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If a subsidiary goes bankrupt, can a receiver or bankruptcy trustee sue the holding company?

June 2019 - Banking and Finance. Legal Developments by IR Global.

More articles by this firm.

The following article discusses session three in the IR Global Virtual Series on 'Limiting Liabilities - Structuring holding companies to withstand insolvency'

England – DF You need to be fairly cautious about saying yes in a situation like this: there are a lot of questions that need to be considered in some detail. The main area to focus on is around the area of directors’ responsibility in the various companies and, broadly, there are six or seven particular areas of misfeasance that the directors may have fallen foul of.

They are;

If they fail to act within their normal powers

If they haven't promoted the success of the company

If they haven’t exercised independent judgment

If they haven’t exercised reasonable care and diligence

If they haven't avoided conflict of interest

If they have accepted benefits from third parties

If they have not declared any interest in the proposed transaction

There is relief and a defence is possible, particularly where the director has acted honestly and reasonably, and, if the circumstances of the case mean it's fair to excuse them from liability.

One particular case showing how a court can apply this defence was that of D’Jan of London, where a director had failed to properly fill in an insurance form as a result of which the company lost money. The director held 99 per cent of the shares and the court felt that he had failed in his duty and yet, while they did make an order against the director, they reduced the amount due which would go to the company’s creditors.

The other interesting principle we have in the UK is called the Duomatic Principle, where there can be a defence to director liability if it can be shown that shareholders who have a right to attend and vote in a general meeting, would have or did consent to what was happening. If the shareholders have actually ratified the relevant misfeasance or breach of fiduciary duty, then that is quite an interesting defence.

In terms of foreign multi-jurisdictional claims, the Principle of Comity exists between states around their accepted rules of mutual conduct. This means practically, that if you issue in one jurisdiction there is often no point in issuing in another which is really beneficial for creditors not to waste time and money in issuing in other jurisdictions. As such, it may be appropriate to go for an injunction in the foreign jurisdiction to stop those second proceedings and ask for recognition of process where you have started proceedings.

U.S – TS The trustee, which in the US is usually the bankrupt company itself, may prosecute for the estate any claims belonging to the bankrupt subsidiary against the parent company and its directors. These include such causes of action as restitution for unjust enrichment and recouping illegal dividends.

In some states, this category also includes a claim by the subsidiary to remedy abuses of the parent by piercing the subsidiary’s own veil, so as to hold the parent responsible for the subsidiary’s debts. In other states veil-piercing claims belong to individual creditors, not to the subsidiary.

Under the Bankruptcy Code, case law also recognises that the bankruptcy court may decree substantive consolidation of the bankrupt company and other entities. In rare cases, this can include merging a non-bankrupt parent company into a bankrupt subsidiary, thus effectively forcing the assets and liabilities of the parent into the bankruptcy estate.

This extraordinary remedy is available only if (1) the parent and subsidiary so disregarded their separate identities that creditors relied on the two companies as one, or (2) the companies’ assets and liabilities were so thoroughly co-mingled that disentangling them would be prohibitively expensive and would harm the creditors of both companies.

The bankruptcy trustee also has special powers under the Bankruptcy Code to pursue avoidance claims and claw back remedies against insiders for preferential transfers made up to one year before the bankruptcy. This includes loan repayments and liquidation of inter-company accounts, by which the parent gained advantage as a creditor outside of the ordinary course of business.

These avoidance powers also apply to fraudulent conveyances, or transfers made by the insolvent subsidiary to the parent without receiving reasonably equivalent value in exchange, or ones intended to hinder, delay, or defraud the subsidiary’s creditors.

A holding company and its directors cannot avoid suit merely because that company is not incorporated or otherwise present in a district where the bankruptcy is filed or because the directors reside elsewhere.

A summons and complaint for a bankruptcy adversary proceeding may be commenced by personal service or first-class mail anywhere in the United States. Service outside the US is also permitted by various means, including internationally recognised procedures.

Canada – FS Trustees in Canada are appointed either by a creditor, who brings an application to court to appoint a receiver, or, sometimes, under a general security agreement or debenture saying that the company is insolvent.

An unsecured creditor can bring an application for bankruptcy and a third-party trustee will be appointed and, of course, the company can make a voluntary assignment to bankruptcy in which case the company chooses the trustee.

Canadian trustees can prosecute anything, if they think that there was an unfair advantage given to directors, shareholders or creditors of the company. We have preference claims that are very similar to unjust preference claims in the UK and the US, where a trustee in bankruptcy can go to a creditor and say;

‘You know in the last two months prior to bankruptcy you were paid CAD100,000 while nobody else got any money, so you have to give us that money back.’

There are a lot of lawsuits for return of what we call unjust preference claims to creditors.

A trustee will also look to reclaim any money paid to directors or related parties within a year of bankruptcy. They can look at contracts between a company and any related party, including lease and rental arrangements.

Trustees see rental arrangements as a possible way of stripping money out of a company. They can go after the company that owns the real estate and force them to pay back some of the money if the rental wasn't on the same terms as it would have been if it was a third party arrangement.

One thing to highlight, is that the rights of bankruptcy trustees are subordinate to the rights of the secured creditor. So, if you are a secured creditor who has appointed a receiver for example, a receiver will liquidate the assets and collect the money from the insolvent company before a bankruptcy trustee can become involved.

There are, however, two claims that a trustee in bankruptcy can pursue for the benefit of the estate and not just for the benefit of the secured creditor.

