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Not So Fast Delaware Court Reigns in Creditor Suits Against Ds & Os

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The legal community has witnessed an explosion of lawsuits brought by creditors or representatives of creditors against the officers or directors of failed businesses. These lawsuits, usually premised on a breach of fiduciary duty running from the officers and directors to the creditors of a business that has entered the zone of insolvency, have certainly not gone unnoticed in America's board rooms or by the carriers of directors and officers liability insurance. However, late last year Delaware's influential Court of Chancery made it clear that those lawsuits are often premised on a misreading of precedent from that court. It also interpreted Delaware statutes to prohibit those suits where the corporation's articles of incorporation include a waiver of the officer's and director's duty of care, even though that waiver was occasioned by no creditor participation. There are significant lessons to be learned from the decision, which is likely to severely limit creditor or creditor-representative lawsuits against corporate officers and directors of Delaware corporations.

The decision came on Nov. 17, 2004, in a case called Production Resources Group L.L.C. v. NCT Group Inc., et al., Del. Ch., C.A. No. 114-N (Nov. 17, 2004). In that case, Vice Chancellor Strine upholds the clear directive of 8 Del. C. §102(b)(7), which has the effect of exculpating a corporate director's or officer's duty of care to the corporation via a provision in a corporation's articles of incorporation. He then criticized a series of court decisions and law review articles that took a prior decision of the Delaware Court of Chancery and twisted it in such a way as to fuel the growth of litigation instituted by creditor representatives against corporate officers and directors on the basis that their management of an insolvent company, or one that has entered the so-called "zone of insolvency," was lacking in due care. When one considers the influence of the Delaware Court of Chancery resulting from the significant number of major corporations incorporated in that state, the case may represent a sea change in case law in this area.

Strine's criticism stems from what he perceives as a profound misreading of prior precedent from the Delaware Chancery Court and, most significantly, its landmark decision in Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp., 1991 Del. Ch. LEXIS 215, 1991 WL 277613 (Del. Ch. Dec. 30, 1991). He makes it clear that corporate creditors ordinarily have no cause of action against corporate officers and directors who in good faith honor whatever obligations they owe to the corporation's creditors. The exceptions to this rule, he enumerates, are instances of fraud by the officers or directors or where there are other grounds to disregard the corporate form, i.e., piercing the corporate veil. In Credit Lyonnais, the court held that the officers and directors of a Delaware corporation are protected by the business-judgment rule "if they, in good faith, pursued a less risky business strategy precisely because they feared that a more risky strategy might render the firm unable to meet its obligations to creditors and other constituencies." Let's take a look at Production Resources Group to see what all the fuss was about.

The Background

We start with a simple collection action, although it soon became anything but simple. The creditor, Production Resources Group, sold a computer system to a Delaware corporation operating its business in Connecticut. When payment for the computer system was not forthcoming, a state court lawsuit was brought in Connecticut and a judgment was recovered. However, through various measures and some sleight of hand, the debtor was able to avoid the creditor collecting on the judgment. With the Connecticut collection action still pending, the judgment creditor sued in the Delaware Court of Chancery to have a receiver appointed for what appeared to be an insolvent corporation. The suit also sought to hold the directors of the judgment debtor liable for various breaches of their fiduciary duties of care and loyalty owed directly to the creditor as well as for breaches of fiduciary duties owed to all creditors. The specific activities complained about included (1) issuing more shares than were authorized, (2) granting liens on corporate assets in favor of one of the directors and in exchange for consulting services of dubious value and (3) manipulating the inflow of funds to a corporate subsidiary so that those funds could not be reached by the judgment debtor. In essence, the creditor was complaining that the directors had used their positions to keep the corporation alive, albeit insolvent, without having to pay the judgment.

In defense, the directors plead that they were protected from suit for a breach of the duty of care because the corporate articles of incorporation included a waiver of the directors' duty of care and that provision was authorized by §102(b)(7) of the Delaware General Corporation Law. Furthermore, they argued that there is no duty of care owed by directors of a Delaware corporation to corporate creditors. Finally, they argued that the appointment of a receiver was a discretionary remedy and that the court's discretion should not be employed in this instance.

The Decision

Receivership. Looking first to the issue of the appointment of a receiver, the court found that the relevant Delaware statute, 8 Del. C. §291, authorizes the Court of Chancery to appoint a receiver if the corporation is insolvent. Appointment of a receiver is not mandatory for every insolvent corporation, and the judge cautioned that courts should not take lightly the decision to have a receiver replace the board of directors.

