Over the past few years, an evolving body of case law has broadened the potential liabilities of directors of corporations operating in the "zone of insolvency." The apparent expansion of the potential pool of plaintiffs and modification of normal corporate law principles protecting the decision-making process have caused significant concern for directors.¹ This evolving body of law has created additional risks for directors and the professionals that advise those directors. Recently, however, the Second Circuit Court of Appeals in Pereira v. Farace² held that the trustee in bankruptcy, when asserting a claim for breach of fiduciary duty against the debtor's directors on behalf of the corporation's creditors, is in no better position than the corporation itself and, as a result, the corporation's exculpatory clause in its charter precluded the trustee from bringing any due care claim seeking monetary awards against the directors. This clarification to the standing and basis for trustee claims in this context provides additional guidance to directors (and the professionals that advise them) in discharging their duties while in the zone of insolvency (and thus subject to the expanded duties to creditors).³

Delaware Law on the Duties of Directors While in the Zone of Insolvency

Many practitioners and commentators would point to the decision of Chancellor Allen in Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp.⁴ as articulating the modern approach to directors' duties when a corporation is insolvent or in the "zone of insolvency." Credit Lyonnais supports the proposition that directors will be protected by the business-judgment rule if they, in good faith, pursued a less-risky business strategy that was more consistent with the interests of creditors rather than the interests of shareholders. Some courts have applied Credit Lyonnais to find that Credit Lyonnais actually created additional fiduciary duties once a company entered the "zone of insolvency."⁵ The ongoing debate among the courts and the commentators relative to the precise contours of the expanded or broadened fiduciary duties in favor of creditors has created additional risk and uncertainty for boards of directors.⁶

Recent Decisions Clarifying Credit Lyonnais

In November 2004, the Delaware Court of Chancery clarified the breadth of officer and director duties in the "zone of insolvency" under Credit Lyonnais.⁷ Specifically, Vice Chancellor Strine's opinion upheld the directive of Del. Code Ann. Title 8 §102(b)(7), the Delaware state law that authorizes corporations to adopt a charter provision that shields a director from the payment of monetary awards based on breaches of the duty of care.⁸ The court made it clear that contrary to expansive readings of Credit Lyonnais, there is no "new body of creditor's rights law."⁹

The Second Circuit's Application of the Exculpation Provision to Trustee Claims

On June 30, 2005, the Second Circuit, applying Delaware law, decided Pereira v. Farace, essentially adopting the Delaware Court of Chancery's analysis in Production Resources with respect to, among other things, the validity of corporate exculpation clauses.¹⁰

In July 2000, John Pereira (the trustee) filed an amended complaint suing certain directors (the defendants) of Trace International Holdings Inc. for, inter alia, breach of fiduciary duty arising from their roles in Trace's financial failure.¹¹ In an opinion dated May 8, 2003, the U.S. District Court for the Southern District of New York held that the defendants breached their fiduciary duties by allowing certain transactions to take place that in turn financially drained Trace.¹² Among other rulings, the district court held that the exculpatory clause in Trace's Articles of Incorporation, which shields officers and directors from liability to Trace for the breach of the duty of care, was inapplicable because the trustee had brought the action for the benefit of the creditors, not Trace (which the district court found was indisputably bound by the exculpation clause in the Articles of Incorporation).¹³ In so holding, the district court rejected the defendants' argument that the "[e]xculpatory [c]lause is inapplicable only to claims by individual creditors, which the trustee lacks standing to assert."¹⁴

Judgment was granted against the defendants, who were found jointly and severally liable.¹⁵ The defendants appealed the district court's decision to the Second Circuit arguing, among other things, that the district court erred in finding that the defendants breached their fiduciary duties to Trace.¹⁶

Validity of Charter Exculpatory Clause under Delaware Law

On appeal, the defendants argued that the trustee, as a legal successor to Trace, lacked standing to bring duty-of-care claims against the defendants because the trustee is bound by Trace's Certificate of Incorporation and Del. Code Ann. Tit. 8, §102(b)(7), both of which shield the defendants from money damages that may be awarded in connection with a violation of the defendants' duty of care.¹⁷

Section 102(b)(7) of Delaware's General Corporation Law authorizes corporations to adopt a charter provision shielding directors from the payment of monetary awards based on breaches of the duty of care.¹⁸ The statute was adopted as a response to the 1985 decision of the Delaware Supreme Court in Smith v. Van Gorkom,¹⁹ upholding director liability for breaching the duty of due care and the ensuing insurance liability crisis.²⁰ The purpose of this statute was to permit stockholders to adopt a provision in the certificate of incorporation to free directors of personal liability in damages for due care violations, but not duty of loyalty violations, bad-faith claims and certain other conduct.²¹ Where a corporation adopts such a provision, money claims for gross negligence are "unavailing."²²

