Almost sixteen years ago, the Delaware Chancery Court’s decision in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. 1991), helped introduce the terms "vicinity of insolvency" and "zone of insolvency" into the legal and business lexicon. Since then, the Chancery Court issued a number of decisions on the question of whether creditors can sue directors of insolvent corporations, or those in the zone of insolvency, for breach of fiduciary duty. In the intervening years, however, the Delaware Supreme Court had never spoken on the issue.
The Chancery Court Limits Direct Creditor Claims. As reported in this earlier post, last September the Chancery Court issued a decision in North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 2006 WL 2588971 (Del. Ch. Sept. 1, 2006) (Chancery Court opinion available here), holding that creditors could not bring a direct action for breach of fiduciary duty against directors of a corporation in the zone of insolvency. This case gave the Delaware Supreme Court the opportunity to issue a definitive ruling on the subject.
The Delaware Supreme Court Affirms. On Friday, May 18, 2007, the Delaware Supreme Court finally ruled on this important question. The Court’s 24-page opinion in North American Catholic Educational Programming, Inc. v. Gheewalla, et al. affirmed the Chancery Court’s decision and made three key rulings:
- When the corporation is in the zone of insolvency, creditors may not bring a direct action against the directors for breach of fiduciary duty;
- When the corporation is in fact insolvent, creditors have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties; and
- Even when the corporation is insolvent, creditors have no right to assert direct claims for breach of fiduciary duty against the directors.
The Supreme Court’s Zone Of Insolvency Analysis. The Delaware Supreme Court first rejected the creditor’s argument that it should be permitted to bring a direct claim for breach of fiduciary duty against the directors when the corporation was in the zone of insolvency:
It is well established that the directors owe their fiduciary obligations to the corporation and its shareholders. While shareholders rely on directors acting as fiduciaries to protect their interests, creditors are afforded protection through contractual agreements, fraud and fraudulent conveyance law, implied covenants of good faith and fair dealing, bankruptcy law, general commercial law and other sources of creditor rights. Delaware courts have traditionally been reluctant to expand existing fiduciary duties. Accordingly, ‘the general rule is that directors do not owe creditors duties beyond the relevant contractual terms.’
The Supreme Court next commented that although it had never addressed the issue of whether creditors have the right to sue directors in the zone of insolvency, the subject had been discussed in several Chancery Court decisions and in many scholarly articles. Among the Chancery Court decisions cited were the Production Resources decision (see earlier post on that decision), which the Supreme Court quoted at length, and the Trenwick America decision (discussed here and here), currently on appeal to the Supreme Court.
Concluding that the creditor could not state a direct claim for breach of fiduciary duty, the Supreme Court held:
In this case, the need for providing directors with definitive guidance compels us to hold that no direct claim for breach of fiduciary duties may be asserted by the creditors of a solvent corporation that is operating in the zone of insolvency. When a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.
The Supreme Court’s Views When The Corporation Is Insolvent. The Delaware Supreme Court next tackled the issue of whether a direct claim for breach of fiduciary duty could be brought against directors when the corporation crossed from the zone of insolvency into actual insolvency:
It is well settled that directors owe fiduciary duties to the corporation. When a corporation is solvent, those duties may be enforced by its shareholders, who have standing to bring derivative actions on behalf of the corporation because they are the ultimate beneficiaries of the corporation’s growth and increased value. When a corporation is insolvent, however, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.
Consequently, the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties. The corporation’s insolvency “makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm’s value.” Therefore, equitable considerations give creditors standing to pursue derivative claims against the directors of an insolvent corporation. Individual creditors of an insolvent corporation have the same incentive to pursue valid derivative claims on its behalf that shareholders have when the corporation is solvent.
(Footnotes omitted; emphasis in original.) Later, the Court stated both its holding on this issue and the reasons for it:
Recognizing that directors of an insolvent corporation owe direct fiduciary duties to creditors, would create uncertainty for directors who have a fiduciary duty to exercise their business judgment in the best interest of the insolvent corporation. To recognize a new right for creditors to bring direct fiduciary claims against those directors would create a conflict between those directors’ duty to maximize the value of the insolvent corporation for the benefit of all those having an interest in it, and the newly recognized direct fiduciary duty to individual creditors. Directors of insolvent corporations must retain the freedom to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation. Accordingly, we hold that individual creditors of an insolvent corporation have no right to assert direct claims for breach of fiduciary duty against corporate directors. Creditors may nonetheless protect their interest by bringing derivative claims on behalf of the insolvent corporation or any other direct nonfiduciary claim, as discussed earlier in this opinion, that may be available for individual creditors.
(Footnotes omitted; emphasis in original.)
Fellow Bloggers Weigh In. Given the decision’s importance, several legal bloggers reported on it almost immediately. These include Scott Riddle at the Georgia Bankruptcy Law Blog, Francis Pileggi at the Delaware Corporate and Commercial Litigation Blog, and three law professors whose articles the Delaware Supreme Court cited in the opinion: Professor Stephen Bainbridge at ProfessorBainbridge.com, Professor Larry Ribstein at Ideoblog, and Professor Fred Tung at Conglomerate.
The Next Big Insolvency Case. The next major decision in the insolvency area should be the Delaware Supreme Court’s decision in the Trenwick America case. In the Chancery Court, Vice Chancellor Strine held that no cause of action for deepening insolvency exists under Delaware law. The appeal was argued before the Delaware Supreme Court on March 14, 2007, and a decision could be handed down in the next month or two. The North American Catholic decision, with its approving quotes from and citations to other recent Chancery Court decisions in this area, raises the question whether the Delaware Supreme Court will again affirm the Chancery Court, this time in the Trenwick America case. Although it’s hard to tell, we may not have to wait much longer to find out.