Directors, by Securing Indemnification Rights, Were Rendered Self-Interested

In GB-SP v. Walker (Nov. 15, 2024), the Delaware Court of Chancery found that directors of Bridgestreet Worldwide, Inc. (the “Company”), by securing indemnification rights for themselves in connection with approving a Foreclosure Agreement with the Company’s creditor, rendered themselves materially conflicted.

As a result, the court reviewed the Plaintiff’s claim—that the directors breached their fiduciary duties in approving the Agreement—under the entire fairness standard. The court found that the Foreclosure Agreement was not entirely fair; that the directors therefore breached their fiduciary duties when they approved it; and that the creditor, an affiliate of private equity firm Versa Capital Management, LLC, aided and abetted the directors’ fiduciary breaches.

Notably, the circumstances were unusual. The scope of the indemnification rights in the Indemnity Agreement between Versa and the Company extended beyond claims arising out of the Foreclosure Agreement, to cover also any claims brought by the company’s controlling stockholder, GB-SP, Inc. (whether relating to the Foreclosure Agreement or not). When the directors sought the indemnification rights, they knew that they had breached GB-SP’s rights under a Shareholders Agreement, and knew that they could not obtain insurance that would cover liability for those breaches because the policy excluded claims from major shareholders.

Key Points

• Under some circumstances, directors may be rendered self-interested when they secure indemnification rights in connection with approving a transaction. Normally, obtaining indemnification rights would not render directors self-interested—because indemnification is commonplace in corporate affairs and does not increase a director’s wealth. In this case, however, the court stressed “the troubling circumstances surrounding the receipt of indemnification.”
• The decision reinforces a recent trend of expanded potential liability for aiding and abetting directors’ fiduciary breaches. There have been several Court of Chancery decisions in recent years in which the court has found buyers or advisors liable, or potentially liable, for aiding and abetting target company directors’ fiduciary breaches in a sale process. Historically, by contrast, the court almost never found aiding and abetting liability for sell-side directors’ fiduciary breaches. In this case, the court found that Versa, by entering into the Indemnity Agreement, exploited the directors’ self-interest and thus induced the directors to approve the Forbearance Agreement, which delivered to Versa “exactly what [it] wanted” (i.e., control and then ownership of the Company).

• The opinion reinforces that the fair-price prong of the entire fairness test may be predominant over the fair-process prong. The court found that the process for approval of the Forbearance Agreement was unfair, but stated that entire fairness nonetheless could have been satisfied if the Agreement had been financially fair. (As neither party had addressed the issue of financial fairness, however, the court held against the directors because they bore the burden of proving entire fairness.)
• The decision also reinforces that the entire fairness standard can be satisfied. While the court found that the Forbearance Agreement was not entirely fair, it found that the consensual foreclosure that followed the Company’s breach of the financial covenants in the Foreclosure Agreement (the “Consensual Foreclosure”) was entirely fair. The court found that, although the directors who approved the Consensual Foreclosure were conflicted, their thorough process indicated that their conflicts did not affect their decision-making, and the foreclosure was financially fair given the Company’s financial position and lack of alternatives.
• The case serves as a reminder of the potential for acquisition of a struggling company outside a regular sale process. For example, a purchaser of all or a substantial part of a company’s existing debt can gain significant influence over the company through financial covenants and veto rights in the debt, and may be able to foreclose on the debt if the company defaults; or a secured lender can acquire a distressed company through a chapter 11 bankruptcy by “credit bidding” the company’s debt. Accordingly, a severely financially struggling company conducting a sale process should keep in mind that a potential bidder may attempt to acquire the company outside the sale process or after the sale process fails; and a potential bidder in the sale process should consider the feasibility of alternative routes to acquiring the company. See “Practice Points” below.

Background. The Company serviced leased apartments and corporate housing through various operating subsidiaries. In November 2011, the Company was deep in debt to its then lender and engaged a financial advisor to lead a broad sale process. Three non-binding letters of intent were submitted, but all were ultimately withdrawn except for Versa’s (with a purchase price of $30.5 million). The Company and Versa could not then agree on a price or deal structure, however. Versa decided instead to purchase the Company’s outstanding senior debt, with the ultimate goal of acquiring the Company.

