Disentangling From an Alter Ego in Bankruptcy Court

It is no secret that distressed companies can leverage the Bankruptcy Code to sell their assets free and clear of liens, claims, encumbrances, judgments or other obligations. After all, it is widely accepted that one of the purposes of bankruptcy law is to give a debtor a “fresh start.” 

The U.S. Bankruptcy Court for the Southern District of New York’s recent decision in Advanced Contracting Solutions, LLC illustrates how a debtor adjudicated to be an alter ego of another company prior to bankruptcy may use a bankruptcy filing, appointment of a chief restructuring officer (CRO), and section 363 sale to obtain a determination that it is no longer an alter ego.

Advanced Contracting Solutions (ACS) filed for bankruptcy shortly after a Sept. 20, 2017, decision by the U.S. District Court for the Southern District of New York that determined ACS was an alter ego of another entity, Navillus Tile, Inc. The court reached this conclusion by considering whether ACS and Navillus maintained similar or identical ownership, management, supervision, business purpose, customers, operations and equipment (i.e., the alter ego factors). 

The court determined that, on balance, these factors weighed in favor of finding ACS was an alter ego of Navillus and, in turn, deemed ACS a party to certain collective bargaining agreements (CBAs) to which Navillus was a signatory.

On Nov. 6, 2017 (the petition date), ACS filed for bankruptcy because it was unable to satisfy an approximately $73.4 million judgment associated with the district court’s decision that was entered in favor of certain unions and related benefits funds.

During its bankruptcy case, ACS filed a section 363 sale motion to sell its business free and clear of all liens, claims and encumbrances (including the judgment and successor liability claims). 

ACS also filed two related pleadings in the bankruptcy court. One sought a determination that ACS was no longer an alter ego of Navillus as of the petition date; the other sought a determination that, even if ACS was still an alter ego, it could reject Navillus’ CBAs pursuant to section 1113 of the Bankruptcy Code.

The Bankruptcy Court held that ACS had sufficiently “disentangled” itself from Navillus as of the petition date, and therefore ACS was no longer the alter ego of Navillus. Significantly, this allowed ACS to sell substantially all of its assets free and clear of successor liability claims related to the judgment and any possibility that ACS would be deemed an alter ego at any point prior to the sale closing, both of which were conditions to closing in the underlying asset purchase agreement.

Because the Bankruptcy Court determined that ACS was no longer an alter ego, it did not reach the issue of whether ACS could reject Navillus’ CBAs.

Only a few courts have previously considered whether an alter ego determination can be unwound, and those courts only discussed the issue at a very high level. Therefore, no specific test or burden for proving disentanglement had been established prior to the decision involving ACS. The Bankruptcy Court concluded that evaluating disentanglement claims required a “fresh application” of the alter ego factors.

Bankruptcy Creates Change of Circumstances

Bankruptcy Court observed that ACS’s business had changed since the District Court’s decision.

The owners/principals of Navillus who held options to purchase ACS during the time period relevant to the District Court’s decision no longer possessed such options.

ACS operated in a different office space from Navillus.

ACS no longer received financial assistance from Navillus or its principals.

ACS maintained its own insurance policies.

Critically, however, the Bankruptcy Court recognized that ACS’s bankruptcy filing fundamentally changed the nature of the business and its operations. In this regard, the Bankruptcy Court noted that the District Court’s alter ego ruling was primarily based on facts from 2013 and 2014—well before the petition date. Prior to the bankruptcy filing, ACS and Navillus were predominantly managed, owned and supervised by the same owner and key employees, but after the petition date ACS appointed a chief revenue officer (CRO) to make critical business decisions.

The CRO ran the section 363 sale process, reviewed the company’s books and records and managed its financial affairs. Moreover, the business decisions of chapter 11 debtors and their managers are also subject to oversight by the U.S. Trustee’s office, investigation by statutory committees, and numerous reporting and other transparency requirements. Therefore, while the Bankruptcy Court noted the unions were correct that ACS and Navillus still largely shared the same management, business purpose, equipment and customers after the petition date, these commonalities became “less significant under the facts and circumstances of [ACS’s bankruptcy] case.”

The Bankruptcy Court’s heavy reliance on the change of circumstances caused by the bankruptcy filing, the CRO’s related testimony, and how many of the alter ego factors still cut in favor of the unions’ and union funds’ position begs the question: Are a bankruptcy filing and appointment of a CRO sufficient to disentangle alter egos? If so, similarly situated entities obtaining an alter ego judgment against a company could face significant difficulty collecting such judgments.

It would be premature to draw sweeping conclusions from one case and one set of facts. That said, this budding issue is intriguing, and labor lawyers, bankruptcy attorneys and their respective clients should monitor how this legal landscape develops. Some clarity may arise on these issues in the near future, as the Bankruptcy Court’s decision is currently on appeal directly to the 2nd Circuit Court of Appeals.

Reposted from Construction Executive, June 2018, a publication of Associated Builders and Contractors. © Copyright 2018. All rights reserved.