Trace adopted this type of exculpatory clause. As noted by the Second Circuit, "[t]his clause makes it abundantly clear that directors are shielded from liability for breaches of the duty of care, but not for (1) improper dividends and redemptions, see [Del. Code Ann. Tit. 8,] §174, or (2) breaches of the duties of good faith or loyalty."²³

Trustee Standing and the Application of the Exculpatory Clause

The trustee argued that despite the existence of the exculpatory clause, the trustee could bring a claim for breach of the duty of care on behalf of the creditors, rather than the corporation.²⁴ The district court held that because the creditors of Trace were allegedly injured by the defendants as a class, it was the trustee, not the creditors, who had standing to bring a claim based on the generalized injury.²⁵

While not disputing the aforementioned district court finding, the Second Circuit disagreed with the district court's conclusion, stating that "because claims that injure all creditors as a class normally belong to the corporation (see Production Resources Group LLC v. NCT Group Inc., 863 A.2d 772, 792-93 (Del. Ch. 2004)), it does not imply that the trustee's rights are greater than the rights the corporation would have against malfeasant directors."²⁶ The Supreme Court has ruled that a bankruptcy "trustee succeeds only to such rights as the bankrupt possessed; and the trustee is subject to all claims and defenses which might have been asserted against the bankrupt but for the filing of the petition."²⁷ Thus, the Second Circuit held, "a bankruptcy trustee has no standing generally to sue third parties on behalf of the estate's creditors, but may only assert claims held by the bankrupt corporation itself."²⁸ In short, the Second Circuit found that the fiduciary duties officers and directors owe to creditors, when the corporation is in fact insolvent, do not expand the rights of the trustee "who may only assert claims of the bankrupt corporation, not its creditors."²⁹

In sum, the Second Circuit found that the trustee stands in the legal shoes of a bankrupt estate that has not acquired creditors' rights to sue (by assignment). Accordingly, the trustee is in the classic position of the trustee referred to in Bank of Marin and is thus subject to all of the defenses that could have been asserted against the bankrupt but for the filing of the bankruptcy petition.³⁰ One of these defenses, according to the Second Circuit, is contained in the exculpatory clause of Trace's Articles of Incorporation.³¹ Thus, the Second Circuit held, the trustee was precluded from bringing any due care claims seeking monetary awards against the directors, whether brought on behalf of Trace's creditors or Trace itself.³²

Conclusion

The Second Circuit decision in Pereira v. Farace is helpful to practitioners and boards alike. The decision clarifies the nature of the claims that may be brought by a bankruptcy trustee and the limitations on those claims under well-developed principles of corporate and bankruptcy law. Claims for breach of the duty of care, if properly exculpated under applicable corporate law, will be precluded by that charter provision.

---

Footnotes

¹ For example, certain courts have held that the exculpation provisions of a corporation's charter would not bar claims by a bankruptcy trustee "on behalf of the corporation's creditors," as the creditors were not parties to the contract—the charter. See, e.g., Pereira v. Cogan, No. 00 CIV. 619 (RWS), 2001 WL 243537 (S.D.N.Y. Mar. 8, 2001), rev'd. sub nom, Pereira v. Farace, No. 03-5053, 2005 WL 1532318 (2d Cir. June 30, 2005); Growe v. Bedard, No. 03-198-B-S, 2004 WL 2677216 (D. Me. Nov. 23, 2004); Steinberg v. Kendig (In re Ben Franklin Retail Stores Inc.), No. 97C7934, 2000 WL 28266 (N.D. Ill. Jan. 12, 2000). Return to article

² No. 03-5053, 2005 WL 1532318 (2d Cir. June 30, 2005). Return to article

³ One interesting aspect here is that where directors have been held liable, the courts have generally focused on a breach of the duty of loyalty (i.e., self-dealing or insider preferences) and not on claims for breach of the duty of care. See 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, 303-07 (2004). If the charter exculpation clause is effective to preclude due care claims and the bankruptcy trustee cannot state a duty of loyalty claim, this reasoning will provide protection to the board of directors as decision-makers. Return to article