One is the unjust preferences I just talked about and the other one is fraudulent conveyance actions, where some of the assets of the company were conveyed, prior to the insolvency or bankruptcy, at an undervalue.

A trustee in bankruptcy could assert that claim independently of the secured creditor, since fraudulent conveyance claims and fraudulent preferences claims are seen as representative actions for the benefit of all creditors, not just secured creditors.

I'd like to wrap up by saying that we also have something in our Bankruptcy and Insolvency Act called Section 38 claims.

If a trustee in bankruptcy does not have funds in the estate to pursue claims against directors or related parties, or even third parties, they can ask the courts for an assignment of that claim under Section 38 and creditors can pursue those claims independently of the trustee.

Italy – MB Discussing this topic, two preliminary observations should be made. First, some recent legislative reforms in Italian bankruptcy law have made it harder for the bankruptcy trustee to start claw back actions. Second, the economic and financial crisis that still affects the Italian economy, often leaves the insolvent subsidiaries with few, if no, assets. These two factors, inter alia, constitute a big push for bankruptcy trustees to look to other possible sources for recovering money and pay the debts of the bankrupt company.

One of the main strategies of bankruptcy trustees for doing this is filing claims for liability of directors’ and auditors, while another option is claiming liability of holding companies.

As mentioned before, in the case of abuse of legal personality, a holding company could be considered directly responsible for subsidiary indebtedness and the bankruptcy be extended to it. These claims can lead to very complicated legal issues, especially if the holding company is a foreign company because there are also issues with regard to jurisdiction and applicable law.

In the case of liability for direction and coordination, the damages that the bankruptcy trustee can claim are the ones suffered by the other shareholders (loss of value of their participation) and the creditors (loss of subsidiary’s assets as guarantee of payment).

With regard to inter-company financing, all monies remitted to the holding company within one year prior to the declaration of bankruptcy must be refunded by the holding company, while, in general, the holding company, being a shareholder, is subordinated to all the other creditors of the subsidiary.

Damages that bankruptcy trustees can claim from the holding company and its directors generally include the surplus of indebtedness generated in case the parent company worsened the subsidiary’s financial situation, for example through unjustified inter-company transactions, or keeping the subsidiary operative without taking care of, or delaying, a proper restructuring.

Bankruptcy trustees can also claim damages connected to a specific wrongdoing, for example, if money were funneled upward to the holding company via a certain unjustified transaction, or if the subsidiary sold goods, services or other assets at below market price to the holding company, or to another company in the same group.

Australia – JC Ordinarily a trustee cannot sue a holding company unless the court is prepared to pierce the corporate veil.

One issue with the historical position is the tension between the use of the phrases ‘lifting the veil’ and ‘piercing the veil’. While the principle of lifting the veil had an established set of common law principles, the courts are rather disinclined to describe a set of principles for the act of piercing the corporate veil. Hence the case law is relatively piecemeal and is not rigid in its application being more fact than principle based.

Australia adopted the UK veil piercing laws in Electric Light and Power Supply Corporation Ltd v Cornack (1911) 11 SR (NSW) 350. This was developed in the cases of Lipman v Jones and Adam v Cape which established three different grounds on which a court may elect to pierce the corporate veil: fraud, agency and group of companies.

The most relevant ground for trustee’s seeking to pierce the veil to claim debt will be the group of companies’ grounds. The ground of fraud was raised in the case of Re Edelsten ex parte Donnelly, but was ultimately unsuccessful.

The trustee of Dr Edelsten’s estate in bankruptcy commenced an action claiming that certain property owned by the VIP Group of companies had been obtained by Edelsten before the bankruptcy had been discharged. The trustee argued that the companies had been incorporated and used for the purpose of evading a legal obligation or perpetrating a fraud.

Subsidiaries may typically fall under the ground of ‘group enterprises’ where the parent company and subsidiaries are operating in such a manner as to make each individual entity indistinguishable. An argument that a subsidiary and parent company form a ‘group enterprise’ can be made where there are overlapping directors, officers, and employees or where there is a partnership between companies in a group.

A court may pierce the corporate veil on the grounds of ‘group enterprises’ where there exists a sufficient degree of common ownership and common enterprise.

Courts will typically not pierce the veil on the grounds of control alone. Rogers AJA, in Briggs v James Hardie & Co Pty Ltd (1989) 16 NSWLR 549 examined a ‘group enterprises’ argument that the plaintiff (a former employee of a subsidiary company who had contracted asbestosis) was entitled to pierce the corporate veil to sue the parent company, because it had the capacity to exercise complete dominion and control over its subsidiary and had in fact exercised that capacity. This argument was dismissed as entirely too simplistic.

Rogers CJ, in Qintex Australia Finance Ltd v Schroders Australia Ltd, noted that the development of the rigid application of the separate legal entity principle to corporate groups is problematic, often resulting in a divergence between the realities of commercial life and the applicable law.

Contributors

S. Fay Sulley (FS) Torkin Manes LLP – Canada East www.irglobal.com/advisor/s-fay-sulley

Trevor (Ted) Swett (TS) Caplin & Drysdale, Chartered – U.S - Washington, D.C. www.irglobal.com/advisor/trevor-swett-iii

James Conomos (JC) James Conomos Lawyers – Australia www.irglobal.com/advisor/james-conomos

David Foster (DF) Barlow Robbins. – England www.irglobal.com/advisor/david-foster

Massimo Boni (MB) Ferrari Pedeferri Boni – Italy www.irglobal.com/advisor/massimo-boni