Do directors owe fiduciary duties to creditors when a company is insolvent?

The Covid-19 pandemic affected companies in a lot of different ways. It forced businesses to adapt to a new reality. Some companies had to make big changes to the way they operated. If the company is struggling financially, do the fiduciary obligations of the company’s directors and officers change? A solvent company can meet its debts and obligations as they come up. An insolvent company can’t. In the middle are companies that are in the “zone of insolvency.” These are companies that are not quite insolvent, but they might be getting there soon. If the company is financially solvent and doing well, their duties might be pretty clear. However, when a company is insolvent or on the brink of insolvency, fiduciary duties can be much more difficult. Regardless of whether the company is solvent, insolvent, or in the zone of insolvency, the directors and officers of the company still owe fiduciary duties. They just need to be cognizant of whom they owe those duties to.

Fiduciary Duties

The basic idea is that in normal times a company’s directors and officers owe the company fiduciary duties. The duties are based on care and loyalty. Good faith is a component of these duties.

The duty of care requires that you act as a reasonably prudent person in the same or similar circumstances. In other words, the duty of care requires you to take into consideration all material information reasonably available. There is support for this standard: In re Walt Disney Co. Derivative Litigation (Del. Ch. 2005); Smith v. Van Gorkom (Del. 1985); Robert Clark, Corporate Law, section 3.4.

The duty of loyalty is pretty much what you’d expect: don’t take advantage of the people you’re serving by deceiving them or otherwise be unfair. Decide on the merits, not based on your personal interest. Be disinterested and independent. The rule is backed by Robert Clark, Corporate Law, section 4.1; Lewis v. Vogelstein (Del. Ch.); Weinberger v. UOP, Inc. (Del. 1983).

Good faith means acting on your honest belief of what’s best for the company, not what’s best for another director’s wallet.

Let’s say you make a good-faith, well-researched decision that blows up in your face. So what? The courts will leave it there; they’re not going to tell you how to run your business. This is the “business judgment rule:” if the court finds that the board acted in good faith and made a sound business decision, they’re not going to second-guess it, even if it doesn’t work out. Courts will usually assume that a business decision is reasonable. That means every director should carefully review whatever information they’re handed, and the board should discuss each decision thoroughly. If a plaintiff disproves the presumption, then the directors must establish the transaction was entirely fair.

In some states, the certificate of incorporation for a corporation can be used to wipe out or at least limit the company directors’ personal liability for breaches of the duty of care. Directors’ personal liability for a breach of the duty of loyalty isn’t usually eliminated this way. Another neat trick some states’ laws can let you do is shield directors from liability for relying on information in the company’s books and records or advice from its employees and expert advisors, if the director relied on the information or advice in good faith. Normally, a company director isn’t personally liable for business judgement calls, even bad ones, unless they committed fraud, acted in their own interest or were grossly negligent.

Duties May Change When a Company Becomes Insolvent

For Directors and Officers facing financial distress caused by Covid-19, understanding your company’s financial health is critical in assessing what to do next. More specifically, at what point, if any, do the fiduciary duties change and, if so, how are those new fiduciary duties to be applied?

A lot of ink has been spilled on the theory that a company’s directors and officers’ duties may change when a company becomes insolvent or nears insolvency. It started with the 1991 Delaware Chancery case, Credit Lyonnais. The court said that what’s best for a corporation may not be what the stockholders, creditors, employees or any other group wants. Credit Lyonnais got everyone excited because some read it to say that as a company gets closer to being insolvent, its directors start owing duties to the company’s creditors. Now the Delaware courts have reined that horse back in.

Subsequent Delaware Chancery cases tell us that being in the “zone of insolvency,” close to insolvent but not quite there, doesn’t matter for purposes of fiduciary claims; insolvency is the only “turning point.” Once the company is actually insolvent, not just inching toward it, creditors can sue derivatively, “on the company’s behalf,” to enforce duties owed to the company, but they can’t bring direct fiduciary claims of their own (Gheewalla, Del. 2007; Quadrant v. Vertin, Del. Ch. 2014). The reason you care about whether you’re insolvent is that if you cross over the insolvent line, the stockholders stop being the ones who benefit if the company succeeds. Instead, it’s the company’s creditors who have the “residual claim,” (Global Asset Capital v. Rubicon, Del. Ch. 2009) and because duties run to the corporation, it means the creditors get to sue the directors derivatively to enforce duties owed to the company.

A company is insolvent in two ways. One is balance sheet insolvency, which just means it owes more than the fair value of what it has. The second is equitable or cash flow insolvency, where it can’t pay debts as they fall due. Sometimes, it’s hard to say exactly when the company goes insolvent. But that’s all the more reason why company directors and officers should be super-informed.