fiduciary duty

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Recent Developments The Financially Troubled Company

Fiduciary Duties And Financial Distress In The Time Of COVID-19

The COVID-19 pandemic has caused unprecedented economic disruption, creating sudden financial distress across industries. Companies are now facing impacts ranging from a dramatic decline in revenue of uncertain duration, to potential setbacks to M&A transactions, to delayed or canceled financing rounds.

With even some previously well-performing companies potentially entering the so-called zone of insolvency, it’s important to review the fiduciary duties owed by directors and officers and how discharging those duties may change in the face of financial distress.

A Refresher On Fiduciary Duties. Let’s start with a high-level overview of the fiduciary duties of directors and officers of a Delaware corporation. This primer is not a substitute for specific legal advice but may help provide context for discussions with counsel.

  • The Key Duties. Under Delaware law, directors and officers owe fiduciary duties of due care and loyalty.
    • The duty of due care requires directors and officers to make informed decisions in good faith and in the best interests of the company.
    • The duty of loyalty requires directors and officers not to engage in self-dealing and to put the interests of the company ahead of their own.
  • Solvency. Under Delaware law, when a company is solvent, the directors and officers owe their fiduciary duties of due care and loyalty to the corporation and to the stockholders.
    • This remains true even for a company in the zone of insolvency (more on that concept below).
    • Stockholders of a solvent company have standing to bring derivative claims for breach of fiduciary duty against directors and officers.
  • Insolvency. When a company is insolvent, meaning it’s not able to pay its creditors in full, the directors and officers still owe their fiduciary duties of due care and loyalty to the corporation.
  • Zone of Insolvency. The zone of insolvency is a term used to describe a company that is still solvent but is approaching insolvency.
    • For a number of years the courts suggested that if a company entered the zone of insolvency, fiduciary duties expanded to include creditors (as well as shareholders).
    • That’s no longer the case. The Delaware Supreme Court clarified that the key inflection point for fiduciary duties is actual insolvency, not the zone of insolvency. Upon actual insolvency, fiduciary duties are still owed to the corporation (rather than being expanded to include creditors) but creditors gain the right to bring derivative claims for breach of fiduciary duty.
    • However, it can be challenging to determine whether a company is still solvent or has already crossed into actual insolvency. The zone of insolvency concept therefore can serve as a useful “caution flag” for directors and officers assessing the issue.
  • Discharging Fiduciary Duties in Insolvency. With that refresher in mind, how should directors and officers best discharge fiduciary duties for a company that has become insolvent? This is a very fact-intensive analysis, and directors and officers should seek specific legal advice for their company’s particular situation, but here are some issues to consider.
    • Generally, the focus should be on maximizing enterprise value without taking undue risk, which will maximize recovery for creditors as the new residual rights holders.
    • Maximizing value may also benefit stockholders but care should be taken if pursuing an upside for stockholders puts creditor recoveries at greater risk.
    • Directors should assess all aspects of the company’s business, seek input from legal and financial advisers where helpful, hold Board meetings as often as needed, follow good corporate process, and continue to avoid conflicts of interest.
    • This will allow directors to enjoy the protection of the business judgment rule, which provides that courts will not second guess a director’s good faith business judgment made with due care.
    • Many companies may have to make immediate or longer-term reductions in expenses and cash burn in an attempt to extend the runway for a turnaround, financing, or sale transaction.
    • If the company has borrowed money from a bank or other secured lender, it’s also critical to assess the lender’s rights, potential remedies, and prospects for a restructuring.
    • Even in difficult situations, maximizing value may mean continuing operations — even though that burns cash — for a limited period to allow the company to complete a sale that the directors believe is likely to close and produce significant value for creditors.
    • In other cases, it may mean winding down (or even shutting down) operations quickly to conserve cash, especially if any asset sale is not expected to generate more than the cash required to pursue it.
    • Restructuring and wind-down alternatives, including Chapter 11 bankruptcy and assignments for the benefit of creditors, may need to be considered as well.

The Unique Impact of COVID-19. The COVID-19 pandemic and government orders precluding non-essential business operations have produced widespread financial impacts.

