Preparing for Bankruptcy Director Liability in the Zone of Insolvency

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Apr 2001

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When a corporation becomes insolvent and prepares for bankruptcy, its directors may
experience legal and/or ethical quandaries. Specifically, certain directors may have
knowledge of fraudulent transfers or other questionable actions. Such transfers and/or
actions, however, are not necessarily outside the best interests of the corporation and
its shareholders.

Regardless, such actions may implicate a director's fiduciary duties, as many courts
have held that a director's fiduciary duties shift when the corporation is in the "zone
of insolvency." Due to these new fiduciary duties, practitioners representing individual
directors, particularly those directors that obtained their board position as part of
a financial arrangement, need to be aware of such duties and the potential for
liability.<a href="#1" name="1a">1</a>

<h3>A Director's Fiduciary Duty to Creditors</h3>

Generally, a corporate director owes a fiduciary duty only to corporate
shareholders. See In re Toy King Distributors Inc., 2000 Bankr. Lexis
1352 at 200 (Bankr. M.D. Fla. 2000). "When a corporation becomes
insolvent, however, the officer or director's fiduciary duties shift to the creditors
of the corporation." See Id. at 200 (citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Ingersoll Publications
Co., 621 A.2d 784, 787-88 (Del. Ch. 1992)</a> (upon insolvency,
the fiduciary duties owed shift from shareholders to creditors)).<a href="#2" name="2a">2</a>

"At a minimum, an officer or director of an insolvent corporation is precluded from
preferring himself to the detriment of creditors in his dealings with the corporation."
See Toy King, supra at 204. Otherwise, "an officer or director may be held
'strictly accountable and liable if corporate funds or property are wasted or mismanaged
due to their inattention to the duties of their trust.'" Id. at 205-06.

Consequently, when in the "zone of insolvency," a director must be aware of these
"shifting" duties. For financiers with a director on an insolvent corporation's board
of directors, this new fiduciary duty may conflict with that individual's fiduciary
duties to his actual employer, the financier. Considering this conflict, many
practitioners would advise that individual director to resign. Recent case law reflects
that such advice is not as learned as it appears.

<h3>Director's Right to Resign</h3>

A Delaware corporate director typically has the right to resign without incurring
any liability or breaching any fiduciary duty. See Frantz Manufacturing Co. et al.
v. EAC Industries, 1985 Del. LEXIS 598, at *22 (Del. 1985).
Indeed, certain courts have held that a director's resignation does not, in and of
itself, breach any duty of loyalty or fiduciary duty to the corporation or its
shareholders. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Telesport Inc., 22 B.R. 527 (Bankr. E.D.
Ark. 1982)</a>.

<blockquote><blockquote>
<hr>
<big><center>
[W]hile a director usually extinguishes his or
her fiduciary duties upon resignation, a
director's fiduciary duties continue for events
set in motion or known about before
resignation.
</center></big>
<hr>
</blockquote></blockquote>

As stated in Telesport, "[c]orporate officers '[are] entitled to resign...for a
good reason, a bad reason or no reason at all, and are entitled to pursue their
chosen field of endeavor in direct competition with [the corporation] so long as there
is no breach of a confidential relationship with [it].'" <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 22 B.R. at
532-33, fn. 8</a>.

<h3>Duty Not to Resign</h3>

On the other hand, certain courts have held that a director's fiduciary duties
include duties that prevent resignation, and extend after resignation for breaches that
occurred or began before resignation. Thus, a director's ability to resign may be
limited, and may not prevent liability after resignation.

Several courts have held that a director cannot resign if the director's resignation
will cause immediate harm or allow harm to occur to the corporation or leave corporate
assets unprotected. For example, in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Reynolds, 28 N.Y.S. 2d 622
(N.Y. S.Ct. 1941)</a>, the court describes the tension between the right to
resign versus the duty to stay because, under certain circumstances, an individual may
be required to continue as a director, despite the right to resign. Gerdes at
649-50. Consequently, "officers and directors...cannot terminate their agency
or accept the resignation of others if the immediate consequence would be to leave the
interests of the company without proper care and protection." Gerdes at 651.

This tension, though apparently contradictory in terms, rejects the defense dubbed
as the "Geronimo theory." The defense would allow a director to freely resign at any
time and absolve him or herself of liability knowing that a transaction dangerous to
the corporation is about to occur. The Fifth Circuit has rejected this defense and
held that a director cannot absolve him or herself of liability by resigning because
it is the same as "if a commercial airline pilot were to negligently aim his airplane
full of passengers at a mountain, bail out before impact, and not be liable because
he was not at the controls when the crash occurred." Xerox Corp. v. Genmoora
Corp. et al., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.2d 345, 355</a> (fn. 60-1) (5th Cir.
1989) (citing Gerdes); see, also, DePinto v. Landoe et al., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.2d
297 (9th Cir. 1969)</a> (applying Arizona law, a director cannot resign and
not oppose a wrongful act of a raid on corporate assets); COR Marketing & Sales
Inc. v. Greyhawk Corp. et al., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.Supp. 437, 442 (W.D.N.Y.
1998)</a> ("directors cannot resign 'if the immediate consequence would be to leave
the interests of the corporation without proper care and protection'"); Benson v.
Braun et al., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… N.Y.S.2d 622, 626 (N.Y. S.Ct. 1956)</a>

