Fiduciary Duties When the Corporation Is in the Zone of Insolvency

Fiduciary Duties When the Corporation Is in the Zone of Insolvency

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When a corporation is solvent, the fiduciary duties of the corporation's board of directors run to the corporation's stockholders and the board's decision-making process is protected by the application of the business judgment rule. When a corporation is insolvent, the fiduciary duties of the board run primarily (if not solely) to the corporation's creditors. Until recently, boards of insolvent or near-insolvent corporations proceeded with trepidation for fear that a court, with the benefit of 20/20 hindsight, would apply heightened scrutiny to their actions under the "entire fairness" standard rather than the "business judgment rule." In addition to the risk of a heightened standard of review, boards have been mindful of the threat of deepening insolvency litigation that has been brought with increasing frequency in recent years. These factors at times have constrained boards of corporations in the zone of insolvency from pursuing value-maximizing strategies for the corporation, which would benefit stockholders as well as creditors.

Two recent opinions from the Delaware Court of Chancery—Production Resources Group L.L.C. v. NCT Group Inc. and Trenwick America Litigation Trust v. Ernst & Young L.L.P.1—have shifted the above landscape.2 Now, directors of an insolvent or nearly insolvent Delaware corporation (and likely other states given the influence of the Delaware Court of Chancery) may embark on value-maximizing strategies for the corporation with comfort that courts will apply the business judgment rule to their actions taken in good faith without self-dealing and without resulting in corporate waste.

Fiduciary Duties Generally

It is well settled that directors and officers of a solvent corporation owe their fiduciary duties to the corporation and its stockholders. To ensure that directors are free to initiate value-maximizing strategies, even if such strategies are inherently risky, corporate law provides directors and officers with the shield of the business judgment rule. By employing the business judgment rule, courts presume that the board acted on an informed basis, in good faith and that their actions are in the best interests of the corporation. Accordingly, under the business judgment rule, directors and officers may not be held accountable for unsuccessful business decisions so long as the decisions are supported by a rational business purpose.3

In the case of insolvency, the fiduciary duties of officers and directors shift and run to the corporation and substantially (if not solely) to its creditors. This distinction is important, as creditors of a corporation may have an entirely different perspective and end-game than the stockholders of the corporation.4 For example, creditors typically want to ensure that the corporation has sufficient assets to repay their claims in full with interest, if applicable. Stockholders, on the other hand, will look for significant returns on their equity investment in the corporation even at the risk of aggressive growth strategies which, if unsuccessful, could result in a worsened financial condition for the corporation.

The Zone of Insolvency

When a corporation is in the zone of insolvency, the case law is unclear as to whether the fiduciary duties of directors and officers shift to creditors (as in the case of insolvency) or whether such duties continue to be owed to stockholders as well.5 In Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp.,6 the Delaware Court of Chancery expressed its views on fiduciary duties of directors of a corporation in the zone of insolvency. The Credit Lyonnais court recognized that directors of a corporation in the zone of insolvency are "not merely the agent of the residue risk bearers"—i.e., stockholders—but owe their fiduciary duties "to the corporate enterprise."7 To articulate this duty, the court stated that "directors will recognize that in managing the business affairs of a solvent corporation in the vicinity of insolvency, circumstances may arise when the right (both the efficient and fair) course to follow for the corporation may diverge from the choice that the stockholders (or the creditors, or the employees, or any single group interested in the corporation) would make if given the opportunity to act."8

A director's fiduciary duty when a corporation is in the zone of insolvency has been further complicated by the risk that action taken by the director, when viewed with 20/20 hindsight, will result in liability for "deepening insolvency" if the action did not have a positive outcome.9 For example, directors may be hesitant to incur new debt or delay the filing of a chapter 11 case to pursue strategies that would preserve value for existing stockholders to avoid liability under a deepening insolvency theory or for a breach of fiduciary duty to the corporation's creditors.

As a result of the Credit Lyonnais decision and the growing threat of deepening-insolvency litigation, some scholars and legal practitioners have applied a narrow reading of Credit Lyonnais and have expressed the view that the decision acts as a sword for creditors as opposed to a shield for directors. As such, directors of corporations in the zone of insolvency may have taken actions based on the assumption that a court, with the benefit of 20/20 hindsight, would apply a higher level of scrutiny to any actions taken by the board and ignore the protection afforded by the business judgment rule.

The Return of the Business Judgment Rule

In Production Resources, the Delaware Court of Chancery suggests that while directors and officers of corporations in the zone of insolvency owe a fiduciary duty to creditors, directors and officers may satisfy that duty by acting in a manner that benefits the corporate enterprise. In reaching its holding, the Court of Chancery articulated its reading of the Credit Lyonnais decision, stating that "Credit Lyonnais provided a shield to directors from stockholders who claimed that the directors had a duty to undertake extreme risk, so long as the corporation would not technically breach any legal obligations."10 This view is in sharp contrast to the view urged by some practitioners and scholars that upon insolvency or near-insolvency, directors and officers are required to take actions solely for the benefit of creditors.

Taking its reasoning a step further, the Court of Chancery stated that while a corporation's debt obligations are a material factor in a board's analysis of whether or not to pursue a particular transaction, "the business judgment rule remains important and provides directors with the ability to make a range of good-faith, prudent judgments about the risks they should undertake on behalf of troubled firms."11

In Trenwick, the court granted a motion to dismiss a deepening insolvency claim against former directors of an insolvent corporation, finding that Delaware law does not recognize deepening insolvency as an independent cause of action. In addition, the court determined that the defendant directors did not breach their fiduciary duties of care or loyalty to the corporation.

