Contributed by Andrea Saavedra
When a Wholly-Owned Subsidiary’s Creditors Seek to Attach Liability to the Parent and Its Board of Directors
Post-Gheewalla, directors of Delaware corporations (and their counsel) let out a collective sigh of relief as the Delaware Chancery Court seemingly put the kibosh, once and for all, on the ability of creditors to assert direct breach of fiduciary duty claims against the directors of a company that is either insolvent or in the so-called “zone of insolvency.”  Issued in 2007, prior to the meltdown in the subprime market when the markets were still flush with cash, the Gheewalla decision affirmed the normative principle underlying fiduciary duty law, that, irrespective of the financial condition of the company, a director’s obligations are to discharge his or her duties to the company in good faith and with the requisite care expected of someone in his or her position, whether the ultimate residual beneficiary (or injured party) of the director’s actions is a shareholder or a creditor.

But then the Financial Panic of 2008 hit.  Suddenly, bankruptcy courts were flooded with cash-poor debtors so overleveraged that existing secured creditors were in the chapter 11 cat-bird seat as they were often not only the sole source of DIP financing, but also likely to constitute the majority of new equity upon exit.  And Official Committees of Unsecured Creditors were often representing constituencies that were left with, at best, warrants and, at worst, nothing except potential litigation claims.  Where there’s a litigation mandate, there’s a search for deep pockets and insurance proceeds.  Once again, directors of debtor companies found themselves on the receiving end of these initiatives.  And while directors may have anticipated becoming defendants in an action brought on behalf of the creditors of the corporation they served, it’s unlikely that they (or their counsel) could have anticipated actions by creditors of a wholly-owned subsidiary.  After all, a director’s duties run to the corporation it serves – not to that corporation’s wholly-owned subsidiary, let alone that subsidiary’s constituencies, right?  A recent decision by the United States Bankruptcy Court for the Southern District of Florida, Official Committee of Unsecured Creditors of TOUSA, Inc. v. Technical Olympic, S.A., et al. (In re TOUSA, Inc.), however, reignites the uncertainty that existed pre-Gheewalla and may cause directors (and their counsel) to hold their breath once more.
In TOUSA, the Creditors’ Committee filed a complaint against, among others, the parent, the parent’s board, and the subsidiary’s board alleging breaches of fiduciary duties and/or aiding and abetting breaches of fiduciary duties in connection with the parent’s decision to authorize the subsidiary to assume certain additional secured loan obligations at a time in which the subsidiary was alleged to have already been insolvent.  The defendants filed motions to dismiss on the grounds that, among other things, they did not owe fiduciary duties to the subsidiary or its creditors.  The TOUSA court completely rejected those arguments.  First, it held that, as a matter of Delaware law, the wholly owned subsidiary’s board clearly owed fiduciary duties to the subsidiary and its creditors once the entity was rendered insolvent.  To the extent that a director served on both the board of the parent and the subsidiary, the TOUSA court further held that, in making a decision for the subsidiary, the dual-service director had to consider the interests of the subsidiary before the interests of the parent.
This portion of the TOUSA decision is not (as) controversial.  When solvent, if the corporation is wholly owned and has no creditors or other constituencies (such as employees) to worry about, it is well established that the dual-director may consider the interests of the parent.  Once insolvent, the dual-director must consider the interests of all stakeholders, as articulated in Gheewalla.  So far, so good – but not so fast.
The decision goes further to hold that the parent and the parent’s board can be held liable for breaches of fiduciary duties that are directly owed to the subsidiary and the subsidiary’s creditors.  The TOUSA court relies on certain Delaware decisions in the partnership/LLC trust fund doctrine context for the proposition that direct liability on account of parental abuse of the subsidiary, when insolvent, is appropriate and that, once insolvent, the subsidiary’s creditors have the right to recover for the breach.
