A fiduciary duty is the duty to act in another party’s interests. Directors and Officers of a Corporation owe fiduciary duties to the Corporation itself and to the Corporation’s Stockholders. Previous blog posts have discussed the two core fiduciary duties owed by Directors and Officers: the duty of care and the duty of loyalty; this blog post discusses how the duties change as the Corporation approaches insolvency.
While this blog post refers to the company as a “Corporation” and the fiduciaries as “Directors” or “Officers” of the Corporation, the same principles are in effect for limited liability companies or limited partnerships. The actors may be called Managers or Members, but share in many (if not most!) of the same obligations to act in another party’s interests.
The Duty of Care requires Officers and Directors of a Corporation to act in an informed basis and after careful consideration of all material facts and circumstances prior to making a business decision. The Duty of Loyalty requires Officers and Directors to act in good faith for the benefit of the Corporation and its stockholders, and not for the Officer/Director’s own interest. Generally, fiduciary duties are owed only to the Corporation and those duties may be enforced by the Stockholders because the Stockholders are the ultimate beneficiaries of the Corporation’s growth and increased value. Fiduciaries duties are generally not owed to creditors, because creditors have contractual duties. However, it was long thought that as the Corporation approaches insolvency and becomes insolvent, such duties would shift to being owed to creditors.
Historically, Delaware’s Chancery Court implied that directors may owe fiduciary duties to creditors when a Corporation is in the “zone of insolvency” but not yet insolvent. Credit Lyonnais Bank Nederland v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. 1991). However, in 2007, the Delaware Supreme Court clarified that directors’ fiduciary duties do not run to creditors while companies are in the “zone of insolvency.” (N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007)).
- “[W]e hold that the creditors of a Delaware corporation that is either insolvent or in the zone of insolvency have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against the corporation’s directors.”
- “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.”
Once the Corporation is insolvent however, Officers and Directors owe fiduciary duties to all of the stakeholders of the Corporation (e.g., stockholders, creditors, employees, etc.) to preserve the existing assets of the Corporation and to maximize their value. Gheewalla, 930 A.2d 92 (Del. 2007)).
In insolvency, the creditors resemble Stockholders and the creditors hold an interest in maximizing the value of the Corporation; the creditors take the place of the Stockholders as the residual beneficiaries of any increase in value, so the creditors are the principal constituency injured by any fiduciary breaches that diminish the Corporation’s value.
However, that does not mean Directors and Officers of an insolvent Corporation must cease operations and liquidate assets. Delaware courts have rejected the “deepening insolvency” theory as a cause of action. Insolvent Corporations may still opt in favor of a particular business strategy—including additional debt—when other, less risky strategies are also available to it, so long as the decision was made in good faith and with due regard for the interests of creditors. Directors and Officers continue to be protected by the business judgment rule and creditors of an insolvent Corporation have no greater right to challenge good faith business decisions than the Stockholders of a solvent Corporation.
In the end, the business judgment rule is a powerful tool for Directors and Officers—and Stockholders—in a solvent, barely solvent or insolvent Corporation. It allows Directors and Officers to make necessary business decisions, without the threat of additional liability, and it provides Stockholders with leaders who are able to make difficult decisions. Without such leadership, all stakeholders would suffer.