Management Chapter 23 Bank Hope From Collecting The Debt Long

Chapter Twenty-Three

Debtor–Creditor Relations and Bankruptcy

A MANAGER’S DILEMMA: PUTTING IT INTO PRACTICE

When is a Dividend an Unlawful Preference?

Issue Presented: Did the transaction described between DMVW and MNVA constitute a

fraudulent transfer or a breach of fiduciary duty by the MNVA board to MNVAs creditors?

The district court held that the Minnesota Uniform Fraudulent Transfer Act did not

apply to the spin-off of DMVW stock through a stock distribution by MNVA to its shareholders,

The Eighth Circuit outlined the duties of directors to creditors as follows:

When a corporation is insolvent, or on the verge of insolvency, its directors and

officers become fiduciaries of the corporate assets for the benefit of creditors.

Even assuming for purposes of analysis that the distribution of DMVW stock left

MNVA nearly or actually insolvent, or that defendants knew, or reasonably

should have known, that insolvency was likely to occur as a result of the

The dissent argued that the breach of fiduciary duty claim should be resolved at trial as

a question of fact, not law. Although there was no Minnesota case dealing with the fiduciary

duty of directors to creditors in connection with a distribution to shareholders, the dissent

asserted that the principle underlying the rule that officers and directors should not use their

unique role to advantage themselves at the expense of corporate creditors should apply not

only to loans but also to distributions to shareholders. The dissent reasoned:

Whether the transaction was a loan or a distribution, when officers or directors

act to the detriment of a corporate creditor to benefit themselves, they have

Even if the directors could legally distribute the stock to shareholders, doing so would

appear to be unethical unless they honestly believed, after due investigation, that the

corporation would have sufficient assets remaining to pay its creditors.

QUESTIONS AND CASE PROBLEMS

Question 1

Issues Presented: (a) Do directors of a corrporation in the zone of insolvency owe a fiduciary

duty to creditors? (b) Under what circumstances will the business judgment rule protect

directors from personal liability for an alleged breach of fiduciary duty?

(a) The court rejected Berg’s contention that the members of Pluris’s board of directors

owed Berg, and all of Pluris’s creditors, a paramount fiduciary duty beginning when Pluris

entered into the “zone of insolvency.” Berg & Berg Enterprises, LLC v. Boyle, 178 Cal. App. 4th

The court explained the rationale behind cases holding that directors owe a fiduciary

dutyto creditors once a corporation enters the zone of insolvency:

[T]he rationale for the general rule of no duty owed to creditors is that it is the

shareholders who own a corporation, which is managed by the directors. In an

economic sense, when a corporation is solvent, it is the shareholders who are the

residual claimants of the corporation’s assets and who are the residual risk-

The court refused to extend the fiduciary duty of directors to creditors beyond the

requirements imposed by the trust fund doctrine, which prohibits self-dealing or the

preferential treatment of creditors. The court limited the scope of the trust fund doctrine in

California to “cases where directors or officers have diverted, dissipated, or unduly risked the

insolvent corporation’s assets.” Accordingly, “the doctrine is not applied to create a duty owed

by directors to creditors solely due to a state of corporate insolvency. Application of the

doctrine requires, in addition, that directors have engaged in conduct that diverted, dissipated,

or unduly risked corporate assets that might otherwise have been used to satisfy creditors’

claims.” The court thus held:

Accordingly, based on this established doctrine, we conclude that under the

Because there was no self dealing or prohibited preferential treatment of

creditors and no actual diversion, dissipation, or undue risking of Pluris’s assets

that were otherwise available to pay creditors’ claims, there was no breach of

duty by the directors. At most, the court found, “these facts allege that another

course of action, if explored and pursued, might have offered more value in the

end or that beneficial, maximum, or more valuable use could thereby have been

made of Pluris’s net operating losses, assuming that the many contingencies

required to successfully do so all would have transpired favorably.”

(b) The court concluded that even if Berg had alleged a breach of fiduciary duty, the

Question 2

Issues Presented: (a) What basis is there for a borrower to object to certain restrictions on a

contract that will be assigned to its lender? (b) What objections can be raised by the other

party to the contract? (c) What are the arguments that can be raised by various parties to

oppose a request by a lender that its loan be personally guaranteed by shareholders or by

another corporation? (d) What advice should the bank’s attorney give about taking a

guaranty from Lumber Corporation?

(a) Newcorp does not want Bank of Hope to interfere in the running of its business by

approving or disapproving day-to-day decisions made in performing its obligations under the

(c) Employees of Newcorp who are not shareholders could object to the guaranty

requirements on the basis that they have no financial stake in Newcorp apart from their

compensation, which is already tied to Newcorp’s performance. The guaranty should be a

limited guaranty, and each employee should be able to revoke it (with no adverse consequences

to Newcorp) if he or she decides to move on.

Question 3

Issues Presented: (a) What defenses can Newcorp raise against Revolving Credit Bank’s

foreclosure? Against Bank of Hope’s foreclosure? (b) What responses can be made by

Revolving Credit Bank in support of such action? (c) How should Bank of Hope respond to

Newcorp’s agreements? (d) What rights does a junior lien holder have in the event of

foreclosure by a senior creditor? (e) What ethical considerations should a lender consider

before setting a foreclosure in motion?

(a) Newcorp will argue that although it was in default under its credit agreement with

Revolving Credit Bank, Revolving Credit Bank waived these defaults when it failed to declare a

default.

(b) Revolving Credit Bank will assert that the credit agreement provides that any

amendments or waivers must be in writing and signed by the bank to be valid. As a result,

Revolving Credit Bank did not waive any defaults when it instituted the lock box arrangement,

and, in addition, there have been subsequent defaults that have not been waived.

