Directors Duties in the Zone of Insolvency the Quandary of the Nonprofit Corp.
In today's climate of corporate scrutiny, directors of corporations teetering on financial insolvency may begin to inquire as to what fiduciary duties are required by members of the board when the board believes, or even suspects, that the corporation is in the "zone of insolvency." In addition, directors of nonprofit companies may ask if the duties change based on the corporation's nonprofit status and corporate mission. This article will discuss in general the zone of insolvency, its accompanying director fiduciary duties and the differences nonprofit corporations face when they enter the zone of insolvency.
The "zone of insolvency" is a concept created to account for a shifting and expanding of a board of directors' fiduciary duties when a company is entering a time of financial distress. Courts have held that fiduciary duties to creditors arise upon a corporation's "insolvency in fact," rather than when a party institutes formal bankruptcy proceedings. See Geyer v. Ingersoll Publications Co., 621 A.2d 784, 787 (Ch. Del. 1992). Therefore, by the time a corporation files bankruptcy it likely has been in, and passed through, the zone of insolvency and is now deemed insolvent. From a board's decision-making perspective, their fiduciary duties may have already expanded at the moment of insolvency in the time before the actual filing of bankruptcy. The first question all directors ask is what criteria are used to determine when a company has entered the "zone of insolvency" (also referred to as the "vicinity of insolvency" or "insolvency in fact").
When Are You in the Zone?
Courts have acknowledged three general financial "tests" to determine the zone of insolvency. If a debtor meets any of the three, it has entered the zone of insolvency. The first test is commonly referred to as the "balance-sheet test." Under the balance-sheet test, a corporation has entered the zone of insolvency at the point in time when the liabilities of the corporation exceed the corporation's assets. This is a straight-forward test that many courts have adopted. The second test is simply a "cash-flow test." Basically, when a corporation is unable to pay its debts as they become due, the corporation has entered the zone of insolvency. Finally, the third test is a transactional analysis. When the corporation enters a transaction that results in unreasonably small capital remaining in the corporation, and the corporation faces an unreasonable risk of insolvency, it has entered the zone of insolvency. See Pereira v. Cogan, 294 B.R. 449, 501 (S.D.N.Y 2003) (using the balance-sheet and cash-flow tests as proper tests in the determination of insolvency); In re Healthco Int'l. Inc., 208 B.R. 288, 300 (Bankr. D. Mass. 1997) (acknowledging that a transaction that leaves a corporation with "unreasonably small capital" creates an unreasonable risk of insolvency). Each test is a fact-intensive inquiry by the board. If a board, after examining a company's financial wherewithal or in analyzing the impact of a potential transaction, determines that the corporation falls within any of the three tests, the corporation has entered the zone of insolvency.
Once the board of directors has determined that the corporation is in the zone of insolvency, the second question the board will ask is what fiduciary duties are owed and to whom. In general, under corporate law, a board of directors of a solvent corporation only owes a fiduciary duty to its shareholders to maximize profit and shareholder worth. For example, the U.S. Bankruptcy Court for the Northern District of Illinois in In re Ben Franklin Retail Stores Inc. found that directors of solvent corporations owe fiduciary duties to shareholders because the shareholders actually own the corporation and management of the corporate assets is vested in the directors. 225 B.R. 646, 652 (Bankr. N.D. Ill. 1998). Also, in Geyer v. Ingersoll Publications Co., the Chancery Court of Delaware recognized the general rule that directors do not owe creditors duties beyond the relevant contractual terms absent special circumstances such as insolvency. 621 A.2d 784, 787 (Ch. Del. 1992). The rationale behind the duty to shareholders is that creditors enter into contracts with corporations upon which their claims are based. Therefore, by definition, a solvent corporation has the ability to satisfy its monetary contractual obligations, and its presumed creditors are protected by the terms of their contracts. Shareholders on the other hand, depend on the managerial skills of the board to achieve a return on their investment and therefore, the law imposes upon the board a fiduciary duty to the vulnerable shareholders.
However, when the corporation is determined to be in the zone of insolvency, creditors can no longer rely on their contracts to ensure payment of their claims. Therefore, when a corporation enters the zone of insolvency, it is well-established that the fiduciary duties of the board shift to include preserving the company's assets for the benefit of creditors. The Second Circuit Appellate Court in In re STN Enterprises recognized that although in most states directors of a solvent corporation do not owe a fiduciary duty to creditors, quite the reverse is true when a corporation becomes insolvent. 779 F.2d 901, 904 (2d. Cir 1985). The shift in duties of the board of directors is an effort to protect creditors when a corporation enters the zone of insolvency because the creditors replace the stockholders as residual claimants on a corporation's cash flow. The bankruptcy court in In re Ben Franklin further opined that the value of creditors' contract claims against an insolvent corporation may be affected by the business decisions of managers, while the claims of the shareholders are worthless. 225 B.R. at 653. As a result, it is the creditors who now occupy the position of residual owners of the corporation, therefore a shift of fiduciary duties by the board to include the creditors is required.
Another reason behind the shift in the boards' fiduciary duties is the potential for opportunistic behavior in times of insolvency. Such behavior may include selling property at fire-sale prices and unreasonable risk-taking by the board. In fact, courts have noted that "the possibility of insolvency can do curious things to incentives, exposing creditors to risks of opportunistic behavior" created by the "ever-present incentive to gamble with other people's money." See Credit Lyonnais Bank of Nederland N.V. v. Pathe Communications Corp., 1991 WL 277613, FN 55 (Del. Ch. 1991); see, also, In re Ben Franklin Retail Stores Inc., 225 B.R. 646, 652 (Bankr. N.D. Ill. 1998). The shifting of duties at the moment of insolvency is meant to further protect the creditors and ensure the protection of their assets.