⁴ No. 12150, 1991 WL 277613 (Del. Ch. Dec. 30, 1991). Return to article

⁵ See, e.g, LaSalle Nat'l. Bank v. Perelman, 82 F.Supp.2d 279, 290 (D. Del. 2000); Weaver v. Kellogg, 216 B.R. 563, 582-84 (S.D. Tex. 1997); Official Comm. of Unsecured Creditors of Buckhead Am. Corp. v. Reliance Capital Group Inc. (In re Buckhead Am. Corp.), 178 B.R. 956, 968-69 (D. Del. 1994); Geyer v. Ingersoll Publ'ns. Co., 621 A. 2d 784 (Del. Ch. 1992). Return to article

⁶ See, e.g., White, Bruce H. and Medford, William L., "Preparing for Bankruptcy: Director Liability in the Zone of Insolvency," Am. Bankr. Inst. J., April 2001, at 30-31 (discussing expanded fiduciary duties in the zone of insolvency and the potential for a limitation on the ability of a director to resign from the board of directors). In addition, in the context of the types of claims available, the courts have continued to take multiple approaches as to whether "deepening insolvency" is a separate, independent tort or simply a measure of damages. See Kittay v. Atl. Bank of N.Y. (In re Global Serv. Group LLC), 316 B.R. 451 (Bankr. S.D.N.Y. 2004) (holding that under New York law, deepening insolvency was a measure of damage and not an independent tort); Official Comm. of Unsecured Creditors v. Credit Suisse First Boston (In re Excite Techs. Inc.), 299 B.R. 732 (Bankr. D. Del. 2003) (finding that deepening insolvency theory is cognizable under Delaware law). Return to article

⁷ See Prod. Res. Group L.L.C. v. NCT Group Inc., 863 A.2d 772 (Del. Ch. 2004). Return to article

⁸ Id. at 793. Return to article

⁹ Id. at 792-93 (adopting the analysis of the court in Angelo, Gordon & Co. v. Allied Riser Comm. Corp., 805 A.2d 221, 229 (Del. Ch. 2002), finding that 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 companies). Return to article

¹⁰ No. 03-5053, 2005 WL 1532318 (2d Cir. June 30, 2005). Return to article

¹¹ See Id. at *1. Return to article

¹² See Id. Return to article

¹³ See Id. at *4. Return to article

¹⁴ Id. Return to article

¹⁵ See Id. at *1. Return to article

¹⁶ See Id. Return to article

¹⁷ See Id. at *10. Return to article

¹⁸ See Del. Code Ann. Tit. 8, §102(b)(7). Return to article

¹⁹ 488 A.2d 858 (Del. 1985). Return to article

²⁰ Cinerama Inc. v. Technicolor Inc., 663 A.2d 1156, 1166 n. 18 (Del. 1995). Return to article

²¹ Malpiede v. Townson, 780 A.2d 1075, 1094-95 (Del. 2001). Return to article

²² Id. at 1095. Return to article

²³ Pereira v. Farace, No. 03-5853, 2005 WL 1532318 at *10 (2d Cir. June 30, 2005). Return to article

²⁴ Id. Return to article

²⁵ See Pereira v. Cogan, No. 00 CIV. 619, 2001 WL 243537 at *11 (S.D.N.Y. March 8, 2001). Return to article

²⁶ Pereira v. Farace, 2005 WL 1532318 at *10. Return to article

²⁷ Bank of Marin v. England, 385 U.S. 99, 101 (1966). Return to article

²⁸ Pereira v. Farace, 2005 WL 1532318 at *10 (quoting Shearson Lehman Hutton Inc. v. Wagoner, 944 F.2d 114, 118 (2d Cir. 1991)). Return to article

²⁹ Id. at *10-11 (citing Prod. Res., 863 A.2d at 793-95) ("[a]lthough §102(b)(7) itself does not mention creditors specifically, its plain terms apply to all claims belonging to the corporation itself, regardless of whether those claims are asserted derivatively by stockholders or by creditors"); see, also, Continuing Creditors' Comm. of Star Telecomms. Inc. v. Edgecomb, No. 03-278-KAJ, 2004 WL 2980736, at *11-*13 (D. Del. Dec. 21, 2004) (applying Production Resources to bar claims in bankruptcy premised on breach of the duty of care, including gross negligence, where the company charter had an exculpatory provision). Return to article

³⁰ See 385 U.S. at 101. Return to article

³¹ Pereira v. Farace, 2005 WL 1532318 at *11. Return to article

³² Id. Return to article