In an important ruling addressing the fiduciary duties of directors of Delaware corporations, the Delaware Supreme Court unambiguously rejected an attempt by a creditor to directly hold a corporation's directors personally liable for breach of fiduciary duty. In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, the Delaware Supreme Court, as a matter of first impression, held that Delaware law does not recognize a creditor's right to bring direct fiduciary claims against the directors of a Delaware corporation when the corporation is insolvent or is operating within the "zone of insolvency."1
The ruling provides definitive guidance to corporate directors regarding their fiduciary duties while managing a corporation operating within the "zone of insolvency." The guidance, as expressed by the court, is:
When a solvent corporation enters 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.
By declining to recognize a new direct cause of action against such directors, the court sought to protect the ability of the directors to provide "effective and proactive leadership" without their efforts being "undermined by the prospect of individual liability for direct claims by creditors."
The court's decision also protects the ability and freedom of directors of insolvent corporations to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation. Driven by concerns that a newly recognized direct fiduciary duty to creditors would conflict with the directors' duty to maximize the value of the insolvent corporation, the court held that individual creditors of an insolvent corporation have no right to assert direct claims for breach of fiduciary duty against corporate directors.
In reaching these holdings, the court was persuaded that the bundle of contractual, tort, and statutory rights that exist within the confines of the debtor/creditor relationship provide creditors sufficient remedies such that an additional, unique layer of protection-in the form of direct fiduciary claims against directors-was unnecessary.
In closing the door on direct fiduciary claims, the court summarized the basic principles applicable to fiduciary duty claims against directors:
- Directors owe fiduciary duties to the corporation.
- When a corporation is solvent, those duties may be enforced by its shareholders, who have standing to bring derivative actions on behalf of the corporation because they are the ultimate beneficiaries of the corporation's growth and increased value.
- When a corporation is insolvent, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.
- Consequently, the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties.
- At all times, claims of this kind belong to the corporation itself.
- 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.
Factual and Procedural Background
North American Catholic Educational Programming Foundation, Inc. ("NACEPF") held certain radio wave spectrum licenses. In March 2001, NACEPF, together with other similar spectrum license-holders (the "Alliance"), entered into a Master Use and Royalty Agreement (the "Master Agreement") with Clearwire Holdings, Inc. ("Clearwire"). Under the Master Agreement, Clearwire could, in certain instances, obtain rights to the licenses held by the Alliance.
Clearwire's major source of funding was Goldman Sachs & Co. ("Goldman Sachs"), which ultimately named the three defendants to Clearwire's Board of Directors (the "Goldman Sachs Directors"). The Goldman Sachs Directors comprised less than a majority of Clearwire's board and were all employed by Goldman Sachs. NACEPF alleged that Goldman Sachs, directly and by and through the Goldman Sachs Directors, controlled Clearwire.
In June 2002, the market for wireless spectrum collapsed, and Clearwire began negotiations with the other Alliance members to end Clearwire's obligations under the Master Agreement. Eventually, Clearwire settled with all the Alliance members except NACEFP. By October 2003, Clearwire had been unable to obtain any further financing and effectively went out of business.
Thereafter, NACEPF filed direct (not derivative) fiduciary claims against the Goldman Sachs Directors as a putative creditor of Clearwire. In its complaint, NACEPF alleged, inter alia, that because Clearwire was either insolvent or in the "zone of insolvency," the Goldman Sachs Directors owed fiduciary duties to NACEPF as a substantial creditor of Clearwire and that the defendants breached those duties. The Goldman Sachs Directors moved to dismiss the complaint on personal jurisdiction grounds and because, as a matter of law, a Delaware corporation's creditors could not assert direct claims against directors for breach of fiduciary duties when the corporation was insolvent or in the "zone of insolvency." The Delaware Chancery Court (Noble, VC) dismissed NACEPF's direct fiduciary claim because it failed to state a claim upon which relief could be granted and dismissed its other claims for want of personal jurisdiction. Thereafter, NACEPF appealed the decision to the Delaware Supreme Court.
