Directors have an unyielding fiduciary duty to protect the interests of the corporation and the stockholders alike. Claims for breaching this duty could result in personal liability and a large money judgment.
There are two main types of defenses to claims for breach of the duty of care: (1) defenses as to liability (e.g., business judgment rule, statute of limitations, and lack of standing) and (2) defenses as to the amount of damages. This article provides a synopsis of both defenses.
A. MOST COMMON DEFENSES AS TO LIABILITY
1. Business Judgment Rule (Duty of Care)
The Business Judgement Rule and the Entire Fairness Standard are Standards of Review — they are the lenses through which courts look at director conduct to determine whether there has been a breach of fiduciary duty.
The business judgment rule creates a presumption in favor of director-approved transactions that their decisions will not be disturbed if they can be attributed to any rational business purpose.[1] A court “will not substitute its own notions of what is or is not sound business judgment” if a board of directors’ actions “can be attributed to any rational business purpose.”[2]
To invoke the rule’s protections in the context of a duty of care, directors “have a duty to inform themselves, prior to making a business decision, of all material information reasonably available to them.”[3]
If the board fails to inform itself fully and in a deliberative manner then it will “lose the protection of the business rule,” and the court is “required to scrutinize the challenged transaction under an entire fairness standard of review.”[4]
“[T]he business judgment rule presumption that a board acted loyally can be rebutted by alleging facts which, if accepted as true, establish that the board was either interested in the outcome of the transaction or lacked the independence to consider objectively whether the transaction was in the best interest of its company and all of its shareholders.”[5]
2. Exculpation (Duty of Care)
Del. Code Ann. tit. 8, § 102(b)(7) “makes it abundantly clear that directors are shielded from liability for breaches of the duty of care.”[6] This provision, however, does not allow the corporation to exculpate officers from damages for breaching a fiduciary duty of care.[7] While directors are afforded extra protection by the provision allowing exculpation clauses eliminating personal liability for damages for breach of the duty of care (but not loyalty), officers are not afforded the same protection.
The majority of states follow this rule.[8]
3. Statute of Limitations
State statutes of limitation for breach of fiduciary duty claims range between three and six years. The bankruptcy petition tolls the statute of limitations for a period of two years. Section 108 of the Bankruptcy Code provides that, if the applicable statute of limitations has not expired before the petition date, the action may be commenced before the later of (i) the end of such period or (ii) 2 years after the petition date.[9] The statute of limitations for a breach of fiduciary duty claim generally begins to run at the time of the wrongful act.[10]
4. In Pari Delicto Rule
The in pari delicto defense is a general principle that is applicable to all causes of action and is commonly invoked regarding claims arising out of illegal contracts, breaches of fiduciary duties, violation of statutory duties, and torts. In the bankruptcy context, the defense is commonly raised against state law causes of action that are property of the estate and avoidance actions arising under either state law or the Bankruptcy Code.[11]
In general, whether the in pari delicto defense is allowed against a trustee depends on whether the trustee is bringing a claim that is property of the estate under section 541 or whether the trustee is bringing a preference or fraudulent transfer claim under sections 544(b), 547(b), or 548(a). When a trustee brings a claim that is property of the estate under section 541, and when the debtor’s agent engaged in wrongful conduct related to the claim, almost all circuits have found that the in pari delicto defense bars the trustee’s claim unless an exception applies.[12] However, claims brought by a trustee under sections 544(b), 547(b), and 548(a) are not similarly subject to the in pari delicto defense. Further, a claim brought by a trustee against a defendant based on the defendant's involvement in the debtor's post-petition activities are not subject to the in pari delicto defense.[13]
Additionally, a distinction lies in who the claim belongs to and when the claim arises. Under section 541(a), the trustee acquires an estate comprised of “all legal or equitable interests of the debtor in property as of the commencement of the case.”[14] Courts have interpreted this to mean that “The trustee succeeds only to such rights as the bankrupt possessed; and the trustee is subject to all claims and defenses which might have been asserted against the bankrupt but for the filing of the petition.”[15] Pursuing claims via section 541, the trustee stands in the shoes of the debtor, and the filing of the bankruptcy petition does not change that.