Versa’s newly formed subsidiary, Domus BWW Funding LLC, acquired all of the secured debt of the Company and its subsidiaries, and the rights associated with it, for about $23 million. Soon after, the Company defaulted on the debt. Versa adopted a loan-to-own strategy (a change in control transaction by which an acquiror becomes the target’s senior secured lender and then obtains ownership of the target’s equity or assets through a liquidation process). Versa and the Company negotiated the Forbearance Agreement, pursuant to which Domus agreed to a forbearance of the debt for five months so long as certain (stringent) financial covenants were met. All of the equity interests in the Company and its subsidiaries were pledged as collateral (whereas only 65% had been pledged under the preexisting credit agreement); and the independent directors on the Company’s seven-person board were replaced with Versa’s designee (Donal Kinsella, who was GB-SP’s owner) and four additional Versa-approved directors.

The same day the Forbearance Agreement was executed, Domus entered into the Indemnity Agreement, as well as a Memorandum of Understanding (the “MOU”) that obligated Domus, in the event of consensual foreclosure, to assume the employment agreements of the Company’s CEO and its President, and to pay retention bonuses to them and other executives.

Within a month thereafter, the Company breached the financial covenants in the Forbearance Agreement. After several months of negotiations, Domus and the Company then agreed to the Consensual Foreclosure, pursuant to which the Company transferred all of the equity of its operating subsidiaries to Domus in exchange for cancellation of approximately $38 million of the remaining $46 million owed to Domus.

GB-SP brought suit. Vice Chancellor Paul Fioravanti held that: (i) the directors in office when the Pre-Forbearance Agreement was approved (the “Pre-Forbearance Directors”) had violated GB-SP’s rights under the Shareholders Agreement; (ii) the Pre-Forbearance Directors breached their fiduciary duties by approving the Forbearance Agreement, as the Indemnity Agreement provided them with a material non-pro-rata benefit and the Agreement was not entirely fair; (iii) Versa aided and abetted the Pre-Forbearance Directors’ fiduciary breaches, as it exploited for its own advantage their conflicts relating to the Indemnity Agreement; and (iv) the directors who approved the Consensual Foreclosure (the “Post-Forbearance Directors”) did not breach their fiduciary duties, as, although they were conflicted, the foreclosure was entirely fair given the directors’ thorough process and the Company’s difficult financial circumstances.

Discussion

Fiduciary duties of directors in the insolvency context. When a Delaware corporation becomes insolvent, the directors owe fiduciary duties to the Company’s residual claimants—that is, the creditors and the stockholders. Generally, the business judgment rule (i.e., judicial deference to the directors’ decisions) would apply with respect to the board’s decisions as to the best route to take to maximize the corporation’s value for the residual claimants. However, if a majority of the directors making the decision were not independent or were materially self-interested, then the entire fairness standard (Delaware’s most stringent standard of review) applies instead.

A majority of the Pre-Forbearance Directors were conflicted. First, the court found that the Company’s CEO and its President (who were Pre-Forbearance Directors) were clearly self-interested in the Forbearance Agreement because, during negotiation of the Agreement, they secured for themselves a promise of continued employment with Versa and retention bonuses in the event of a consensual foreclosure. Second, although calling it a “closer call,” the court found that all the Pre-Forbearance Directors were self-interested in the Forbearance Agreement because, during  negotiation of the Agreement, they secured for themselves the Indemnity Agreement—at a time when they knew they had breached the Shareholders Agreement; knew that the Company’s D&O insurance provider had refused the Company’s requests to eliminate the major stockholder exclusion from its D&O policy; and knew that two other insurers also had refused to provide a policy without such an exclusion.

The Forbearance Agreement did not satisfy entire fairness. Entire fairness is satisfied if the court, under a “unitary analysis,” determines that both the process and the price were fair. With respect to process, the court stated that the Forbearance Agreement being “a bad deal” for the Company was not indicative of an unfair process given the Company’s precarious financial position and its minimal leverage against a senior secured creditor that could foreclose at any time. Other factors indicated the process was unfair, however: “[T]he Pre-Forbearance Directors stiff-armed…GB-SP throughout negotiations, pushed through the deal in a manner designed to avoid stockholder detection, and prioritized terms benefitting them personally over those benefiting [the Company].” The Pre-Forbearance Directors “consistently pushed and even increased their ask” relating to indemnification, while the record did not reflect “similarly persistent efforts” to improve the Company’s financial covenants. The court cited open issues lists the Company had prepared, with indemnification at the top while the financial covenants “appeared lower on the list.”

