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The Delaware Receivership Proceeding: Another Tool for Debt and Equity Holders

Thursday, December 20, 2012

By Brian M. Rostocki and Diana Rabeh,Reed Smith

Receivership proceedings are on the rise in the Delaware Court of Chancery's docket. Such proceedings serve as another tool for debt and equity holders to protect their investment, especially for distressed companies in which such investments were made. The increasing utilization of receivership proceedings (and the results obtained) has made it clear that state court receiverships are uniquely suitable for managing certain disputes effectively and efficiently. Although the grounds for appointment of a receiver vary, there are practical reasons for filing a receivership action, especially in the Delaware Court of Chancery, including speed, the ability to obtain interim relief, cost, and flexibility of the remedy.

I. Grounds for Appointment of State Court Receivership

The Delaware Code provides a number of grounds for the appointment of a receiver. One of the most common purposes of a corporate receivership is the preservation of assets in the liquidation and winding up of corporate affairs. The Delaware General Corporation Law (“DGCL”), for example, contains several sections concerning the receivership remedy.

Under 8 Del. C. §279, a creditor, stockholder, director or any other person who shows “good cause” can petition the Court of Chancery that a receiver be appointed for a dissolved corporation. The “primary purpose” of Section 279 “is to safeguard the collection and administration of still existing property interests of a dissolved corporation” and is “the statutory mechanism by which an already dissolved corporation may conclude its ‘unfinished business' after its officers have been discharged and its legal existence ended.”1 For example, In the Matter of Texas Eastern Overseas, Inc.,2 the Court of Chancery granted an industrial cleaning facility's petition to appoint a receiver of a dissolved Delaware corporation, which was the former owner of the facility, pursuant to 8 Del. C. §279, because the cleaning facility demonstrated that the company had undistributed assets in the form of rights under one or more insurance policies and the appointment of a receiver would assist the facility's pursuit of a bonafide claim for contribution caused by hazardous substances that were released when the dissolved corporation owned the facility.3

In addition, 8 Del. C. §291 empowers the Court of Chancery with broad discretion to appoint a receiver for an insolvent corporation upon application of a creditor or shareholder “to take charge of its assets, estate, effects, business and affairs, and … to do all other acts which might be done by the corporation and which may be necessary or proper.” Under Section 291, the appointment of a receiver of an insolvent corporation lies within the sole discretion of the Court and is only appropriate “if the company is insolvent and exigent circumstances warrant such relief.”4 Insolvency under Section 291 exists where the company's liabilities exceed its assets (also known as balance sheet insolvency), or where the company is unable to meet its current obligations in the ordinary course of business (also known as equitable insolvency).5 Examples of exigent circumstances warranting the appointment of a receiver include the risk of fraud, self-dealing transactions, or the dissipation of assets.6 Moreover, the appointment of a receiver under Section 291 must be “necessary to protect the rights and interests of either the company or the moving parties.”7 “Stated differently, to obtain a receivership under Section 291, the plaintiff must demonstrate that appointment of a receiver is necessary to protect the insolvent corporation's creditors or shareholders by showing ‘some benefit that such an appointment would produce or some harm it could avoid.’”8

Under 8 Del. C. § 226(a)(1)-(3), a receiver may be appointed if there is deadlock at the board or stockholder level, or if “[t]he corporation has abandoned its business and has failed within reasonable time to take steps to dissolve, liquidate or distribute its assets.” For example, in Bentas v. Haseotes, the Court of Chancery found the appointment of a receiver was warranted where the board was deadlocked in electing successors to directors of corporation whose voting stock was equally divided among four siblings because even though the status quo of a board of two elected directors and two holdover directors was not harming the corporation, the holdover directors could exercise negative control by blocking corporate action.9

Furthermore, 8 Del. C. §322 provides: “Whenever any corporation shall refuse, fail or neglect to obey any order or decree of any court of this State within the time fixed by the Court for its observance, such refusal, failure or neglect shall be a sufficient ground for the appointment of a receiver of the corporation by the Court of Chancery.” For instance, the Court of Chancery has appointed a receiver for a corporation that failed to comply with an order directing the corporation to hold an annual meeting of stockholders.10

Similarly, alternative entity statutes authorize a creditor, partner of a limited partnership, and limited liability company member or manager to seek, upon the filing of a certification of cancellation for the alternative entity, the appointment of a receiver or trustee upon a showing of “good cause.”11 The Court of Chancery has found that “good cause” exists for the appointment a receiver where a company failed to settle and close the limited partnership's business because it retained assets and had outstanding liabilities when it cancelled its certificate of limited partnership.12 In addition, the Court of Chancery for, “cause shown,” also has the power to order and supervise the “winding up” of an alternative entity.13 There are likely other facts that would meet the “for cause” standard.

