The Gheewalla Case: The Delaware Supreme Court Clarifies Directors’ Duties in Bankruptcy

In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, the Delaware Supreme Court settled a nagging question about corporate directors’ duties and liabilities to creditors, holding 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.”  The court explained:

[D]irectors owe their fiduciary obligations to the corporation and its shareholders. . . .  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.

The Court therefore rejected Vice Chancellor Strine‘s conclusion in Production Resources Group v. NCT Group, Inc. that creditors of an insolvent companies may bring direct claims against directors for breach of fiduciary duties.  However, the Court concluded that “the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties.”

In reaching these conclusions, the Court’s position was closer to the one espoused by me and and Kelli Alces in our article, Directors’ Duties in Failing Firms, than to the theory espoused by Steve Bainbridge in Much Ado About Little? Directors’ Fiduciary Duties in the Vicinity of Insolvency.

Because I think that the differences between the papers help in understanding the Gheewalla opinion, I think it’s worth laying out our respective positions.

Steve and I agree that directors should have no fiduciary duty to creditors outside insolvency, though our reasoning differs.  Under my theory, such a duty is fundamentally inconsistent with the nature of fiduciary duties.  Steve, by contrast, reasons that creditors are more able to contract for protection than shareholders.

More importantly for present purposes, Steve and I disagree about the insolvency scenario.  Steve takes the view that directors’ duties should be exclusively to the residual claimants, which are the creditors in insolvency.  I believe, and the Delaware courts have long held–including in the language quoted above in Gheewalla–that the directors’ duties are to the corporation.  It follows from my theory that while the creditors might be able to maintain a derivative suit (more on this below), they cannot maintain a direct claim, which would inherently be based on a duty and injury distinctly to the creditors.

Characterizing the duty as one to “the corporation” is not a meaningless “reification,” as Steve argues—it is a sensible way of expressing the application of the business judgment rule.  In the insolvency/duty situation, the Delaware courts are, indeed, using the concept wisely.  The point here is that the directors have great discretion in using their powers, cabined only by the capacious business judgment rule.  Their only obligation is to use their best judgment on behalf of the entity that employs them–that is, the corporation.  The courts hesitate to question director business judgments as to which corporate interest a director should favor just as they hesitate to question director judgments in countless other respects.  As Alces and I note:

[T]he limits on courts’ ability to make these [business] judgments argue against courts forcing directors to choose between shareholder and creditor interests when the two conflict.

Steve worries that a duty to the “corporation” leaves the directors free to act unwisely and, to some extent, selfishly.  He’s absolutely right.  But the problem, to the extent that it is a problem rather than an intrinsic aspect of corporate governance, lies in the business judgment rule, which is a notoriously weak tool for disciplining agency costs.

This is all that Chancellor Allen was saying in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., where he held that managing creditors did not breach a duty to a 98% shareholder by failing to sell corporate assets, despite the shareholder’s need for capital, because an auction would have brought only a “fire sale” price.  Although in footnote 55 of that opinion Chancellor Allen laid out how the directors might act for the benefit of the “corporation” in a hypothetical case, he was not saying that the directors would breach their duty if they reached a different decision than the one he described in his hypothetical.  Rather, he was merely pointing out that directors face a tricky task in exercising their judgment given multiple corporate constituencies.  Interestingly, Gheewalla involves a similar–but converse–scenario where the board allegedly acted on behalf of the shareholders rather than the creditors.

The bottom line is that, while both my theory and Steve’s can explain why creditors have no claim in the zone of insolvency, only my approach can explain why the creditors have no direct claim when the corporation is insolvent.  Further, the Court’s dictum favoring creditor derivative actions is consistent with my theory, since a derivative action is necessarily brought on behalf of the “corporation.”  (Although this “reifies” the corporation, Steve would agree that this is a necessary evil in this context.)  But I do have reservations about the propriety of creditor derivative suits.  Alces and I note that creditor derivative suits

may add costly complexity to bankruptcy proceedings and interfere with orderly reorganizations and workouts.  Moreover, any problems with the trustee refusing to prosecute worthwhile claims can be dealt with by replacing the trustee.  In any event, given potential problems with creditor derivative suits, the bankruptcy court should play an active role in screening these suits.

We add:

In sum, although there is some authority for creditor derivative suits in bankruptcy, the weight of authority and policy is against such actions.  Moreover, even if such suits were allowed, this would not change the subject of directors’ duties.  The creditors would be suing to enforce directors duties’ to the corporation rather than specifically to the creditors, whether in or out of the insolvency scenario.

The whole issue of creditor derivative suits is a matter of federal bankruptcy policy rather than state law.  Kelli has written separately–and well–on these issues in Enforcing Corporate Fiduciary Duties in Bankruptcy.