As you may already know, directors always owe a fiduciary duty to the corporation for which they are director. This post-will cover the heightened level of fiduciary duty directors owe a corporation’s stockholders or creditors when a company faces insolvency.
Importantly, much of the corporation’s law within the United States is either controlled or influenced by Delaware law. As many viewers will already know, a large percentage of publicly traded corporations are organized in Delaware for a number of different reasons, many having to do with that State’s laws regarding the amount of public disclosure corporate boards are required to make. When a company is solvent, the law is clear that directors owe a fiduciary duty to the shareholders. That duty of care is defined as “the same amount of care that an ordinarily careful and prudent person uses in similar circumstances.” The rule requires that directors reasonably inform themselves before making a decision of all relevant information and alternatives. Directors are normally immune from personal liability for any breaches of that duty of care, except where it involves intentional misconduct, bad faith, or a knowing violation of law.
Separate from the duty of care, is the director’s duty of loyalty. That duty requires directors to act in good faith for the benefit of the corporation and its stockholders. The rule further requires that directors refrain from acting out of self-interest in a way that might injure the corporation or its stockholders or may private the stockholders of an opportunity or advantage. The “business judgment rule” does not protect directors from breaches of their duty of loyalty.
1. Business judgment rule
The business judgment rule works to protect directors if they comply with their fiduciary duties of care and loyalty. The business judgment rule requires three things. 1) the directors must stand formed with the relevant facts; 2) and must act in good faith; 3) the directors must act in the best interest of the corporation. Assuming that the directors do not act with gross negligence, the business judgment rule protects them from breach of fiduciary duty claims for failed business decisions that resulted in the company’s bankruptcy. Assuming the directors are reasonably intended to benefit the corporation and all of its stockholders, courts are precluded from second-guessing the director’s decisions.
Courts in Delaware have even ruled that as long as directors make decisions that are rationally designed to maximize the company’s value, those directors are protected by the business judgment rule “even if the board is not independent and even if the potential benefit to the creditors and stockholders is disproportionate. However, those same courts have held that Board decisions that result in direct transfers to controlling shareholders from an insolvent company will be evaluated under the “entire fairness” standard.
2. Directors Duties of Insolvent Companies
If a company becomes insolvent, directors still owe a fiduciary duty to the company, but the fiduciary duty shifts primarily from the stockholders to creditors. Because creditors are risk of not being paid by insolvent corporations despite their contractual rights, courts view their rights as needing additional protection. Insolvency, which is an event that occurs before bankruptcy, directors are required to focus on creditors because the interest of stockholders are subordinate to those creditors. If a corporation enters bankruptcy the creditor’s claims are placed above the stockholders claims. For this reason, directors are required to protect the company’s assets during insolvency to ensure that their use to satisfy creditors’ claims first.
There are two test used to determine insolvency. The first is the cash flow test which is satisfied if a corporation is unable to pay its debts as they come due in the ordinary course of business. The second test is the balance sheet test which instructs that a corporation is insolvent if its liabilities exceed the reasonable market value of its assets. Both tests have difficulty. The balance sheet test is vulnerable to concerns regarding the choice of methodology for valuing the company’s assets and liabilities. The cash flow test can fail if a temporary cash flow problem gives the appearance of insolvency when the company is not actually insolvent.
3. What Duties do Directors Owe Creditors During Insolvency?
The Delaware Supreme Court has held that directors owe no duty of loyalty or fiduciary duty to creditors of an insolvent corporation. Creditors are barred from bringing actions based on “particularized harm,” but are allowed to bring derivative suits on behalf of the corporation against the directors for breach of their fiduciary duty. In the same way that shareholders have standing to sue corporations that are solvent, the Delaware Supreme Court has found that creditors have standing to bring claims against insolvent corporations. However, the same rule does not apply to LLCs in Delaware.
4. Procedural Requirements
One requirement under Delaware law is that creditors wishing to bring a derivative lawsuit must first make a demand of the Board of Directors or demonstrate that such a demand would be futile. Unlike stockholders, creditors are not required to show contemporaneous ownership at the time of the alleged wrongdoing and throughout litigation. Further creditors are not required to show that the company they are suing is continuously insolvent. Rather, it creditors need only show that the company was insolvent at the time the suit was filed and that the creditor still has a claim to debt.
If the corporation files for bankruptcy, an automatic stay prohibits creditors from taking any action. Further because the derivative claims become property of the debtor’s estate in bankruptcy, normally only the debtor or trustee can assert a breach of fiduciary duty claims against the directors. This regularly creates a conflict between the Board of Directors and management which are normally aligned thereby causing the estate to pursue derivative breach of fiduciary duty claims against the directors. Delaware courts have suggested the because creditors are normally protected by “strong covenants, liens on assets, and other negotiated contractual provisions” as well as the implied covenant of good faith and fair dealing in the fraudulent transfer laws, creditors derivative claims based on breach of fiduciary duties will succeed only under very limited circumstances and should be a final resort.
5. Zone of Insolvency
Most Courts have ruled that director’s fiduciary duties and duties of loyalty do not change when companies are in the “zone of insolvency.” In other words, creditors are not favored over stockholders even when those interests diverge. Frequently “out of the money” stockholders apply pressure to directors to engage in high risk behavior, because those stockholders have nothing to lose and everything to gain. Justice frequently creditors pressure directors to act conservatively and preserve corporate assets in order to satisfy the creditor’s debts. When creditors and stockholders interest, directors should balance those competing interests. The directors’ behavior while the company is in the zone of insolvency may be later subject to heightened scrutiny by the courts to ensure that the directors are complying with both of fiduciary duties as well as their duty of loyalty.
6. Deepening Insolvency
Some courts around the country have found that directors unnecessarily protracting the life of the Company and thereby driving the company deeper into insolvency. In those jurisdictions that adhere to this view, being overly optimistic and espousing strategies the result in deeper insolvency and subsequent harmed creditors can subject directors to liability.
7. Insuring the Risk
Delaware law, which many states follow, allows corporations to ensure directors against the risk of negligent behavior in their role as directors. The name of this insurance is directors’ and officers’ insurance (D&O insurance). There are three different types of this type of insurance. Side A coverage which is normally referred to as direct coverage, covers directors and officers individually and is used in instances where corporations do not indemnify directors and officers for their losses. That insurance pays benefits directly to the directors and officers and insures that payment even during bankruptcy. Side The coverage, commonly referred to as indemnification coverage, reimburses a corporation for payments the corporation makes to directors and officers as required by the Company’s corporate governance documents. Because the money is paid to corporations, bankruptcy courts have decided that these policies of the property of the state. Liability Applied to Both Side A and Side B can pose problems, because the corporation and its officers or competing for the same funds. Side C coverage protects the corporation for losses it incurs primarily from securities claims. Like Side B coverage, side C coverage may become property of the estate in bankruptcy proceedings.
In a separate long post, we will discuss the steps directors should take to avoid personal liability.