(d) ABC, as holder of the junior deed of trust, has the following options:

i. It can accelerate the debt secured by the junior deed of trust, but most likely, it

will be prohibited by the terms of a subordination agreement with Bank of Hope from

collecting the debt as long as Bank of Hope’s debt is outstanding.

iii. ABC, if it is in a position to do so, may offer to pay off Bank of Hope in order to

assume Bank of Hope’s first priority lien position and thereby protect its own deed of

trust.

(e) In general, even though a lending agreement may specify conditions of default and

those conditions can be violated by the borrower, not every default by a borrower merits the

Question 4

Issues Presented: (a) Is the lease an executory contract? Can a bankrupt tenant assume and

assign a favorable lease without the landlord’s consent? (b) What rights/claims does a

landlord have regarding unpaid rent when a tenant files for bankruptcy? Can a bankrupt

tenant reject an unfavorable lease? What are a landlord’s rights to cash and letter–of-credit

security deposits in the event a bankrupt tenant rejects the lease? (c) Can a favorable patent

license be assumed and/or assigned by a bankrupt licensee without the licensor’s consent?

(a) A lease is an executory contract—a contract that has not yet been fully performed—

and the debtor has the right to either assume or reject the lease.

A bankrupt tenant may assume and assign a favorable lease without the landlord’s

(b) If the tenant is in default on the lease and the trustee or DIP wishes to assume it, the

DIP must cure the breach and provide adequate assurance of future performance. Once

assumed, the lease obligations are allowable as administrative expenses, as with other

authorized post-petition transactions.

(c) Section 365(c) of the Bankruptcy Code provides that a debtor may not “assume or

assign” any executory contract if (1) applicable nonbankruptcy law excuses the nondebtor from

Whether a nonexclusive patent license can be assumed by the debtor will depend upon

which law applies to the case. The U.S. Courts of Appeals for the Third, Fourth, and Ninth

Circuits have held that a debtor may not assume an intellectual property license subject to

assume or assign an exclusive patent license.

Question 5

Issue Presented: Are termination benefits specified in a pre-petition employment agreement

entitled to priority as administrative expenses when the employee is terminated after

rendering post-petition services?

Mason claimed that the termination benefits specified in her pre-petition employment

agreement were entitled to first priority as administrative expenses because she was terminated

after performing post-petition services and after a qualifying change in control had taken place

The U.S. Court of Appeals for the First Circuit upheld the bankruptcy court’s grant of

summary judgment in favor of the Committee, denying administrative priority status to

Mason’s claim. In re FBI Distribution Corp. v. Mason, 330 F.3d 36 (1st Cir. 2003). It noted that in

general, for a claim to qualify as an administrative expense (1) it must arise from a post-petition

Mason is entitled to receive the reasonable value of the beneficial services

rendered during the reorganization. For these services, she was fully

compensated by the debtor in possession: she received her full salary plus fringe

benefits pursuant to the terms of her Employment Agreement for all the services

she rendered postpetitiion. Absent a court approved assumption of her

Employment Agreement, this was all she is entitled to receive.

Question 6

Issue Presented: Is acrimony between a debtor in possession (DIP) and certain

creditors sufficient cause to justify appointment of a trustee?

The U.S. Court of Appeals for the Third Circuit began by noting that appointment of a

trustee should be the exception rather than the rule. Nevertheless, a court does have the power

to appoint a trustee “for cause, including fraud, dishonesty, incompetence, or gross

Question 7

Issues Presented: (a) Is an option to buy property an executory contract? (b) If

Southmark had given written notice of its intent to exercise the option, but had not

yet paid the purchase price, before filing for bankruptcy, would the option have been

an executory contract? (c) Why was the option not automatically terminated when

Southmark filed under Chapter 11?

(a) The U.S. Court of Appeals for the Ninth Circuit noted that an executory contract is

one “on which performance remains due to some extent on both sides,” and that a contract is

executory if “the obligations of both parties are so unperformed that the failure of either party

to complete performance would constitute a material breach” that would excuse the

performance of the other party. In the case of a paid-for but unexercised option, each side may

(b) Applying the same analysis, the Ninth Circuit noted in dicta that an option would be

an executory contract “where the optionee has announced that he is exercising the option, but

has not yet followed through with the payment at the option price.”

(c) The Bankruptcy Code provides that the trustee (or DIP in the case of a Chapter 11

Question 8

Issue Presented: May a debtor’s prebankruptcy equity holders, over the objection of a

senior class of impaired creditors, contribute new capital and receive ownership

interests in the reorganized entity, when that opportunity is given exclusively to the

old equity holders?

The Bank of America will argue that a cramdown can occur only if the court finds that

the plan does not discriminate unfairly and is fair and equitable, and if at least one non-insider

impaired class has voted to accept the plan. Bankruptcy Code Section 1129(b)(2)(B)(ii) provides

that with respect to a class of unsecured claims, the condition that a plan be “fair and equitable”

includes the requirement that “the holder of any claim or interest that is junior to the claims of

such class will not receive or retain under the plan on account of such junior claim or interest

any property.”

The U.S. Supreme Court rejected the equity holders’ argument, concluding that “the

better reading of subsection (b)(2)(b)(ii) recognizes that a causal relationship between holding

the prior claim or interest and receiving or retaining property is what activates the absolute

priority rule.” Bank of America National Trust & Savings Assn. v. 203 North LaSalle Street

Partnership, 526 U.S. 434 (1999). It criticized the position advanced by the government, as amicus

curiae, that an old equity holder simply cannot take any property under a plan in which

creditors are not paid in full, reasoning that a truly full-value transaction, whereby the old