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

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

More from IR Global