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E-MailThis post comes to us from John L. Reed of Edwards Angell Palmer & Dodge. We thank John and his colleagues for allowing us to bring this insightful Memorandum to our readers. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.
In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, the Delaware Supreme Court, in a case of first impression, provided some clarity on the controversial issue of whether and to what extent creditors have the ability to assert fiduciary duty claims against directors. The Supreme Court held, unequivocally, that “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 [a] corporation’s directors.” Rather, the court noted, creditors can protect their interests by asserting derivative fiduciary duty claims on behalf of an insolvent corporation or by asserting any applicable direct non-fiduciary duty-based claims. In the opinion, the Court pointed out that the plaintiff asserted only a direct claim for breach of fiduciary duty and waived any basis to pursue such a claim derivatively.
While the Gheewalla decision put to rest the issue of a creditor’s ability to pursue direct claims for breach of fiduciary duty, there remain unresolved questions about (1) whether the Delaware Supreme Court has modified the historical “insolvency” test under Delaware’s corporate law; (2) the rights and roles of creditors and the timing of derivative claims by creditors; and (3) exactly how directors are supposed to balance the competing interests of corporate constituencies when the company is insolvent but nonetheless operating.
Those questions, and others, are discussed in a Memorandum available for readers here. Below, I summarize some of the crucial considerations for directors of distressed companies in the future.
What is The “Insolvency” Standard?
“Insolvency” for purposes of pursuing a derivative claim under Delaware’s corporate law may be different from “insolvency” as generally understood by most practitioners. Historically, there have been two principal tests for insolvency: (1) inability to pay debts as they come due; and (2) liabilities exceed the fair market value of assets. These are also the tests set forth in Delaware’s Fraudulent Transfers Act, 6 Del. C. 1302(a)-(b). Although the Gheewalla Court clearly stated that “[c]reditors may . . . protect their interest by bringing derivative claims on behalf of [an] insolvent corporation” (emphasis added), the standard articulated in Gheewalla appears to have added something to the second prong of the historical insolvency test.
The Court articulated that test as follows: “A deficiency of assets below liabilities with no reasonable prospect that the business can be successfully continued in the face thereof.” (Emphasis added.) The additional language was adopted from the Court of Chancery’s decision below as well as the Court of Chancery’s prior decision in Production Resources Group v. NCT Group, Inc. This additional language makes the standard somewhat different from some earlier Delaware precedent and United States Supreme Court precedent, which follow the balance-sheet approach, i.e., measuring liabilities against the fair market value of assets. (For examples, see Geyer v. Ingersoll Publications Co., a 1992 Chancery decision, or the Supreme Court of the United States’s 1899 decision in McDonald v. Williams.)
In Production Resources, the Court was addressing a request for appointment of a receiver under Section 291 of the Delaware General Corporation Law, which may explain the additional language focusing on continuation of the business. Moreover, according to Gheewalla, the corporation in that case was insolvent and, while not in bankruptcy, was “out of business,” which may explain why the Gheewalla Court invoked the Court of Chancery’s expansive definition of insolvency. However, one could argue that, regardless whether a company is out of business or operating, Gheewalla has announced a rule of law that imposes an additional burden on creditors before they can pursue derivative claims. If so, such a test would have serious implications in practice. Many firms, including many public companies with large market capitalization and significant long-term promise operate as viable entities even though a creditor could argue that they are technically “insolvent” under a balance-sheet test because of the companies’ inability to include future profits as an intangible asset.
Is There Dual Standing?
If a company is paying its debts as they come due and is viable notwithstanding a balance-sheet analysis–but creditors can nevertheless bring a derivative claim under such circumstances–is there dual standing, such that stockholders have a simultaneous right to bring a claim? If the answer is “yes,” can stockholders take a position contrary to that of the creditors in the litigation? Or do stockholders lose standing to sue derivatively if the company is insolvent? No Delaware decision states that shareholders lose standing to bring derivative claims in such a situation–and what would be the basis for depriving stockholders of standing when they retain an equity interest in the company?
Nonetheless, it is noteworthy that the Gheewalla Court explicitly stated that “creditors take the place of shareholders as the residual beneficiaries of any increase in value” resulting from a derivative claim. (Emphasis added.) “Replacement” of an interest seems inconsistent with dual standing. Does Gheewalla mean that stockholders lose standing to bring derivative claims when the company is insolvent?
What is the Impact on Director Decision Making?
Importantly, the Delaware courts have made it clear that directors, in the exercise of their business judgment, are free to engage in entrepreneurial risk-taking. Thus, when fiduciary claims are asserted in the context of insolvency, such claims are likely to focus, to various degrees, on whether (1) the board’s decision was outside the bounds of reasonable business judgment and thus shifted too much risk to creditors; or (2) the directors disregarded the stockholders’ interests by foregoing potentially lucrative business strategies in order to preserve assets for creditors. The central question may well be whether the directors’ fiduciary duties are primarily to the corporation and its stockholders or whether, when the company is insolvent, the directors’ fiduciary duties rest only with the corporation, and thus directors cannot favor the interests of one constituency (like stockholders) over another (like creditors).
While theoretical legal analyses are nice, directors want to avoid potential liability for their decisionmaking. This is an even greater concern if the fiduciary-duty claim is being pursued in a bankruptcy proceeding, where advancement of defense costs from the bankrupt company may not be available, leaving directors to rely on a quickly-depleting directors’ and officers insurance policy for their defense. Clearly, a stockholder or creditor asserting a derivative claim will have to demonstrate that the directors breached either their duty of care or their duty of loyalty, but the analysis is not crystal clear.
When a company ultimately fails, imagine being a former director facing claims by creditors who have obtained leave from the bankruptcy court to bring the action in a non-Delaware court with a right to a jury trial and who are arguing that not enough weight was given to preserving assets–that is, that the probability of success for projects initiated before the bankruptcy was so low that pursuing those projects was not a valid business judgment. When does a business plan get so risky–if ever–that the board is obligated to seek to preserve assets for creditors rather than generate returns for shareholders? Although the law may be clear that directors owe their fiduciary duties to the corporation–and there is some deference to business judgment absent disabling conflicts of interest–weighing the interests of stockholders and creditors may not be easy for directors sitting on the boards of distressed companies.
