By Lee C. Hodge, Ward and Smith, P.A.
Editor’s Note: Lee Hodge is a member of the Business Practice Group at Ward and Smith, P.A.
A member of a corporation’s board of directors always must direct the corporation in a manner that is consistent with the director’s fiduciary duties of care, loyalty, and good faith. These duties are owed to the corporation as an entity, and the interpretation of such duties have been the subject of much litigation in all states. However, when a corporation is insolvent or is nearing insolvency, the fiduciary duties of a director expand to include a duty to treat all similarly situated creditors equally. This additional fiduciary duty is especially significant during the current economic climate in which many previously healthy corporations are facing balance sheet and cash flow problems. Directors of corporations that are insolvent or approaching insolvency must be careful not to violate the additional fiduciary duty they owe to creditors, because a breach of this duty could result in personal liability for the director.
What are Fiduciary Duties and Why Do We Need Them?
Fiduciary duties are the obligations that certain corporate actors, including members of a corporation’s board of directors, owe to the corporation. While North Carolina corporate law provides that certain executive officers of a corporation also owe fiduciary duties to the corporations they serve, this article is limited to the fiduciary duties owed by members of a corporation’s board of directors and does not address the fiduciary duties owed by corporate management or the fiduciary duties and obligations of owners and managers of other business entities, such as members or managers of a limited liability company, or partners of a general or limited partnership.
Fiduciary duties provide the general standards of conduct to which directors must adhere in making decisions for the corporation in order to avoid facing personal liability. Like other states, North Carolina corporate law imposes fiduciary duties on directors in order to balance two competing demands: the need for directors to have sufficient discretion to take risks in managing the corporation without the fear of personal liability, and the need to hold directors personally liable when they take certain actions that are not in the best interests of the corporation.
General Fiduciary Duties
When a corporation is solvent, its directors owe the following fiduciary duties to the corporation as an entity:
• Duty of Care – The duty to direct the affairs of the corporation using the level of care that an ordinarily prudent person in a position similar to that of the director would exercise under conditions similar to those the director faces – For example, a director is under a duty to stay reasonably informed about the financial condition and management of the corporation.
• Duty of Loyalty – The duty to act in a manner that the director reasonably believes is in the corporation’s, not the director’s or any third party’s, best interests – For example, a director of a company that develops heart-related biomedical devices cannot personally purchase a valuable heart-related biomedical device patent without first providing the corporation with the opportunity to purchase the patent.
• Duty of Good Faith – The duty to discharge the director’s duties in good faith – While some states (including Delaware, which has one of the most advanced bodies of corporate law) provide that the duty of good faith is part of the duty of loyalty, North Carolina corporate law delineates the duty of good faith separately from the other fiduciary duties owed by corporate directors.
The Expansion of Fiduciary Duties When a Corporation Nears Insolvency
When a corporation is nearing insolvency, or in fact becomes insolvent, the fiduciary duties of a corporate director expand to add another duty: the duty to treat all similarly-situated creditors of the corporation equally. For example, upon insolvency or the entry of the corporation into the so-called "zone of insolvency," as that phrase is explained below, all similarly-situated secured creditors and all similarly-situated unsecured creditors should be treated equally, although secured creditors may be treated differently from unsecured creditors. This additional duty, however, raises three primary questions: (1) when does the fiduciary duty arise, (2) what does the fiduciary duty require of directors, and (3) how can a creditor enforce its rights under the expanded duty?
• When does the fiduciary duty arise?: North Carolina courts have not provided clear guidance regarding when the duty of corporate directors to treat all similarly-situated creditors equally arises. North Carolina courts generally have stated that this expanded duty arises when the director’s corporation is on the verge of insolvency and, thus, is within the so-called "zone of insolvency," or is in the dissolution and winding up process. Although the question of whether a corporation is within the zone of insolvency is determined on a case by case basis, the North Carolina courts have considered the following factors: (1) whether the liabilities on the corporation’s balance sheet exceed the assets on the corporation’s balance sheet (known as "balance sheet insolvency"), (2) whether the corporation is able to pay its bills as they come due in the ordinary course of business (known as "cash flow insolvency"), (3) whether there are plans for the corporation to cease doing business, and (4) whether there is a reasonable expectation that the corporation will cease doing business. Since there is no clear threshold in North Carolina for determining when a corporation is nearing the zone of insolvency, directors of corporations with balance sheet and/or cash flow issues should be careful to judge their actions in light of the fact that they may owe the creditors of the corporation a fiduciary duty.
• What does the expanded fiduciary duty require of directors?: Once a corporation is within the zone of insolvency or, worse, is insolvent, the directors of the corporation must ensure that all payments to similarly situated creditors (e.g., secured creditors or unsecured creditors) are made on a pro rata basis.
• How can a corporate creditor enforce its rights against a director personally?: If the directors of a corporation that has entered the zone of insolvency breach the fiduciary duty they owe to the corporation’s creditors, each such creditor may be entitled to bring an action against the directors either on its own behalf or in the form of a derivative action on behalf of the corporation, seeking to hold the directors personally liable. If the creditor brings an action on its own behalf, the creditor will be entitled to any proceeds received as a result of the lawsuit. However, in order to bring a direct action, the creditor must suffer an individual injury separate and distinct from any injury suffered by the corporation. For example, if one secured creditor is paid nothing while all other similarly-situated secured creditors are paid in full, that creditor would be entitled to bring a direct action against the corporation’s directors. Alternatively, the creditor may bring a derivative action, in which case the corporation will be entitled to the proceeds received, and the creditor that brought the derivative action will share those proceeds with all other creditors entitled to be paid. While broadly drafted indemnification provisions and substantial director and officer insurance policies may provide some comfort for directors, the threat of personal liability is real and should not be taken lightly.
Conclusion
Corporate directors guiding distressed companies through today’s difficult economic times face an immense amount of pressure and stress. To add to the already mounting pressure a distressed corporate situation can cause, directors need to be aware of their expanded fiduciary duty to treat all of the corporation’s similarly-situated creditors equally once the corporation enters the zone of insolvency. Consequently, in the event of insolvency or near insolvency, it is even more important for such directors to maintain communication with the corporation’s executive officers, obtain competent legal advice, and ensure that the corporation’s indemnification provisions and director and officer insurance policies are up to date.
© 2009, Ward and Smith, P.A.
Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Lee C. Hodge practices in the Business Practice Group where he concentrates his practice on business formations, acquisitions, and other transactional matters. Comments or questions may be sent to lch@wardandsmith.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.
