Seventh Circuit Holds That Adverse Domination Doctrine Does Not Toll Statute of Limitations On Claims Against Debtor’s Principals When A Creditors’ Committee Is Appointed

When a corporation files a case under Chapter 7 of the United States Bankruptcy Code, a “bankruptcy estate,” consisting of all of the corporation’s assets as of the petition date, including causes of action against the corporation’s officer and directors, is created and a trustee is appointed to administer the estate.  The trustee’s powers include the power to sue on behalf of the estate.  The trustee has until the later of two years after the petition date or the date on which the statute of limitations provided by non-bankruptcy law would expire in which to sue.

When a corporation files a case under Chapter 11 of the Code, the same bankruptcy estate is created.  However, no trustee is appointed automatically.  The corporation, serving as “debtor-in-possession,” presumptively maintains dominion and control over the property of the estate and is given the same powers that a Chapter 7 trustee would have to administer it.  The bankruptcy court can appoint a trustee, but only upon a showing of “cause,” including “fraud, dishonesty, incompetence, or gross mismanagement…by current management.”

To provide for some oversight in the absence of a trustee, the Code provides for the appointment of a committee of creditors holding unsecured claims.  The committee’s powers include the power to investigate the debtor’s affairs and to consult with the debtor-in-possession concerning the contents of a Chapter 11 plan, but do not include the power to sue on behalf of the estate.  A committee may be given authority to sue on behalf of the estate by the bankruptcy court.  Most courts require a committee to show that it made demand on the debtor-in-possession to sue and that the debtor-in-possession unjustifiably refused to sue before the committee can be given authority to sue on behalf of the estate.

In its August 11, 2017 opinion in In re Emerald Casino, Inc., the United States Court of Appeals for the Seventh Circuit held that the interplay of these statutory provisions permitted the former officers, directors, and shareholders of a corporate debtor to escape liability to the estate for breach of fiduciary duties to the debtor corporation.  The debtor, Emerald, originally operated a casino in East DuBuque, Illinois.  When competition from casinos across the border in Iowa cut into Emerald’s business, Emerald requested permission from the Illinois Gaming Board (“IGB”) to relocate.  The IGB denied that request, but Emerald successfully lobbied the Illinois legislature for a change in the law to allow relocation.  The revised law was approved by the legislature on May 5, 1999 and signed into law by the Governor a month later.  After the law was changed, the IGB, interpreting the law as mandatory, gave permission to Emerald to relocate to Rosemont, Illinois.

In 1998, before the law was changed, Kevin Flynn and Joseph McQuaid, an officer of Emerald, had met with Rosemont’s Mayor and representatives of two Rosemont corporations to discuss the relocation of Emerald’s casino.  Flynn discussed issuing stock in Emerald to the Mayor and those corporations.  At about the same time that the legislature enacted the law that Emerald had lobbied for, Flynn, McQuaid, and John McMahon, another Emerald officer, met with a Rosemont architect to discuss plans for a new Rosemont casino.

After the Illinois legislature enacted the new law, but before the Governor signed it, Kevin Flynn’s father, Donald, increased his stock ownership in Emerald.  Donald then sold some of his new stock to outside investors, at least several of whom had connections to Rosemont’s Mayor and Rosemont’s state representative. Emerald also issued stock to Kevin Flynn, McQuaid, McMahon, and Kevin Larson.  McMahon, Larson, and McQuaid were given new job titles and were elected to Emerald’s board of directors.  Kevin Flynn, who previously held no position with Emerald, was elected Chairman of the Board and appointed Emerald’s Chief Executive Officer.

Five days after the Governor signed the new law, Emerald applied to Rosemont to be allowed to operate a casino there.  Rosemont granted the application the day it was received.  Within a month, Emerald had executed a site access agreement and a letter of intent to memorialize the terms of Emerald’s relocation to Rosemont.  Within four months after the Governor signed the new law, Emerald had hired a general contractor and had at least nine contracts with construction companies and architecture firms.  Emerald disclosed none of these contracts to the IGB even though regulations required it to “periodically disclose changes in or new agreements, whether oral or written, relating to … [c]onstruction contracts.”

