Editor’s Note: Lance Martin is an attorney practicing in the Financial Institutions Section of Ward and Smith, P.A. TechLaw is a regular weekly feature in WRAL Local Tech Wire.
RALEIGH, N.C. – Consider this scenario: You are the director of a corporation in financial distress. Profits are down, cash flow is tight, and the corporation is staring at bankruptcy. The corporation’s creditors (e.g., landlords, banks, and vendors) are putting pressure on the business to pay up. The creditors, looking out for their individual interests, are telling you that, as a member of the board of directors, you have a duty to see that they are paid in addition to your fiduciary duties to the corporation and its shareholders. They don’t want the board to take any action that may reduce the assets or value of the corporation or that will erode their position.
For your part, you want to do what you believe will save the corporation, but the action you take may be at the expense of one or more creditors. You want to negotiate with each creditor, but you don’t want the specter of direct liability to them looming over the negotiations. Do you have a fiduciary duty to the corporation’s creditors, particularly when the corporation is nearly bankrupt?
To Whom Does a Director Owe a Fiduciary Duty?
In May, the Delaware Supreme Court ruled that creditors of a Delaware corporation which is either insolvent or nearly so (within a so-called “zone of insolvency”) cannot bring claims for breach of fiduciary duty against that corporation’s directors. It was a welcome decision, because it resolves uncertainty created by previous Delaware court opinions that raised the specter of fiduciary duties owed to creditors by directors of corporations in the zone of insolvency. The decision is controlling law with respect to directors of corporations organized in Delaware, even if the headquarters of the company is in North Carolina.
Although the decision is not binding on North Carolina courts for companies incorporated in this state, the North Carolina courts, for historical reasons, will consider this decision and its reasoning in resolving any dispute on a similar issue for the directors of North Carolina corporations. The North Carolina courts often follow the decisions of the Delaware courts on corporate matters.
The Fiduciary Duties of Directors
As a general rule, corporate directors owe fiduciary duties to shareholders and the corporation. These include the duty of care and the duty of loyalty. The duty of care requires directors to exercise that degree of care that an ordinarily prudent person would exercise under the same or similar circumstances. By contrast, the duty of loyalty prohibits self-dealing and the taking of business opportunities away from the corporation for the personal gain of the director.
Courts examine compliance with these duties by using the "business judgment rule," which presumes that directors make business decisions on an informed basis, in good faith, and in the honest belief that the decisions made were in the best interests of the corporation.
Confusion and Uncertainty from Delaware
Before the recent decision, it was unclear whether or to what extent a creditor of a Delaware corporation could bring a direct claim against corporate directors for a breach of a fiduciary duty for decisions made by the Board which resulted in the corporation being financially unable to pay the creditor. For the last decade, commentators have hotly debated this issue, as well as when the corporation should be deemed to be within the "zone of insolvency" such that the directors might have such a duty to the corporation’s creditors.
While there has never been an exact definition of the “zone of insolvency,” it was clear that, prior to the recent decision, an issue existed as to the potential liability of directors at any time a company’s liabilities exceeded its assets or the company was unable to pay its debts as they became due. In other words, there was a potential problem if a company was either broke or almost broke.
Prior to the recent decision, the Delaware courts had suggested that directors of a corporation that was either insolvent or in the zone of insolvency might owe a duty to the corporation’s creditors since those creditors might end up owning the corporation’s residual value. Many commentators (and directors) reacted with outrage and worried that at any time a corporation was in the undefined "zone of insolvency," its directors might have a new fiduciary duty to balance creditors’ interests with the interests of all other constituencies of the corporation.
Some Clarity and Guidance from Delaware
The recent Delaware Supreme Court decision involved a direct action by creditors against the directors of a corporation for breach of fiduciary duty. The court ruled that creditors of a corporation in the zone of insolvency may not bring a direct claim against a corporate director for breach of a fiduciary duty.
The court noted that directors of corporations within the zone of insolvency “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.” In so doing, the court provided directors with guidance for carrying out their duties in the zone of insolvency.
Again without defining the parameters of the “zone of insolvency,” the court reasoned that it is precisely during this period of dire financial distress that a corporation most needs the sure-handed leadership of its directors. The directors need to be able to negotiate creatively and in good faith with the corporation’s creditors, andthe prospect of individual liability arising from the pursuit of direct claims by creditors would undermine their ability to do so.
Creditors have other protections available to them. They may protect themselves through contract terms, covenants, and liens on corporate assets. They also may rely on general commercial law, implied covenants of good faith and fair dealing, and the law of fraudulent conveyances. And while the court rejected direct claims by creditors, it recognized that creditors of an insolvent corporation still may bring derivative claims against directors on behalf of the corporation for breach of the directors’ fiduciary duties to the corporation. With these protections firmly in place, creditors simply did not need an additional fiduciary duty from corporate directors.
Comfort for Directors
The recent Delaware Supreme Court decision has provided significant guidance for directors faced with difficult decisions for financially-distressed corporations. First, the holding clarifies that the fiduciary duties of directors of insolvent corporations pertain to the corporation itself and its shareholders, not to its creditors. Second, by removing the possibility of direct suits by creditors against directors, the decision removes significant negotiating leverage from creditors.
Creditors still have a remedy in derivative suits, but they must clear considerable procedural hurdles to bring them. When these suits are successful, any recovery will be for the benefit of the corporation, however, and not to any individual creditor. Directors now may negotiate and make decisions with an eye toward maximizing value for the corporation and, by extension, to the benefit of all interested parties, without fear that they will be breaching a direct fiduciary duty to individual creditors.
In summary, by ruling that directors of financially-distressed corporations owe fiduciary duties to shareholders and the corporation itself, the Delaware Supreme Court has made it much easier for directors to exercise their business judgment without exposure to direct liability suits brought by unhappy creditors. While the decision does not bind North Carolina courts, the reasoning is precise, consistent with historical practice, and brings the state that has raised the possibility of director liability to a creditor back to the fold.
Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Lance P. Martin is a member of the firm’s Financial Institutions Section. He represents banks and other financial institutions in a range of litigation, transactional, and regulatory matters. He can be reached at email@example.com.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.