In re Ultimate Escapes Holdings: Delaware Bankruptcy Court Applies Business Judgment Rule to Protect Corporate Fiduciaries

Practical Law Legal Update 9-594-7705 (Approx. 7 pages)

In re Ultimate Escapes Holdings: Delaware Bankruptcy Court Applies Business Judgment Rule to Protect Corporate Fiduciaries

by Practical Law Bankruptcy & Restructuring and Practical Law Finance

Background

Ultimate Escapes Holdings, LLC (Ultimate Escapes) was a luxury destination club that provided its 1,250 members with access to high-end vacation residences. Ultimate Escapes Holdings, LLC and various affiliates (Debtors) struggled financially in the years following the financial crisis and downturn in the real estate market.

In early 2010, the Debtors sought to alleviate their financial difficulties by merging with one of their major competitors, Club Holdings. The Debtors and Club Holdings entered into a mutual confidentiality agreement and a letter of intent, which together bound the parties to keep the terms of the contemplated transaction confidential. In June 2010, Ultimate Escapes' board of directors (Board) adopted a resolution authorizing the company and Mr. Tousignant, as CEO, to finalize and execute documents for the merger with Club Holdings.

While the parties were negotiating the deal, Ultimate Escapes experienced a liquidity crisis. Mr. Tousignant and Mr. Keith, the Chairman of the Board (together, Defendants), issued personal advances to cover certain cash shortfalls as they attempted to keep the company alive long enough to close the merger with Club Holdings. In July 2010, Ultimate Escapes concluded that it did not have sufficient cash to meet upcoming payroll obligations due by August 6. Despite a number of attempts to raise enough cash to cover Ultimate Escapes' immediate cash needs, Mr. Tousignant's efforts fell $115,000 short.

Mr. Tousignant negotiated and executed the "August 6th Agreement" with Club Holdings. Under this agreement, Club Holdings was to provide $115,000 to Ultimate Escapes, in exchange for Ultimate Escapes using its best efforts to transfer three properties and 30 members to Club Holdings. The parties also agreed to waive the non-solicitation and non-compete provisions in their confidentiality agreement and letter of intent, presumably to facilitate the transfer of members. Mr. Tousignant did not submit the August 6th Agreement to the Board before executing it and closing the transaction.

In September 2010, the merger talks came to a halt. Club Holdings then engaged in a mass solicitation of all Ultimate Escapes members, claiming that it was entitled to do so under the terms of the August 6 Agreement.

On September 20, 2010, the Debtors filed for bankruptcy, partly in an effort to stop the solicitation of Ultimate Escapes' members. The Court granted the Debtors' motion to reject the August 6th Agreement, but denied their request for a temporary restraining order enjoining Club Holdings from soliciting Ultimate Escapes' members. Eventually, the Debtors sold most of their assets to third parties, including Ultimate Escapes' membership list. On December 8, 2011, the Court confirmed the Debtors' plan of reorganization, which created a Liquidating Trust and appointed a Trustee authorized to pursue the Debtors' litigation claims.

On September 19, 2012, the Trustee filed a Complaint arguing that the Defendants breached their fiduciary duties of care, loyalty and good faith. The Trustee claimed that the Court should apply either the entire fairness or enhanced scrutiny review and that the Defendants should not be protected by the business judgment rule, which the Trustee argued was rebutted by the fact that they:

Were grossly negligent in entering into the August 6th Agreement.
Were motivated by their own self-interests rather than the best interests of the Debtors.
Irrationally wasted corporate assets by entering into the August 6th Agreement.

Outcome

The Court rejected the Trustee's argument, holding that:

The August 6th Agreement was only intended for the transfer of member information for the limited purpose of converting about 30 of Ultimate Escapes' members to Club Holdings.
Mr. Tousignant's actions in negotiating and executing the August 6th Agreement are protected by the business judgment rule.
The Trustee has neither articulated nor proven any breach of Mr. Tousignant's duty of loyalty or duty of care.

The Court rejected all claims against Mr. Keith because there was no evidence that he approved or had actual knowledge of the August 6th Agreement. Rather, the record reflected that Mr. Tousignant negotiated and executed the August 6th Agreement without the approval of Mr. Keith or the full Board.

Business Judgment Rule

The Court concluded that the business judgment rule applied to the actions of Mr. Tousignant. The business judgment rule creates a presumption that the directors of a corporation acted "independently, with due care, in good faith, and in the honest belief that their actions were in the stockholders' best interests." When the business judgment rule applies, the court will uphold the board's decision unless it cannot be attributed to any rational purpose. In this case, the Court noted that the record did not contain facts to support a reasonable inference that the decision to enter into the August 6th Agreement was a breach of Mr. Tousignant's duty of loyalty or duty of care. In other words, the record did not support a reasonable inference that Mr. Tousignant was either interested in the transaction or failed to adequately inform himself before entering into the Agreement.

The Court then held that Mr. Tousigant's decision to enter into the August 6th Agreement was protected by the business judgment rule because it could be attributed to the rational business purpose of meeting payroll and avoiding bankruptcy.

Duty of Loyalty

The Court rejected the Trustee's argument that Mr. Tousignant breached his duty of loyalty by acting with self-interest when negotiating and executing the August 6th Agreement. The duty of loyalty requires that a corporate fiduciary act with "undivided and unselfish loyalty to the corporation" and that "there shall be no conflict between duty and self-interest."

