Managing Financially Distressed Corporations: A Director’s Enhanced Obligation to Consider and Balance Interests Owed to the Entire Corporate Enterprise - ABA YLD 101 Practice Series

By Jay Shah

The current economic climate presents corporate management with a challenging business environment. On September 15, 2009, U.S. Federal Reserve Chairman Ben Bernanke announced that, from a technical perspective 1, the recession characterized as the worst since the Great Depression had ended. Bernanke’s statement, while encouraging, requires consideration in the proper perspective. The unfortunate economic reality is that many corporations, particularly those with highly leveraged debt structures, inadequate access to public and/or private capital markets and inventory overcapacity issues, exist, and will continue to exist throughout 2010 and beyond, in a “financially distressed state. 2

One-time financially sound corporations unable and/or unprepared to adequately navigate these arduous times face an increased risk of litigation from persons with a vested interest in the corporation’s performance: shareholder and creditors. Therefore, management should expect enhanced scrutiny to internal controls, financial reporting and specific decisions that, reviewed in hindsight, contributed to a debt default or statutory insolvency ( i.e. bankruptcy). For this reason, management should be cognizant of their responsibilities once a corporation is financially distressed and operating in a state of insolvency.

The recent Delaware 3 decision, North American Catholic Educational Programming Foundation Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007) (“ Gheewalla”), confirmed that directors managing insolvent corporations not only have traditional fiduciary responsibilities toward the corporation and its shareholders, but also toward the corporation’s creditors.

Gheewalla: Creditor Rights and Director Fiduciary Obligations for Financially Distressed Corporations

Gheewalla provides guidance as to whom director fiduciary duties are owed as the corporation enters a state of insolvency and the extent of creditor rights during insolvent or near insolvent corporate states. The Gheewalla Court (the “Court”) examined earlier decisions, such as Geyer v. Ingersoll Publications Co. [621 A.2d. 784 (Del. Ch. 1992)] and Production Resources Group V. NCT Group, Inc. [863 A.2d 772 (Del. Ch. 2004)], which held that during periods of solvency, director fiduciary duties are only owed to the corporation and its shareholders; however, when the corporation becomes insolvent or enters the “zone of insolvency,” these duties are transitioned to creditors. Those earlier decisions imputed fiduciary rights to creditors during the “zone of insolvency,” an undefined, amorphous, ever-changing stage covering an indefinite period prior to insolvency, and implicitly permitted individual creditors to bring direct claims against a corporation.

The Court, perhaps anticipating the current economic crisis and subsequent increase in director related litigation, slightly narrowed the common law rights provided to creditors in earlier decisions. The Court held that: (i) directors do not owe a direct fiduciary obligation to individual creditors of a corporation that is insolvent or operating in the zone of insolvency; and (ii) creditors of insolvent corporations only have proper standing to bring a derivative claim, for breaches of fiduciary duties that negatively affect the value of the corporation.

“Direct claims by individual creditors provide individual creditors with the same fiduciary standing as shareholders in addition to the protections already afforded by contract, statute and common law.” “While shareholders rely on directors acting as fiduciaries to protect their interest, creditors are afforded protection through contractual arrangements, fraud and fraudulent conveyance law, implied covenants of good faith and fair dealing, bankruptcy law, general commercial law and other sources of creditor rights.” Gheewalla, 930 A.2d at 99.

Notwithstanding the fact that the Court distinguished its decision from previous decisions, the Court further confirmed that directors managing insolvent corporations have a fiduciary obligation to consider and balance interests owed to the entire corporate enterprise. An enhanced fiduciary obligation is both logical and necessary from a business perspective, because once a corporation is financially distressed and operating in a state of insolvency, creditors and shareholders benefit from diverging corporate strategies.

Relationship between Directors and the Corporation

The corporate structure divides ownership responsibilities and management rights. Equity owners ( i.e. shareholders) have ownership responsibilities and therefore have the right to vote on and approve significant decisions, including director appointment; in comparison, directors have management rights and are therefore responsible for the management of the business and affairs of the corporation. This bifurcated approach is premised on two fundamental concepts, both of which are essential in preserving the corporate structure.

First, board decisions are aligned with the best interests of the corporation and its shareholders, because directors owe fiduciary duties of care and loyalty to the corporation and to its shareholders: in that capacity, directors are obligated to (i) use independent judgment and act on a diligent, informed basis (“Duty of Care”), and (ii) act in good faith and in the best interests of the corporation, which at a minimum requires that the best interests of a corporation and its shareholders take precedence over any interest possessed by any director (“Duty of Loyalty”).

Second, board decisions made in furtherance of these management responsibilities are protected by the “business judgment rule,” which presumes that the directors of a corporation act on an informed basis, in good faith, and in the honest belief that any action they take is in the best interest of their corporation: the business judgment rule is basic standard of judicial inquiry with respect to directors’ decisions.

Generally, directors do not owe fiduciary duties to a corporation’s creditors. Creditors’ rights are protected through contractual arrangements, fraudulent conveyance law and bankruptcy law. However, directors governing financially distressed corporations have expanded fiduciary duty obligations that require directors to consider the interests of the entire corporate enterprise.

Shareholders vs. Creditors: Insolvency Creates Conflicting Interests

Of primary concern to both shareholders and creditors is the maximization of their return on their principal investment. During periods of “financial soundness,” identifiable by growth, wealth creation and wealth preservation, creditors and shareholders have aligned interests; however, once a corporation is financially distressed and operating in a state of insolvency, creditors and shareholders benefit from diverging corporate strategies. This divergence is directly attributable to priority rights in the dissolution, bankruptcy and wind-down process. Shareholders, holding the lowest priority to remaining assets, have an incentive to avoid bankruptcy and therefore prefer riskier transactions focused on wealth creation. Conversely, creditors, particularly those with first or second lien positions, prefer conservative decisions focused on wealth preservation. Corporate insolvency directly correlates to a shift in the allocation of economic risk. During periods of financial solvency, shareholders are the primary bearers of economic risk; however, when the firm is insolvent or approaching insolvency, creditors are the primary bearers of economic risk.

