Monday, November 3, 2014
This comes up every now and then. It's the question to whom directors of an insolvent corporation owe fiduciary duties. Creditors argue that in the "zone of insolvency" the directors' fidcuiary duties switch to them rather than the stockholders as residual claimants. That formulation has always been troubling because when might the "zone of insolvency" kick in? Hard to say. For example, are internet companies or other start-ups running losses in the "zone of insolvency"? In any event, in Gheewalla the Delaware Supreme Court ruled "creditors of a Delaware corporation that is either insolvent or in the zone of insolvency have no right... to assert direct claims for breach of fiduciary duty against the corporation's directors."
But this issue continues to appear. In its latest version (Quandrant v Vertin), the directors of an insolvent corporation engaged in highly risky transactions that, if successful, would have paid off handsomely for the controlling shareholder, and, if unsuccessful, would have left the corporation an empty shell. Creditors sought to hold directors liable for making risky decisions that would have benefitted the controller at their expense, they argued. This gave Vice Chancellor Laster an opportunity to put his spin on this issue:
I do not believe it is accurate any longer to say that the directors of an insolvent corporation owe fiduciary duties to creditors. It remains true that insolvency "marks a shift in Delaware law," butthat shift does not refer to an actual shift of duties to creditors (duties do not shift to creditors). Instead, the shift refers primarily to standing: upon a corporation's insolvency, its creditors gain standing to bring derivative actions for breach of fiduciary duty, something they may not do if the corporation is solvent, even if it is in the zone of insolvency (citations omitted) ...
The fiduciary duties that creditors gain derivative standing to enforce are not special duties to creditors, but rather the fiduciary duties that directors owe to the corporation to maximize its value for the benefit of all residual claimants.
That may seem subtle, but it's important. Notice that the vocabulary used here is that directors have obligations to maximize the value of the corporation for the benefit of all residual claimants. Even in insolvency, stockholders remain residual claimaints. At no point do we see some sort of magical shifting of duties from the corporation to the creditors. What happens is that once a corporation is insolvent, creditors may gain standing, but the duties of the board do not change. That means boards of insolvent corporations are under no fiduciary duty to preserve capital and resources for the benefit of creditors.