This shift in duties, however, does not mean that a board of directors should not consider other constituencies in their decision-making process. In fact, directors are faced with the task of considering all constituencies, including creditors. The seminal case regarding the duties of a board of directors is Credit Lyonnais Bank, 1991 WL 277613. In Credit Lyonnais, the Chancery Court of Delaware opined that "where a corporation is operating in the vicinity of insolvency, a board of directors is not merely the agent of the residue risk-bearers, but owes its duty to the corporate enterprise." Id. at 34. In a famous footnote, the court went on to explain that directors have an obligation to consider the "community of interest that the corporation represents" when making decisions in the vicinity of insolvency. Id. at fn. 55.
Credit Lyonnais concerned a controlling 98 percent shareholder who attempted a leveraged buyout of MGM. Unfortunately, the transaction proved to be disastrous for the shareholder and the creditors. After the buyout, MGM was faced with a shortage of cash, resulting in MGM not being able to pay its debts as they came due. As a consequence, in only five months from the closing of the acquisition of MGM, several vendors forced MGM into bankruptcy. To exit bankruptcy, the principal shareholder entered into a contract ceding control to the lender that had financed the buyout in exchange for additional loans. After exiting bankruptcy, per the contract, once the debt was paid down to a certain amount the shareholder would regain control of MGM. Therefore, the shareholder had a vested interest in pursuing certain asset sales. As time progressed, the shareholder demanded that the directors, who were designed by the lender, sell certain assets needed to pay down the debt to return control to the shareholder. In addition, the shareholder took various actions in an attempt to exert control over the MGM operations in breach of his agreement with the lender. However, even with all the pressure exerted by the shareholder, the board of directors refused to approve the transactions forwarded by the shareholder, and the shareholder sued the directors for breach of fiduciary duty.
The chancery court held that there was not a breach by the board of directors of any duty to the shareholder because the directors "owed their supervening loyalty to MGM, the corporate entity." Id. at 34. The problem in Credit Lyonnais is that the board of directors could reasonably suspect that the shareholder might have wasted corporate assets in an attempt to regain control of the company at a time when creditors were at risk of non-payment of their claims. The chancery court held that "the MGM board...had an obligation to the community of interest that sustained the corporation, to exercise judgment in an informed, good-faith effort to maximize the corporation's long-term wealth-creating capacity." Id. Therefore, the chancery court's decision resulted in limiting director liability to shareholders by stating that the directors' duty was to serve the interests of all the constituencies, without preference to any. Hence, the concept of directors' shifting fiduciary duty was born.
[U]pon entering the zone of insolvency, a board of directors has a fiduciary duty to consider all constituencies of the nonprofit corporation, including the creditors and the beneficiaries of the charitable mission of the corporation.
In sum, a director's fiduciary duty while in the zone of insolvency requires the director to take creditor interests into account along with the interests of all constituencies of the corporation. See In re Adelphia Communications Corp.,
2003 WL 22316543, *32 (Bankr. S.D.N.Y. 2003) ("Lionel may well be read as holding that even though equity is junior to creditors, the views of equity cannot be ignored, but that principle cannot be stretched to also prohibit debtors from giving considerable weight to the views of creditors."); In re Global Crossing Ltd., 295 B.R. 726, 745 (Bankr. S.D.N.Y. 2003) (stating that the concerns of the debtors' creditor constituents should be considered, so long as it is not given "undue weight"). It becomes apparent to directors that this shift of duties creates a conflict between shareholder interests and creditor interests, which requires the board to thoroughly investigate and document its decisions.
It is clear that when in the zone of insolvency duties of directors of public or private corporations shift from profit maximization to protecting the assets of the estates for the benefit of creditors. However, it is not so clear who the directors owe a fiduciary duty to in the case of nonprofit corporations. The main difference between public or private corporations and nonprofit corporations is that the latter is not formed to create profit and therefore, directors do not owe a duty to shareholders. Instead, directors of a nonprofit corporation owe a duty to fulfill the corporate purpose of the organization. These corporations are established with specified purposes such as charitable, benevolent or religious purposes. A nonprofit corporation's federal tax-exempt status is dependent upon providing a community service. In exchange for the nonprofit status, the attorney general of the state of incorporation will monitor the corporation and ensure it is operating for the benefit of those whom it was formed and whose purpose it serves.
However, when the nonprofit corporation enters the zone of insolvency the directors may inquire whether a shift of fiduciary duty to the creditors is required or whether the duty remains to fulfill the mission as required by the nonprofit status of the organization. In addition, the directors may feel pressure from the state attorney general—who is charged with ensuring that the corporate purpose is fulfilled by the corporation, even if it may be at the expense of the creditors.
The shift of director fiduciary duties is still applicable to nonprofit organizations. The charitable mission and its beneficiaries are akin to the shareholders of a public corporation. Upon insolvency, the creditors of a nonprofit corporation assume the same risk as the creditors of a public corporation: nonpayment of their contractual obligations. The creditors, therefore, are the primary parties in both types of corporations and maintain an interest in the assets of the estates. As a result, upon entering the zone of insolvency, a board of directors has a fiduciary duty to consider all constituencies of the nonprofit corporation, including the creditors and the beneficiaries of the charitable mission of the corporation.