The United States Bankruptcy Court for the District of Delaware recently issued an opinion that could mean that directors and officers of insolvent entities face liability for damages caused by the failure to timely file for bankruptcy protection.
On January 5, 2017, in the case In re Simplexity, LLC, Judge Kevin Gross denied a motion to dismiss a complaint filed against Simplexity's officers, directors and managers by a chapter 7 trustee appointed in the case. The court did not rule as to whether there was any merit to the claims but rather found that potential claims existed based on the allegations made by the trustee. In that case, the trustee sued 11 individuals and the debtor's sponsor, including certain individuals, for "grossly negligent refusal" to protect the company and seek chapter 11 protection to minimize potential claims against the debtor. The action sought damages totaling more than $40 million and an award equal to claims against the estate and the return of pre-petition asset transfers made by the company to Versa during the year before the chapter 11 filing.
On March 10, 2014, after repeated warnings, Simplexity's lender swept all cash from the company's accounts, leaving Simplexity with virtually nothing to operate. In the following days, Simplexity was forced to terminate most of its employees and shut down its business. Simplexity filed for chapter 11 bankruptcy protection on March 16, 2014. After Simplexity sold its assets under section 363 of the Bankruptcy Code, the case was converted to chapter 7 in January 2015. The trustee’s complaint alleges that the lender notifications should have triggered a protective chapter 11 filing at the direction of the officers and directors.
Simplexity's limited liability company agreement and operating documents had full waivers of duty allowable under Delaware law. Notwithstanding the corporate liability shields contained in Simplexity's operating agreement, Judge Gross concluded that the officers and directors were not protected by the waivers. Judge Gross also rejected arguments that Delaware's deference to fairly made corporate business judgment warranted dismissal of the action. Further, despite precedent under Delaware law that "deepening insolvency" does not state a claim upon which relief can be granted, Judge Gross allowed the trustee's claims against the directors, officers and managers for failure to file to protect assets and going concern value.
The trustee's action will move forward against Simplexity's former officers, directors and managers, Versa, and individuals who held managerial posts with Versa.
Delaware law affords certain protections to officers and directors of a company, including the ability to reduce or remove fiduciary duties. This case threatens to limit the breadth of these protections. Notwithstanding the standard exculpation provisions contained in the corporate documents, Judge Gross held that an exculpatory clause is an affirmative defense to be proven by a defendant and accordingly will not provide a basis for dismissal at the pleading stage.
Though Judge Gross did not rule on the issue of negligence, the opinion permits the trustee's claims of gross negligence for delaying a bankruptcy filing to go forward notwithstanding the Delaware law protections. Company management should consider this in their decision whether and when to file for bankruptcy protection. The trustee's complaint and the Simplexity opinion suggest that management may be held liable for the damages that occur when a bankruptcy filing is delayed.
At minimum, this opinion indicates that the decision not to file could be looked at with 20/20 hindsight by trustees, creditors and other parties in interest.
Find out more by contacting the authors.