With respect to financial fairness, the court stated that the parties largely did not address the issue (for example, they offered no expert testimony). GB-SP focused on the fact that the directors received personal benefits in exchange for their approval; and the directors simply argued that the transaction must be fair because the Company was in default and the Forbearance Agreement provided it with $12 million and a bit more runway before the ultimate foreclosure. The court stated that nothing in the record indicated whether “the Pre-Forbearance Directors could…have obtained better financial terms [for the Company] if they had not been so focused on obtaining…indemnity from Versa,” nor even whether “allowing Domus to foreclose on the collateral would have been a worse outcome for the Company than the Forbearance Agreement.” What was clear, however, was that the directors had the burden of proving financial fairness, and, leaving it unaddressed, the burden was not satisfied.

Versa aided and abetted. The court found that Versa exploited to its own advantage the Pre-Forbearance Directors’ conflicts of interest relating to their desire for indemnification for claims GB-SP might bring with respect to the Shareholders Agreement. The directors obtained the indemnification they sought; and the Forbearance Agreement “delivered to [Versa] exactly what [it] wanted”—namely, the remaining 35% equity in the Company’s operating subsidiaries as collateral and control of the Company’s board, which, shortly thereafter, resulted in ownership of the Company.

A majority of the Post-Forbearance Directors were conflicted. (i) The court held that the CEO and the President were self-interested in the Consensual Foreclosure because, under the MOU, in the event of a consensual foreclosure they were entitled to have their employment continued by Domus and to be paid bonuses. As no evidence was provided as to alternate sources of income of either of them, the court concluded that their salary and bonuses were material to them. The court noted that the directors would have received these same benefits under other transaction structures (for example, if the Company had filed for bankruptcy and Domus had purchased it out of bankruptcy)—but, the court stated, “a disinterested director would have had full flexibility to consider potential paths forward for the Company on the merits without the influence of personal financial gain attached to one of the transaction alternatives.” (ii) The court held that a third director was self-interested because his company had been selected to be the assignee in the ABC (assignment for the benefit of creditors) proceedings authorized in connection with the Consensual Foreclosure (with a fee of $425,000). (iii) The court held that a fourth director was not independent of Versa, as Versa had “tapped him” twice before to serve as a director of companies that Versa would then acquire out of bankruptcy. “This pattern…indicate[d] that [he], unlike a typical independent director, had an expectation that Versa would consider him for future director appointments.”

The Consensual Forbearance satisfied entire fairness, however. With respect to the process, the court stressed that, notwithstanding the majority-conflicted board and a conflicted key negotiator, the directors actively and thoroughly considered the Company’s financial situation, the terms of the Consensual Foreclosure, and the limited potential viability of alternatives. Also, the court noted, Kinsella was on the board for this process and participated actively—raising challenges, pushing for alternatives, and promoting boardroom discussion; and the Post-Forbearance Directors “responded constructively to Kinsella’s vocal dissent….” With respect to financial fairness, the court concluded that “[t]he Company may not have gotten any cash, or even satisfaction or release of all its debts, but, based on the circumstances, the price [it] received was fair.”

Damages. The court noted that, as neither of the parties had provided a damages analysis, it was difficult to determine damages. For breaches of the Shareholders Agreement, the court refused to award rescission given the long delay between the events and the bringing of litigation. The court awarded nominal damages of $1 for the contractual breaches, plus, as required under the Shareholders Agreement, attorneys’ fees and expenses related to this claim. For the Pre-Forbearance Directors’ fiduciary breach, the court held that the directors could not retain the benefits they received as a result of their breach, and so were liable to the Company for all amounts paid to them or their counsel under the Indemnity Agreement and their retention bonuses. For Versa’s aiding and abetting, the court ordered equitable subordination—that is, subordination of the Company’s outstanding debt to Versa to that of the Company’s other creditors as to any amounts received by the Company from the Pre-Forbearance Directors pursuant to the court’s ruling.