Duties Owed When the Corporation is Insolvent or Operating in the "Zone of Insolvency"
In Delaware, it is well established that directors owe their fiduciary obligations to the corporation and its shareholders.2 Typically, creditors cannot allege fiduciary duty claims against directors of solvent corporations.3 It is presumed that creditors are capable of protecting themselves through the contractual agreements that govern their relationships with firms.4 Given the legal tools that exist to protect creditors, Delaware corporate law expects that the directors of a solvent corporation will cause the firm to undertake economic activities that maximize the value of the firm's cash flows primarily for the benefit of the residual risk-bearers: the owners of the firm's equity capital.5 As long as the firm honors the legal obligations it owes to the company's creditors in good faith, the directors may pursue the course of action that they believe is best for the firm and its stockholders.6 Indeed, in general, creditors must look to the firm itself for payment, rather than its directors or stockholders, except in instances of fraud or when other grounds exist to disregard the corporate form.7
When a firm has reached the point of insolvency, it is settled that under Delaware law, the firm's directors are said to owe fiduciary duties for the benefit of the company's creditors.8 Similarly, the Delaware Chancery Court recognized, in the seminal case of Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp, that directors have an obligation, when a corporation is in the "zone of insolvency," to the community of interests that sustained the corporation, to exercise judgment in an informed, good-faith effort to maximize the corporation's long-term wealth-creating capacity.9
Directors may continue to take reasonable business risks and seek profitable strategies even when a corporation is insolvent or in the "zone of insolvency."10 By taking those risks, however, the director remains protected by the business judgment rule.11
The Delaware Supreme Court's Holding and Reasoning
No Direct Fiduciary Claim when Corporation is in Zone of Insolvency. After concluding that NACEPF satisfactorily alleged that Clearwire was insolvent or operating within the "zone of insolvency," the court turned its attention to whether Delaware law recognized a creditor's right to bring direct fiduciary claims against the directors of a Delaware corporation, which was operating in the "zone of insolvency." The court held that no direct claim for breach of fiduciary duties may be asserted by creditors of solvent debtors operating in the "zone of insolvency."12
In reaching this decision, the court noted that when a solvent corporation is navigating in the "zone of insolvency," Delaware directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interest of the corporation for the benefit of its shareholder owners.13
[A]n otherwise solvent corporation operating in the "zone of insolvency" is one in most need of effective and proactive leadership-as well as the ability to negotiate in good faith with its creditors-goals which would likely be significantly undermined by the prospect of individual liability arising from the pursuit of direct claims by creditors.14
In turn, the solvent corporation's creditors are generally protected by their negotiated agreements, their security instruments, the implied covenant of good faith and fair dealing, fraudulent conveyance law, and bankruptcy law.15 These existing protections render the imposition of an additional, unique layer of protection through direct claims of breach of fiduciary duty unnecessary.16 Moreover, the court noted that any benefit derived by the recognition of such additional direct claims would be minimal and significantly outweighed by the costs to economic efficiency.17
No Direct Fiduciary Claim When Corporation is Insolvent.The court also closed the door on a creditor's right to bring direct fiduciary claims against directors of an insolvent corporation.18 The court reasoned that a new right for creditors to bring direct fiduciary claims against these directors would create uncertainty for directors who have a fiduciary duty to exercise their business judgment in the best interest of an insolvent corporation.19 A direct right of action would also create a conflict between the duty of the directors 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 the individual creditors.20 "Directors of insolvent corporations must retain the freedom to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation."21
Derivative Fiduciary Claims Remain Viable When Corporation is Insolvent.Although the NACEPF did not allege and ultimately waived a derivative fiduciary claim against the Goldman Sachs Directors, the court nevertheless held that creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duty.22 The court opined that a corporation's insolvency makes creditors the principal constituency injured by any fiduciary breaches that diminish the firm's value.23 As such, "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."24
The Delaware Supreme Court's decision in Gheewalla provides corporate directors with a safe harbor to exercise business judgment for the best interests of the corporation, irrespective of whether the corporation is within the "zone of insolvency" or insolvent. By declining to recognize a new cause of action for direct fiduciary claims by creditors, the court's ruling establishes a greater level of certainty in directors' dealings with creditors when their corporations are insolvent or in the "zone of insolvency." Creditors are not left without recourse, however, as the court reiterated that a creditor has a continuing right to proceed with derivative fiduciary claims, or with any available direct claims that arise from the debtor/creditor relationship.
1. The "zone of insolvency" is a concept created to account for the shifting and expanding of a board of directors' fiduciary duties when a company is entering a time of financial distress. See Peterman, Nancy A., Directors' Duties In The Zone Of Insolvency: The Quandary Of The Nonprofit Corp.,23-MAR Am. Bankr. Inst. J. 12, *12 (.2004). The court in Gheewalla found it unnecessary to define the term "zone of insolvency" in its opinion. See North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2007 WL 1454454, *5 (Del.Supr., May 18, 2007).
2. North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2007 WL 1454454, *6 (Del.Supr., May 18, 2007)
3. Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772, 787 (Del.Ch.,2004)
8. Id. at 791.
9. Credit Lyonnais BankNederland, N.V. v. Pathe Communications Corp., 1991 WL 277613, *34, n. 55 (Del.Ch., Dec. 30, 1991).
10. TrenwickAmericaLitigation Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 205 (Del.Ch.2006).
12. Gheewalla, 2007 WL 1454454, *7.
15. Id.at *6.
18. Prior to the court's decision in Gheewalla, several Delaware Chancery Court decisions stated in dicta that a possibility existed that certain board conduct toward a particular creditor could support a direct claim for breach of fiduciary duty. See Production Resources Group, 863 A.2d at 798, 800; Big Lots Stores, Inc. v. Bain Capital Fund VVI, LLC, 2006 WL 846121 (Del Ch. 2006)(stating in dicta that any potentially cognizable direct claims asserted by creditors in actual insolvency should confined to the limited circumstances in Production Resources Group)
19. Gheewalla, 2007 WL 1454454, *8.
22. Id., *6.
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