When a company encounters financial distress, the board’s fiduciary duties may expand beyond the basic obligation to shareholders. This article considers the general rules of fiduciary duty applicable to directors under Delaware corporate law, how a financial distress situation can affect those duties, and what counsel and boards should consider as a company nears the “zone of insolvency.”
Fiduciary Duties of Directors and Officers
The duties of a corporation’s directors and officers are governed by applicable state law. For general discussion purposes, this article will focus on the fiduciary duties of directors and officers of Delaware corporations and highlight certain state specific variations. Those duties are typically defined as the duty of loyalty and the duty of care. It should be noted that the managers and “control persons” of limited liability companies are also required to adhere to the duties of loyalty and care, absent contrary provisions in the company’s limited liability agreement.
The Duty of Loyalty
Directors and officers of a corporation owe a fiduciary duty of loyalty to the company and its shareholders. This duty requires that, in all instances, the fiduciaries act in the best interest of the corporation and its shareholders. The duty of loyalty includes the obligation to refrain from any conduct that would injure the corporation and its shareholders, or deprive them of profit or advantage. The duty of loyalty also carries with it the requirement that the directors and officers of the corporation perform their obligations in good faith. Breach of the duty of loyalty is implicated by conflicts of interest, self-dealing, the disclosure of corporate confidences, the disregard of good-faith performance standards, and abuse and/or misappropriation of corporate opportunities.
The Duty of Care
Directors and officers also owe a duty of care to the corporation. The duty of care requires that directors and officers of a corporation carry out their responsibilities with the requisite degree of care and prudence. In order to satisfy the duty of care, the directors and officers must inform themselves of all material reasonably available to them before making a business decision. In making such decisions, the directors and officers are allowed to (and in some circumstances, may be obligated to) consult with and/or rely on the advice of experts including lawyers, accountants, and financial advisors. In addition to being well-informed, the directors and officers are also required to take action with the requite degree of care and prudence under the circumstances.
The Business Judgment Rule
The business judgment rule establishes a standard for judicial review of the conduct of directors of a corporation. In such reviews, there is a presumption that in making business decisions, the directors of a corporation acted on an informed basis, in good faith, and with the belief that the actions taken or decisions made were in the best interest of the corporation. It is essentially the codification of the “benefit of the doubt” given to corporate directors. A plaintiff challenging the actions of corporate fiduciaries must plead sufficient facts to demonstrate it can meet all of the legal elements required to overcome the business judgment rule presumption. In application of the business judgment rule, the court will refrain from substituting its own view for those of the directors of the corporation after the fact.
The presumption may be overcome by pleading and proving facts that demonstrate the director(s) failed to uphold the duties of loyalty or care, or lacked good faith in the exercise of his or her duties. Once the initial pleading standard is met, the director(s) have the burden of proof to show that the actions taken or decisions made were fair to the corporation and its shareholders. The business judgment presumption is unavailable where fraud, bad faith, or self-dealing on the part of the director(s) is established.
Still, courts recognize that, perhaps more so than ever, during times of financial distress, directors and officers of a corporation require the flexibility to act diligently, negotiate fiercely, and exercise discretion in making business decisions. Accordingly, business decisions made by disinterested and independent directors on an informed basis and with a good faith belief that the decision will serve the best interest of the company are protected by the business judgment rule.
When the Tide Turns Toward Insolvency
The directors and officers of a corporation owe fiduciary duties to the corporation and its shareholders. Creditors of a solvent corporation are generally not owed duties beyond adherence to the contractual terms of engagement. When a corporation nears or reaches the point of insolvency, there are often questions about changes in the fiduciary duties of directors and officers of the corporation.
Historically, courts have found that once a corporation becomes insolvent, or reaches the “zone of insolvency,” the fiduciary duties owed by its directors and officers are extended to creditors of the corporation. However, in recent years, courts following the lead of the Delaware Supreme Court and the Delaware Chancery Court have clarified the law on fiduciary duties to emphasize that there is no change in the duties owed and to whom, but rather in the limited circumstance of insolvency the creditors of the corporation have standing to assert derivative claims against the directors and officers on behalf of the corporation. The Delaware Supreme Court in North American Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007), held that while fiduciary duties are always owed to the corporation and its shareholders, and creditors are owed no special duties when the company is financially distressed (i.e., zone of insolvency), once the company is actually insolvent, fiduciary duties are owed to the corporation as an “enterprise” with the creditors taking the place of shareholders as the principal constituency. During insolvency, the directors and officers of the corporation may in good faith, with the benefit of the business judgment rule, continue to pursue strategies to turn the company around. The strategies employed may, however, be subject to challenge. Directors and officers of distressed companies are therefore well advised to carefully consider proposed actions, whether to incur additional debt or simply keep the doors open, along with the alternatives and consequences of such proposed actions.