The Trustee argued that Mr. Tousignant was interested in the August 6th Agreement because he:

Wanted to protect his equity in the company.
Had an economic interest in avoiding a default and possible bankruptcy.
Wanted to avoid criminal liability under the law associated with failing to timely pay employee wages.

The Trustee also alleged that the sale of the membership list was a waste of corporate assets.

First, the Court rejected the Trustee's argument that Mr. Tousignant was interested in the August 6th Agreement because he wanted to protect his equity in the company. Rather, the Court believed that Mr. Tousignant had "every incentive and every right" to seek to protect his equity in the company. Citing Chen v. Howard-Anderson, the Court reasoned that a director who is also a shareholder of his corporation is likely to share the interests of the corporation's shareholders because it is in his interest, as a shareholder, to negotiate a transaction that will maximize returns for all shareholders (see 87 A.3d 648 (Del. Ch.2014) and Legal Update, Chen v. Howard-Anderson: Chancery Court Describes Limits of Exculpation in Revlon Deals, Suggests Business Judgment if Vote Fully Informed).

Second, the Court rejected the Trustee's argument that Mr. Tousignant received a personal benefit from the transaction that was not equally shared by the shareholders when he entered into the August 6th Agreement. The Trustee argued that Mr. Tousignant would benefit if the company could avoid a default and bankruptcy because of:

His personal guarantees on certain real estate assets held by the Debtors.
The $50,000 personal advance he made on behalf of the company.
The $89 million personal indemnity guarantee that would be triggered by a bankruptcy filing.
The potential loss of his employment compensation.

The Court rejected these arguments, reasoning that Mr. Tousignant's decision to enter into the August 6th Agreement was "simply an act in furtherance of this transaction [the Club Holdings merger], seen at that moment as the best possible outcome for the company." It further noted that there was no evidence that Mr. Tousignant "intentionally acted with a purpose other than that of advancing the best interests of the corporation."

Third, the Court rejected the Trustee's argument that Mr. Tousignant suffered from a conflict of interest because he did not want to face criminal liability for missing payroll. Rather, the Court found that Mr. Tousignant's decision to enter into the August 6th Agreement and thereby make payroll upheld his corporate responsibility to affirmatively "protect the interests of the corporation committed to his charge, but also to refrain from doing anything that would work injury to the corporation."

Finally, the Court rejected the Trustee's argument that the sale of Ultimate Escapes' membership list under the August 6th Agreement constituted a waste of corporate assets. The Court reasoned that the August 6th Agreement provided only for a limited solicitation of members because it did not:

Constitute a sale of Ultimate Escapes' membership information or membership list, as it was ultimately able to sell certain properties and its membership list in bankruptcy for about $14 million.
Discuss the sale of an asset, either tangible or intangible; rather, it only modified the confidentiality restrictions in the parties' confidentiality agreement and letter of intent.

Given these considerations, the Court held that Mr. Tousignant did not act in bad faith or engage in corporate waste by allowing this limited solicitation, and that to hold otherwise "would require a finding that Tousignant transacted in an egregious or irrational manner or that the August 6th Agreement was 'so far beyond the bounds of reasonable business judgment that its only explanation is bad faith.'"

Duty of Care

The Court next rejected the Trustee's argument that Mr. Tousignant breached his duty of care by failing to:

Adequately inform himself of the provisions in the August 6th Agreement.
Failing to seek the advice or approval of the Board or outside advisors before entering into the August 6th Agreement.

Under Delaware law, the duty of care requires that directors of a corporation:

Use that amount of care that ordinarily careful and prudent men would use in similar circumstances.
Consider all material information reasonably available.

Also, under Delaware law, deliberately failing to inform oneself constitutes grossly negligent conduct and a breach of the duty of care. However, if a director or officer performed a reasonable investigation and acted in good faith, honest mistakes will not be penalized.

The Court rejected the Trustee's arguments on the following grounds:

Mr. Tousignant was vested with the authority to enter into the August 6th Agreement because the Debtors' Board "authorized and empowered" him in June 2010 "to take such action and to incur such expenses as is or may be reasonably necessary in connection with the consummation of the [Club Holdings merger] transaction." Therefore, Mr. Tousignant required no further Board approval to execute the August 6th Agreement.
Contrary to the Trustee's argument that Mr. Tousignant did not explore alternative financing options, Mr. Tousignant did pursue various options before ultimately entering into the August 6th Agreement. Therefore, he executed the August 6th Agreement with the honest belief that it was the only means to meet the company's cash needs.

Practical Implications

While fiduciary duty cases are often fact-dependent, this decision serves as a reminder that the business judgment rule continues to protect corporate fiduciaries when a business suddenly fails, if their actions are reasonably intended to benefit the corporation and all of its stakeholders. It also demonstrates that courts will not judge a corporate fiduciary's actions in hindsight or second-guess its decisions, if the corporate fiduciary acted rationally after diligently informing itself and placed the company's interests above its own.

For more information on fiduciary duties, see Practice Notes, Fiduciary Duties of Directors of Financially Troubled Corporations and Fiduciary Duties of the Board of Directors.

In re Ultimate Escapes Holdings: Delaware Bankruptcy Court Applies Business Judgment Rule to Protect Corporate Fiduciaries | Practical Law