Moreover, the Delaware Court of Chancery has the “inherent equitable power to appoint a receiver” as necessitated by the exigencies of the case before it.14 This type of receivership can be appointed, whether or not the corporation is dissolved or insolvent, and is normally remedial in nature. The Court exercises this equitable power with restraint.15 Indeed, the Court will use its equitable powers to appoint a receiver “when fraud and gross mismanagement by corporate officers, causing real imminent danger of great loss, clearly appears, and cannot be otherwise prevented.”16 Although this remedial type of receivership is more difficult to obtain, the Court will invoke its equitable powers when necessary to save a corporation from gross mismanagement or to rectify failures of the company to comply with its obligations under Court orders or other governing documents.

In addition, the Court's equity power can be invoked for the appointment of a receiver pendente lite for a solvent or insolvent company as an interim remedy under appropriate circumstances. Specifically, the Court has the power to appoint a receiver pendente lite “when it is necessary for the prevention of manifest wrong and injury, and where the plaintiff would otherwise be in danger of suffering irreparable loss.”17 For example, the Court of Chancery's equitable authority permits the appointment of a receiver pendente lite to protect plaintiff's interests pending a decision on appointment of permanent receiver or as an interim remedy to preserve assets until litigation is resolved.18 The Court of Chancery can also utilize its discretion for an interim remedy that is less drastic than a receiver pendente lite. For example, in Wells Fargo Bank, N.A. v. Medical Development International Ltd., et al., the Court appointed a Chief Restructuring Officer of the companies at issue where Wells Fargo, also seeking a permanent receiver and damages for breach of contract, had demonstrated that the financial condition of the companies had deteriorated dramatically and the companies were not being operated in the best interests of their stakeholders, including Wells Fargo.19

Finally, contractual agreements may include a provision providing for the appointment of a receiver under certain circumstances. For example, parties may contractually agree in a mortgage that, after a default, the lender is entitled to the immediate appointment of a receiver to collect rent or manage and maintain a property during the pendency of a mortgage foreclosure action.20

II. How Receivership Proceedings Compare With Bankruptcy Proceedings
For debt and equity holders, receivership proceedings may be a more effective tool then bankruptcy proceedings where the entity is insolvent. Although a receiver's duties have similarities to those of a bankruptcy trustee, the appointment of a receiver under Delaware law differs from bankruptcy trustees in many procedural and practical ways. First, bankruptcy proceedings operate under a uniform set of federal rules, whereas the Court of Chancery rules are very flexible and the powers of the receiver can be constructed as deemed necessary for the insolvent corporation.21 Unlike a bankruptcy trustee, whose duties and powers are generally prescribed by statute, the Court of Chancery has discretion to appoint a receiver as appropriate under the circumstances of the case and the parties can even recommend a receiver candidate.22 Second, a federal bankruptcy judge's powers exceed the reach of a state court judge and the federal bankruptcy court can exercise jurisdiction over any assets of the debtor located anywhere in the United States.23 However, these benefits often come at a cost, as bankruptcy proceedings are both expensive and lengthy. Last, there are procedural impediments to the filing of a bankruptcy proceeding by a debt or equity holder. In contrast to a state receivership which may be instituted by a single creditor or equity holder regardless of the size of its claim, involuntary bankruptcy cases are commenced upon the petition of a minimum of three creditors if the debtor has 12 or more creditors, or a single creditor if the debtor has less than 12 creditors.24 The petitioning creditor(s) must also hold an aggregate of $14,425 in unsecured claims that are “not contingent as to liability or the subject of a bona fide dispute as to liability or amount.”25 In addition, a voluntary bankruptcy petition can also be blocked by a deadlock or by a corporate governance provision that requires a super majority vote for a bankruptcy filing.26 The cost, speed, and flexible procedural rules are the key factors to why a Delaware receivership proceeding may be better suited than a bankruptcy proceeding for debt and equity holders of an insolvent corporation.
III. Recent Successes of State Court Receivership Proceedings
There are a number of advantages for instituting a statutory receivership action or seeking a receivership as a remedy to a dispute in the Delaware Court of Chancery. The Delaware Court of Chancery receivership procedures are fairly detailed, yet offer a great degree of flexibility in administering a receivership proceeding. Indeed, Court of Chancery Rule 148 provides “that the Court may relieve the receivers or trustees from complying with all or any of the duties and procedures set forth in Rules 149 through 168 [which govern receiverships] and may impose such other duties or prescribe such other procedures as the Court may deem appropriate.”