  • Companies that have been performing well previously, but are now experiencing financial distress primarily because of COVID-19, may need to assess factors that go beyond those of a traditional distressed company.
  • These could include, among others: financial contingency planning based on the possible duration of the pandemic and stay-at-home or similar orders; negotiations with lenders for short or near-term debt service extensions, additional liquidity, or a restructuring of loan facilities; and potential changes in customer preferences or supplier availability once the pandemic eases.
  • In addition, COVID-19 has prompted federal, state, and local governments to consider assistance programs for specific industries and potentially for businesses across the economy.
  • If these programs are enacted, companies will have to assess whether they are eligible for financial assistance, the conditions placed on receiving assistance, and how long it could take before relief would actually be received.

Conclusion. The COVID-19 pandemic has disrupted businesses across the economy and caused unexpected and immediate financial impacts. Directors and officers faced with managing through these issues will benefit from specific legal advice about their fiduciary duties and how best to discharge them in these newly uncertain times.

 

 

Photo by Drew Beamer on Unsplash

The Financially Troubled Company

The Venture-Backed Company Running Out Of Cash: Fiduciary Duties And Wind Down Options

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Many start-up companies backed by venture capital financing, especially those still in the development phase or which otherwise are not cash flow breakeven, at some point may face the prospect of running out of cash. Although many will timely close another round of financing, others may not. This post focuses on options available to companies when investors have decided not to fund and the company needs to consider a wind down.

Fiduciary Duties And Maximizing Value. Let’s start with a refresher on the fiduciary duties of directors and officers of a Delaware corporation in financial distress. Please note that this high-level overview is no substitute for actual legal advice on a company’s specific situation.

  • Under Delaware law, directors and officers owe fiduciary duties of due care and loyalty. The duty of due care requires directors and officers to make fully-informed, good faith decisions in the best interests of the company. The duty of loyalty imposes on directors and officers the obligation not to engage in self-dealing and instead to put the interests of the company ahead of their own.
  • When a company is solvent, the directors and officers owe their fiduciary duties of due care and loyalty to the corporation and its stockholders. That remains true even if the company is in the so-called “zone of insolvency.”
  • When a company is insolvent and will not be able to pay its creditors in full, the directors and officers still owe their fiduciary duties of due care and loyalty to the corporation. However, upon insolvency, the creditors have the right to bring derivative (but not direct) claims for breach of fiduciary duty against directors and officers.
  • Follow this link for more on the key Delaware decision discussing the fiduciary duties of directors and officers in the insolvency context.
  • Remember, it can be challenging to determine whether a company is just in the zone of insolvency (meaning still solvent but approaching insolvency) or whether it has crossed the line into actual insolvency.
  • Discharging fiduciary duties when a company is insolvent means a focus on maximizing enterprise value. This is a highly fact-dependent exercise with no one-size-fits-all approach. In some cases, maximizing value may mean continuing operations — even though that burns dwindling cash — to allow the company to complete a sale that the directors believe is likely to close and produce significant value for creditors. In other cases, it may mean winding down (or even shutting down) operations quickly to conserve cash, especially if any asset sale is not expected to generate more than the cash required to pursue it.
  • These complexities make it critical for directors and officers of a company in financial distress to get legal advice tailored to the specific facts and circumstances at hand.

Legal Options For A Wind Down. When the board decides that the company needs to wind down, options range from an informal approach all the way to a public bankruptcy filing. Note that if the company owes money to a bank or other secured creditor, the lender’s right to foreclose on the company’s assets could become a paramount consideration and affect how the wind down is accomplished. Although beyond the scope of this post to analyze each wind down option in detail, the following is a brief overview of different approaches, together with links giving more information.

