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April 23rd, 2009 The Responsibilities of Directors Before and After Company Insolvency — Some Practical Considerations |
Corporate directors of a financially healthy and solvent company have a fiduciary responsibility solely to the corporation and its stockholders and do not have a duty to creditors beyond the contractual duty owed by the company.
In today’s economy, many companies face unprecedented financial strains and, as the financial situation deteriorates and nears insolvency (aka zone of insolvency) directors must consider the impact of their decisions on the company’s creditors as well. Once a company has passed the threshold of insolvency, the beneficiaries of a director’s fiduciary duties in many jurisdictions include the creditors of the company because, as courts have reasoned, the equity owned by its stockholders is worthless and the burdens of poor decision-making by management fall on the corporation’s creditors.
Generally, the fiduciary duties of a director are the duty of care and the duty of loyalty. The duty of care requires a director to be fully informed of all material information reasonably available, acting with due care and consulting with officers, employees and outside experts as reasonably necessary to make informed decisions. The duty of loyalty requires that a director act solely in the best interests of the company without personal or private motive, avoiding self-dealing and any conflict of interest that may compromise the director’s independent decision-making process.
Until fairly recently, the prevailing wisdom was to advise boards of directors that the shift in their fiduciary duties occurred once the company entered the zone of insolvency. Recent case law in Delaware has rejected this premise, and, moreover, prohibited the rights of creditors to bring direct claims against directors for breaches of fiduciary duty even when the company is insolvent. See North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 930 A.D.2d 92 (Del. 2007). However, “creditors may nonetheless protect their interest by bringing derivative claims on behalf of the insolvent corporation or any other direct nonfiduciary claim . . . that may be available for individual creditors.” Id. at 94. In Trenwick America Litigation Trust v. Billet, 906 A.D.2d 168, 175 (Del Ch. 2006), the court held that “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 equity holders. Even when the firm is insolvent, directors are free to pursue value maximizing strategies, while recognizing that the firm’s creditors have become residual claimants and the advancement of their best interests has become the firm’s principal objective.”
While these legal clarifications permit directors to focus on maximizing corporate value, the impact on creditors must be carefully considered as it remains difficult to assess when a company actually crosses the threshold of insolvency. Under Delaware law, a company is considered insolvent if it fails one of several tests, including whether its total liabilities exceed its total assets, the so-called “balance sheet insolvency test” or whether the company is unable to pay its debts when due, the so-called “equitable insolvency test.” Other states employ other tests.
Because of the subjective nature of these insolvency tests, the board of a distressed company exercising its fiduciary duties must remain cognizant of the impact of its decisions on the corporation’s creditors. In next week’s post, I’ll outline some of the concrete steps and precautions that a director of a financially distressed company can take.
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