Practice Points

• A financially struggling company engaged in a sale process should be aware of the potential for acquisition of the company at a lower price through acquisition of the company’s debt. In a sale process in this context, the company, before rejecting all bids because they are too low, should keep in mind that, if the sale process fails, the company might be acquired at an even lower price through acquisition of its debt or other means. A company may wish to consider, when entering into nondisclosure or standstill agreements in a sale process, providing that any bidder participating in the sale process cannot acquire the company’s outstanding debt (or cannot do so for less than its bid or indication of interest in the sale process) for a specified period of time following the end of the sale process.In addition to the loan-to-own strategy (discussed above) and the consensual foreclosure route ultimately followed in GB-SP, a secured lender can also acquire a distressed company through a chapter 11 bankruptcy by credit bidding its debt—that is, offsetting its purchase price against the company’s debt (or the creditor’s claim). Notably, in most instances a first priority secured creditor may be permitted to credit bid, dollar for dollar, the full face value of the debt in these scenarios (even where the debt was acquired in the secondary market at a steeply discounted price). Buyers of distressed assets often prefer to acquire companies out of a bankruptcy process—although the many advantages and disadvantages have to be weighed based on the particular facts and circumstances in each case, among the advantages are: the ability to cherry-pick assets and liabilities; to reject burdensome contracts and leases; to eliminate successor liability risk; and to obtain more certainty, as the sale transaction is blessed by the bankruptcy court (avoiding the second-guessing litigation risk seen in GB-SP).

• Consider whether granting indemnification rights gives rise to director self-interest. This result may obtain when the indemnification covers claims that are excluded from the D&O insurance policy and cannot otherwise be obtained—and particularly if the directors are aware of a likelihood of such claims being brought. Generally, directors negotiating an agreement for the company should not focus on terms in which they have self-interest at the expense of financial covenants or other terms applicable to the company. In addition, directors should establish a record that reflects the prioritization of Company-related terms over terms in which they have self-interest—including by drafting appropriate emails (see below) and keeping Company-related issues at the top (and directors’ self-interested issues at the bottom) of open issues lists and meeting agendas.
• Do not leave relevant issues unaddressed in litigation. Generally, parties should provide the court with a damages analysis, rather than leaving it to the court to do its own analysis (which it may decline to do). We would note the relatively minimal nature of the damages awarded in GB-SP notwithstanding the court’s clear, strong disapproval of the Pre-Forbearance Directors’ actions. Also, with respect to entire fairness, parties should address not only issues relating to fairness of the process, but also financial fairness. Without such analysis, the court may decline to conduct its own analysis of financial fairness and then decide against whichever party has the burden of proof.
• Overall context matters. In GB-SP, the board delayed for a few months seating GB-SP’s director-designee, granted relatively modest retention bonuses in the face of significant upheaval and uncertainty at the company, and secured indemnification protection for the directors. None of these factors normally would necessarily give rise to entire fairness review and potential personal liability of directors. A board should keep in mind, however, that the overall context may give rise to such review and potential liability if the court views the directors as having sought to push through a transaction from which they would obtain material non-ratable benefits, particularly if obtaining such benefits appears to have been a strong focus of their efforts.
• Director independence. There are significant advantages to a private equity firm in having at least one or two clearly independent directors on the board of a portfolio company. It should be kept in mind that a court may view a pattern of appointing the same person as a director of various portfolio companies as rendering the person non-independent of the firm. It should also be kept in mind that a director’s obtaining non-ratable benefits from a transaction will render the director self-interested only if the benefits are material. Therefore, the parties should address whether alleged non-ratable benefits are material to directors—including by addressing the director’s other income (as the court might, by default, consider, for example, a promise of continued employment or a retention bonus to be material if no information is provided as to what the director’s other sources of income are).

• Court criticism; need for care with emails. Directors, managers and advisors should be aware that, as we have often noted, in recent years the Delaware courts have regularly (as in GB-SP) provided detailed background facts in their opinions, and have called out for criticism, naming names, persons and firms whose actions the court views as improper—even when the court ultimately finds no legal violations and/or only minimal liability. Also, it bear  external company emails and other informal communications that provide the basis for the court to reach conclusions against a company, its directors, or advisors relating to issues such as their intentions, priorities, state of mind, and the like. Email and other informal communications relating to corporate transactions or decision-making must be drafted with the same care and judgment as is applied to more formal corporate communications. The importance of appropriate email drafting should be emphasized to directors and managers as part of their on-boarding, with regular reminders thereafter.