The summary of recent cases below illustrates how the appointment of a receiver can be appropriate for effectuating a proper remedy for resolving a wide-range of disputes.

• Estate of Badii ex rel. Badii v. Metropolitan Hospice, Inc., 2012 BL 60021 (Del. Ch. Mar. 12, 2012). In Badii, the estate of the company's largest shareholder and cofounder Susan Badii, and holder of 52% of the company's nonvoting common stock, disagreed with the Board of Directors on how to implement a reorganization of the company and sought the appointment of a receiver under 8 Del. C. §291.27 The Delaware Court of Chancery found that exigent circumstances warranted the appointment of a receiver for an insolvent company deadlocked over how to discharge a $1.9 million tax lien.28 The insolvent company was at risk of losing a favorable settlement opportunity with the IRS due to a deadlock between voting and non-voting shareholders over how to implement the reorganization of the company necessary for the discharge of the liability.29 The Court reasoned that, under the circumstances of indisputable insolvency, a time-sensitive opportunity to settle a ‘value-destroying’ tax debt, and the Board's insistence on a dubious self-interested transaction, there was sufficient exigency to justify the appointment of a receiver.30 Accordingly, the Court granted the receiver the power to “determine, and to execute promptly whatever steps are necessary to effect the discharge of the federal tax liability,” and after the discharge is issued by the IRS, “attempt to resolve outstanding creditor and shareholder claims to all parties' mutual satisfaction.” 31 In addition to the authority contemplated under 8 Del. C. §291, the Court granted the receiver the power to “exercise independent business judgment to implement, in relation to the IRS offer, or to otherwise recommend whatever steps [the receiver] determines, in good faith, will maximize the value of the company for its various stakeholders under the circumstances.”32

• Jagodzinski v. Silicon Valley Innovation Co., LLC, 2012 BL 38784 (Del. Ch. Feb. 14, 2012). The case involved a suit by a member of a limited liability company, seeking access to the company's books and records to obtain information for a possible derivative suit.33 After the company failed to comply with the Court's orders on three separate occasions to produce certain books and records, the Court granted plaintiff's motion to hold the company in contempt and appointed a receiver to enforce compliance.34 Because “Delaware law is silent on the appointment of a receiver for a limited liability company” under these circumstances, the Court relied on its inherent equitable powers to appoint a receiver under Section 18-1104.35 The Court held that the appointment of a receiver was “necessary to cure the contempt by effecting the production ordered under 6 Del. C. §18-305 [the books and records statute for limited liability companies].”36 In fashioning this remedy, the Court rejected the plaintiff's request that the receiver be giving broad powers to manage the company, including the power to pursue any claims belonging to the company.37 Instead, the Court determined that “the powers of the receiver shall be limited to retrieving and producing the documents this Court ordered [the company] to produce” and the receiver would be discharged once the receiver has completed its efforts to collect and produce the books and records, except that the plaintiff could pursue a broader receivership depending on the documents uncovered.38

• Papastavrou v. Stage III Technologies, LLC, et al, C.A. No. 5300 (Del. Ch. Dec. 2, 2012) (TRANSCRIPT). In this matter, an investor in a limited liability company sought certain books and records and an accounting of an improperly dissolved company pursuant to his statutory and contractual rights.39 Here, the investor failed to receive notification of the dissolution of the company or an accounting as required under the operating agreement. At trial, the Court determined that the proper remedy would be the appointment of the investor as a receiver of the company under Section 18-805 “to the extent necessary for the final settlement of the unfinished business of the limited liability company.”40 Specifically, the receiver was authorized to “explor[e] the issues [that] otherwise would have been identified in the accounting and organiz[e] and review[] the books and records.”41 Although the Court did not grant the receiver the authority to pursue claims on behalf of the company at that time, the Court noted that the receiver could apply for an expansion of the receivership if it deemed necessary.42 The Court further ordered that the reasonable attorneys' fees and costs related to the receivership would be borne by the defendant as a remedy for his breach of the LLC agreement.43

