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Subsidiary Can Exercise Actual Control Over Parent Sufficient to Create a Fiduciary Relationship Says Bankruptcy Court

Burtch v. Owlstone, Inc. (In re Advance Nanotech, Inc.), Adv. No. 13-51215 (MFW), 2014 WL 1320145 (Bankr. D. Del. Apr. 2, 2014)

On April 2, 2014, the Honorable Mary F. Walrath issued a Memorandum Opinion denying a motion to dismiss brought by a non-debtor subsidiary challenging breach of fiduciary duty claims asserted by a chapter 7 trustee on behalf of a bankrupt-parent.  In doing so, the Court made an interesting (and perhaps controversial) conclusion – it is possible for a subsidiary to exercise actual control over its parent sufficient to create a fiduciary obligation.

In 2004, Advance Nanotech, Inc. (“AVNA”) acquired a 60% ownership interest in Owlstone, Inc. (“Owlstone”) and became its principal funding source.  In 2007 and 2008, AVNA generated $7.42 million for Owlstone’s operations by issuing notes (“Senior Secured Notes”) secured by its equity in Owlstone.  In return for its investment, AVNA’s equity interest in Owlstone increased to 83.1%.  It also became the holder of $2.64 million of Owlstone’s debt.  Critically, following the transaction, AVNA fired its CEO and CFO, and hired Owlstone’s CEO and CFO (Bader and Finn, respectively).  Bader and Finn continued to serve as Owlstone’s CEO and CFO.

Shortly thereafter, both AVNA and Owlstone faced a liquidity crisis.  Bader and Finn, tasked with fundraising for AVNA, negotiated a $1.7 million bridge loan with Ingalls & Snyder, LLC (“I & S”), a holder of AVNA’s Senior Secured Notes.  Attempts at further fundraising through a sale of AVNA stock failed when AVNA could not obtain unanimous consent of the holders of the Senior Secured Notes, which was a prerequisite to any dilution of AVNA stock.  Failing to raise funds through a sale of AVNA stock, it is alleged that Bader, with the advice of an I & S principal, had Owlstone offer its own stock for sale, which did not necessitate noteholder consent.  While the sale raised funds for Owlstone, it severely diluted AVNA’s ownership interest in Owlstone.  Thereafter, Bader and Finn resigned from their CEO and CFO positions at AVNA, but remained on with Owlstone.  With no cash and diluted assets, AVNA defaulted on its Senior Secured Notes and, on March 15, 2011, was forced into an involuntary chapter 7 proceeding.  The instant complaint was commenced by the chapter 7 trustee (the “Trustee”) against Owlstone for, among other things, breach of fiduciary duties created by actual control.*  Owlstone moved to dismiss, arguing that the notion that a subsidiary can control its parent is contrary to settled law and common sense.

The Bankruptcy Court began its analysis by noting that, in Delaware, a fiduciary relationship does not exist between a debtor and a creditor unless control “is established by facts demonstrating that ‘through personal or other relationships the [individuals] are beholden to the controlling person.’”  Edgewater Growth Capital Partners LP v. H.I.G. Capital Inc., 68 A.3d 197, 229-30 (Del. Ch. 2013) (internal citation omitted).  Contrary to Owlstone’s argument that settled law dictates that a subsidiary cannot control its parent, the Court found that the cases cited by Owlstone in support “merely assumed that, as a general rule, subsidiaries are subject to the direction and control of their parent entities.”  Notably, the Court concluded that “[t]here is no legal principle that states a subsidiary can never exercise actual control over its parent.”  The Court further noted that if, during AVNA’s fundraising process, the CEO and CFO of AVNA (who also served in those roles for Owlstone) “switched sides” to act for Owlstone’s benefit, Owlstone may have acted to control AVNA’s fundraising process and by extension AVNA itself, thereby creating fiduciary obligations owed by Owlstone to AVNA.  Applying the facts to these legal conclusions, the Court ultimately permitted the Trustee’s claim for breach of fiduciary duty to survive because, drawing all inferences in favor of the Trustee, the complaint alleged sufficient facts to make the aforementioned scenario “plausible”.

This novel concept, that a subsidiary can exert actual control over its parent notwithstanding the parent’s super-majority ownership of the subsidiary’s outstanding stock, will likely be the focus of future litigation in the Delaware Bankruptcy Court and elsewhere, especially if chapter 7 trustees pursue this avenue of recovery against profitable non-debtor subsidiaries.  However, parties should be mindful of the procedural posture of the case, which on a motion to dismiss forced the Court to draw all reasonable inferences in favor of the non-moving party, as well as the unique circumstances under which the ruling was made.  We will continue to monitor the proceedings as they develop and look forward to the inevitable commentary to come regarding the Court’s conclusions.

*The Trustee also brought claims against Owlstone for aiding and abetting breaches of fiduciary duty and equitable subordination.  In addition, I & S as well as one of its principals faced claims for breaches of fiduciary duty and aiding and abetting breaches of fiduciary duty.  Ultimately, the Court refused to dismiss the claims against Owlstone, I & S, and the principal for aiding and abetting breaches of fiduciary duty.  Similarly, the Court denied dismissal of the equitable subordination claim asserted against Owlstone.  Despite the foregoing, the Court granted partial dismissal of the breach of fiduciary duty claims against I & S and the principal, holding that the Trustee’s allegations were insufficient to infer actual control over AVNA by these defendants and thus the creation of fiduciary duties.  Leave to amend the complaint, however, was granted.