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Preparing for Bankruptcy Director Liability in the Zone of Insolvency

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When a corporation becomes insolvent and prepares for bankruptcy, its directors may experience legal and/or ethical quandaries. Specifically, certain directors may have knowledge of fraudulent transfers or other questionable actions. Such transfers and/or actions, however, are not necessarily outside the best interests of the corporation and its shareholders.

Regardless, such actions may implicate a director's fiduciary duties, as many courts have held that a director's fiduciary duties shift when the corporation is in the "zone of insolvency." Due to these new fiduciary duties, practitioners representing individual directors, particularly those directors that obtained their board position as part of a financial arrangement, need to be aware of such duties and the potential for liability.1

A Director's Fiduciary Duty to Creditors

Generally, a corporate director owes a fiduciary duty only to corporate shareholders. See In re Toy King Distributors Inc., 2000 Bankr. Lexis 1352 at 200 (Bankr. M.D. Fla. 2000). "When a corporation becomes insolvent, however, the officer or director's fiduciary duties shift to the creditors of the corporation." See Id. at 200 (citing Geyer v. Ingersoll Publications Co., 621 A.2d 784, 787-88 (Del. Ch. 1992) (upon insolvency, the fiduciary duties owed shift from shareholders to creditors)).2

"At a minimum, an officer or director of an insolvent corporation is precluded from preferring himself to the detriment of creditors in his dealings with the corporation." See Toy King, supra at 204. Otherwise, "an officer or director may be held 'strictly accountable and liable if corporate funds or property are wasted or mismanaged due to their inattention to the duties of their trust.'" Id. at 205-06.

Consequently, when in the "zone of insolvency," a director must be aware of these "shifting" duties. For financiers with a director on an insolvent corporation's board of directors, this new fiduciary duty may conflict with that individual's fiduciary duties to his actual employer, the financier. Considering this conflict, many practitioners would advise that individual director to resign. Recent case law reflects that such advice is not as learned as it appears.

Director's Right to Resign

A Delaware corporate director typically has the right to resign without incurring any liability or breaching any fiduciary duty. See Frantz Manufacturing Co. et al. v. EAC Industries, 1985 Del. LEXIS 598, at *22 (Del. 1985). Indeed, certain courts have held that a director's resignation does not, in and of itself, breach any duty of loyalty or fiduciary duty to the corporation or its shareholders. See In re Telesport Inc., 22 B.R. 527 (Bankr. E.D. Ark. 1982).


[W]hile a director usually extinguishes his or her fiduciary duties upon resignation, a director's fiduciary duties continue for events set in motion or known about before resignation.

As stated in Telesport, "[c]orporate officers '[are] entitled to resign...for a good reason, a bad reason or no reason at all, and are entitled to pursue their chosen field of endeavor in direct competition with [the corporation] so long as there is no breach of a confidential relationship with [it].'" Telesport, 22 B.R. at 532-33, fn. 8.

Duty Not to Resign

On the other hand, certain courts have held that a director's fiduciary duties include duties that prevent resignation, and extend after resignation for breaches that occurred or began before resignation. Thus, a director's ability to resign may be limited, and may not prevent liability after resignation.

Several courts have held that a director cannot resign if the director's resignation will cause immediate harm or allow harm to occur to the corporation or leave corporate assets unprotected. For example, in Gerdes v. Reynolds, 28 N.Y.S. 2d 622 (N.Y. S.Ct. 1941), the court describes the tension between the right to resign versus the duty to stay because, under certain circumstances, an individual may be required to continue as a director, despite the right to resign. Gerdes at 649-50. Consequently, "officers and directors...cannot terminate their agency or accept the resignation of others if the immediate consequence would be to leave the interests of the company without proper care and protection." Gerdes at 651.

