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Just as the 1990s proved that emerging growth companies offer the potential for sky-high returns, this decade has revealed the high risks of investing in those companies. Billions of dollars invested in emerging growth companies have evaporated, leaving many investors and creditors holding the bag and angry. Investments in emerging growth companies are risky because they often require significant, up-front cash investments and very long-term visions of success and profitability. Reaching that profitability involves high cash-burn rates and a relentless drive to go forward. But what if these visions are ultimately unreachable? At some point, many of these companies begin running short on cash and must face a crucial choice: Keep fighting or pull the plug. To complicate matters, as their company teeters on insolvency, directors and officers’ duties suddenly change. A return to the company’s investors now becomes secondary, and, instead, management has a fiduciary duty to shepherd the company’s remaining assets for the benefit of creditors. Two recent cases have shed light on these duties — and liabilities — of officers and directors. The first case, Angelo, Gordon & Co. L.P. v. Allied Riser Communications Corp., 2002 WL 208074 (Del. Ch. 2002) decided by the Delaware Chancery Court, clarifies the standard applicable to decisions made by management when in this zone of insolvency. The second case, Official Committee of Unsecured Creditors v. R.F. Lafferty & Co. Inc., 267 F.3d 340 (3d Cir. 2001), makes clear that bankrupt companies may sue their officers and directors for deepening the company’s insolvency. It is fairly common knowledge that directors and officers have a fiduciary duty to creditors when their company is insolvent. But what is unclear is how decisions made in that “zone of insolvency” must be judged. The Delaware Chancery Court’s decision in Allied Riserfinally establishes the standard to review the actions and decisions of directors and officers when their companies are insolvent. In fact, the decision arises from the approval by Allied Riser’s board of a merger designed to save Allied Riser from going out of business. ALLIED RISER’S FINANCIAL TROUBLES Allied Riser is a provider of broadband data, video and voice communications that planned to install voice and data traffic infrastructure in office buildings throughout the United States and Canada. To cover the required up-front investment, Allied issued $124 million in 7.5 percent convertible subordinated notes pursuant to a June 28, 2000, indenture. Despite its good start, Allied suffered a $374 million net loss by September 2001 and was in fact insolvent on a balance-sheet basis at the time of the proposed merger. Faced with these and other difficult financial circumstances, Allied hired Houlihan Lokey Howard & Zukin, an investment banking firm, to review its business and strategic alternatives. Cogent Communications Group Inc. approached Allied on Aug. 4, 2001, about the possibility of a strategic relationship. The board, advised of the possible transaction, authorized management to negotiate, and directed Houlihan Lokey to assist in conducting the required due diligence. Thereafter, the board met several times to review the status of the merger agreement, as well as to consider other alternatives, such as bankruptcy or liquidation. It also formally retained Houlihan Lokey as financial advisor and requested its analysis of the combined Allied-Cogent entity’s ability to meet its obligations, as well as the value the merger would generate for all of Allied’s creditors and interest holders. Under the proposed deal, Allied would merge into a wholly owned Cogent subsidiary and be the surviving entity. Each share of Allied stock would be converted into the right to receive a fractional share of Cogent stock. The notes would stay in place, but Cogent would execute a supplemental indenture making itself an additional obligor on the notes. Its creditors would get a security interest in all of Allied’s assets, including its cash. The notes would in effect be subordinate in the combined entity. Houlihan Lokey presented the board with its findings on the value and fairness of the proposed merger. It advised the board that, in its opinion, the merger and the exchange of Allied shares were financially fair to Allied shareholders and creditors, on an aggregate basis. This opinion was later confirmed in writing to the board. After more discussion, the board unanimously approved the merger. After this approval, Cogent and Allied renegotiated several merger terms because of financial changes in the condition of the companies since the signing of the merger agreement. The Allied board considered these new developments, but without any further fairness opinion from Houlihan Lokey. After again considering the financial condition of each company, the status of Allied’s long-term liabilities and other available alternatives, the board nonetheless approved the merger as modified. As this history indicates, Allied’s board was closely involved in the development of the merger, repeatedly considered Allied’s alternatives and generally adhered to its duties to guide the company through these difficult times. THE COURT’S DECISION On Dec. 7, 2001, the noteholders sued Allied and its board, alleging, among other things, that the board breached its fiduciary duty to its creditors. The noteholders later amended their complaint, adding claims of breach of indenture and seeking a preliminary injunction to stop the merger. Addressing this request for an injunction, the court first analyzed whether the noteholders had a reasonable probability of success on the merits, considering head-on the claims arising out of Allied’s insolvency. The court aptly noted that, while it is commonplace to say that the Allied directors owe a fiduciary duty to the noteholders because of its balance-sheet insolvency, the standard to apply was less clear. This fiduciary relationship must be considered in connection with the authorization of the merger, but how are directors to make these decisions? Should a best-interest-of-the-creditors test apply, or will the usual business-judgment standard suffice? The noteholders argued against the business-judgment test, because the directors owned or represented 28 percent of Allied’s common stock but had no similar interest in the notes. Thus, they were interested in the merger and their actions were