Several of us Credit Slips bloggers regularly teach or write about corporate bankruptcy, although we have not been writing about business issues much lately. I’m going to change that, at least for today. A recent case from the Delaware Court of Chancery raised the issue of exactly what a state court can do in the face of a litigant’s threat to file bankruptcy.

The case is Esopus Creek Value LP v. Hauf, No. 2487-N (Del. Ch. Nov. 29, 2006), and it involved some creative transactional planning. A company wanted to sell its major subsidiary, a deal that would require the approval of its shareholders. Although the company was doing well financially, it had previous financial problems and had not prepared audited financial statements. So what? Regulations of the U.S. Securities Exchange Commission bar companies from calling shareholder meetings and soliciting proxies if they have not been able to prepare audited financial statements and file SEC reports. That’s what. No shareholders’ meeting, no deal. The lawyers then hit upon what seemed like a great idea: put the company into bankruptcy and sell the subsidiary through the bankruptcy process. That is where the fun begins.

Because the bankruptcy filing looked liked it was designed solely to circumvent the state law requirement of a shareholder vote, the Delaware Court of Chancery entered an order prohibiting the company from making any agreement to sell its assets that was not conditioned upon approval of the shareholders. So what? This time, I don’t have a "that’s what."

OK, I get the practical effect of the court’s action–the company is not going to snub the Chancery Court and likely will seek some exemption from the SEC to go ahead with its shareholder meetings. But I don’t understand what legal effect the court’s order could have.

The state court is trying to interfere with the federal bankruptcy process, and this is why people who care about bankruptcy law should care about this case. The U.S. bankruptcy law does not require persons to be insolvent to file bankruptcy, but it does require the bankruptcy filing to be in good faith. The Chancery Court recognized that it could not, as a state court, tell a federal bankruptcy court how to rule on good faith. The Chancery Court also recognized that a federal bankruptcy court would ignore a state court order barring the company from filing bankruptcy altogether. Instead, the state court crafted its order to require a shareholder vote before the company sold its assets, a concern that lies at the heart of state corporate law.

Why isn’t the state court order like any other state-law right? Delaware state law already was clear in requiring a shareholder vote before a company sold its assets. What does the state court order add? Sure, a federal bankruptcy proceeding may interfere with or alter a state law right in which the state has an important interest, but that is what federal bankruptcy proceedings do. The state also has an important interest in seeing its state collection laws are enforced, but a federal bankruptcy court would not, for example, enforce a state court order that prohibited assets from being transferred other than to satisfy a certain judicial lien.

Lying at the heart of this case, however, is something else. In this case, a solvent company planned to file bankruptcy for the sole reason of evading state law. Surely a bankruptcy court should dismiss  such a bankruptcy filing for a lack of good faith. In the parlance of bankruptcy experts, this is known as a "no brainer," but we also all know dismissal might not happen if a bankruptcy filing were to occur. I suspect that divergence of law in the books versus law on the ground drives the Chancery Court opinion. The bankruptcy courts do not police the corporate bankruptcy petitions (or actions once the case is filed) with the same vigor they once did. Jurisdictional competition appears to be the motivating force. The irony here is that the Delaware bankruptcy court has been accused of being at the center of this competition. This is a controversial topic, and the comments are open.