Corporate officers and directors who want to understand when a bankruptcy court may second-guess their decisions if their company fails need look no further than the Delaware bankruptcy court’s recent decision in Gavin v. Tousignant (In re Ultimate Escapes Holdings, LLC).
Failed Business, Failed Merger
Ultimate Escapes was formed in September 2009 to operate a “luxury destination club” that would provide its “members” with access to high-end vacation residences. Profits came from charging initiation fees, annual dues, and for al la carte services. By 2010, the company had approximately 1250 members.
Despite rapid initial growth, Ultimate Escapes was crushed by the financial crisis, which caused a sharp contraction in the luxury destination club market. Within 6 months of its founding, the company was seeking a merger just to survive. On March 1, 2010, Ultimate Escapes and Club Holdings, a major competitor, signed a confidentiality agreement to explore such a merger. Ultimate Escapes and Club Holdings exchanged membership lists during due diligence, but were prohibited from directly soliciting each others’ members by the confidentiality agreement. On June 10, 2010, Ultimate Escapes’ board authorized its officers to finalize merger documentation with Club Holdings.
While the companies negotiated the terms of the merger with Ultimate Escapes’ secured lender, Ultimate Escapes realized that it would be unable to make its August 6 payroll. Ultimate Escapes negotiated a factoring agreement with a third party that bridged the majority of the financing gap, but a $115,000 shortfall remained. To raise the remaining funds, on August 6, Ultimate Escapes agreed to transfer certain properties and 30 members to Club Holdings. Ultimate Escapes also waived the prohibition against Club Holdings directly soliciting these members.
Unbeknownst to Club Holdings, Ultimate Escapes was simultaneously marketing its assets to other potential buyers. That effort went awry when one of Ultimate Escapes’ restructuring professionals accidentally emailed the details of the marketing efforts to a Club Holdings executive. Club Holdings responded by soliciting all of Ultimate Escapes’ members using membership information exchanged in the merger negotiations. In an effort to halt the solicitation, Ultimate Escapes filed for chapter 11 protection.
Ultimate Escapes quickly filed motions asking for authority to reject the August 6 agreement with Club Holdings and a temporary restraining order halting the solicitation of its members. The bankruptcy court granted the rejection motion, but denied the TRO. Eventually, the bulk of Ultimate Escapes’ property (including its member list) was sold off in bankruptcy to third parties. Thereafter, the bankruptcy court confirmed a plan of “reorganization” for Ultimate Escapes that created a trust empowered to commence litigation against those responsible for the company’s failure.
Breach of Fiduciary Duty Claims
Officers and directors owe duties of care and loyalty to their corporation. The duty of loyalty requires undivided loyalty to the corporation. The duty of care requires that fiduciaries (a) use the amount of care that an ordinarily careful and prudent individual would use in similar circumstances and (b) consider all material information reasonably available.
Standard of Review
Courts can apply three standards of review to breach of fiduciary duty claims. The default standard is the “business judgment rule,” which creates a presumption that fiduciaries act independently, with due care, in good faith, and with an honest belief that their actions will benefit shareholders. Where the business judgment rule applies, a court will not question a decision unless it cannot be attributed to any rational purpose. Alternatively, “enhanced scrutiny” may be applied to actions in connection with changes of corporate control, hostile takeovers, proxy fights and similar situations. Finally, courts may examine the “entire fairness” of a transaction if an actual conflict of interest exists.
The Ultimate Escapes trustee filed a complaint against James Tousignant (an officer and director of Ultimate Escapes) and Richard Keith (a director of Ultimate Escapes) alleging that they breached their duties of loyalty and care in connection with the negotiation and execution of the August 6 agreement. According to the trustee, the August 6 agreement eliminated Club Holding’s non-solicitation obligations not only as to 30 members to be transferred, but as to all of Ultimate Escapes’ members and thus effectively transferred the company’s entire 1250 person membership at a price that was appropriate for only 30 members.
Bankruptcy Court’s Reasoning
After a trial, the court rejected all claims against Mr. Keith on the grounds that he did not sign the August 6 agreement and that it was negotiated and executed without his knowledge or approval.
Turning to the claims against Mr. Tousignant, the bankruptcy court concluded that he was protected by the business judgment rule because no evidence supported a reasonable inference that Mr. Tousignant was self-interested in the transaction or that he failed to adequately inform himself. Mr. Tousignant was not self-interested merely because he held an equity stake in the company that could have been wiped out in bankruptcy (which was the likely result if the August 6 transaction had not gone forward). To the contrary, the court found that his equity stake aligned his interests with other stockholders’.
In rejecting the claim that Mr. Tousignant did not adequately inform himself of the transaction, the court emphasized that the proper question was what he knew and did at the time of the transaction. He could not be faulted for the fact that Club Holdings ultimately mass solicited Ultimate Escapes’ members in violation of Ultimate Escapes’ understanding of the confidentiality agreement.
Finally, the August 6 agreement served a rational business purpose—it was intended to ensure that the company could make payroll and avoid bankruptcy.
Fiduciaries Not to be Second-Guessed for Rational, Disinterested Decisions that End Badly
The Delaware bankruptcy court’s decision reaffirmed longstanding principles of Delaware corporate law. Corporate fiduciaries should not be second-guessed as long as they do not place their interests above those of the company and make rational (if imperfect) decisions after a diligent effort to inform themselves.