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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. 

Business Bankruptcy Issues The Financially Troubled Company

Reclamation: Can A Vendor “Get The Goods” From An Insolvent Customer?

Although vendors sell goods to get paid, it doesn’t always work out that way. If the customer is insolvent or files bankruptcy, the vendor may be stuck with an unpaid account. To make matters worse, some customers (especially those with limited prospects for financing) may even "load up" on inventory and then file bankruptcy without paying. Regardless of why it happens, no one wants to ship goods and not get paid.

Some vendors, however, may be able to take advantage of a special, although limited, right to get back or "reclaim" certain of the goods. This reclamation right is part of both the Uniform Commercial Code and the Bankruptcy Code. The recent 2005 amendments to the bankruptcy laws, known as the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (called "BAPCPA"), made some significant changes that have enhanced a vendor’s rights in a bankruptcy. This post discusses how reclamation rights play out both before and after bankruptcy.

Reclamation before bankruptcy. If the customer has not filed for bankruptcy, a vendor’s reclamation rights are governed by the Uniform Commercial Code (known as the "UCC"). UCC Section 2-702 is the UCC"s reclamation statute. It provides a seller with the right to reclaim goods that a customer received on credit "while insolvent" if the seller makes a demand within ten days after the customer received the goods. This 10-day period means that, absent a bankruptcy, a vendor’s reclamation right will be limited to reclaiming only those goods received by the customer in the ten days prior to the demand.

  • Under the UCC, "insolvent" means (A) having generally ceased to pay debts in the ordinary course of business other than as a result of good faith dispute; (B) being unable to pay debts as they become due; or (C) being insolvent within the meaning of federal bankruptcy law.
  • Under the federal Bankruptcy Code, insolvent means that the entity’s debts exceed the value of its assets at a fair valuation. This is essentially a balance sheet test but, importantly, one using market value and not financial reporting standards such as GAAP. Because they are prepared for a different purpose, GAAP balance sheets tend to overstate asset values and understate actual liabilities compared to the bankruptcy balance sheet test. Companies that might seem solvent under GAAP could be insolvent under the UCC or the Bankruptcy Code.
  • If the customer misrepresented its solvency in writing during the three months before the delivery of the goods in question, then the 10-day limitation does not apply.

The UCC reclamation demand. To exercise a reclamation right before bankruptcy, the vendor must make a demand. The demand should be in writing, directed to the customer, identify which goods are being reclaimed to the extent that information is available, include a general statement reclaiming all goods received by the customer from the vendor during the applicable time period, and demand that the goods be segregated. Vendors should consult with counsel to be sure the demand adequately protects their reclamation rights.

Reclamation after bankruptcy. Because of changes made in the 2005 amendments to the Bankruptcy Code, applicable to all bankruptcy cases filed on or after October 17, 2005, the filing of a bankruptcy now actually expands a vendor’s reclamation rights. These new provisions apply in both Chapter 11 reorganization cases and Chapter 7 liquidation cases. Some of the key changes include:

  • A new, 45-day bankruptcy reclamation right has been added to Section 546(c) of the Bankruptcy Code. Prior to this change, the Bankruptcy Code had merely incorporated the UCC’s 10-day period. Now, once a bankruptcy is filed, a vendor can assert a reclamation demand for goods received within 45 days of the bankruptcy filing.
  • The goods must have been sold in the "ordinary course" of the vendor’s business and the debtor must have received the goods while insolvent (using the Bankruptcy Code’s definition of insolvent discussed above).
  • The reclamation demand must be in writing and made within 45 days of the receipt of the goods by the customer (now the debtor in bankruptcy).
  • If the 45-day period expires after the bankruptcy case is filed, the vendor must make the reclamation demand within 20 days after the bankruptcy filing.
  • As with pre-bankruptcy demands under the UCC, the demand should identify the goods being reclaimed, include a general statement reclaiming all goods received by the debtor from the vendor during the 45-day period, and demand that the goods be segregated. Vendors may also want to file a notice of reclamation with the bankruptcy court.

Sold goods and other issues. Whether before or after a bankruptcy filing, a vendor will lose its right to reclaim any goods that the customer sells before or after receiving the vendor’s reclamation demand. 

  • Absent an agreement with the customer or a reclamation program approved by the bankruptcy court (see this example from the Delphi case, which was filed before the new BAPCPA rules took effect), a vendor may be forced to seek and obtain a court order preventing further sales of goods while its reclamation claim is pending. 
  • This "sold goods" problem has probably become more important because BAPCPA removed language from the prior version of Section 546(c) that had allowed a bankruptcy court to give a reclaiming vendor an administrative claim (with priority over unsecured claims and certain other claims) in lieu of a return of the goods.
  • Both the UCC and the Bankruptcy Code require that the debtor itself must have received the goods for them to be reclaimed. Thus, goods that are drop shipped or otherwise delivered first to the debtor’s own customer likely will not be able to be reclaimed.
  • If the debtor made a misrepresentation of its solvency and then filed bankruptcy, it’s unclear whether the 45-day rule in bankruptcy will govern or whether, like under the UCC, no time limit will apply. Keep in mind, however, that often goods shipped as far back as 45 days or longer, and sometimes even as few as 10 days for debtors with fast inventory turns, may already have been sold and thus will not be subject to reclamation. 

Rights of secured creditors. A vendor’s reclamation right is further limited by the possibility that the debtor may have granted a bank or other creditor a security interest in the goods, which will be senior to the reclamation right.  As amended in 2005, Section 546(c) now expressly makes reclamation rights subject to the prior rights of a secured creditor with a security interest in goods or their proceeds.

New administrative claim for 20-day goods. Even if a vendor fails to make a reclamation demand, all may not be lost. A new Bankruptcy Code section, Section 503(b)(9), added by BAPCPA, gives vendors an administrative priority claim for the value of any goods received by the debtor within 20 days prior to the bankruptcy filing if the goods were sold in the ordinary course of the debtor’s business. (I intend to discuss this new provision in a future post.) For now, note that it may be an important "fall back" right for vendors who fail to make a reclamation demand or who are unable to reclaim goods for other reasons.

Impact of new reclamation right on debtors and other creditors. With every new right also comes new burdens. Vendors certainly have greeted as good news the ability to reclaim goods received by a debtor as far back as 45 days. The impact of these changes on debtors, however, remains unclear. Some bankruptcy attorneys wonder whether this expanded reclamation right, together with the administrative claim for 20-day goods and certain other changes made by BAPCPA, will make it more difficult for debtors to reorganize or otherwise to pay unsecured creditors.

As always, get good legal advice. Reclamation can involve a number of twists and turns. Vendors who think they may have reclamation rights should be sure to get legal advice immediately upon learning of a customer’s insolvency or bankruptcy to protect their interests, just as debtors should to know their own rights in response to reclamation demands.