Delaware Chancery Court Takes Fresh Look At Zone of Insolvency

In 1999, Production Resources Group, L.L.C. (PRG) obtained a $2 million judgment against NCT Group, Inc. arising from its sale of computer systems. Despite its efforts thereafter, PRG was unsuccessful in collecting on that judgment. Moreover, despite the existence of the judgment, NCT continued to operate, due in part to cash infusions by the wife of a former NCT director. NCT's public filings, the court noted, revealed that it was balance-sheet insolvent and that it had been unable to pay several debts as they came due.

In furtherance of its collection efforts, PRG then sued NCT Group in the Delaware Court of Chancery seeking the appointment of a receiver and alleging that NCT Group long ago became insolvent and that its board and top officer had committed various breaches of fiduciary duty. Moreover, PRG argued that it had the right to assert these claims as direct claims not subject to the exculpatory charter provisions that protect NCT directors from due care claims by shareholders.

NCT, its directors, and several officers moved to dismiss for failure to state a claim upon which relief can be granted. NCT Group argued that PRG had failed to plead the facts that state a fiduciary duty claim. In fact, the defendants argued, the complaint's allegations of breach of fiduciary duty, at most, plead a “duty of care claim” that would be exculpated by provisions within NCT's certificate of incorporation. Fiduciary duty claims belong to the corporation — even if it is insolvent — and fall within the scope of that exculpatory charter clause.

The Court's Decision

The court found that PRG plead sufficient facts to survive a motion to dismiss with respect to NCT's insolvency and to support the discretionary appointment of receiver, but indeed found PRG's fiduciary duty count more problematic. As to that count, the Court rejected PRG's reasoning, holding that claims of this type are classically derivative, “in the sense that they involve an injury to the corporation as an entity and any harm to the stockholders and creditors is purely derivative of the direct financial harm to the corporation itself. The fact that the corporation has become insolvent does not turn such claims into direct creditor claims, it simply provides creditors with standing to assert those claims.” That so, Section 102(b)(7)'s exculpatory provisions still protect directors in these circumstances.

The Court's Reasoning

The court started with a fundamental premise: that the law limits creditors' ability to assert fiduciary claims against directors because creditors are protected by their contractual agreements and a well-established body of fraudulent-transfer law. That so, as long as directors observe their legal obligations to a company's creditors in good faith, they are entitled as fiduciaries to pursue the course of action that they believe is best for the firm and its stockholders.

In its view, Credit Lyonnais did not break from these fundamental points, but merely held that directors have discretion to temper the risk that they take on behalf of the equity holders when the firm is in the “zone of insolvency.” The holding and spirit of that decision emphasized that the business judgment rule protects directors if they, in good faith, pursued a less risky business strategy because they fear that a more risky strategy might render the firm unable to meet its legal obligations to creditors and other constituencies. In the zone of insolvency, a director's duty was to the “corporate enterprise” itself, and to maximize its value in order to serve all the entity's constituencies. Therefore, Credit Lyonnais in fact provided a shield to directors from stockholders who claimed that the director had a duty to undertake extreme risk so long as the company would not technically breach any legal obligations. By providing directors with this shield, creditors benefited.

Further, the court found that a right to pursue direct claims against directors and officers was not created by Credit Lyonnais. Insolvency merely placed creditors in the shoes of the shareholders as the typical residual risk-bearers. Some courts, the court noted, have analogized the insolvent-company situation to that of a trust – hence the development of the “Trust Fund Doctrine” where the directors become trustees tasked with preserving capital for the benefit of creditors who are deemed to have an equity-interest in the firm's assets. In the court's view, the transformation of creditors into residual owners does not change the nature of the harm in a typical breach of fiduciary duty claim. Whether brought by creditors or shareholders, claims for self-dealing or other improper harm to the economic value of the firm remain derivative, with either shareholders or creditors suing to recover for a harm done to the corporation as an economic entity and any recovery logically flowing to the corporation. Then, creditors may benefit derivatively to the extent of their claim against the firm's assets. “The reason for this bears repeating — the fact of insolvency does not change the primary object of the director's duties, which is the firm itself. The firm's insolvency simply makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm's value and logically give them standing to pursue these claims to rectify that injury.”