“The so-called Wagoner rule stands for the well-settled proposition that a bankrupt corporation, and by extension, an entity that stands in the corporation’s shoes, lacks standing to assert claims against third parties for defrauding the corporation where the third parties assisted corporate managers in committing the alleged fraud.”[16] Under the Bankruptcy Code, a trustee “stands in the shoes of the bankrupt corporation and has standing to bring any suit that the bankrupt corporation could have instituted had it not petitioned for bankruptcy.”[17]
Because the trustee stands in the shoes of the corporation, wrongdoing of the corporation is in-turn imputed to him.[18] Note, however, that the in pari delicto rule does not apply to claims brought against insiders of the debtors.[19]
5. Standing.
(a) Standing of Debtor-in Possession or Trustee
Under section 541(a)(1), all the debtor’s property, including all the legal or equitable interests belonging to him, becomes property of the estate.[20] After the commencement of a case under chapter 11 and before the confirmation of a plan, the standing of the debtor-in-possession or the court-appointed trustee to sue the directors for breach of fiduciary duties is, generally, not seriously questioned.
There is, however, an exception to this rule when the claim being asserted by the debtor-in-possession belongs to a different entity.[21]
(b) Standing of Official Committee of Creditors
A creditor’s committee appointed under section 1102 may obtain standing to bring actions on the behalf of the corporation if the trustee or the corporate officers fail to pursue litigation that is in the best interests of the estate.[22]
(c) Standing of Individual Creditors
Creditors have standing to assert fiduciary duty claims as residual beneficiaries when corporation is either balance sheet insolvent or cash flow insolvent.[23]
(d) Standing of Plan Trustee
After the confirmation of a chapter 11 plan, the conclusion about who has the standing or the authority to pursue claims for breaches of fiduciary duties varies depending on the content and the provisions of the plan.
The plan may create a litigation or liquidating trust and assign the claims belonging to the debtor’s estate to the trust, transferring the (exclusive) authority to sue to the litigation or liquidating trustee.
The trustee asserts a direct, not a derivative claim, as the litigation trust is the new owner of the claim. Additionally, some trusts provide a mechanism by which creditors can assign their individual claims to the trust for the trustee to pursue.[24]
[1] 473 Odyssey Partners, L.P. v. Fleming Cos., 735 A.2d 386, 407 (Del. Ch. 1999).
[2] Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971).
[3] Cede & Co. v. Technicolor Inc., 634 A.2d 345, 367 (Del. 1993) (internal citation omitted).
[4] Id.; see also In re Bridgeport Holdings, Inc., 388 B.R. 548, 569 (Bankr. D. Del. 2008).
[5] Orman v. Cullman, 794 A.2d 5, 22 (Del. Ch. 2002) (emphasis in original).
[6] Pereira v. Farace, 413 F.3d 330, 341-42 (2d Cir. 2005).
[7] See In re Bank of Am. Corp. Sec., Derivative, and Emp. Ret. Income Security Act (ERISA) Litig., 757 F. Supp. 2d 260, 338 (S.D.N.Y. 2010).
[8] See, e.g., Nystrom v. Vuppuluri (In re Essar Steel Minnesota LLC) (In re Essar Steel Minnesota LLC), 2019 WL 2246712, at *8 (Bankr. D. Del. May 23, 2019) (“Minnesota, like Delaware, permits corporations to limit the liability of their managers and governors…. Other courts, addressing substantially identical exculpation provisions in similar circumstances, have held that when an exculpation provision is raised against a duty of care claim ‘that is the end of the case.’”) (internal citations omitted).
[9] 11 U.S.C. § 108(a).
[10] David B. Lilly Co. v. Fisher, 18 F.3d 1112, 1117 (3d Cir. Del. 1994).
[11] See, e.g., In re Hedged-Investments Assocs., Inc., 84 F.3d 1281, 1284-85 (10th Cir. 1996) (defense raised against claim brought via section 541); Terlecky v. Abels, 260 B.R. 446, 453 (S.D. Ohio 2001) (defense raised against claim brought under section 544); In re Kmart Corp., 318 B.R. 409, 415 (Bankr. N.D. Ill. 2004) (defense raised against preferential transfer action brought via section 547); In re Pers. and Bus. Ins. Agency, 334 F.3d 239, 245–47 (3d Cir. 2003) (defense raised against fraudulent transfer claim raised via section 548).
[12] See, e.g., Mosier v. Callister, Nebeker & McCullough, 546 F.3d 1271, 1276 (10th Cir. 2008); Gray v. Evercore Restructuring, LLC, 544 F.3d 320, 324–25 (5th Cir. 2008); Nisselson v. Lernout, 469 F.3d 143, 153 (1st Cir. 2006); Official Comm. of Unsecured Creditors of PSA, Inc. v. Edwards, 437 F.3d 1145, 1149–56 (11th Cir. 2006); Logan v. JKV Real Estate Servs. (In re Bogdan), 414 F.3d 507, 514–15 (4th Cir. 2005) (noting exception where claims have been assigned to trustee); Grassmueck v. Am. Shorthorn Ass’n, 402 F.3d 833, 836–37 (8th Cir. 2005); Official Comm. of Unsecured Creditors of Color Tile Inc., v. Coopers & Lybrand, LLP, 322 F.3d 147, 158 (2d Cir. 2003); Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 354–60 (3d Cir. 2001); Terlecky v. Hurd (In re Dublin Sec., Inc.), 133 F.3d 377, 380 (6th Cir. 1997).