  • Informal wind down: In an informal wind down, the company typically tries to find a buyer for its assets, eventually lays off its employees, and shuts down any unsold business operations, but does not complete a formal end to the corporate existence. This lack of finality can leave legal loose ends, so alternatives should be carefully considered.
  • Corporate dissolution: A corporate dissolution is a formal process under Delaware law, typically managed by a company officer, for winding up the affairs of the corporation, liquidating assets, and ending the company’s legal existence. A company may choose to do a corporate dissolution when it doesn’t need bankruptcy protection (and prefers not to file bankruptcy) but wants a formal, legal wind down of the corporate entity. Follow this link for more details on corporate dissolution.
  • Assignment for the benefit of creditors: Many states, notably including California and Delaware, recognize a formal process through which a company can hire a professional fiduciary and make a general assignment of the company’s assets and liabilities to that fiduciary, known as the Assignee. In California, no court filing is involved. The Assignee in turn is charged with liquidating the company’s assets for the benefit of creditors, who are notified of the ABC process and instructed to submit claims to the Assignee. If a buyer has been identified, an Assignee may be able to close an asset sale soon after the ABC is made. Follow this link for a an in-depth look at the ABC process.
  • Chapter 7 bankruptcy: A Chapter 7 bankruptcy is a public filing with the United States Bankruptcy Court. A bankruptcy trustee is appointed to take control of all of the company’s assets, including the company’s attorney-client privilege, and the directors and officers no longer have any decision-making authority over the company or its assets. A Chapter 7 trustee rarely operates the business and instead typically terminates any remaining employees and liquidates all assets of the company. The filing triggers the bankruptcy automatic stay, which prevents secured creditors from foreclosing on the company’s assets and creditors from pursuing or continuing lawsuits. The trustee has authority to bring litigation claims on behalf of the corporation, often to recover preferential transfers but sometimes asserting breach of fiduciary duty claims against directors or officers. Unlike a dissolution or an ABC, the bankruptcy trustee in charge of the liquidation process is not chosen by the company.
  • Chapter 11 bankruptcy: A Chapter 11 bankruptcy is also a public filing with the U.S. Bankruptcy Court, and it similarly triggers the bankruptcy automatic stay. Unlike a Chapter 7 bankruptcy, in Chapter 11 — often known as a reorganization bankruptcy — the board and management remain in control of the company’s assets (at least initially) as a “debtor in possession” or DIP. Business operations often continue and funding them and the higher cost of the Chapter 11 process require DIP financing and/or use of a lender’s cash collateral. One primary use of Chapter 11 by a venture-backed company is to sell assets “free and clear” of liens, claims and interests through a Bankruptcy Court-approved sale process under Section 363 of the Bankruptcy Code. Follow this link for a discussion of how a Section 363 bankruptcy sale in the right circumstances can maximize value for creditors and shareholders.

Conclusion. When a company’s cash is running out and investors have decided not to provide additional financing, the board may conclude that a wind down is required to fulfill fiduciary duties and maximize value. The discussion above is a general description of certain wind down options. Determining whether any of these paths is best for a particular company is fact-specific and dependent on many factors. Be sure to get advice from experienced corporate and insolvency counsel when considering wind down or other restructuring options.

Recent Developments The Financially Troubled Company

Delaware Supreme Court Affirms Ruling Protecting Managers Of Insolvent LLCs

Creditor Derivative Claims Against Fiduciaries Of Insolvent Corporate Entities. In a 2007 decision in North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 930 A.2d 92 (Del. 2007), the Delaware Supreme Court held that directors of an insolvent Delaware corporation could be sued derivatively by creditors for breaches of fiduciary duty. For a discussion of the case, you may find this earlier post of interest: "Delaware Supreme Court Addresses, For The First Time, Whether Creditors Can Sue Directors For Breach Of Fiduciary Duty When The Corporation Is Insolvent Or In The Zone Of Insolvency." 

What About LLCs? The Gheewalla decision clarified that creditors of a Delaware corporation that is insolvent (but not one only in the "zone of insolvency") can assert derivative claims against the corporation’s directors. That led many to wonder whether the same ruling would be extended to managers of Delaware limited liability companies ("LLCs"), the LLC equivalent of a corporation’s directors. 

