The fundamental component to structured finance transactions is the bankruptcy remote structure. One of the keys to this structure is the independent director.¹ The independent director’s consent is necessary to file a voluntary bankruptcy proceeding. A recent decision out of the Southern District of New York demonstrates the volatility of the so-called bankruptcy remote structure vis-a-vis the independent director.

In In re Kingston Square Associates, 214 B.R. 713 (Bankr. S.D.N.Y., 1997), in order to circumvent the independent director’s veto right on filing a voluntary petition, the debtors’ principal paid a law firm to solicit creditors to file involuntary chapter 11 petitions. Despite the obvious orchestration of the involuntary filings on the eve of foreclosure, the court refused to dismiss the filings pursuant to §1112(b) and found there was no fraudulent or deceitful purpose in the coordination of efforts primarily because of the possibility of reorganization.

The Kingston Square case involved a traditional commercial mortgage-backed securitization involving some 38 entities that were controlled by one individual, Morton L. Ginsberg. All 38 entities were financed in restructurings in either 1991 or 1993 by Chase Manhattan Bank and wholly owned subsidiaries of Donaldson, Lufkin & Jenrette Securities Corp. (DLJ). Eleven of these entities were involved in the involuntary proceedings, and the remaining entities were in receivership. The debtors owned multi-family real property in Florida and metropolitan New York. Chase and the DLJ subsidiaries financed approximately $277.25 million in the restructurings. In each financing, a trust was created to issue certificates. These certificates were underwritten by DLJ, which then packaged the certificates to sell to investors. The investors’ repayment was secured by a pool of mortgages on various real properties. After the debtors took a turn for the worse, DLJ repurchased all of the certificates from the investors. The bylaws for each debtor corporation (or of the corporate general partner) included the traditional provision requiring the unanimous consent of the board of directors, including the independent director, to file a voluntary petition.

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..corporate formalities can be overlooked if there is a legitimate ability or reason to reorganize the debtor.

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The independent director for each board of directors was a former New York lawyer who practiced in the residential mortgage-backed securities area and worked for five years for investment companies, including three years with DLJ. After leaving DLJ, he became a consultant for DLJ for various transactions. He received an hourly consulting fee and an annual fee to serve as the independent director for various companies, including all of the debtors. His director’s fee was initially paid out of the operations of the properties. However, it appears that once the payments were in arrears, the fee was paid at least in part by the DLJ subsidiary.

In the face of pending foreclosure proceedings against all 38 companies, Ginsberg hired a law firm to solicit creditors to file involuntary petitions against the 11 debtors. The law firm circulated letters to various creditors of the debtors asking the recipients to join as petitioning creditors and made it clear that an undisclosed third party would cover the fees and expenses of the law firm. The undisclosed third party was an entity controlled by Ginsberg. Despite the broad solicitation, only one trade creditor and various professionals agreed to file the petitions.

The lenders sought to dismiss the cases pursuant to §1112(b), claiming that the orchestration of the involuntary proceedings with the view of circumventing the independent director’s veto power was collusive and prima facie bad faith. After a thorough analysis of the facts in the case, the court concluded that dismissal of the cases was not warranted. The court stated:

I do not dispute that orchestration is suggestive of bad faith, but standing alone as it does here, it is not sufficient grounds for dismissal. The movants have failed to demonstrate that the respondents’ coordination of efforts to file these cases constitutes a fraudulent or deceitful purpose... In fact...equity may exist in the properties as a group...

One overriding factor in favor of the debtors was the lack of "independence" of the independent director. The independent director was wholly uninvolved in the activities of the debtors despite their financial woes. In fact, it was not until the court strongly suggested it that the entire board met to consider the debtors’ financial condition. From his testimony, which was riddled with inconsistencies and inaccuracies, the independent director demonstrated that he failed to observe his fiduciary obligations and that he was nothing more than a pawn for DLJ. Obviously struck by his lack of credibility, the court stated, "If he is the ‘independent’ director, it was in name only." It was this factor that supported the debtors’ position that it would have been futile to follow corporate formalities to seek to file a voluntary petition.

This case may simply be viewed as a reaction to the not-so-independent independent director. At a minimum, it should prompt a second look by those involved in structured financings to ensure that the independent director is truly independent and that the director is, in fact, complying with his fiduciary obligations. However, the court’s holding can be read in a much broader context—that corporate formalities can be overlooked if there is a legitimate ability or reason to reorganize the debtor. Although rating agencies (the entities who drive the independent director requirements) do not appear to have reacted to this case by requiring any changes to the corporate bylaws, it would appear that the pitfall of the broader interpretation of this case may be avoided by either: (i) an agreement by all other creditors not to file an involuntary petition against the debtor; or, if this is not feasible, (ii) an agreement by the principal(s) of the debtor not to solicit creditors to file involuntary petitions.

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Footnotes

¹An "independent director" is a director who is not at the time of initial appointment and has not been at any time during the preceding five years: (a) a stockholder, director, officer, employee or partner of the borrower, general partner or affiliate of any of them; (b) a customer, supplier or other person who derives more than 10 percent of its purchases or revenues from its activities with the borrower, general partner or affiliate of any of them; (c) a person or other entity controlling or under common control with any such stockholder, partner, customer, supplier or other person; or (d) a member of the immediate family of any such stockholder, director, officer, employee, partner, customer, supplier or other person. The term "control" means the possession, directly or indirectly, of the power to direct or cause the direction of management policies or activities of a person or entity, whether through ownership of voting securities, by contract or otherwise. Return to Text