Court Provides Long-Awaited Clarity on
Corporate Directors’ Duties to Creditors
Colleen E. McManus, Special Counsel in the firm’s Bankruptcy, Reorganization & Creditors’ Rights group, represents creditors, creditors’ committees, trustees and debtors-in-possession in Chapter 7 and Chapter 11 bankruptcy proceedings, as well as out-of-court restructurings and disputes. She has particular experience advising developers, lenders, landlords, franchisors and other creditors on bankruptcy and troubled company issues. Colleen can be reached at 312.521.2695 or cmcmanus@muchshelist.com.
By Colleen E. McManus
Businesspeople and lawyers have long debated what fiduciary duties and potential liabilities arise once a company begins to encounter financial difficulty. In a decision that should have far-reaching impact, the Delaware Supreme Court recently ruled that creditors of an insolvent company, or a company operating in the zone of insolvency, cannot bring a direct action for breach of fiduciary duties against the company’s directors.
Solvency versus Insolvency
The directors of a company are obligated to uphold certain fiduciary duties, meaning they are charged with acting in the best interests of the company and its shareholders. These fiduciary duties are typically categorized as the duty of care (which requires that a director be informed about all facts material to a decision before taking action) and the duty of loyalty (which requires that a director’s action be driven only by the best interests of the company and its shareholders).
While a company is solvent, its shareholders, as beneficiaries of its growth and value, may take legal action based on a director’s or officer’s breach of fiduciary duties by bringing a derivative lawsuit. In a derivative suit, the shareholders seek action not on their own behalf but on their company’s behalf; that is, the company, not any individual shareholder, stands to gain from a successful derivative suit.
A company becomes insolvent if its liabilities exceed the value of its assets or if it becomes unable to pay its debts as they come due. A company enters the zone of insolvency when there is a risk that creditors will not be paid (for instance, when the company suffers a liquidity crisis, even if it still technically qualifies as solvent). If a company becomes insolvent, it is the creditors who are principally injured by a director’s breach of fiduciary duty, which diminishes both the company’s value and its ability to pay debts. Accordingly, the creditors take the place of the shareholders as beneficiaries and may pursue a derivative suit—on the company’s behalf—for breach of fiduciary duties by a director. In May 2007, the Delaware Supreme Court heard a corporate matter of first impression, and its decision effectively closes the door to certain actions against corporate directors of insolvent companies.
The Delaware Case
In National American Catholic Educational Programming Foundation, Inc. v. Gheewalla, et al., the plaintiff (NACEPF) alleged that the defendants, who were directors of Clearwire Holdings, Inc., controlled Clearwire insofar as its only source of funding was Goldman Sachs & Co., which had appointed those directors to Clearwire’s board. NACEPF alleged in its complaint that the defendants (i) used their power to favor Goldman Sachs’ agenda in breach of their fiduciary duties; (ii) fraudulently induced it to enter into a contract with Clearwire; (iii) improperly interfered with NACEPF’s business opportunities; and (iv) breached their fiduciary duties to it as a creditor while Clearwire was insolvent or within the zone of insolvency.
When the defendants moved to dismiss the case, the Delaware Court of Chancery granted their motion, and NACEPF appealed. Subsequently, the Delaware Supreme Court affirmed the Chancery Court’s decision, holding that creditors of an insolvent company or a company operating in the zone of insolvency cannot bring a direct action for breach of fiduciary duties against the directors.
Before the decision against NACEPF, judicial decisions had left open the question of what fiduciary claims, if any, creditors could bring against directors of an insolvent company or a company operating in the zone of insolvency. In the NACEPF case, the court reasoned that if the directors of an insolvent company owed direct fiduciary duties to creditors, they would face uncertainty and conflict given the preexisting fiduciary duty to exercise their business judgment and maximize value for the benefit of the insolvent company. The court emphasized that corporate directors must have the freedom to engage in negotiations with particular creditors for the benefit of the company. In conclusion, the court explained that its decision does not preclude creditors from bringing derivative, but not direct, claims for breach of fiduciary duties against directors of insolvent companies.
Implications of the Decision
Many companies become incorporated in Delaware because of the state’s corporate-friendly laws. (For example, Delaware law features barriers to the derivative lawsuits discussed above.) Delaware courts frequently hear cases involving what the national legal community considers groundbreaking corporate issues. As a result, even where Delaware law is not legally binding in a particular situation, courts in other states look to Delaware for guidance. Although the NACEPF decision appears to be a narrow holding, it nonetheless represents a victory for corporate America.
Directors remain free to do business according to the best interests of their companies without more shackles from aggressive creditors. But the decision is not as litigation-averse as it seems. First, creditors and debtors will continue to debate what constitutes insolvency—not so much as a legal definition but as a determination based on facts germane to their particular situation. Second, creditors still have numerous litigation options, including fraudulent transfer actions, breach of contract actions and replevin, as well as the ability to force an involuntary bankruptcy. In short, alert, well-advised creditors can still gain ground against an insolvent company; they just have one less tool at their disposal.
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