By: Scott B. Riddle, Esq.
I have previously posted (follow the link to the Delaware Litigation Blog) on the subject of whether creditors have a direct action against directors of a corporaton that has entered the zone of insolvency. Chief Justice Steele’s comments were prophetic. Yesterday, in an opinion that will likely have a far reaching affect (even if we only consider Delaware corporations), the Delaware Supreme Court ruled that creditors of an insolvent corporation do not have a direct action against directors (and presumably officers?) for breach of fiduciary. Note that while Chief Justice Steele participated in the case, he did not write the opinion. Thanks to Ideoblog for the tip.
In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, et al, No. 521,2006, 2007 Del. LEXIS 227 (Del. May 18, 2007), the issue before the court – one of first impression for the Delaware Supreme Court – was whether creditors of an insolvent corporation may bring a direct action (as opposed to a derivative action) against directors for breach of fiduciary duty. The Court said no.
This Court has never directly addressed the zone of insolvency issue involving directors’ purported fiduciary duties to creditors that is presented by NACEPF in this appeal. That subject has been discussed, however, in several judicial opinions and many scholarly articles. …
Direct Claims For Breach of Fiduciary Duty May Not Be Asserted by Creditors
It is well settled that directors owe fiduciary duties to the corporation. When a corporation is solvent, those duties may be enforced by its shareholders, who have standing to bring derivative actions on behalf of the corporation because they are the ultimate beneficiaries of the corporation’s growth and increased value. When a corporation is insolvent, however, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.
Consequently, the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties. The corporation’s insolvency "makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm’s value." Therefore, equitable considerations give creditors standing to pursue derivative claims against the directors of an insolvent corporation. Individual creditors of an insolvent corporation have the same incentive to pursue valid derivative claims on its behalf that shareholders have when the corporation is solvent.
In Production Resources, the Court of Chancery recognized that–in most, if not all instances–creditors of insolvent corporations could bring derivative claims against directors of an insolvent corporation for breach of fiduciary duty. In that case, in response to the creditor plaintiff’s contention that derivative claims for breach of fiduciary duty were transformed into direct claims upon insolvency, the Court of Chancery stated:
The fact that the corporation has become insolvent does not turn [derivative] claims into direct creditor claims, it simply provides creditors with standing to assert those claims. At all times, claims of this kind belong to the corporation itself because even if the improper acts occur when the firm is insolvent, they operate to injure the firm in the first instance by reducing its value, injuring creditors only indirectly by diminishing the value of the firm and therefore the assets from which the creditors may satisfy their claims.
Nevertheless, in Production Resources, the Court of Chancery stated that it was "not prepared to rule out" the possibility that the creditor plaintiff had alleged conduct that "might support" a limited direct claim. Since the complaint in Production Resources sufficiently alleged a derivative claim, however, it was unnecessary to decide if creditors had a legal right to bring direct fiduciary claims against directors in the insolvency context.
In this case, NACEPF did not attempt to allege a derivative claim in Count II of its Complaint. It only asserted a direct claim against the director Defendants for alleged breaches of fiduciary duty when Clearwire was insolvent. The Court of Chancery did not decide that issue. Instead, the Court of Chancery assumed arguendo that a direct claim for a breach of fiduciary duty to a creditor is legally cognizable in the context of actual insolvency. It then held that Count II of NACEPF’s Complaint failed to state such a direct creditor claim because it did not satisfy the pleading requirements described by the decisions in Production Resources and Big Lots Stores, Inc. v. Bain Capital Fund VVI, LLC.
To date, the Court of Chancery has never recognized that a creditor has the right to assert a direct claim for breach of fiduciary duty against the directors of an insolvent corporation. However, prior to this opinion, that possibility remained an open question because of the "arguendo assumption" in this case and the dicta in Production Resources and Big Lots Stores. In this opinion, we recognize "the pragmatic conduct-regulating legal realms . . . calls for more precise conceptual line drawing."
Recognizing that directors of an insolvent corporation owe direct fiduciary duties to creditors, would create uncertainty for directors who have a fiduciary duty to exercise their business judgment in the best interest of the insolvent corporation. To recognize a new right for creditors to bring direct fiduciary claims against those directors would create a conflict between those directors’ duty to maximize the value of the insolvent corporation for the benefit of all those having an interest in it, and the newly recognized direct fiduciary duty to individual creditors. Directors of insolvent corporations must retain the freedom to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation.
Accordingly, we hold that individual creditors of an insolvent corporation have no right to assert direct claims for breach of fiduciary duty against corporate directors. Creditors may nonetheless protect their interest by bringing derivative claims on behalf of the insolvent corporation or any other direct nonfiduciary claim, as discussed earlier in this opinion, that may be available for individual creditors.
[Bold Emphasis Added; Footnotes omitted]