In rejecting deepening insolvency as an independent cause of action under Delaware law, the court in Trenwick reasoned that "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."12 2006 WL 2434228 at *3. This is the case even though the beneficiaries of the fiduciary duties owed by directors of an insolvent corporation are a corporation's creditors, rather than its stockholders.13 Directors of an insolvent corporation have this ability because "Delaware law imposes no absolute obligation on the board of a corporation that is unable to pay its bills to cease operations and to liquidate."14 Given the ability of directors of an insolvent corporation to pursue, in good faith, strategies for maximizing value of the insolvent corporation, "'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."15 Despite rejecting deepening insolvency as an independent cause of action, the Trenwick court emphasized that "insolvency...is an important contextual fact in the fiduciary duty metric," such that the fact of a corporation's insolvency "might weigh heavily" in a court's analysis of whether a board fulfilled its fiduciary duties in allowing an insolvent corporation to incur additional debt for the purpose of continuing operations.16

In reaching its conclusions, the court revisited Production Resources and Credit Lyonnais, and confirmed that the business judgment rule applies in the context of the zone of insolvency.

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... 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.17

Going further, the Court of Chancery stated that:

[i]f 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.18

Increasingly Complex Chapter 11 Cases

The timing of the Delaware Chancery Court's clarification of the fiduciary duties owed by directors and officers of corporations in the zone of insolvency is apt given the trend that large chapter 11 cases have become, and will increasingly become, more complex as the number of represented constituencies continues to increase. For example, it is no longer unusual for there to be, among others, first lienholders, second lienholders, an unsecured creditors' committee and an equity committee19 actively involved in a large chapter 11 case. To complicate matters, each constituency may very well have different end-games and views of how the restructuring should be completed. Absent the application of the business judgment rule and a clear focus by directors on maximizing the value of the corporate enterprise, the decision-making process of directors of troubled corporations would be significantly hampered.

Conclusion

Application of the business judgment rule will afford directors of troubled corporations the comfort to pursue value-maximizing strategies for the corporate enterprise as a whole, even if such a strategy includes the incurrence of additional debt obligations. However, in determining whether or not to pursue a particular strategy, directors must make their decisions in the context of the corporation's insolvency or near insolvency and with the recognition of the corporation's legal obligations. Given this context, a board of directors of a corporation in the zone of insolvency could employ strategies that may result in the short-term incurrence of additional debt in an attempt to preserve value for stockholders and unsecured creditors so long as there is a valid business justification and the strategy is mindful of the corporation's legal obligations.

To best protect directors, counsel should ensure that the decision-making process is well documented, and that any chosen course of action is prudent in the context of insolvency and the corporation's legal obligations, is in good faith, will maximize value for the corporate enterprise as opposed to any particular constituency and is not likely to result in the waste of corporate assets.

 

Footnotes

1 863 A.2d 772 (Del. Ch. 2004); 906 A.2d 168 (Del. Ch. 2006).

2 Note that the Delaware Supreme Court has not spoken to this level of clarity.

3 Cieri, Richard M. and Riela, Michael J., "Protecting Directors and Officers of Corporations that Are Insolvent or in the Zone or Vicinity of Insolvency; Important Considerations, Practical Solutions," 2 DePaul Bus. & Com. L.J. 295, 299.

4 See id. at 301.

5 See id. at 302.

6 1991 WL 277613 (Del. Ch. Dec. 30, 1991).

7 Id. at *34.

8 Id. at fn. 55.

9 See, e.g., Official Comm. of Unsec. Creditors v. R.F. Lafferty, 267 F.3d 340 (3d Cir. 2001) (finding liability for deepening insolvency under Pennsylvania law); OHC Liquidation Trust v. Credit Suisse First Boston (In re Oakwood Homes Corp.), 340 B.R. 510, 527-528 (Bankr. D. Del. Mar. 31, 2006) (finding that Delaware, New York and North Carolina would recognize a deepening insolvency cause of action); In re Exide Technologies Inc., 299 B.R. 732, 752 (Bankr. D. Del. 2003) (finding that Delaware would recognize a claim for deepening insolvency); but see Trenwick, 2006 WL 2434228 at*28-29 (holding that there is no separate cause of action for deepening insolvency under Delaware law); In re CitX Corp., 448 F.3d 672, 680 n. 11 (3d Cir. 2006) (rejecting the notion that a negligence claim can sustain a claim for deepening insolvency); In re Parmalat, 383 F. Supp. 2d 587, 602 (S.D.N.Y. 2005) (declining to recognize a separate tort for deepening insolvency under North Carolina law); Alberts v. Tuft (In re Greater Southeast Community Hosp. Corp.), 333 B.R. 506, 517 (Bankr. D. D.C. 2005) (declining to recognize the tort of deepening insolvency under the law of the District of Columbia); In re Global Service Group Inc., 316 B.R. 451, 459 (Bankr. S.D.N.Y. 2004) (rejecting the tort of deepening insolvency under New York law).

10 Production Resources, 863 A.2d at 788.

11 Id. at 788, n. 52.

12 906 A.2d at 174.

13 Id.

14 Id. at 204.

15 Id. at 174.

16 Id.

17 Id.

18 Id. at 205.

19 Recently, there has been a growing trend to appoint equity committees in large chapter 11 cases. See, e.g., In re Dana Corp., et al., 06-10354 (BRL) (Bankr. S.D.N.Y. Mar. 3, 2006); In re Calpine Corp., et al., 05-60200 (BRL) (Bankr. S.D.N.Y. Dec. 20, 2005); In re Delphi Corp., et al., 05-44481 (RDD) (Bankr. S.D.N.Y. Oct. 8, 2005); In re Mirant Corp., et al., 03-46591 (DML) (Bankr. N.D. Tex. Jul. 14, 2003).

Journal Date: 
Wednesday, November 1, 2006