Contributed by Doron P. Kenter.
“Always look out for Number One, but don’t step in Number Two” – Rodney Dangerfield
“What-eva – I’ll do what I want [as long as my company is solvent]” – Eric Cartman, South Park
It is widely known that under Delaware law, officers and directors of a solvent corporation owe fiduciary duties not to the corporation’s creditors, but to the corporation’s shareholders, who bear the risks and rewards of any rise or fall in the company’s value. In Lightsway Litig. Servs., LLC v. Yung (In re Tropicana Entmt., LLC), the United States Bankruptcy Court for the District of Delaware teaches us that the logical consequence of this regime of fiduciary duties is that officers and directors of a solvent corporation who are also the sole owners of that corporation are charged with maximizing value for themselves, even where those actions may negatively impact the corporation itself.
The story begins with a consortium of related hotels and casinos across five states. The companies were owned by William J. Yung, through intermediate companies including Wimar Tahoe Corporation. After the debtors confirmed a plan of reorganization, a litigation trust was created to pursue certain “insider causes of action.” The trustee for the litigation trust filed a complaint against Yung, Wimar, and other entities controlled by Yung, alleging that Yung had driven the company into insolvency as a result of his misdeeds in operating the casinos.
Yung’s Acquisition and Management of the Casinos
In 2007, Wimar acquired Aztar, Inc., which owned five casino properties, two of which were located in the major markets of Atlantic City and Las Vegas. Notwithstanding Yung’s public admission that he and his company had limited experience operating a full-scale casino resort in Atlantic City or Las Vegas, and that the acquisition could “strain” Wimar’s resources, Wimar completed its acquisition of Aztar for approximately $2.1 billion. After Wimar’s cost-cutting measures, several of the casinos spiraled out of control. The Tropicana in Atlantic City suffered from a “cleanliness crisis” – which included a shortage of soap and cleaning supplies, bugs in beverages, overflowing toilets, and a litany of other unpleasantries – and ultimately led to a denial of the casino’s gaming license. And despite a finding from a state agency that the casino’s only hope for success would involve Yung stepping aside as the sole director of the casino, Yung refused to cede control. Layoffs and other cost-cutting measures caused several other casinos to suffer physical damages, penalties, and other operational stress. Yung and Wimar were plainly unable to operate the newly-acquired properties, allegedly resulting in hundreds of millions of dollars in losses.
The Action Against Yung and His Companies
The litigation trustee sued Yung, Wimar, and others in the bankruptcy court, alleging, among other causes of action, that they had breached their fiduciary duties in managing the casinos. The defendants moved to dismiss, arguing (among other things) that Yung did not owe any fiduciary duty to the debtors at the time of the alleged misdeeds.
The Court Dismisses the Claims for Breach of Fiduciary Duty
Citing to N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, Judge Carey first explained that when a corporation is solvent, a director’s fiduciary duties may be enforced by the corporation’s shareholders, “who have standing to bring derivative actions on behalf of the corporation because they are the ultimate beneficiaries of the corporation’s growth and increased value.” When a corporation is insolvent, however, it is the corporation’s creditors who may enforce these duties by bringing an action against the director because they “take the place of the shareholders as the residual beneficiaries of any increase in value.” Applied to the facts before the bankruptcy court, the fiduciary duties owed by Yung to the debtors when the debtors were solvent ultimately flowed to Wimar, the sole shareholder and parent of the debtors. Citing to Trenwick Am. Litig. Trust v. Ernt & Young, L.L.P., the court observed that “in a parent and wholly-owned subsidiary context, directors of the subsidiary are obligated only to manage the affairs of the subsidiary in the best interests of the parent and its shareholder.” Accordingly, because wholly-owned subsidiaries are formed for the benefit of the parent, a subsidiary’s directors must manage the subsidiary with loyalty to the parent, even if the actions make the subsidiary itself less valuable. In light of the nature of these duties, Yung’s duties to the debtors ultimately flowed back to Yung himself, insofar as he was obligated to manage the debtors in the best interest of Wimar, which he was, in turn, obligated to manage in his own best interest.
If, on the other hand, the debtors were insolvent at the time of the alleged misconduct (or the misconduct caused the debtors to become insolvent), the duties would change, and Yung would owe fiduciary duties to the debtors’ creditors, rather than to Wimar (and then back to himself). In light of these shifting duties, the trustee alleged that “Yung’s misconduct propelled the Debtors into insolvency.” The bankruptcy court was not convinced, and held that the mere recitation of “insolvency” or “financial collapse” cannot support a claim that the company was insolvent at the time of Yung’s alleged misdeeds, or that his misdeeds caused the company to become insolvent. Instead, those seeking to demonstrate insolvency must plead facts showing that the company either (i) had liabilities exceeding its assets, with no reasonable prospect of continuing the business or (ii) was unable to pay its obligations as they became due. Because the trustee failed to allege any facts to support such a finding (even after being given an opportunity to amend the complaint to remedy the initial deficiencies), the bankruptcy court concluded that the company was not insolvent, and that Yung’s fiduciary duties had therefore not shifted away from his initial duties, which ultimately flowed back to Yung for his own benefit.
To survive a motion to dismiss, a complaint is viewed in the light most favorable to the nonmoving party. To withstand even this level of scrutiny, a complaint must allege facts to support a cause of action. As we’ve noted, in Delaware, directors of solvent corporations owe their duties to the shareholders of the corporation. In Tropicana, the sole director and officer was also the sole owner of the casino enterprise, which meant that his fiduciary duties flowed back to himself, so long as the company remained solvent – and that he could justifiably take actions that reduced the company’s value, so long as the actions benefited him personally. Though this seems unfair at first glance, if a company remains fully solvent notwithstanding any reductions in equity value, then arguably creditors are not harmed. Indeed, dividends to shareholders are simply one form of such actions that reduce the value of a company while benefiting the company’s owners. Not so terrible after all.
Take comfort, those who mourn the decline of the Tropicana. Even though the bankruptcy court dismissed the trustee’s claims for breach of fiduciary duty, the trustee was not left without recourse. The court left intact the trustee’s claims for breach of contract and for breach of the implied covenant of good faith and fair dealing, and left open the possibility for the trustee to subsequently seek to equitably subordinate Yung’s substantial claims against the debtors. These claims remain subject to further fact-finding and litigation in due course.