Determining the Point of Insolvency
To establish insolvency, courts have required a showing of either “balance sheet insolvency” or “equitable insolvency.” Balance sheet insolvency (sometimes referred to as “bankruptcy insolvency”) considers whether the company’s liabilities exceed its assets and will continue to do so for the foreseeable future. This test stems from the Bankruptcy Code definition of insolvency. Because of the broad definition of liabilities (including contingent, unliquidated, and disputed obligations) and assets (i.e., all tangible and intangible property interests at fair market value), the balance sheet insolvency test can be sensitive to variations in the inputs used under generally accepted accounting principles. By way of example, including contingent liability related to pending litigation or an outstanding guaranty may thrust an otherwise solvent entity into insolvency. For this reason, many courts, including the Delaware Court of Chancery, opt for the equitable insolvency test which considers simply whether the company is able to pay its debts as they become due.
Determining the point of insolvency can be a difficult task, but is an important exercise inasmuch as it influences the duties of the directors and officers and the rights of creditors to initiate suit for breach of fiduciary duty. This is not, however; to suggest that creditors are without recourse to limit exposure when a company is in the zone of insolvency. To be sure, creditors are free at any time (absent a bankruptcy stay or other court order) to take action to enforce contract terms or exercise other statutory non-derivative actions. As one court explained, “Both state law and federal law provide a panoply of remedies in order to protect creditors injured by a wrongful conveyance, including avoidance, attachment, injunctions, appointment of a receiver, and virtually any other relief the circumstances may require.” Trenwick American Litigation Trust v. Ernst & Young, LLP, 906 A.2d 168, 199 (Del. Ch. 2006).
In the bankruptcy context, the fiduciary duties of directors and officers of a reorganizing corporation are expanded to include duties owed under applicable state law (i.e., duty of loyalty and duty of care) and statutory obligations prescribed by the Bankruptcy Code. The reorganizing corporation in bankruptcy is recognized as a “debtor-in-possession” and is charged with the rights and responsibilities of a trustee in bankruptcy. The debtor-in-possession or “DIP” (and by extension the directors and officers who remain on the job during bankruptcy) is therefore a statutory fiduciary, pursuant to applicable provisions of the Bankruptcy Code. In its fiduciary capacity, the DIP must consider the interests of creditors (whether secured or unsecured) and shareholders. The chief objective of the DIP is to maximize the value of the bankruptcy estate for the benefit of all interested parties.
At various stages in the bankruptcy proceedings, the interests of the DIP’s constituencies may differ or conflict. For instance, the sale of corporate assets may satisfy certain creditors, but leave little or nothing for other stakeholders (i.e., unsecured creditors and shareholders). Or, a particular plan proposal may contemplate a change in control, ownership, or operations that never would have been considered by current ownership outside of the bankruptcy context. In such circumstances, the duty of loyalty would compel the DIP to give due consideration to the issues and act in a manner that is fair to each constituency group, maximizes the value of the estate, and avoids self-dealing.
While bankruptcy does expand the fiduciary responsibilities, it also allows for additional protections for directors and officers of distressed companies. For example, controversial transactions or decisions that fall outside the company’s ordinary course of business must be disclosed and approved by the bankruptcy court. Approval of non-ordinary course transactions is contingent upon a showing of a reasonable exercise of the DIP’s business judgment in pursuing the transaction. Once court approval is granted, the directors and officers of the company may rely on the approval order as some evidence of the reasonableness of the decision in the face of a challenge. Another example of bankruptcy protections not otherwise available is the opportunity to include specific findings of fact and conclusions of law regarding the directors’ and officers’ good faith and exercise fiduciary duties in the reorganization plan and confirmation order – which carry injunctive provisions. Such an order can serve to bar, or at least limit, claims of breach of fiduciary duty that may otherwise be lodged against the directors and officers of the debtor corporation.
Make Sure You Are Covered
One of the most important issues the directors and officers of any corporation, but certainly a financially distressed entity, should have a handle on is the scope and availability of insurance coverage. In the midst of a financial crisis, the directors and officers of a corporation may find greater exposure to personal liability than any other time. There may be creditors, shareholders, regulators, and other fiduciaries challenging the actions and decisions of the board through lawsuits and administrative proceedings. All while the board and corporate officers are doing their best to keep the ship afloat. In the best case scenario, they have planned well ahead of the storm to assure not only compliance with fiduciary obligations, but appropriate coverage to guard against claims of personal liability for corporate failure.
