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Shareholders Retain Significant Rights in Bankruptcy
The Fight for Control of U.S. Energy Systems, Inc.
by David L. Barrack, Andrea B. Schwartz
Aug 27, 2008
(TMA International Headquarters)
More than 20 years ago, U.S. Bankruptcy Court Judge Burton Lifland of the Southern District of New York, entered an order enjoining a state court action to compel a shareholders’ meeting in the Johns-Manville1 bankruptcy case, a difficult, multi-party/multi-committee asbestos case brought under the then nascent Bankruptcy Reform Act of 1978.
The shareholders sought the meeting to remove existing directors and to elect new ones so that a modified reorganization plan that would provide a more favorable treatment to the equity holders could be proposed. The Bankruptcy Court’s injunction was intended to save an extremely lengthy, hard-fought resolution reached among many of the other parties in the case with respect to the proposal of a reorganization plan.
The U.S. District Court affirmed that decision. But despite the effort and time expended by the parties and the court to reach the resolution in the case, the 2d U.S. Circuit Court of Appeals reversed, holding that the “right to compel a shareholders’ meeting for the purpose of electing a new board subsists during reorganization proceedings.”2
The 2d Circuit established that this right could be impaired only by the issuance of an injunction based on a showing that the shareholders were guilty of “clear abuse” in calling such a meeting.3 The Delaware courts soon followed, holding similarly that shareholders’ rights continue during bankruptcy, irrespective of the degree of insolvency of the company.4
Notwithstanding these decisions by highly regarded courts upholding the rights of shareholders to govern their companies during a bankruptcy case, it does not appear that shareholders often have sought to do so to gain leverage in Chapter 11 negotiations. Few courts since Johns-Manville have published decisions on the corporate governance rights of shareholders in the context of bankruptcy proceedings.
That is, until the former CEO of U.S. Energy Systems, Inc., sought to enforce a pre-petition Chancery Court decision requiring the company to hold a shareholders’ meeting at which the incumbent directors could be removed after commencement of a Chapter 11 case in the Southern District of New York.5
This article details the recent corporate governance fight in the U.S. Energy Systems bankruptcy case. This area may provide fertile ground for otherwise disenfranchised shareholders to participate more meaningfully in Chapter 11 proceedings.
Regaining Control
For the most part, shareholders are largely disenfranchised once a company files for bankruptcy protection. The U.S. Bankruptcy Code grants very limited rights to shareholders, such as the right to appear and be heard by the Bankruptcy Court and the right to vote on a plan of reorganization.
Although the United States Trustee may appoint a committee of equity security holders under Section 1102 of the Bankruptcy Code, in most cases, the estate is insolvent and an equity committee is not constituted. Shareholders generally are left to rely on the decisions of the company’s incumbent management directors and any newly appointed crisis manager to protect and advance their interests.
Under most state laws and related corporate governance documents, shareholders hold very powerful corporate governance rights, including the right to call a shareholders’ meeting and to replace a board of directors.6 These rights reflect the well-established policy of “corporate democracy” that underlies state business and corporation laws.
These corporate governance rights are not affected by the automatic stay embodied in Bankruptcy Code Section 362. Thus, if shareholders are displeased with the way directors or the chief restructuring officer (CRO) are managing the debtor or directing the course of the Chapter 11 case, they may invoke these rights to regain control of the company by removing the incumbent directors and electing new directors. In such a case, the new directors may change the course of the case, perhaps terminating the services of the incumbent CRO.
Such an undertaking likely would impact the direction of the reorganization already commenced by the incumbent board significantly. It certainly would cause a delay in the reorganization and possibly the loss of or the renegotiation of agreements already in place with some of the debtor’s creditors.
Recently, the Delaware Chancery Court and the U.S. Bankruptcy Court for the Southern District of New York had the opportunity to consider the interplay between these corporate governance rights under Delaware law and the federal bankruptcy laws.
In Fogel v. U.S. Energy Systems, Inc.,7 the Delaware Chancery Court rendered a decision following a trial that Asher Fogel, the former chairman, CEO, and president of U.S. Energy validly called a special meeting of the company’s shareholders and that the company wrongfully failed to schedule the meeting.8 Fogel’s stated purpose for the meeting was to remove existing directors and to elect a new board of directors.
Fogel filed a motion requesting that the Chancery Court enter an order implementing its decision, set a date for the shareholders’ meeting, and preserve the status quo until that meeting was held. Prior to a hearing on Fogel’s motion, however, the company filed a voluntary bankruptcy petition under Chapter 11 in the Southern District of New York. The filing was authorized by the company’s incumbent directors.
Following commencement of its bankruptcy case, U.S. Energy Systems asserted that the Chancery Court proceedings were subject to the Bankruptcy Code’s automatic stay.9 The company argued to the Chancery Court (and later to the Bankruptcy Court) that the continuation of the Delaware proceedings was automatically stayed by the commencement of the bankruptcy case and that the Chancery Court was barred from entering an order implementing its pre-petition trial decision and setting a date for the shareholders’ meeting.
The company also contended that because it was under the protection of the federal bankruptcy laws, the Bankruptcy Court was the sole judicial forum to determine whether the automatic stay applied to the Chancery Court proceedings. Fogel argued that (i) entry of the implementing order was a “ministerial act” and therefore not a “continuation of a judicial proceeding” subject to the automatic stay, (ii) the automatic stay does not affect corporate governance rights and (iii) the Delaware Chancery Court was the proper forum to determine who should control U.S. Energy, a Delaware corporation.