Direct or Derivative Claims. Next, the court tackled the issue of whether the creditor had a direct cause of action against the directors for breach of fiduciary duty. In general, the answer was no. In the court's view, fiduciary duties are owed by a corporation's directors to its stockholders and to the enterprise as a whole. A breach of these duties, which include the duties of care, candor and undivided loyalty, give rise to a derivative action, i.e., stockholders can sue a director on behalf of the corporation with any recovery going to the corporation. Directors do not have similar fiduciary duties to creditors to whom directors owe only a "contract duty," supplemented by the law of fraudulent conveyances and by federal bankruptcy law. There is a change to this paradigm when a corporation becomes insolvent, or is in the "zone of insolvency," in that creditors, which are entitled to be paid from corporate assets before payment to equity-holders, are also afforded the right to bring a breach of fiduciary duty claim against directors. However, that claim in the hands of creditors is still derivative so that any recovery goes to the corporation. In the context of a bankruptcy, the derivative claim would be "property of the estate" to be administered by the debtor-in-possession (DIP), trustee or other creditor representative. Creditors still benefit because they get paid ahead of stockholders, but the recovery will be shared pro rata.

Waiving the Duty of Care. As for the creditor's pursuit of its particular claims in this case, the court threw out all counts based on an alleged breach of the directors' duty of care. The court first found that the directors owed no duty of care directly to the creditor. Second, to the extent a duty of care was implicated, it was derivative in nature, and the corporation had adopted a provision in its articles of incorporation that waived any liability of its directors for breach of the duty of care. The fact that creditors were not party to the adoption of the waiver in the articles of incorporation was of no matter to the court. The rights being pursued by the creditor were derivative in nature, i.e., on behalf of the corporation that had seen fit to waive liability stemming from the duty of care.

What Remains for the Creditor to Pursue. The creditor was still in the game, as the court allowed several of the counts in the complaint to survive the motion to dismiss and proceed to trial. The court's willingness to allow these matters to proceed to trial was perhaps influenced by the rather egregious facts alleged. Two of the surviving counts were derivative in nature, i.e., the creditor could bring the action against the directors on behalf of the corporation. These included counts that the directors had breached the obligation of a director under Delaware law not to act in bad faith or to act in breach of the duty of loyalty (self-interest). These counts were supported by allegations that transfers of money made to insiders, i.e., relatives of the investor, were excessive compensation for consulting services. The court felt that these might be actionable as self-dealing by the investor and bad faith on the part of the other board members. Another two of the surviving counts were direct causes of action by the creditor and included allegations that the directors had breached an obligation under Delaware law not to breach a specific promise made to a creditor or to intentionally hinder a creditor's effort to obtain payment. In the court's view, directors of a Delaware corporation have a duty to be impartial, i.e., to treat creditors fairly and not to prefer one creditor over another without any legitimate basis for favoritism. These counts were supported by allegations that the directors had broken specific promises made directly to the creditor and, by their allowing funds to be infused into a subsidiary rather than the parent, had taken particular steps to disadvantage the creditor in its efforts to be paid.

The Future

Waivers of the Duty of Care. Assuming they are adopted in accordance with Delaware corporate law such that they effectively become part of a Delaware corporation's articles of incorporation, waivers of the duty of care owed by corporate officers and directors to the corporate enterprise are enforceable. They will effectively shield directors and officers from duty of care liability whether to stockholders or creditors. They are the most effective way to prevent an officer or director from liability based on the duty of care.

Direct vs. Derivative Causes of Action Against Corporate Officers and Directors. The zone of insolvency contains no special cause of action for creditors against corporate officers or directors. They simply do not owe the corporate creditors a fiduciary duty. Instead, entering the zone of insolvency merely enlarges the group afforded the ability (or standing) to pursue a derivative cause of action on behalf of the corporate enterprise. Where once stockholders alone held the right to pursue a derivative cause of action against corporate officers and directors for harming the corporate enterprise by their actions or failures to act, corporate creditors acquire that ability once the zone of insolvency has been reached.

In addition, creditors retain what they have always had, i.e., the ability to pursue directly corporate officers or directors who cause them direct harm by either committing a tort directed against the creditor or by providing the basis for an equitable remedy, such as piercing the corporate veil by not adhering to the formalities of corporate law. Otherwise, and in the absence of a guaranty or a violation of state law (including fraudulent transfer laws), corporate officers and directors are not liable to a corporation's creditors.

Credit Lyonnais. This case should not be cited for the proposition that corporate directors and officers owe a fiduciary duty to anyone other than to the corporate enterprise. In Strine's words, "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 company would not technically breach any legal obligations."

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Sunday, May 1, 2005

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