Having established this critical point, the court noted that Section 102(b)(7) authorizes the corporate charter provisions that insulate directors from personal liability to the corporation for breaches of their duty of care. Thus, even creditors asserting derivative claims are subject to these exculpatory charter provisions. In the court's view, this ruling is necessary in order for the statute's evident purpose — encouraging capable persons to serve as directors of corporations by providing them with the freedom to make risky, good faith business decisions without fear of personal liability — to be implemented.

In fact, these provisions are perhaps most necessary when “a fact-finder, in view of hindsight bias in its knowledge of the fact that the debtor's business strategy did not pan out, will conclude that the directors have acted with less than due care, even if they did not.” The mere fact that creditors have standing to pursue an insolvent corporation's claim against directors, or that the corporation's claim has been assigned as an asset to creditors somehow transforms the claim into one excepted from Section 102(b)(7) would defeat the very purpose of the statute.

Nonetheless, the court concluded that, given the pattern of dealing alleged in the Complaint, it could not dismiss PRG's fiduciary duty count, but allowed it to proceed subject to the limitations expressed in its opinion.

Conclusion

For bankruptcy practitioners, Production Resources' greatest impact may be felt by unsecured creditors committees and trustees seeking to hold directors and officers liable for mismanagement leading to bankruptcy. Among other things, the case calls into question the concept of direct claims against these targets, and firmly supports the viability of “due care” exculpation provisions. Given the court's ruling, those provisions may be sufficient to defeat creditor claims for breach of fiduciary duty by motion to dismiss or by early motions for summary judgment.

Over a decade ago, a Delaware Chancery Court's footnote in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications, 1991 WL 277613 (Del. Ch. 1991), established the “zone of insolvency” as something to be feared by directors and officers and served as a catalyst for countless creditor lawsuits. Claims by creditors committee and trustees against directors and officers for breach of fiduciary duties owed to creditors have since become commonplace.

But in a decision that may have equally great repercussion both in the Boardroom and in bankruptcy cases, the Delaware Chancery Court has revisited zone-of-insolvency case law and limited this ever-expanding legal theory. In Production Resources Group, L.L.C. v. NCT Group, Inc., 2004 WL 2647593 (Del. Ch. 2004), that court has held that the zone-of-insolvency theory does not provide direct claims against directors and officers and was instead intended to protect directors and officers. Further, directors and officers may be wholly protected from these due care and mismanagement claims by virtue of charter exculpation provisions duly adopted pursuant to Delaware Code's Section 102(b)(7).

Background

In 1999, Production Resources Group, L.L.C. (PRG) obtained a $2 million judgment against NCT Group, Inc. arising from its sale of computer systems. Despite its efforts thereafter, PRG was unsuccessful in collecting on that judgment. Moreover, despite the existence of the judgment, NCT continued to operate, due in part to cash infusions by the wife of a former NCT director. NCT's public filings, the court noted, revealed that it was balance-sheet insolvent and that it had been unable to pay several debts as they came due.

In furtherance of its collection efforts, PRG then sued NCT Group in the Delaware Court of Chancery seeking the appointment of a receiver and alleging that NCT Group long ago became insolvent and that its board and top officer had committed various breaches of fiduciary duty. Moreover, PRG argued that it had the right to assert these claims as direct claims not subject to the exculpatory charter provisions that protect NCT directors from due care claims by shareholders.

NCT, its directors, and several officers moved to dismiss for failure to state a claim upon which relief can be granted. NCT Group argued that PRG had failed to plead the facts that state a fiduciary duty claim. In fact, the defendants argued, the complaint's allegations of breach of fiduciary duty, at most, plead a “duty of care claim” that would be exculpated by provisions within NCT's certificate of incorporation. Fiduciary duty claims belong to the corporation — even if it is insolvent — and fall within the scope of that exculpatory charter clause.