[13] In re Hoang, 449 B.R. 850, 854–55 (Bankr. D. Md. 2011) (denying imputation of DIP’s post-petition asset-concealment scheme to trustee, and therefore not allowing co-conspirators to assert in pari delicto defense); In re Sia, 349 B.R. 640, 655 (Bankr. D. Haw. 2006) (where debtor engaged in both pre- and post-petition conspiracy to commit fraud, holding that where trustee’s claims under section 541 are based on alleged post-petition wrongdoing then the trustee has standing and it does not matter that the debtor was in pari delicto).
[14] 11 U.S.C. § 541(a)(1).
[15] Bank of Marin v. England, 385 U.S. 99, 101, 87 S. Ct. 274, 17 L. Ed. 2d 197 (1966)).
[16] Cobalt Multifamily Inv’rs I, LLC v. Shapiro, 857 F. Supp. 2d 419, 425 (S.D.N.Y. 2012).
[17] Feltman v. Kossoff & Kossoff, LLP (In re TS Emp’t, Inc.), 603 B.R. 700, 706 (Bankr. S.D.N.Y. 2019).
[18] Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114, 119 (2d Cir. 1991).
[19] See, e.g., Feltman v. Kossoff & Kossoff, LLP (In re TS Emp’t, Inc.), 603 B.R. 700, 707 (Bankr. S.D.N.Y. 2019) (“The Wagoner rule does not apply to insiders.”) (citing In re Optimal U.S. Litig., 813 F. Supp. 2d 383, 400 (S.D.N.Y. 2011) (“[I]n pari delicto does not apply to the actions of fiduciaries who are insiders in the sense that they are on the board or in management, or in some other way control the corporation.” (internal citations omitted)); see also Secs. Inv’r Prot. Corp. v. Bernard L. Madoff Inv. Secs. LLC (In re Madoff Sec.), 987 F. Supp. 2d 311, 322 (S.D.N.Y. 2013).
[20] 11 U.S.C. § 541(a)(1).
[21] See, e.g., Zucker v. Rodriguez, 919 F.3d 649 (1st Cir. 2019) (holding that FDIC, as failed bank’s receiver, rather than plan administrator for bank holding company’s Chapter 11 estate, owned claims against holding company’s former directors and officers for negligence and breach of fiduciary duties owed to holding company based on wholly-owned subsidiary bank’s failure); see also Caplin v. Marine Midland Grace Trust Co., 406 U.S. 416, 428 (1972) (the Bankruptcy Code does not authorize a trustee to “collect money not owed to the estate” and accordingly prohibits a trustee from suing on behalf of the estate’s creditors).
[22] Official Comm. of Unsecured Creditors ex rel. Cybergenics Corp. v. Chinery, 330 F.3d 548, 568 (3d Cir. 2003) (“[T]he ability to confer derivative standing upon creditors’ committees is a straightforward application of bankruptcy courts’ equitable powers.”); Official Comm. of Unsecured Creditors v. NewKey Grp., LLC (In re SGK Ventures, LLC), 521 B.R. 842, 847-48 (Bankr. N.D. Ill. 2014) (committee may be given standing to pursue claims against officers and directors).
[23] Quadrant Structured Prods. Co., Ltd. v. Vertin, 115 A.3d 535, 556 (Del. Ch. 2015); N. Am. Catholic Edu. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007) (creditors of an insolvent corporation have standing as the residual beneficiaries of the corporation to assert claims on behalf of the corporation for breaches of fiduciary duty against directors of the corporation).
[24] See, e.g., Grede v. Bank of New York Mellon (In re Sentinel Mgmt. Grp., Inc.), 598 F.3d 899, 902-03 (7th Cir. 2010) (trustee of plan liquidation trust may pursue creditor claims that have been assigned to it under plan); cf. Williams v. Cal. 1st Bank, 859 F.2d 664, 666 (9th Cir. 1988) (trustee cannot bring claims on behalf of the estate’s creditors, even when they have expressly “assigned their claims to the Trustee”).