New Delaware Supreme Court Opinion Limits D&O Claims of Insolvent Companies

Solvent corporations can generally do whatever they like with their assets. Officers and directors only have to account to their shareholders. On the other hand, insolvent corporations and those in the “zone of insolvency” may be required to consider the interest of creditors.¹ The Delaware Supreme Court recently clarified the limitations on potential liability for officers and directors of companies that are insolvent or in the zone of insolvency.² The court held that creditors cannot bring direct claims against officers and directors of insolvent companies and companies in the zone of insolvency. Creditors may only bring derivative claims against the officers and directors for damages suffered by the insolvent corporation.

The Duties of D & O's in Circumstances Where the Company Is Solvent
Generally, the courts have identified two separate duties of officers and directors to the corporation: (1) a duty of care and (2) a duty of loyalty.³

In its corporate charter, a corporation may insulate officers and directors from personal liability for breach of the duty of care. Significantly, the Chancery Court has held that corporate charter provisions that protect directors from personal liability to the corporation for breach of the duty of care, 8 Del. Code §102(b)(7), apply equally to creditors’ derivative claims.⁶

1. Duty of care. The duty of care requires a director to perform his or her duties “as an ordinarily prudent person managing their own affairs.”⁴ “A decision is taken with due care when from an array of alternatives, the directors employ a procedure to pick the one that best advances the interests of the corporation.”⁵
2. Duty of loyalty. The duty of loyalty requires that a director’s duties be performed in good faith and in a manner the director believes to be in, or not opposed to, the best interests of the company. Failure to satisfy the duty of loyalty tends to arise when directors have conflicts, i.e., an interest in a potential transaction different from the interests of other stockholders.
3. The business judgment rule. Directors’ duties are generally scrutinized under the business judgment rule. The business judgment rule protects a “noninterested” director from liability where the director has exercised reasonable care and good-faith judgment. The decision of a board resulting from an informed opinion, based on good process and full disclosure, will not be second-guessed by the courts. On the other hand, the business judgment rule does not shield a director if there is fraud, illegality or corporate waste. Litigation challenging directors’ actions generally alleges that directors did not satisfy their duties of loyalty and care and therefore were not protected by the business judgment rule. Ultimately, the integrity of the board’s substance and process determines whether a court will overturn its decision.

The court concluded that the legal obligations of officers and directors do not change when the company nears insolvency. They bear the same duties of care and loyalty. “When a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.”

Creditors’ Rights Are Generally Limited to the Terms of Their Contracts
The North American Catholic Educational Programming court stated: “While shareholders rely on directors acting as fiduciaries to protect their interests, creditors are afforded protection through contractual agreements, fraud and fraudulent conveyance law, implied covenants of good faith and fair dealing, bankruptcy law, general commercial law and other sources of creditor rights.”⁷ “Accordingly, ‘the general rule is that directors do not owe creditors duties beyond the relevant contractual terms.’”⁸

No Direct Claims May Be Brought by Creditors against Officers and Directors, Even When the Corporation is Insolvent or Operating in the “Zone of Insolvency”
The Delaware Supreme Court acknowledged that “[w]hen a corporation is insolvent, … its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.”⁹ However, the court flatly rejected the argument that creditors could bring direct claims for breach of fiduciary against directors. “The creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties.”¹⁰
Nevertheless, the court concluded that: “[t]o 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.”¹¹ “Directors of insolvent corporations must retain the freedom to engage in vigorous, good-faith negotiations with individual creditors for the benefit of the corporation.”¹²

What Should Officers and Directors Take Away from the North American Catholic Programming Decision?
To summarize, the type of claims that may be brought against the officers and directors of a corporation do not change upon insolvency. However, officers’ and directors’ exercise of their duties of loyalty and care may be subject to scrutiny by an additional class of potential claimants-creditors-once the company enters the “zone of insolvency.”