The new law required Emerald to have at least 20 percent minority and female ownership (16 percent and 4 percent, respectively) within twelve months of relocating.  IGB regulations required Emerald to obtain IGB approval before issuing stock.  McQuaid sold stock in Emerald to 23 minority and female investors without obtaining IGB approval.

Later in 1999, Emerald’s casino license came up for renewal.  The IGB conducted a 15 month investigation, motivated at least in part by a belief that Emerald’s owners had ties to organized crime.  During the investigation, Flynn and McQuaid told the IGB falsely that Emerald had not considered relocating to Rosemont until after the law was changed in 1999.  Flynn, McQuaid, and Larson all told the IGB that Flynn had no role at Emerald before June 1999 even though he had met with Rosemont’s Mayor on its behalf in 1998, had lobbied for the new law, and had attended board of directors meetings before June of 1999.  The IGB discovered Emerald’s previously undisclosed construction contracts and sales of stock to minority investors.  Based on the results of its investigation, the IGB issued a notice in early 2001 of its intent to revoke Emerald’s license.

In an attempt to forestall the revocation of Emerald’s license, certain of its creditors filed an involuntary bankruptcy petition seeking to have Emerald placed into Chapter 7 bankruptcy.  Emerald responded by converting its case to a Chapter 11 case.  While in Chapter 11, Emerald appealed the revocation of its license.  However, after Emerald had exhausted all avenues for keeping its license without success, Emerald’s case was converted to a Chapter 7 case in 2007.

The trustee sued Kevin Flynn, McQuaid, McMahon, and Larson, asserting that their improper dealings with Rosemont and false statements to, and concealment of information from, the IGB breached fiduciary duties to Emerald and had caused Emerald to lose its license, valued at hundreds of thousands of dollars.  Flynn, McQuaid, McMahon, and Larson moved to dismiss the breach of fiduciary duty claims on the grounds that they were barred by the five year statute of limitations provided for by Illinois law.

The trustee responded that under the “adverse domination doctrine,” the statute of limitations did not begin to run until Emerald’s case was converted to a Chapter 7 case and Flynn, McQuaid, McMahon, and Larson ceased to control Emerald. That doctrine, as recognized in Illinois and other states, including Maryland, “tolls the statute of limitations for claims by a corporation against its officers and directors while the corporation is controlled by those wrongdoing officers or directors.”  The doctrine “creates a rebuttable presumption that knowledge of the injury will not be available to the corporation as long as the corporation is controlled by wrongdoing officers and directors.” A defendant can overcome that presumption by showing “that someone other than the wrongdoing directors had knowledge of the cause of action and both the ability and the motivation to bring suit.”

Flynn, McQuaid, McMahon, and Larson argued that the creditors’ committee appointed in Emerald’s Chapter 11 case had the ability and motivation to sue them so that the presumption was rebutted.  The trustee responded that the committee could not sue because it had not been given authority by the bankruptcy court to sue on behalf of the estate and might not have been given permission to sue had it asked.

The Seventh Circuit sided with Flynn, McQuaid, McMahon, and Larson.  It said that, “The Creditors’ Committee had the ability to sue, albeit circumscribed by several requirements. But those limitations didn’t render the Creditors’ Committee unable to sue.”  The Court said, “If the Creditors’ Committee had petitioned the bankruptcy court, and if the court had denied leave, only then could we say that the committee was unable to bring the claim.”

The Seventh Circuit’s decision is problematic for creditors’ committees.  As the trustee argued to the Seventh Circuit to no avail, until Emerald’s case was converted to a Chapter 7 case, the committee was siding with Emerald in its attempt to retain its license.  Filing a motion for authority to sue Emerald’s officers and directors on behalf of Emerald would certainly have strained the relationship between the committee and Emerald.  The Seventh Circuit’s decision leaves committees having to choose between burning bridges with Chapter 11 debtors promptly or risking the loss of valuable claims that the estate may have against the debtor’s principals.