The Chancery Court’s Decision. In November 2010, the Delaware Chancery Court answered the question, somewhat surprisingly, with a decisive "no." In CML V, LLC v. Bax, 6 A.3d 238 (Del.Ch. 2010), the Chancery Court held that creditors could not bring derivative actions for breach of fiduciary duty against managers of insolvent LLCs, chiefly because the relevant Delaware LLC Act provision limited standing to bring such suits only to LLC members and their assignees. For a discussion of the Chancery Court decision, follow the link to a November 2010 post on the blog entitled "New Ruling Finds Important Protection For Managers Of Insolvent Delaware LLCs."

The Delaware Supreme Court Decision. The decision was appealed to the Delaware Supreme Court. On September 2, 2011, the Delaware Supreme Court issued an opinion analyzing the Delaware LLC Act and affirming the Chancery Court’s decision. A copy of the Delaware Supreme Court’s opinion is available through this link.

  • The Delaware Supreme Court held that the literal terms of the Delaware LLC Act, specifically 6 Del. C. section 18-1002, limits standing to bring derivative claims only to LLC members and their assignees because the LLC Act provides that only they are "proper plaintiffs." The Delaware Supreme Court held that this statute was unambiguous and expressly limits standing only to LLC members and their assignees. The creditor plaintiff argued that it was "absurd" for the result to be different as between a corporation and LLC, but the Delaware Supreme Court held that the Delaware General Assembly "was well suited to make that policy choice and we must honor that choice." 
  • The plaintiff also claimed that by limiting standing, the statute violated the Delaware Constitution’s prohibition against curtailing the Chancery Court’s jurisdiction to less than the general equity jurisdiction of the High Court of Chancery of Great Britain as it existed in 1792, when Delaware ratified its first constitution. The Delaware Supreme Court rejected the argument holding that, among other reasons, Delaware limited liability companies, unlike corporations, came into existence only in 1992 and therefore did not exist in 1792. In addition, the LLC statute was properly able to both grant and limit derivative standing.

Creditor Options. Recognizing that this standing provision could limit creditor remedies in the event of insolvency, the Delaware Supreme Court discussed one remedial option available to creditors. In footnote 20 of the opinion, the Court stated:

Admittedly, this approach is not the only option the General Assembly had, and we make no normative comment on the General Assembly’s policy choice. Our only purpose here is to explain that limiting derivative standing to members and assignees in a contractual entity like an LLC is not absurd because other interest holders–like creditors–have other options–as, for example, negotiating automatic assignment of membership interests upon insolvency clauses into the credit agreement and requiring the members and governing board to amend the LLC agreement accordingly.

Key Observations. As the Delaware Supreme Court noted, certain creditors may require that the LLC agreement be amended to provide for automatic assignment of membership interests to the creditors upon insolvency. If so, those creditors would then have standing to bring derivative claims. However, absent such provisions, under the Delaware Supreme Court’s decision:

  • Managers of a Delaware LLC will not be subject to derivative claims by creditors if the entity becomes insolvent, although it is far less certain that the standing statute would preclude a bankruptcy trustee from bringing claims on behalf of the LLC itself;
  • An insolvent LLC’s creditors will not have derivative standing to bring potential D&O type claims; and
  • These creditors will be limited to contractual remedies against the LLC to protect themselves. 

Although Delaware LLCs and corporations share many common features, this new Delaware Supreme Court decision makes clear that the automatic derivative standing of creditors upon insolvency is one important distinction.

Recent Developments The Financially Troubled Company

New Ruling Finds Important Protection For Managers Of Insolvent Delaware LLCs

Derivative Claims Against Directors Of An Insolvent Delaware Corporation. With its 2007 decision in North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 930 A.2d 92 (Del. 2007), the Delaware Supreme Court held that directors of an insolvent Delaware corporation could be sued derivatively by creditors for breaches of fiduciary duty. To read that decision, click on the case name in the prior sentence. For a discussion of the case, you may find this earlier post of interest: "Delaware Supreme Court Addresses, For The First Time, Whether Creditors Can Sue Directors For Breach Of Fiduciary Duty When The Corporation Is Insolvent Or In The Zone Of Insolvency."

