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Delaware Supreme Court Issues First Opinion Regarding Director Fiduciary Duties to Creditors
May 25, 2007
The existence and scope of fiduciary duties that directors owe to a corporation's creditors has historically been a matter of some controversy. On May 18, 2007, in North Am. Catholic Ed. Programming Found. Inc. v. Rob Gheewalla, the Delaware Supreme Court issued its first decision on this issue in an attempt to provide some clear guidance to directors regarding the scope of their duties. While the decision provides a "brightline" rule that creditors cannot maintain "direct" actions against directors of a company—whether solvent or insolvent—we believe it leaves the controversial issue of "zone of insolvency" fiduciary duties as imprecise as it was before the decision.
The case involved a lawsuit brought by creditors of Clearwire Holdings Inc. ("Clearwire") alleging, inter alia, direct claims that Clearwire's directors had breached fiduciary duties owed to the creditors in the manner that they managed Clearwire's business while Clearwire was either insolvent or in the "zone of insolvency." Specifically, the creditors alleged that the directors (a) failed to preserve adequately the value of Clearwire's assets after it was clear that Clearwire could not continue as a going concern and (b) took actions solely for the benefit of Clearwire's equity investors. Importantly, the creditors specifically waived any right to bring a "derivative" claim on behalf of Clearwire against the directors, seeking instead to assert "direct" claims by the creditors.
The case presented two issues, (a) whether a corporation's creditors may assert "direct" fiduciary duty claims against directors for conduct while the corporation is in the "zone of insolvency" and (b) whether creditors can assert such direct claims when the corporation is actually insolvent.
No Direct Creditor Claims
Seeking to provide clear guidance to directors, the Court unequivocally concluded that creditors cannot maintain any "direct" action against directors of a corporation, whether the corporation is insolvent or merely in the "zone of insolvency." This is not a surprising result, given that shareholders, to whom directors always owe fiduciary duties, cannot maintain "direct" claims against directors, but rather must pursue their claims derivatively for the benefit of the corporation. But the decision answered an open issue regarding "direct" creditor claims that had been created by a prior Delaware Chancery Court ruling and, arguably, had been encouraged by various Bankruptcy Courts interpreting Delaware law. The Court's decision did not specifically preclude creditors from seeking to assert derivative fiduciary duty claims against directors but, as discussed below, limited those claims to situations where the corporation is proven to have been insolvent.
Duties During the "Zone of Insolvency"
The more surprising aspect of the decision is the position that Court took with respect to the scope of fiduciary duties while a corporation is in the "zone of insolvency." The trend in prior case law had indicated that, during this time, directors' fiduciary duties can expand from being owed exclusively to shareholders to also being owed to other constituencies, including creditors. The Delaware Supreme Court took a different approach, drawing what it intended as a brightline between insolvency and solvency:
When a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.
. . . .
It is well settled that directors owe fiduciary duties to the corporation. When a corporation is solvent, those duties may be enforced by its shareholders, who have standing to bring derivative actions on behalf of the corporation because they are the ultimate beneficiaries of the corporation's growth and increased value. When a corporation is insolvent, however, its creditors take the place of shareholders as the residual beneficiaries of any increase in value.
The decision limits creditor claims for breach of fiduciary duty to derivative claims arising while the corporation is "insolvent."
At first glance, the Court's clear "solvency" divide would seem to eliminate liability for "zone of insolvency" activities. However, because "solvency" is not an obvious absolute that will necessarily be known with certainty at any given time, directors of a financially-troubled company in the "zone of insolvency" will continue to face risk of liability to creditors for breach of fiduciary duty. An action taken at a time when the directors believed the corporation to be solvent, may look very different in subsequent litigation if a creditor is able to prove insolvency with the benefit of hindsight.
Accordingly, prudent directors of financially troubled corporations will continue to take into consideration both the interests of shareholders and creditors when making crucial business decisions. While the decision may have articulated a theoretically "bright" legal line, its practical impact may change very little about the way in which boards of directors will make decisions in the "zone of insolvency." Well-advised directors should, and will, continue to give due regard to the interests of creditors.