The 'Zone of Insolvency'

The Duty of Loyalty

Directors and officers are also obligated to act in good faith, in the best interests of the corporation and its shareholders, and to refrain from using their positions of trust and confidence to further their private interests. Where a director or officer has a conflict of interest in a corporate opportunity ' meaning that he or she may stand to gain or may appear to gain some personal benefit from a corporate transaction, pecuniary or non-pecuniary ' the conflicted director or officer is required to act in good faith and make a full disclosure of his or her conflict of interest.

Furthermore, to avoid a breach of duty of loyalty, the business transaction must also be a fair bargain. Generally, the duty of loyalty is preserved if a corporate action is approved by a majority of disinterested directors or officers.

The Business Judgment Rule

When directors and officers make business decisions that are reasonably informed, rational and made in good faith in a manner reasonably believed to be in the best interests of the corporation, their decisions will be protected by the business judgment rule. This creates a presumption that directors and officers, in reaching the decision in question, upheld their fiduciary duties to the shareholders and the corporation. The rule further operates as a substantive protection for directors and officers by not holding decision-makers liable for business outcomes that prove to be unwise or unprofitable.

Simply put, courts will not substitute their own business judgment for that of the directors and officers. The business judgment rule serves the important purpose of allowing directors and officers to fairly assess the risks and rewards of business opportunities without fear of personal liability for unprofitable results.

Corporations in the 'Zone of Insolvency'

These fiduciary duties and concepts generally apply to all corporations. The question has arisen over time, however, whether and to what extent the fiduciary duties of directors and officers may shift to benefit creditors of a corporation that is in or nearing the “zone of insolvency.”

The “zone of insolvency” is a loosely defined term that represents the state of a corporation in financial distress. A corporation may be said to be in the zone of insolvency if it is nearing the point where: 1) it lacks the ability to pay its debts as they come due in the ordinary course of business; or 2) the sum of the corporation's liabilities exceeds the sum of its assets.

Despite a lack of legal foundation for the assertion, many corporations believe ' and many professionals have advised ' that as a corporation nears the zone of insolvency, the directors' and officers' fiduciary duties of care and loyalty are owed to the creditors of the corporation, rather than the corporation and its shareholders.

The Delaware Supreme Court decision of North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007) clarified that directors' and officers' fiduciary duties are owed to the corporation and its shareholders, even when the corporation is in or nearing the zone of insolvency.

Directors and officers of a corporation in the zone of insolvency must continue to act with the goal of maximizing shareholder value in developing strategies to overcome financial hardship. A variety of strategies may be reasonable and viable solutions for a company facing insolvency, including without limitation, filing a voluntary petition for protection under Chapter 7 or Chapter 11 of the Bankruptcy Code, incurring additional indebtedness to fund the operation of the business or new business opportunity, and engaging in a sale or merger with an interested buyer.

In Trenwick America Litigation Trust v. Ernst & Young, L.L.P , 906 A.2d 168 (Del. Ch. 2006), the Delaware Court of Chancery held that “even when a corporation is solvent, the notion that directors should pursue the best interest of the equity holders does not prevent them from making ' myriad ' judgments about how generous or stingy to be to other corporate constituencies.” Trenwick 906 A.2d at 195 n. 75.

The business judgment rule serves to allow directors and officers to consider high-risk strategies to remedy financial hardship, as often such strategies are warranted to reach the best result for shareholders.

'Deepening Insolvency'

As a result of the misconception that directors and officers owe fiduciary duties to creditors when the corporation is nearing the zone of insolvency, a theory that directors and officers can be directly liable to creditors for the “deepening insolvency” of the corporation developed. The term “deepening insolvency” refers to the notion that directors and officers acted without due care to prolong the life of a financially unstable corporation and, as a result, accumulated more debt in the name of the company and created more exposure for creditors.

In Trenwick, the court concluded that deepening insolvency is not an independent cause of action. The court held that the board of directors and management of even an insolvent corporation may pursue, in good faith, strategies to maximize the value of the corporation. Courts have subsequently ruled that the legal significance of the theory of deepening insolvency is that it is a viable measure of damages in a proper case against the directors or officers of a corporation.

Creditors' Rights

The landmark cases of Gheewalla and Trenwick clarified that at all times, up until the point of insolvency, directors and officers owe fiduciary duties to the corporation and its shareholders, and not to third-party creditors.

The idea that creditors of a corporation in financial distress should be protected, however, was not lost on Delaware courts. Rather than a shift in fiduciary duties, as the common misconception held, the courts held that there is a continuity of fiduciary duties owed to the stakeholders of a corporation, whether the corporation is solvent, financially unstable or insolvent. When a corporation becomes insolvent, its creditors take the place of its shareholders as the residual beneficiaries of any increase in value. The courts stress that, regardless of the financial condition of the corporation, the directors' and officers' duties to exercise due care and loyalty to the corporation and ultimately maximize stakeholder value remain the same.

The practical effect of these holdings is that once a corporation becomes legally insolvent, creditors may, like shareholders of a solvent corporation, bring a derivative action against the directors and officers of the corporation for breach of fiduciary duties.

Director and Officer Liability

Directors and officers are separate and distinct from the corporations they serve, and therefore are not liable in a personal capacity for a corporation's debts and liabilities. The rationale behind the corporate form is that directors and officers, in seeking to maximize shareholder wealth, should consider all business strategies, including risky ones. Directors and officers will inevitably make business decisions that will not result in financial success, and the fear of being held personally liable would inhibit objective thinking and progressive strategies.

Generally, the corporate veil will only be pierced when directors and officers have harmed the corporation by acting with gross negligence or engaging in fraud or a self-dealing transaction. Shareholders have the right to bring a derivative, but not a direct, lawsuit against the corporation's officers and directors in these situations, as they are the parties to whom directors and officers owe fiduciary duties.

When a corporation enters or is nearing the zone of insolvency, the law governing director and liability remains unchanged. However, as discussed herein, when a corporation reaches the point of insolvency, creditors step into the shoes of the shareholders of the corporation and gain standing to bring a derivative action against the directors and officers of the corporation for breach of fiduciary duties.

Gheewalla and Trenwick further dispelled the notion that creditors have a direct cause of action against directors and officers of a corporation for the diminished value of a corporation during insolvency or the period leading up thereto. The reasoning is that allowing individual creditors to directly sue a director or officer of a corporation would create an inherent conflict of interest between negotiating with one creditor versus maximizing the value of the enterprise to benefit the corporation and all creditors. Moreover, shareholders, the beneficiaries of directors' and officers' fiduciary duties in solvency, do not have such a right.

Conclusion

Directors and officers must exercise the duties of care and loyalty in making the decisions of corporate action. Those duties must include making decisions that are in the best interest of creditors and other constituencies of the corporation. If the corporation is solvent, the creditors' interests are not foremost because they will be paid in full. If the corporation is insolvent, however, those interests must be factored into all decisions because there is a practical concern of defaulting on obligations to creditors. The prudent director and officer make decisions that are in the best interest of the corporation, and the constituencies of the corporation likely impacted by such action.

Daniel F. Blanks is a partner in the Jacksonville, FL, office of Nelson Mullins Riley & Scarborough LLP. He counsels clients in matters related to bankruptcy, financial restructuring, distressed asset acquisitions, commercial workouts and commercial litigation. Kelly Dunn is an associate in the same office, where she practices in the areas of business and corporate law. The authors can be reached at [email protected] and [email protected], respectively