Fiduciary duties of a director of a Delaware corporation, the current standard.
Steven D. Goldberg, Esq. Wilmington, DE
sgoldberg@stevendgoldberg.com
http://www.stevendgoldberg.com
Contact me if you need assistance in forming/organizing a Delaware business entity or any matter of Delaware law. Delaware Forms and Publications are available at http://www.delawarellclaw.com
Generally I write about limited liability companies, however some corporate decision will directly impact upon LLC law. The case I discuss today is one of those decisions.
In 2007 the Delaware Supreme court decided the case of North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, et al., (Del. Supr. 2007) 930 A2d 92. Prior to the release of this decision the Chancery cases and commentators had hinted at the concept that a director had a distinct and cognizable fiduciary duty to the corporation’s creditors while operating in the “zone of insolvency” and when “insolvent”. Ghewalla holds that creditors of an Delaware corporation have no direct right to sue the directors for a breach of fiduciary duties while operating in the “zone of insolvency”. Additionally the creditors of an “insolvent” Delaware corporation do not have a direct right to sue the Directors for breach of fiduciary duties to the creditor, though in insolvency the creditors do have the right to sue derivatively. Many practitioers initially thought that this decision did not change the landscape as the creditors could accomplish derivately what they could not accomplish directly. These derivative claims, in my view, are based upon the same fiduciary duties which the directors have irrespectively of insolvency and the Court did not create or recognize a new or enhanced set of duties owed to creditors in their capacity as creditors. New or enhanced duties would create an impossible delemma for directors of a troubled corporation.
The director defendants served as directors of Clearwire Holdings, Inc., at the behest of their employer Goldman Sachs & Co. The complaint alleges that the defendants, though less than a majority of the directors, were able to dominate the company as Goldman was its only source of funding. The plaintiff is a creditor of Clearwire and asserted a direct (not derivative) claim for breach of fiduciary duties against the defendants while Clearwire was either insolvent or operated in the zone of insolvency.
The Court spointed out that this is a matter of first impression. Justice Holland, writing for the Court at 94 stated:
In this opinion, we hold that the creditors of a Delaware corporation that is either insolvent or in the zone of insolvency have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against the corporation’s directors.
Note that the Court used the word “direct” and not “derivative”. As this case involved a direct action, the court could have stopped there, however the Court then went on to examine whether a creditor had any derivative rights. The Court concluded, based upon earlier Chancery decisions, that creditors have the right to bring derivative claims when the company is insolvent.
At 101 Justice Holland stated:
Delaware Corporate law provides for a separation of control from ownership. The directors of Delaware corporations have “the legal responsibility to manage the business of a corporation for the benefit of its shareholders owners. Accordingly, fiduciary duties are imposed upon the directors to regulate their conduct when performing that function. Although the fiduciary duties of directors are unremitting:
the exact cause of conduct that must be charted to properly discharge that responsibility will change in the specific context of the action the director is taking with regard to either the corporation or its shareholders. This Court has endeavored to provide the directors with clear signal beacons and brightly lined channel markers as they navigate with due care, good faith, a loyalty on behalf of a Delaware corporation and its shareholders. This Court has also endeavored to mark the safe harbors clearly. [citations omitted]
Justice Holland then attempted to provide that guidance:
In this case, the need for providing directors with definitive guidance compels us to hold that no direct claim for breach of fiduciary duties may be asserted by the creditors of a solvent corporation that is operating in the zone of insolvency. 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. … (101)
In discussing the insolvent corporation the Court stated at 101, “[w]hen a corporation is insolvent, however, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.” The Court held “[c]onsequently, the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties. The corporation’s insolvency ‘makes the creditors the principle constituency injured by any fiduciary breaches that diminish the firm’s value’. Therefore, equitable considerations give creditors standing to pursue derivative claims against the directors of an insolvent corporation. Individual creditors of an insolvent corporation have the same incentive to pursue valid derivative claims on its behalf that shareholders have when the corporation is solvent.”
Having acknowledged that there exists a derivative right for creditors of an insolvent corporation, the Court emphasizedthat there is no direct right of creditors to sue directors under a fiduciary duty theory. What the Court did not address was whether the fiduciary duties owed by the directors when the corporation is insolvent are manifestly different from the fiduciary duties that are owed to the corporation and its shareholder owners when the corporation is solvent or in the zone of insolvency. Some commentators opined that there are distinct duties owed to creditors in their position as creditors drawing from bankruptcy law. However the Court did hold at 103 “Directors of insolvent corporations must retain the freedom to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation.”
If as the Court said, creditors are the principal constituency injured by any fiduciary breaches that diminish the firm’s value, then the creditors when asserting derivative claims have no greater rights than would a shareholder in the same position within a solvent corporation. “…[C]laims of this kind belong to the corporation itself because even if the improper acts occur when the corporation is insolvent, they operate to injure the firm in the first instance by reducing its value, injuring creditors only indirectly by diminishing the value of the firm and therefore the assets from which the creditors may satisfy their claims.” (102)
It is my conclusion that the fiduciary duties which the directors of a Delaware corporation owe to to the corporation and its stockholder owners do not change in insolvency, however the creditors have the right in insolvency to step into the rights of the shareholder owners and sue derivatively on behalf of the corporation. To hold otherwise would place the directors in a dilemma when the corporation is in the zone of insolvency, always having to determine whether the corporation was insolvent and thereby triggering a different set of fiduciary duties. Such a holding would be contrary to the “brightly lined chanel markers” referred to by Justice Holland.
In a thoughtful article published in the August 2009 issue of The Business Lawyer, Volume 64, Number 4 at pae 1087, Sabin Willett wrote “Gheewalla and the Director’s Dilema. In this article he thoroughly reviews the case law and commentators opinions on Ghewalla. I recomend this article to you.
Whether your company is a Delaware corporation or a LLC where fiduciary duties have not either been eliminated or limited, careful drafting is required. I have an active Delaware business practice as well as a practice in Delaware’s State and Federal courts. If you or your client have a business matter or a matter which you wish to litigate in Delaware or has a matter pending in Delaware, we would appreciate the opportunity to consult with you regarding our representation. Please remember that we do not accept representation without a written engagement letter.