Although the Chancery Court was not convinced by the argument that the entry of its order was a “ministerial act,” the court rejected U.S. Energy System’s position in its entirety, holding that “corporate governance does not cease when a company files a petition under Chapter 11 and that issues of corporate governance are best left to the courts of the state of incorporation.”10
The Chancery Court noted that in NKFW Partners v. Saxon Industries, Inc.,11 it properly had applied the “clear abuse” test first developed by the 2d Circuit Court of Appeals, under which stockholders’ rights to vote for directors “and thus to control corporate policy…will not be disturbed unless a clear case of abuse is made out.”12 The court further observed that its decision in Saxon had been affirmed by the Delaware Supreme Court, which opined that “absent other compelling legal or equitable factors, insolvency alone, irrespective of degree, does not divest the stockholders of a Delaware corporation of their right to exercise the powers of corporate democracy.”13
The Delaware Chancery Court also recognized that several Bankruptcy Courts, including those in the Southern District of New York, have deferred to state court proceedings on issues of corporate governance, such as the scheduling of a shareholders’ meeting.14 The Delaware court referred to the 2d Circuit’s decision in Johns-Manville, in which the appeals court opined that a “bankruptcy court should not lightly employ its equitable power to block an election of a new board of directors.”15
The Chancery Court observed that Johns-Manville “reaffirms and reiterates ‘the well-settled rule that the right to compel a stockholders’ meeting for the purpose of electing a new board subsists during reorganization proceedings,’” and “[t]o interfere with this right, a challenger must show that a shareholder is ‘guilty of clear abuse,’ a determination that turns on ‘whether rehabilitation [of the debtor] will be seriously threatened, rather than merely delayed.’”16
The Second Circuit in Johns-Manville explained that “‘[c]lear abuse’ requires a showing that the stockholders’ action in seeking to elect a new board of directors ‘demonstrates a willingness to risk rehabilitation altogether in order to win a larger share for equity.’”17 Notably, the appeals court stressed that “[t]he fact that the stockholders’ action may be motivated by a desire to arrogate more bargaining power in the negotiation of a reorganization plan, without more, does not constitute clear abuse.”18
Finding no showing on the part of U.S. Energy Systems that Fogel was guilty of “clear abuse,” the Chancery Court granted Fogel’s request to schedule the shareholders’ meeting.
Panoply of Rights
Corporate shareholders and other “equity holders” hold a panoply of rights under state laws, bylaws, and certificates of incorporation. These go well beyond the right to elect directors. The finely crafted balance of bargaining power in a bankruptcy case may face a significant upset if shareholders who are outside the reach of the automatic stay begin to assert their governance rights in state courts as opposed to the debtor’s home court, the bankruptcy court.
The lessons for crisis managers, directors, officers, and shareholders from Fogel are clear. As aptly stated by the Delaware Chancery Court, “[T]he passage into bankruptcy does not sound the death knell for the stockholders’ role in corporate governance.19…If the primary purpose of Chapter 11 is the rehabilitation of debtor corporations, there is no reason to disenfranchise equity holders so long as their exercise of voting rights does not impair such rehabilitation.”20
Thus, although it may appear that shareholders will have little influence on the reorganization of a corporate debtor in a bankruptcy case when the United States Trustee does not appoint an equity committee, shareholders rightfully may use their corporate governance rights to gain leverage in negotiations involving their rights, such as in the formulation of a plan of reorganization.
In addition, practitioners should be aware that in light of Fogel, Bankruptcy Court may not be the only forum in which they should expect to litigate the applicability of the automatic stay, at least when corporate governance rights are at issue.
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1 Johns-Manville Corp. v. The Equity Security Holders Comm. (In re Johns-Manville, Corp.), 52 B.R. 879 (Bankr. S.D.N.Y.), aff’d, 60 B.R. 842 (S.D.N.Y. 1986).
2 Johns-Manville Corp. v. The Equity Security Holders Comm. (In re Johns-Manville, Corp.), 801 F.2d 60 (2d Cir. 1986) (citing In re Bush Terminal Co., 78 F.2d 662, 664 (2d Cir. 1935); In re Saxon Indus., 39 B.R. 49, 50 (Bankr. S.D.N.Y. 1984); and In re Lionel Corp., 30 B.R. 327, 330 (Bankr. S.D.N.Y. 1983)).
3 Johns-Manville, 801 F.2d at 65 (citing In re J.P. Linahan, Inc., 111 F.2d 590, 592 (2d Cir. 1940)).
4 See NKFW Partners v. Saxon Indus., Inc., No. 7468, 1984 WL 8234 (Del. Ch. Aug. 8, 1984), aff’d sub nom., Saxon Indus., Inc. v. NKFW Partners, 488 A.2d 1298, 1300 (Del. 1985).
5 In re U.S. Energy Sys., Inc., Case No. 08-10054 (RDD) (Bankr. S.D.N.Y. filed Jan. 9, 2008).
6 See, e.g., N.Y. Bus. Corp. Law Sections 602, 603 and 612.
7Fogel v. U.S. Energy Sys., Inc., No. 3271-CC (Del. Ch. filed Oct. 4, 2007).
8 Fulbright & Jaworski