What About LLCs? The Gheewalla decision clarified that creditors of a Delaware corporation that is insolvent (but not one only in the "zone of insolvency") can assert derivative claims against the corporation’s directors, but a question remained: Would that same ruling extend to managers of Delaware limited liability companies, the LLC equivalent of a corporation’s directors. Although a number of commentators and some court decisions assumed that it would, a recent Delaware Chancery Court decision has answered the question, somewhat surprisingly, with a decisive "no."

New Chancery Court Ruling. In the new decision, CML V, LLC v. Bax, C.A. No. 5373-VCL (Del.Ch. Nov. 3, 2010), the Delaware Chancery Court undertook an extensive analysis of the Delaware LLC Act and also examined the issue more broadly.

  • The Court held that under the literal terms of the Delaware LLC Act, specifically 6 Del. C. section 18-1002, only LLC members and their assignees have standing to bring derivative claims because the LLC Act provides that only they are "proper plaintiffs." The LLC Act does not give an insolvent LLC’s creditors standing to bring derivative claims. The situation is different for creditors of insolvent corporations because the governing Delaware corporation statutes do not impose exclusive derivative standing provisions.
  • Although the Chancery Court acknowledged that arguments could be made for allowing creditors to bring derivative actions against managers of an insolvent LLC, the Court saw no reason to set aside the literal reading of the LLC Act’s standing provision. The Court also noted that the Delaware Limited Partnership Act has a similar exclusive standing provision.

For a full discussion of the decision, including a link to the opinion itself, be sure to read Francis G.X. Pileggi’s excellent post entitled "Chancery Bars Derivative Claim of Creditor Against Insolvent LLC, Based on LLC Act."  

Impact On An Insolvent LLC’s Creditors. So where does this new decision leave creditors of an insolvent Delaware LLC?

  • Under the Chancery Court decision, unlike directors of a Delaware corporation, managers of a Delaware LLC are not be subject to derivative claims by creditors if the entity becomes insolvent. 
  • If the decision is followed by other courts — specifically including bankruptcy courts where claims involving managers of bankrupt LLCs may more often be litigated — then an insolvent LLC’s creditors will not have access to potential D&O type claims. Instead, those creditors will have to rely on contractual remedies against the LLC to protect themselves. 

Stay Tuned. As noted, the bankruptcy court is often the forum where insolvency-related matters are litigated. Should these claims be pursued outside of the Chancery Court, it will be interesting to see how other courts interpret the Delaware LLC Act’s provisions. 

Recent Developments The Financially Troubled Company

California Court of Appeal Provides Guidance For Directors Of Financially Distressed California Corporations

As I have reported over the past several years, Delaware courts, including the Delaware Supreme Court, have addressed the nature of a director’s fiduciary duties when a Delaware corporation is insolvent or in the "zone of insolvency," most notably with the 2007 decision in North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 930 A.2d 92 (Del. 2007). To read that decision, click on the case name in the prior sentence. For a discussion of that case, you may find this earlier post of interest: "Delaware Supreme Court Addresses, For The First Time, Whether Creditors Can Sue Directors For Breach Of Fiduciary Duty When The Corporation Is Insolvent Or In The Zone Of Insolvency."

California courts, however, did not have occasion to consider fiduciary duty issues involving directors of financially distressed California corporations until recently. In a decision called Berg & Berg Enterprises, LLC v. Boyle, the California Court of Appeal for the Sixth Appellate District has provided directors of California corporations facing potential insolvency with meaningful guidance on the scope of their fiduciary duties, including the application of California’s "trust fund doctrine." 

It will be interesting to see whether other California courts, perhaps eventually including the California Supreme Court, will have opportunity in the months and years ahead to consider these important issues to directors and officers.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Delaware Supreme Court Issues Long-Awaited Decision In Deepening Insolvency Case

On August 14, 2007, the Delaware Supreme Court, sitting en Banc and following oral argument, issued its decision in the Trenwick America Litigation Trust v. Billet deepening insolvency case. Rather than write its own opinion, the Delaware Supreme Court released a two-page order affirming Vice Chancellor Strine’s August 10, 2006 Chancery Court decision "on the basis of and for the reasons assigned by" the Chancery Court in its opinion. A copy of the Chancery Court opinion is available here. 