In reaching this conclusion, the TOUSA court also relied on two separate post-Gheewalla decisions to support its rationale: In re the Brown Schools, and In re Southwest Supermarkets, LLC Just as in the TOUSA decision, the Delaware Bankruptcy Court (Walrath, J.) in Brown Schools denied motions to dismiss a complaint brought against the parent and parent’s directors by the chapter 7 trustee of the parent’s majority-owned subsidiary-debtor.  In his complaint, the chapter 7 trustee sought to recover damages arising from alleged breaches of fiduciary duties.  In denying dismissal of the fiduciary breach claims as disguised “deepening insolvency” claims, though, Judge Walrath did not go so far as the TOUSA court to hold that the parent or its directors owed direct duties to the subsidiary or its creditors.  Instead, Judge Walrath recognized that, under established Delaware precedent, creditors, as the residual beneficiaries of an insolvent corporation, have standing to bring such traditional claims on behalf of the corporation.  Whether the parent or its directors actually owed such direct fiduciary duties to the debtor or its creditors was not addressed by the court.
The TOUSA court appears to rely on dicta from the Southwest Supermarkets decision to reach its conclusion that a parent and its board of directors owe a direct duty to a subsidiary and its creditors.  The specific issue in Southwest Supermarkets was whether, under Delaware law, the officers and directors of a wholly owned subsidiary owe fiduciary duties to the subsidiary, or only the parent.  In concluding that directors of a wholly owned subsidiary owe duties to the parent as well as the subsidiary, the Arizona Bankruptcy Court, relying on Gheewalla, further noted that its conclusion was particularly correct in the insolvency context where, “[o]nce the subsidiary becomes insolvent, Delaware law recognizes that the fiduciary duties shift to the creditors.” In re Southwest Supermarkets, LLC, 376 B.R. at 285.  (emphasis added).  Thus, the Southwest Supermarkets decision supports the TOUSA court’s conclusion that, once insolvent, the duties of directors of a subsidiary shift to the subsidiary’s creditors.  Southwest Supermarkets, however, provides no support for TOUSA’s proposition that directors of a parent owe fiduciary duties to the subsidiary’s creditors.
In this manner, TOUSA appears to muddy the issue of duty shifting that Gheewalla aimed to clarify, i.e., that a director’s duties never shift but rather that, when a corporation is insolvent, creditors, rather than shareholders, are empowered with derivative standing to bring fiduciary duty claims against the borrower’s directors on behalf of the corporation itself.  Perhaps, however, the TOUSA decision can better be explained as the court’s attempt to discourage parents and their boards from taking actions for the benefit of the parent that could adversely affect the interests of the subsidiary and its constituents.  From this light, the TOUSA decision appears to be a creative way for the court to attach liability in an area where it has determined that the parent was not merely neglectful of the interests of its subsidiary, but outright abusive so as to essentially raid the subsidiary’s value for the benefit of the parent.  This principle in corporate law as applied to majority shareholders is not novel; a parent can be held liable for obligations of its subsidiary under principles of alter ego or veil piercing.  Applying principles of fiduciary duty and corporate governance, however, to allow direct claims against the directors of a parent for actions taken by the subsidiary does appear to represent a significant expansion of Delaware corporate law.
If read broadly, TOUSA suggests that, in anything that they do, the parent’s directors may have to consider the impact of their decisions on the subsidiary and its own constituents when the subsidiary is in financial distress and that failure to do so could result in a direct claim for breach of fiduciary duty.  If it is taken to this extreme and adopted by other courts, then TOUSA will have laid open the blame game and second-guessing opportunities for creditors – not only of the parent but of its subsidiaries – as to valid business judgments made by a parent’s board in high times when the business later finds itself in distress.  In any event, awareness of the decision is important as many companies are not yet out of the woods of the Great Recession, and boards need to be aware of the creative ways in which courts may allow creditors to recover their losses (or gain leverage in their negotiations) when a company becomes distressed or files for bankruptcy relief.  So maybe it’s time to hold our breaths once more.