August 30, 2018 Practice Points

D&O Fiduciary Duties During Insolvency

Where available, derivative actions are a powerful tool that allow creditors to look beyond their debtor, when insolvency has left them holding the bag.

By Sara Ann Brown

Corporate officers and directors are the linchpin of corporate governance in the United States, and while we traditionally think of their duties flowing directly to the company and stockholders, there is an important—and often overlooked—exception: insolvency. The doctrine varies greatly state-to-state, but once a company is insolvent, many jurisdictions hold that directors and officers owe creditors a fiduciary duty to maintain the assets of the corporation. As one court explained, “What changes upon insolvency is the constituency: the creditors are now the ‘risk bearers’ so they now have the right, like stockholders, to bring a derivative action in the corporation’s name against directors who ‘unduly risk’ corporate assets.” AWTR Liquidation, Inc., 548 B.R. 300, 325 (C.D. Cal. 2016). (See also Quadrant Structured Products Co., Ltd. v. Vertin, 115 A.3d 535, 546 (Del. Ch. 2015).)

Creditors’ right to bring a derivative action on behalf of a corporation for breach of fiduciary duty is a common-law doctrine that responds to a problem courts and legislatures have wrestled with for nearly 200 years: how to adequately protect creditors of insolvent corporations. (See Wood v. Dummer, 3 Mason 309; 30 F. Cas. 435, 437 (C.C.D. Me. 1824).) The purpose of derivative actions is to prevent the “‘failure of justice’ that would result if conflicted or disloyal fiduciaries could prevent a corporation from pursuing valid claims, including claims against its own directors and officers.” Quadrant, 115 A.3d at 549. When a corporation is solvent, only its stockholders have standing to pursue a derivative suit. But when a corporation is insolvent, creditors have the same incentive to pursue derivative claims as individual shareholders do during periods of solvency. N. Am. Catholic Educ. Programming Found., v. Gheewalla, 930 A.2d 92, 101 (Del. 2007).

Lawmakers have taken a different tack, establishing fraudulent transfer causes of action that give creditors an avenue to recover certain transfers of an insolvent debtor’s assets in satisfaction of their claims (e.g.,Section 548 of the Bankruptcy Code and the Uniform Fraudulent Transfer Act). In contrast to creditor-derivative suits, fraudulent transfer actions are asserted against transferees—the entities and individuals that received assets from an insolvent debtor. While recovery for fraudulent transfer claims is capped at the amount owed to creditors (see Ohio Uniform Fraudulent Transfer Act, Ohio Rev. Code Ann. § 1336.07(A)(1)), the recovery from breach of fiduciary duty claims flows to the corporation and then to creditors and, after all debts are paid, to stockholders. (See Quadrant, 115 A.3d at 554.) But owing to their shared foundation, creditor-derivative claims are often asserted in concert with fraudulent transfer claims by aggrieved creditors and bankruptcy trustees acting on their behalf. (See, e.g., AWTR Liquidation, 548 B.R. at 309.)

For attorneys analyzing creditor-derivative suits, the threshold question to address is whether the law of incorporation recognizes a creditor’s right to assert a derivative suit at all and, if it does, when such suit is allowed. In Delaware, for example, a creditor has standing to assert a derivative fiduciary duty claim when a corporation becomes insolvent and retains that standing through judgment even if, during the course of litigation, the corporation recovers. Quadrant, 115 A.3d at 554. But other jurisdictions have limited the doctrine and only permit derivative suits by creditors when a corporation is insolvent and “has ceased to carry on business, and does not intend to resume[.]” Aurelius Capital Master, Ltd. v. Acosta, 3:13-CV-1173-P, 2014 WL 10505127, at *4 (N.D. Tex. Jan. 28, 2014) (quoting Lyons–Thomas Hardware Co. v. Perry Stove Mfg. Co., 86 Tex. 143, 158, 24 S.W. 16, 21 (1893)).

As it stands today, the availability of derivative standing to creditors varies across jurisdictions. But where available, derivative actions are a powerful tool that allow creditors to look beyond their debtor when insolvency has left them holding the bag.

Sara Ann Brown is a trial lawyer at Foley Gardere, Foley & Lardner LLP, and focuses on bankruptcy litigation and complex commercial disputes. She also clerked for the Honorable Harry Lee Hudspeth in the U.S. District Court for the Western District of Texas.

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