Insolvency: The Lack of Definitive Guidance

While Gheewalla narrowed certain rights imputed to creditors in earlier decisions, the Court confirmed the fundamental premise of those decisions by holding that directors managing insolvent corporations not only have traditional fiduciary responsibilities toward the corporation and its shareholders, but also toward the corporation’s creditors. Recurring operating losses, negative cash flow, adverse financial ratios, growing payables and credit denial are indicative characteristics of a financially distressed corporation, not necessarily an insolvent corporation. Therefore, critical to director compliance and effective management is a proper determination of when a corporation is operating in a state of insolvency.

The Court failed to establish a bright-line test or provide definitive guidance regarding when a corporation is operating in a state of insolvency for the purposes of enhanced fiduciary duty obligations. Important to consider is that fact that common law “insolvency” and statutory insolvency ( i.e. bankruptcy) are separate, distinguishable solvency states. Compared to statutory insolvency, characterized by a definitive bright-line statutory bankruptcy filing, Delaware courts have adopted a more expansive definition of insolvency; in the fiduciary duty context, insolvency can, and often does, arise prior to a corporation filing for bankruptcy.

Cash Flow Test vs. Balance Sheet Test

Gheewalla identified two primary tests to determine if and whether a corporation is operating in a state of insolvency: (i) a Balance Sheet Test – a corporation’s liabilities exceed its assets; and (ii) a Cash-Flow Test – a corporation has insufficient cash flow to meet maturing obligations as they fall due in the ordinary course of business ( e.g. payroll, fixed overhead expenses, etc.). Application of these tests illustrates the uncertainty associated with an accurate determination of a corporation’s true financial state. A corporation may be operating in a state of insolvency under one test, but not the other. Application of the Balance-Sheet Test to newly formed corporations, or highly intensive R&D and/or technology-based corporations would be ineffective, because their value resides largely in intangible assets.  

The lack of a universal standard or exacting definition of “insolvency” combined with the retrospective manner in which insolvency is determined signifies the importance of well-balanced decision making in times of financial distress. Further, improper solvency state determinations subject the board to potential claims of breach of fiduciary duties. For example, if management, of a financially distressed corporation, incorrectly determines that the corporation is insolvent and, as a result of that decision, considers the interests of creditors above that of the corporation’s shareholders, the board would be subject to shareholder-based breach of fiduciary duty claims.

Director Fiduciary Duties: The Insolvent Corporation

Directors governing corporations operating in a state of insolvency not only have traditional fiduciary responsibilities toward the corporation and its shareholders, but also toward the corporation’s creditors. For clarification, directors are not required to prioritize creditors’ interests ahead of the interests of the corporation or its shareholders; rather, directors are required to consider and balance the interests owed to the entire corporate enterprise, which includes both shareholders and creditors: “directors of an insolvent corporation owe duties to the entire corporate enterprise rather than any single group interested in the corporation.” Gheewalla, 930 A.2d at 101.  Traditional fiduciary duties of loyalty and care govern director action even after the corporation enters a state of insolvency; therefore, a director’s fundamental purpose and responsibility - to maximize the economic value of the corporation – remains constant, regardless of the corporation’s solvency state. Therefore, directors governing insolvent or near insolvent corporations would be prudent to consider capital preservation responsibilities now owed to creditors, in conjunction with wealth creation decisions, such as the reduction of debt. Litigation considerations arise when directors engage in corporate actions that that provide a benefit to shareholders to the detriment of creditors: (i) the payment of dividends, (ii) the redemption of stock and (iii) the decision to engage in high risk/low probability actions that are most likely to result in the corporation’s inability to fully, or partially, repay creditors.

Going Forward

As discussed, directors managing financially distressed, insolvent corporations should exercise heightened diligence and care with respect to financial and operational decisions. Heightened fiduciary obligations do not necessarily translate to an increased exposure to liability. Traditional, fundamental director protections, for well-informed, business judgment decisions, remain intact regardless of a corporation’s financial state. Directors will not be held liable for well-informed, business judgment decisions aimed at capital growth regardless of the corporation’s financial condition. Notwithstanding this point, implementing good practices that promote the effective monitoring of corporate performance can minimize individual director risk and facilitate director compliance. These good practices include: completing periodic, timely evaluations of the corporation’s capital structure, debt obligations and short-term liquidity requirements; comparing the corporation’s financial performance to internal projections and the external business environment; supplementing internal board findings with analysis provided by accountants, auditors, attorneys, and other knowledgeable experts; confirming the adequacy of indemnification provisions and D&O insurance coverage; and staying fully informed of events that have a substantial effect on the corporation’s financial state. These general, universally applicable procedures would increase management’s preparedness to effectively manage a financially distressed corporation.


1 Economists define “recession” as two consecutive fiscal quarters of negative growth. For perspective, during fiscal years 2008 and 2009, the United State’s economy experienced four consecutive fiscal quarters of negative growth.
2  “financially distressed state” is a corporate finance term used to indicate a condition when a company is unable, or has difficulty, honoring debt related obligations.
3 This article focuses solely on Delaware corporate law, since it is fairly well developed and often a source of precedent and guidance for other jurisdictions.

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About the Author

Jay Shah is an attorney with Haskell Slaughter Young & Rediker, LLC, and practices in the firm’s Birmingham office where he is a member of the Transactional Practice Group. He represents clients in a variety of business and financial matters. He can be reached at 205-254-1452 or jvs@hsy.com

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