Corporate Insolvency and Director and Officer Fiduciary Duties: What’s a Lawyer to Do?

The Professional Ethics Committee for the State Bar of Texas recently issued Opinion No. 603 regarding a lawyer’s duties when he or she represents an insolvent corporation. The opinion was based on a situation [1] in which the company’s sole shareholder was also its sole officer and sole director, engaging in conduct that the company lawyer concluded breached her fiduciary duties to the company. The lawyer advised the corporate director that, although her intended conduct would not harm the company, it could “significantly harm” the company’s creditors. He further advised her to cease and desist her conduct, and she refused. Moreover, the director specifically instructed the lawyer not to share his advice with the company’s creditors.

Opinion No. 603 states that, as a general rule, a lawyer may not reveal such “confidential information” to “a person that the client has instructed is not to receive the information” unless the lawyer “has reason to believe it is necessary” to reveal such confidential information “in order to prevent the client from committing a criminal or fraudulent act.” [2] The opinion provides a snapshot of what in the real world would be a far more complicated story of that lawyer’s continuing legal representation of the corporate director as the company struggles to survive. This article will discuss the lawyer’s potential courses of action as the corporate director’s legal adviser assuming, of course, that he does not terminate the relationship, a possibility that the opinion discusses.

Generally speaking, directors and officers have duties of loyalty and care to the company, which they must exercise in good faith. [3] When acting within the scope of their fiduciary duties, directors and officers are entitled to a presumption that they acted on an informed, independent, good-faith basis and with the honest belief that the action was in the company’s best interest. [4] This presumption, called the “business-judgment rule,” may be rebutted. [5] Directors’ and officers’ fiduciary duties are for the exclusive benefit of shareholders of a solvent company. To the extent of any breach thereof, shareholders may maintain derivative causes of action on the company’s behalf against (and collect damages from) the breaching directors and officers. [6]

Creditors typically cannot bring such causes of action on behalf of a solvent company because their rights are solely contractual in nature. However, when the company is insolvent, creditors become the residual risk bearers, which means that they now benefit from the directors’ and officers’ fiduciary duties and have the same standing as shareholders to sue and collect damages for any breach of those duties. [7]

Opinion No. 603 does not describe why a corporate director’s conduct breaches his or her fiduciary duties. It is well established that some activities that could ultimately harm the interests of the residual risk bearers (whether shareholders or creditors), including deciding to stay in business, taking on new debt, selling the company or delay seeking (or deciding not to seek) bankruptcy protection, do not without more breach directors’ and officers’ fiduciary duties. Other conduct is generally considered to violate such fiduciary duties, including acts of corporate waste, self-dealing, usurpation of corporate opportunities and failing to recuse when faced with a conflict of interest. [8]

If such conduct does not harm the company, then how can creditors sue the corporate director? Can the creditors be harmed as residual risk bearers? Solving this conundrum is essential to understanding how the lawyer should be advising the corporate director.

For the sake of discussion, assume that the corporate director has breached her fiduciary duties because she has an inherent conflict of interest regarding a decision that, if made by an independent director, would not constitute such a breach. This assumption is consistent with the opinion’s scenario in which there is no such independent director.

This situation could arise when determining whether to borrow additional amounts at a (perhaps exorbitantly) high interest rate in order to keep the company in business long enough to recover and once again become solvent (thus benefitting the corporate director as sole shareholder). A further complication to consider is whether the contemplated borrowing transaction is based on a feasible business plan—a determination that the lawyer may not be competent to make without himself obtaining expert advice. If the business plan—and the company itself—were to fail, creditors would be harmed if their recoveries were diminished because the new lender was paid before them.

In such a situation, the lawyer cannot merely advise the corporate director not to undertake the borrowing because of the conflict of interest. That would be simplistic and not necessarily in the company’s best interest. Moreover, the corporate director is likely to be in denial, perhaps even uttering such famous last words as: “We’ll get through this bad patch and then everything will be fine.” But all is not lost. While the conflict of interest would likely mean that the corporate director could not avail herself of the business-judgment rule if she were to undertake the borrowing transaction, it does not mean that she is automatically liable to creditors for a breach of fiduciary duty. [9] Any court later reviewing the transaction would do so under the “entire fairness” doctrine, but the lawyer likely would not want to advise his client to leave herself exposed to the vagaries of a comprehensive, ex post facto review likely occurring many years after the fact. [10]

Better advice would be to avoid the conflict of interest entirely by hiring a disinterested, outside (presumably a corporate restructuring) adviser as a corporate officer, but such advice is often easier to articulate than it is to deliver. One could easily imagine that the lawyer might have to deliver his advice in the tough love context of “If you don’t work with me to come up with a reasonable course of action that will allow you to avail yourself of the business-judgment rule, I may have to consider withdrawing from my representation.”

If the corporate director were to come to her senses and heed the lawyer’s advice, the corporate officer could then determine whether the company should engage in the borrowing transaction. The lawyer and corporate officer could also work together to further advise the corporate director on what to do next.

Such advice likely would include discussing the merits (and demerits) of filing for bankruptcy protection, where the rules governing both the corporate director’s and lawyer’s duties and responsibilities take on additional layers of complexity—issues to be addressed another day.