware’s prohibition on deepening insolvency claims, the trustee tried to couch its claim as one for breach of the duty of loyalty by alleging that Hoku used the proceeds of its many loans to make payments to certain defendants, including board members.  According to the court, however, there were no details about such payments and, “in the absence of any such detail, it is impossible for the Court to determine whether a plausible claim exists.”
Finally, the court addressed the allegation that the board of directors placed the interests of Hoku’s subsidiary ahead of Hoku by paying the subsidiary’s creditors at a time when certain directors were allegedly conflicted as a result of serving on the board of both the parent and subsidiary.  In dismissing these allegations as a basis to support a claim for breach of the duty of loyalty, the court noted that, under Delaware law, “if the interests of the beneficiaries to whom [a] dual fiduciary owes duties are aligned, then there is no conflict of interest.”  To the court, it was clear that “because [Hoku] solely owned the subsidiary, and the polysilicon project was [Hoku’s] principal undertaking, [the subsidiary’s] success was [Hoku’s] success, and vice versa.” Under these facts, the court held that the interests of the two corporations were fully aligned and that the breach of loyalty claims targeting the boards’ spending decisions must fail.
Takeaway
Although the depth of Hoku’s insolvency may be uncommon, the existence of a complicated relationship between a struggling corporation and its equity owner is not.  Indeed, it is not uncommon for an equity owner to find itself (or its affiliates) in multiple places within a struggling corporation’s capital structure as owners often try to salvage their initial investments through further investments.  Hoku highlights some of the risks that a board of directors appointed by that owner may face, particularly with respect to allegations concerning a breach of the duty of loyalty.  Nevertheless, Hoku likewise highlights the many protections available to a board of directors under Delaware law, including the business judgment rule.