The End Of Deepening Insolvency In Delaware. By adopting the basis and reasoning of the lower court’s opinion, the Delaware Supreme Court ratified Vice Chancellor Strine’s decision that there is no cause of action for deepening insolvency under Delaware law. Apparently concluding that no opinion of its own was necessary given the Chancery Court’s clear opinion below, the Delaware Supreme Court has put to rest the cause of action for deepening insolvency under Delaware law. Prior to the lower court’s decision in Trenwick, some bankruptcy and other federal courts had incorrectly predicted that Delaware would recognize this cause of action.

A Second Look At Vice Chancellor Strine’s Trenwick Opinion. Now that the Delaware Supreme Court has affirmed the Chancery Court’s decision and its reasons, the lower court’s opinion merits further consideration. As discussed in this August 2006 post on the Chancery Court’s decision, Vice Chancellor Strine held, in unequivocal terms, that there is no cause of action for deepening insolvency under Delaware law. To give context to the opinion’s legal analysis, some of its more important sections are quoted below at length:

Delaware law does not recognize this catchy term as a cause of action, because catchy though the term may be, it does not express a coherent concept. Even when a firm is insolvent, its directors may, in the appropriate exercise of their business judgment, take action that might, if it does not pan out, result in the firm being painted in a deeper hue of red. The fact that the residual claimants of the firm at that time are creditors does not mean that the directors cannot choose to continue the firm’s operations in the hope that they can expand the inadequate pie such that the firm’s creditors get a greater recovery. By doing so, the directors do not become a guarantor of success.  Put simply, under Delaware law, ‘deepening insolvency’ is no more of a cause of action when a firm is insolvent than a cause of action for ‘shallowing profitability’ would be when a firm is solvent. Existing equitable causes of action for breach of fiduciary duty, and existing legal causes of action for fraud, fraudulent conveyance, and breach of contract are the appropriate means by which to challenge the actions of boards of insolvent corporations.

Refusal to embrace deepening insolvency as a cause of action is required by settled principles of Delaware law. So, too, is a refusal to extend to creditors a solicitude not given to equityholders. Creditors are better placed than equityholders and other corporate constituencies (think employees) to protect themselves against the risk of firm failure.

The incantation of the word insolvency, or even more amorphously, the words zone of insolvency should not declare open season on corporate fiduciaries. Directors are expected to seek profit for stockholders, even at risk of failure.  With the prospect of profit often comes the potential for defeat.

The general rule embraced by Delaware is the sound one.  So long as directors are respectful of the corporation’s obligation to honor the legal rights of its creditors, they should be free to pursue in good faith profit for the corporation’s equityholders.  Even when the firm is insolvent, directors are free to pursue value maximizing strategies, while recognizing that the firm’s creditors have become its residual claimants and the advancement of their best interests has become the firm’s principal objective.

Delaware law imposes no absolute obligation on the board of a company that is unable to pay its bills to cease operations and to liquidate. Even when the company is insolvent, the board may pursue, in good faith, strategies to maximize the value of the firm. As a thoughtful federal decision recognizes, Chapter 11 of the Bankruptcy Code expresses a societal recognition that an insolvent corporation’s creditors (and society as a whole) may benefit if the corporation continues to conduct operations in the hope of turning things around.

If the board of an insolvent corporation, acting with due diligence and good faith, pursues a business strategy that it believes will increase the corporation’s value, but that also involves the incurrence of additional debt, it does not become a guarantor of that strategy’s success. That the strategy results in continued insolvency and an even more insolvent entity does not in itself give rise to a cause of action. Rather, in such a scenario the directors are protected by the business judgment rule. To conclude otherwise would fundamentally transform Delaware law.