The Court's Decision

The court found that PRG plead sufficient facts to survive a motion to dismiss with respect to NCT's insolvency and to support the discretionary appointment of receiver, but indeed found PRG's fiduciary duty count more problematic. As to that count, the Court rejected PRG's reasoning, holding that claims of this type are classically derivative, “in the sense that they involve an injury to the corporation as an entity and any harm to the stockholders and creditors is purely derivative of the direct financial harm to the corporation itself. The fact that the corporation has become insolvent does not turn such claims into direct creditor claims, it simply provides creditors with standing to assert those claims.” That so, Section 102(b)(7)'s exculpatory provisions still protect directors in these circumstances.

The Court's Reasoning

The court started with a fundamental premise: that the law limits creditors' ability to assert fiduciary claims against directors because creditors are protected by their contractual agreements and a well-established body of fraudulent-transfer law. That so, as long as directors observe their legal obligations to a company's creditors in good faith, they are entitled as fiduciaries to pursue the course of action that they believe is best for the firm and its stockholders.

In its view, Credit Lyonnais did not break from these fundamental points, but merely held that directors have discretion to temper the risk that they take on behalf of the equity holders when the firm is in the “zone of insolvency.” The holding and spirit of that decision emphasized that the business judgment rule protects directors if they, in good faith, pursued a less risky business strategy because they fear that a more risky strategy might render the firm unable to meet its legal obligations to creditors and other constituencies. In the zone of insolvency, a director's duty was to the “corporate enterprise” itself, and to maximize its value in order to serve all the entity's constituencies. Therefore, Credit Lyonnais in fact provided a shield to directors from stockholders who claimed that the director had a duty to undertake extreme risk so long as the company would not technically breach any legal obligations. By providing directors with this shield, creditors benefited.

Further, the court found that a right to pursue direct claims against directors and officers was not created by Credit Lyonnais. Insolvency merely placed creditors in the shoes of the shareholders as the typical residual risk-bearers. Some courts, the court noted, have analogized the insolvent-company situation to that of a trust – hence the development of the “Trust Fund Doctrine” where the directors become trustees tasked with preserving capital for the benefit of creditors who are deemed to have an equity-interest in the firm's assets. In the court's view, the transformation of creditors into residual owners does not change the nature of the harm in a typical breach of fiduciary duty claim. Whether brought by creditors or shareholders, claims for self-dealing or other improper harm to the economic value of the firm remain derivative, with either shareholders or creditors suing to recover for a harm done to the corporation as an economic entity and any recovery logically flowing to the corporation. Then, creditors may benefit derivatively to the extent of their claim against the firm's assets. “The reason for this bears repeating — the fact of insolvency does not change the primary object of the director's duties, which is the firm itself. The firm's insolvency simply makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm's value and logically give them standing to pursue these claims to rectify that injury.”

Having established this critical point, the court noted that Section 102(b)(7) authorizes the corporate charter provisions that insulate directors from personal liability to the corporation for breaches of their duty of care. Thus, even creditors asserting derivative claims are subject to these exculpatory charter provisions. In the court's view, this ruling is necessary in order for the statute's evident purpose — encouraging capable persons to serve as directors of corporations by providing them with the freedom to make risky, good faith business decisions without fear of personal liability — to be implemented.

In fact, these provisions are perhaps most necessary when “a fact-finder, in view of hindsight bias in its knowledge of the fact that the debtor's business strategy did not pan out, will conclude that the directors have acted with less than due care, even if they did not.” The mere fact that creditors have standing to pursue an insolvent corporation's claim against directors, or that the corporation's claim has been assigned as an asset to creditors somehow transforms the claim into one excepted from Section 102(b)(7) would defeat the very purpose of the statute.

Nonetheless, the court concluded that, given the pattern of dealing alleged in the Complaint, it could not dismiss PRG's fiduciary duty count, but allowed it to proceed subject to the limitations expressed in its opinion.

Conclusion

For bankruptcy practitioners, Production Resources' greatest impact may be felt by unsecured creditors committees and trustees seeking to hold directors and officers liable for mismanagement leading to bankruptcy. Among other things, the case calls into question the concept of direct claims against these targets, and firmly supports the viability of “due care” exculpation provisions. Given the court's ruling, those provisions may be sufficient to defeat creditor claims for breach of fiduciary duty by motion to dismiss or by early motions for summary judgment.