not entitled to the business-judgment rule presumptions. But the directors countered that their stock interest was significantly lower than 28 percent, and, given its traded value, insignificant. They further argued that they are entitled to the protection of the business-judgment rule because they acted in good faith, relying in part on a 1992 case, In re RegO Co., 623 A.2d 92 (Del. Ch. 1992), in which the business-judgment rule was applied in the context of a statutory dissolution. The court concluded that, even when the law recognizes that directors’ duties encompass the interests of creditors, there is still room to apply the business-judgment rule. Thus, to overcome the presumption of regularity attending the application of the business-judgment rule, noteholders — indeed any creditors — must carry an initial burden of showing circumstances supporting an inference that the directors did not act in good faith after a reasonable investigation. The court held that the noteholders had failed to meet this burden with respect to the directors’ financial interest in the transaction. The noteholders further argued that the directors’ interests as shareholders led them to approve the merger with a resulting entity whose business prospects were so risky as to support a conclusion that the directors were not acting in good faith. But based on the record before it, the court again concluded that the noteholders had failed to carry their burden of proof on this issue. The court acknowledged, but did not find dispositive, that Houlihan Lokey questioned the adequacy and completeness of Cogent’s Form S-4 disclosures, after it issued its fairness opinion. In fact, Houlihan Lokey cast some doubt on the fairness of the transaction because of those recent financial developments. Despite these doubts, the board decided not to retain Houlihan Lokey to update its opinion. That is, even despite certain financial changes after the opinion was issued, the board reviewed the business issues involved and the impact of the changes and decided that an update was not necessary. Thus, the court’s decision supports the board’s right to review the pertinent financial circumstances involved, and to make a business decision, without reliance on an independent “fairness” opinion. For every Allied Riser board that takes its duties seriously and acts to preserve company value, there are others that simply do not. As recent headlines show, officers and directors can improperly continue the life of a company and deepen its insolvency. Courts have increasingly recognized a corporation’s cause of action against its officers and directors for deepening insolvency. The core of this cause of action rests on the fact that officers and directors, either negligently or fraudulently, extended the life of a business, by calling creditors to extend credit or by eliminating possible recovery by other interest holders because of a failure to face facts. Typically, these causes of actions divide into distinct claims: a mismanagement claim against the officers and directors and a misrepresentation claim against both management and the auditors. DEEPENING-INSOLVENCY CLAIMS More recently, the 3rd U.S. Circuit Court of Appeals gave an enormous boost to deepening-insolvency causes of action in its decision in Official Committee of Unsecured Creditors v. R.F. Lafferty & Co. Inc., 267 F.3d 340 (3d Cir. 2001). The facts of Laffertyperhaps present the worst-case scenari The company was nothing more than a Ponzi scheme. During its fraudulent lifetime, it issued false debt certificates to raise funds. When the scheme ultimately collapsed, the company was forced to file for bankruptcy protection. The appointed creditors’ committee later brought claims on behalf of the two debtor corporations against management and several third parties who conspired with the debtors’ management to induce the company to issue the debt certificates fraudulently and thereby deepen its insolvency. The committee alleged that these third parties expanded the debtors’ debt out of “all proportion to its ability to repay and forced it into bankruptcy.” These actions, fraudulent expansion of corporate debt and prolongation of corporate life, caused injury to the debtors’ corporate property. The defendants moved to dismiss the action on several grounds, and the district court granted that motion. But the 3rd Circuit reversed. The appeals court reviewed the history of deepening-insolvency actions, noting that such causes of actions have a firm foundation in state law and simply make sense. By deepening their company’s insolvency, officers and directors may harm the remaining value of its assets. And, to the extent that a company must file for bankruptcy while burdened by excessive debt, they create operational limitations that hamper the company’s chances for reorganization. Many of these problems can be resolved, or significantly mitigated, if directors and officers timely dissolve a company, rather than keep it afloat with spurious debt. The 3rd Circuit’s decision offers strong support for deepening-insolvency suits against a company’s officers and directors, even though the court ultimately ruled that the creditors’ committee stood in the shoes of the corporation and was equally guilty of wrongdoing, effectively barring any recovery. But that has not limited Lafferty’s impact. Indeed, a U.S. bankruptcy court, citing Lafferty, recently upheld a complaint brought by a Chapter 7 trustee against a debtor’s financial advisor under a deepening-insolvency theory in In re Flagship Healthcare Inc., 269 B.R. 721 (Bankr. S.D. Fla. 2001). Given the inherent risk associated with emerging companies, insolvency and bankruptcy remain very real possibilities. As Laffertyand its growing progeny show, directors and officers can subject themselves to significant liability if they fail to assess their company’s chances and financial situation in a realistic and timely manner. Allied Riser’s support for the business-judgment rule offers directors and officers a means of navigating these troubled waters, but it also requires that they fulfill their duties to review pertinent information and make decisions in good faith. Luis Salazar is a shareholder in the Miami office of Greenberg Traurig, www.greenbergtraurig.comand a member of the firm’s national corporate reorganization, bankruptcy and restructuring department. He can be reached at [email protected].

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