The rejection of an independent cause of action for deepening insolvency does not absolve directors of insolvent corporations of responsibility.  Rather, it remits plaintiffs to the contents of their traditional toolkit, which contains, among other things, causes of action for breach of fiduciary duty and for fraud.  The contours of these causes of action have been carefully shaped by generations of experience, in order to balance the societal interests in protecting investors and creditors against exploitation by directors and in providing directors with sufficient insulation so that they can seek to create wealth through the good faith pursuit of business strategies that involve a risk of failure.  If a plaintiff cannot state a claim that the directors of an insolvent corporation acted disloyally or without due care in implementing a business strategy, it may not cure that deficiency simply by alleging that the corporation became more insolvent as a result of the failed strategy.

Moreover, the fact of insolvency does not render the concept of “deepening insolvency” a more logical one than the concept of “shallowing profitability.”  That is, the mere fact that a business in the red gets redder when a business decision goes wrong and a business in the black gets paler does not explain why the law should recognize an independent cause of action based on the decline in enterprise value in the crimson setting and not in the darker one.  If in either setting the directors remain responsible to exercise their business judgment considering the company’s business context, then the appropriate tool to examine the conduct of the directors is the traditional fiduciary duty ruler.  No doubt the fact of insolvency might weigh heavily in a court’s analysis of, for example, whether the board acted with fidelity and care in deciding to undertake more debt to continue the company’s operations, but that is the proper role of insolvency, to act as an important contextual fact in the fiduciary duty metric. In that context, our law already requires the directors of an insolvent corporation to consider, as fiduciaries, the interests of the corporation’s creditors who, by definition, are owed more than the corporation has the wallet to repay.

In so ruling, I reach a result consistent with a growing body of federal jurisprudence, which has recognized that those federal courts that became infatuated with the concept, did not look closely enough at the object of their ardor.  Among the earlier federal decisions embracing the notion – by way of a hopeful prediction of state law – that deepening insolvency should be recognized as a cause of action admittedly were three decisions from within the federal Circuit of which Delaware is a part.  None of those decisions explains the rationale for concluding that deepening insolvency should be recognized as a cause of action or how such recognition would be consistent with traditional concepts of fiduciary responsibility.

The Delaware Supreme Court’s adoption of the basis and reasoning of the Chancery Court’s strongly-worded opinion represents the end of the road for the deepening insolvency cause of action under Delaware law.

Hints In The Gheewalla Decision? Interestingly, in its brief order the Delaware Supreme Court dropped a footnote giving not only the citation for the Chancery Court’s decision, Trenwick America Litig, Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006), but also an intriguing comment: "Accord North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2007 WL 1453705 (Del. Supr. 2007)." This was a reference to its own decision of May 18, 2007 (opinion available here) holding that creditors cannot bring a direct cause of action for breach of fiduciary duty against directors of corporations that are insolvent or in the zone of insolvency.

  • As discussed in an earlier post on the Gheewalla decision, the Delaware Supreme Court opinion cited the lower court decision in Trenwick favorably, as well as the earlier Chancery Court decision in Production Resources (opinion available here), discussed in another earlier post. 
  • The "Accord" reference in its Trenwick order suggests that the Delaware Supreme Court believed that its May 2007 Gheewalla decision foreshadowed this week’s affirmance of the Chancery Court’s Trenwick decision and reasoning.

More Clarity For Directors. With the adoption of the Chancery Court’s opinion in Trenwick, and its own opinion in Gheewalla, the Delaware Supreme Court has effectively endorsed the trend in recent Chancery Court decisions to limit certain efforts to expand the liability of directors of insolvent or nearly insolvent corporations. Nearly sixteen years have passed since the Chancery Court’s decision in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. 1991), introduced us to the terms "vicinity of insolvency" and "zone of insolvency." Although the Delaware Supreme Court has left some questions open, these new decisions help provide meaningful guidance on how directors of financially troubled Delaware corporations should discharge their fiduciary duties.  

Recent Developments The Financially Troubled Company

Delaware Supreme Court Addresses, For The First Time, Whether Creditors Can Sue Directors For Breach Of Fiduciary Duty When The Corporation Is Insolvent Or In The Zone Of Insolvency

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.’

(Footnotes omitted.)

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.

(Footnotes omitted.)

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.