• Williams v. Calypso Wireless, Inc., 2012 BL 33964 (Del. Ch. Feb. 8, 2012). In Williams, the plaintiff brought a summary proceeding challenging his removal as a director of the Company.44 Shortly after filing the litigation, the plaintiff moved to hold the defendants in contempt of the Order directing the Company to hold an annual meeting of the stockholders and sought the appointment of a receiver pursuant to 8 Del. C. §322.45 The Court determined that the appointment of a receiver was warranted in light of the Company's protracted failure to comply with an order of the Court requiring an annual shareholder meeting, its glaring violations of the federal securities laws, its financial situation and state of its records, and the absence of any credible plan to bring the Company into compliance.46 The Court found the circumstances of the case called for not only a receiver to conduct the annual meeting of stockholders and set the newly elected board as justified under 8 Del. C. §322, but a “receiver with a broader charge.”47 Specifically, the Court appointed a receiver to dissolve the corporation and wind up its affairs and granted the receiver the power to sell the company's assets, discharge its debts and distribute any remaining amounts to stockholders.48 The receiver was also granted the authority contemplated by 8 Del. C. §291, including the power to prosecute and defend all claims and suits in the name of the corporation.49 The Court explained that although appointment of a receiver to dissolve the entity and wind up its affairs was a “drastic step,” it was necessary given that the Company was “not an operating business in the traditional sense,” but rather simply a holding company with only one significant asset – a patent.50

• Wells Fargo Bank, N.A. v. Medical Development International Ltd., et al., C.A. No. 7352 (Del. Ch. Sept. 7, 2012) (Order). The case involved a suit against prison-service provider Medical Development International Ltd., MDI Holdings, Inc., and Medical Network Providers, Inc. over the repayment of $30 million in loans provided by Wells Fargo Bank, N.A. In addition to a breach of contract claim, Wells Fargo, sought the appointment of a receiver pursuant to 8 Del. C. §291 and a receiver pendente lite pursuant to Court of Chancery Rule 149.51 The defendants were further contractually obligated to maintain a Chief Restructuring Officer as a condition of Wells Fargo's agreement to forbear on the loan.52 The Court granted Wells Fargo's motion, in part, and appointed a Chief Restructuring Officer during the pendency of the litigation with full authority to manage and restructure the operations of the defendants and all of its affiliated companies (the “Companies”), and further revised the Order to provide the receiver with additional powers to safeguard the assets of the Company.53 The Court later entered an Order in favor of Wells Fargo on all counts, awarding a $30 million judgment in favor of Wells Fargo and appointing a permanent receiver pursuant to 8 Del. C. § 291.54 The Order authorized the permanent receiver to take possession and control over the Companies and “all real, personal, tangible, and intangible property” and “all rights and interests” of the Companies (the “Receivership Estate”).55 The Order further granted the receiver the power “to do any and all acts necessary for the proper and lawful conduct of the receivership,” including dissolving, winding down and liquidating the Companies, “mak[ing] any decisions on behalf of the Companies and the Receivership Estate without interference by the Board of Directors for the Companies,” and instituting and defending against any and all claims and lawsuits in the name of the Companies.56

IV. Conclusion
The Delaware Court of Chancery offers an attractive environment for not only insolvency-based receivership proceedings, but also the use of receiverships as a remedy against a solvent corporation struggling with internal board disputes or refusing to comply with a Court's order. Given the flexible and efficient nature of a receivership action, debt and/or equity holders and their counsel should evaluate whether a receivership is the appropriate vehicle for providing a flexible and speedy solution to a dispute they may be facing.

Brian Rostocki is a partner in Reed Smith LLP's Wilmington, Delaware office. His practice emphasizes business and complex litigation. Brian has litigated numerous complex business disputes in the Delaware courts and has also appeared on behalf of the firm's clients in state and federal courts throughout the United States, including private arbitrations and mediations.

Diana Rabeh is an associate in Reed Smith's Commercial Litigation Group. Diana's practice focuses on complex commercial litigation matters involving a number of substantive areas, including contract disputes, business torts, aviation and products liability.

Brian and Diana were counsel to some of the parties in the cases cited herein. The views expressed in this article are those of the authors and not of Reed Smith or its clients.

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