This tension, though apparently contradictory in terms, rejects the defense dubbed as the "Geronimo theory." The defense would allow a director to freely resign at any time and absolve him or herself of liability knowing that a transaction dangerous to the corporation is about to occur. The Fifth Circuit has rejected this defense and held that a director cannot absolve him or herself of liability by resigning because it is the same as "if a commercial airline pilot were to negligently aim his airplane full of passengers at a mountain, bail out before impact, and not be liable because he was not at the controls when the crash occurred." Xerox Corp. v. Genmoora Corp. et al., 888 F.2d 345, 355 (fn. 60-1) (5th Cir. 1989) (citing Gerdes); see, also, DePinto v. Landoe et al., 411 F.2d 297 (9th Cir. 1969) (applying Arizona law, a director cannot resign and not oppose a wrongful act of a raid on corporate assets); COR Marketing & Sales Inc. v. Greyhawk Corp. et al., 994 F.Supp. 437, 442 (W.D.N.Y. 1998) ("directors cannot resign 'if the immediate consequence would be to leave the interests of the corporation without proper care and protection'"); Benson v. Braun et al., 155 N.Y.S.2d 622, 626 (N.Y. S.Ct. 1956) (directors are typically free to resign, but cannot resign knowing the successors intend to loot the company); Sebastian v. Zuromski, 1993 U.S. Dist. LEXIS 2008, *15-18 (N.D. Ill. 1993) (ordinarily a director may resign, but "[T]he wrong complained of here is the resignation itself. It is not inconceivable that fiduciary duties may obligate a person not to abandon a venture such as a partnership or close corporation."); FDIC v. Barton et al., 1998 U.S. Dist. LEXIS 5203, *19-*21 (E.D. La. 1998) (rejection of a rule that resignation terminates fiduciary duties, when a director fails to prevent a transaction dangerous to the corporation or to make an objection known).

Thus, if a director's resignation would cause or allow harm to the corporation or leave the interests of the corporation unprotected, the director is not free to resign. Resignation at such an inopportune time may therefore result in a breach of fiduciary duty. Regardless of timing, liability may accrue after resignation.

After all, directors are responsible for losses resulting from their own neglect of duty before resignation, and resignation does not absolve him or her for breach of a duty. See FDIC v. Wheat et al., 970 F.2d 124, 128 (5th Cir. 1992); District 65, UAW, et al. v. Harper & Row Publishers, et al., 576 F.Supp. 1468 (S.D.N.Y. 1983) (liable for breaches of duty if the breach was committed while a fiduciary); Sandage v. Planned Investment Corp., et al., 160 Ariz. 287, 772 P.2d 1140, 1144 (Ariz. Ct. App. 1988) ("...when a transaction has its inception while the fiduciary relationship is in existence, an employee, by resigning and not disclosing all he knows about the negotiations, cannot subsequently continue and consummate the transaction in a manner in violation of his fiduciary duty...").

Similarly, resignation does not free a director of all fiduciary obligations. See Quark Inc. v. Harley, 1998 U.S. App. LEXIS 3864, *23 (10th Cir. 1998) (a director has a duty to maintain corporate confidences acquired before resignation); T.A. Pelsue Co. v. Grand Enterprises Inc. et al., 782 F.Supp. 1476 (D. Colo. 1991) (former director breaches fiduciary duty if he or she engages in transactions that had inception before termination of relationship or were based on information obtained during that relationship); E.J. McKernan Co. et al. v. Gregory et al., 252 Ill. App. 3d 514, 623 N.E.2d 981 (Ill. App. Ct. 1993) (resignation of an officer will not sever liability for a transaction completed after termination that began during the relationship or based on information gained during the relationship); C&Y Corp. et al. v. General Biometrics Inc., 896 P.2d 47 (Utah Ct. App. 1995) (fiduciary duties only extend after resignation if the transaction had its inception while the fiduciary relationship existed); In re Toy King Distributors Inc., 2000 Bankr. LEXIS 1352, *198 (resignation does not necessarily sever fiduciary duties).

Thus, when advising a current director, it is wise to advise of the implication of resignation and the potential for liability occurring thereafter. These concepts are of particular concern for financiers that condition financing upon the receipt of a board position. The financier/director now has fiduciary duties to the insolvent corporation, possibly the financier, and the insolvent corporation's creditors. Resigning will not relieve liability and therefore could create liability. Such a director is wise to obtain legal counsel and review these implications and the corresponding options prior to resigning. Indeed, perhaps the better option is to abstain from action while advising other directors of the potential conflict.

Conclusion

Although a director may generally resign at any time for any reason, a director's right to resign must always be qualified by his or her fiduciary duties to shareholders, or creditors in the event of insolvency. Further, while a director usually extinguishes his or her fiduciary duties upon resignation, a director's fiduciary duties continue for events set in motion or known about before resignation.

The simple rule is that a director may resign at any time without incurring any liability as long as (1) no harm will be caused or allowed by the resignation and the corporate assets are protected, (2) there were no acts by the director in violation of fiduciary duties before resignation, and (3) there are no post-resignation acts that violate any ongoing fiduciary duties.


Footnotes

1 Practitioners should also be aware of the potential conflict of interest in representing both a corporation and its officers/directors. Return to article

2 Due to the large percentage of Delaware incorporations, as well as differing state laws, this article reflects Delaware state law and does not reflect the law of every state. Return to article

Journal Date: 
Sunday, April 1, 2001

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