(directors are typically free to resign, but cannot resign knowing the successors
intend to loot the company); Sebastian v. Zuromski, 1993 U.S. Dist. LEXIS
2008, *15-18 (N.D. Ill. 1993) (ordinarily a director may resign,
but "[T]he wrong complained of here is the resignation itself. It is not inconceivable
that fiduciary duties may obligate a person not to abandon a venture such as a
partnership or close corporation."); FDIC v. Barton et al., 1998 U.S.
Dist. LEXIS 5203, *19-*21 (E.D. La. 1998) (rejection of a rule
that resignation terminates fiduciary duties, when a director fails to prevent a
transaction dangerous to the corporation or to make an objection known).

Thus, if a director's resignation would cause or allow harm to the corporation or
leave the interests of the corporation unprotected, the director is not free to
resign. Resignation at such an inopportune time may therefore result in a breach of
fiduciary duty. Regardless of timing, liability may accrue after resignation.

After all, directors are responsible for losses resulting from their own neglect
of duty before resignation, and resignation does not absolve him or her for breach
of a duty. See FDIC v. Wheat et al., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.2d 124, 128 (5th
Cir. 1992)</a>; District 65, UAW, et al. v. Harper & Row Publishers, et
al., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.Supp. 1468 (S.D.N.Y. 1983)</a> (liable for breaches of duty
if the breach was committed while a fiduciary); Sandage v. Planned Investment
Corp., et al., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Ariz. 287, 772 P.2d 1140, 1144 (Ariz.
Ct. App. 1988)</a> ("...when a transaction has its inception while the fiduciary
relationship is in existence, an employee, by resigning and not disclosing all he
knows about the negotiations, cannot subsequently continue and consummate the transaction
in a manner in violation of his fiduciary duty...").

Similarly, resignation does not free a director of all fiduciary obligations. See
Quark Inc. v. Harley, 1998 U.S. App. LEXIS 3864, *23 (10th
Cir. 1998) (a director has a duty to maintain corporate confidences acquired
before resignation); T.A. Pelsue Co. v. Grand Enterprises Inc. et al.,
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.Supp. 1476 (D. Colo. 1991)</a> (former director breaches fiduciary
duty if he or she engages in transactions that had inception before termination of
relationship or were based on information obtained during that relationship); E.J.
McKernan Co. et al. v. Gregory et al., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Ill. App. 3d 514, 623
N.E.2d 981 (Ill. App. Ct. 1993)</a> (resignation of an officer will not
sever liability for a transaction completed after termination that began during the
relationship or based on information gained during the relationship); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Corp. et
al. v. General Biometrics Inc., 896 P.2d 47 (Utah Ct. App. 1995)</a>

(fiduciary duties only extend after resignation if the transaction had its inception
while the fiduciary relationship existed); In re Toy King Distributors Inc., 2000 Bankr. LEXIS 1352, *198 (resignation does not necessarily sever
fiduciary duties).

Thus, when advising a current director, it is wise to advise of the implication
of resignation and the potential for liability occurring thereafter. These concepts are
of particular concern for financiers that condition financing upon the receipt of a
board position. The financier/director now has fiduciary duties to the insolvent
corporation, possibly the financier, and the insolvent corporation's creditors. Resigning
will not relieve liability and therefore could create liability. Such a director is
wise to obtain legal counsel and review these implications and the corresponding options
prior to resigning. Indeed, perhaps the better option is to abstain from action while
advising other directors of the potential conflict.

<h3>Conclusion</h3>

Although a director may generally resign at any time for any reason, a director's
right to resign must always be qualified by his or her fiduciary duties to
shareholders, or creditors in the event of insolvency. Further, while a director
usually extinguishes his or her fiduciary duties upon resignation, a director's fiduciary
duties continue for events set in motion or known about before resignation.

The simple rule is that a director may resign at any time without incurring any
liability as long as (1) no harm will be caused or allowed by the resignation and
the corporate assets are protected, (2) there were no acts by the director in
violation of fiduciary duties before resignation, and (3) there are no
post-resignation acts that violate any ongoing fiduciary duties.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Practitioners should also be aware of the potential conflict of interest in representing both a corporation and its officers/directors. <a href="#1a">Return to article</a>

<a name="2">2</a> Due to the large percentage of Delaware incorporations, as well as differing state laws, this article reflects Delaware state
law and does not reflect the law of every state. <a href="#2a">Return to article</a>

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Sunday, April 1, 2001 - 12:00

Bankruptcy Rule

2001