Corporations generally include provisions in their bylaws and articles of incorporation to indemnify the directors and officers for losses arising out of claims based on their employment or service to the corporation. If the corporation is financially distressed, the promise to indemnify will provide little solace to the director or officer being threatened with suit or government action. The corporation’s insurance policies may be the only source of financial protection the directors and officers have against claims lodged against them. Even absent a finding of liability, the costs to investigate and defend a claim against a director or officer of a corporation can be monumental. Directors and officers (and counsel) should therefore carefully review the company’s D&O insurance coverage (on a routine basis) and require adjustments where necessary.
Types of D&O Policy Coverage
To begin with, the directors and officers should understand the distinctions between various coverage options.
- A-Side Policies – Directly covers directors and officers against personal liability in the absence of indemnification from the debtor insured.
- B-Side Policies – Reimburses the company for its indemnification of directors and officers.
- C-Side Policies – Directly covers the company for securities based claims.
Important Policy Provisions
There are also key policy provisions that should be reviewed, considered, or modified if necessary. Here are some examples.
Insured vs. Insured Exclusions
Many D&O policies include provisions that exclude coverage when one insured sues another (i.e., corporation vs. board member). Such provisions can be troublesome in the even a trustee or receiver initiates suit against former board members on behalf of the corporation. In such circumstances, and because the trustee “steps into the shoes” of the corporation, carriers have sought to deny coverage pursuant to the terms of an insured vs. insured exclusion. Counsel for directors and officers should therefore carefully review policy provisions and negotiate limitations or exceptions for statutory fiduciaries such as trustees and/or receivers.
Certain policies impose limitations or prerequisites to coverage based on initial contributions by the insured. Under such policies there is no coverage or obligation for the insurance company to fund defense costs, unless and until an initial retention layer (similar to a deductible) has been satisfied. A financially distressed corporation may be unable to meet such self-insurance obligations. Courts, particularly in the bankruptcy context, have recognized this and directed practical solutions, reasoning:
The failure of a bankrupt insured to fund a self-insured retention does not relieve the insurer of the obligation to pay claims under the policy. This is so because where (as in this case) an insured debtor has paid the policy premium in full, the insurance policy is not an executory contract for purposes of § 365 of the Bankruptcy Code, even where the debtor has continuing obligations, such as the payment of a self-insured retention, a deductible, or a premium. Failure of the debtor to perform these continuing obligations does not excuse the insurer from performance under the contract, but gives rise to an unsecured claim by the insurer for any damages incurred by reason of the debtor's breach of the policy. In short, courts interpreting § 365 of the Bankruptcy Code have made it clear that, for purposes of that provision, the debtor's payment of the policy premium constitutes substantial compliance with its contractual obligations.
American Safety Indemnity Co. v. Vanderveer Estates Holdings, LLC (In re Vanderveer Estates Holding, LLC), 328 B.R. 18, 25 (Bankr. E.D.N.Y. 2005).
In recent years, many challenges to corporate board action have resulted from or been related to findings and action by state or federal regulators (i.e., SEC, EPA, FDIC, etc.). Yet, D&O policies generally exclude coverage for actions initiated by government agencies. The directors and officers of corporations, particularly in highly regulated industries, should be careful to insure against overly broad exclusions.
Most D&O policies provide coverage for “claims made” prior to the expiration of the policy terms. Yet, the directors and officers of a corporation may have exposure to claims arising from their positions well past the date a particular policy expires. Indeed, many state law statutes of limitations for breach of fiduciary duty claims don’t begin to run until alleged wrongful acts are discovered. And, in the bankruptcy context, federal law provides additional tolling provisions that may extend the deadline to assert claims well beyond policy expiration dates. Accordingly, “tail coverage” provisions are available to establish an “extended reporting period” to close the gap on exposure.
The reality of today is, when a business fails, blame may be placed on the directors and officers, whether or not there has been any wrongdoing. Directors and officers of distressed corporations (and the attorneys that represent them) must have a clear understanding regarding the obligations that are owed to the corporation, its shareholders, and other constituency groups. Due diligence, advance planning, and careful, good-faith, informed decision making can reduce liability and avoid personal exposure. But, make sure there is adequate and effective insurance coverage – just in case.