United States: Delaware Supreme Court Limits Scope Of “Zone Of Insolvency” Fiduciary Duties

Last Updated: October 12 2007
Article by Eric McKay Esq

In a significant Delaware law decision regarding creditors’ ability to sue corporate fiduciaries, the Delaware Supreme Court recently addressed the issue of whether a corporate director owes fiduciary duties to the creditors of a company that is insolvent or in the “zone of insolvency.” In North American Catholic Educ. Programming Found., Inc. v. Gheewalla, the court concluded that directors of a solvent Delaware corporation that is operating in the zone of insolvency owe their fiduciary duties to the corporation and its shareholders, and not creditors. The court also ruled that the fiduciary duties of directors of an insolvent corporation continue to be owed to the corporation. In the case of an insolvent corporation, however, creditors, as the true economic stakeholders in the enterprise, have standing to pursue derivative claims for directors’ breaches of fiduciary duty to the corporation.

Background

North American Catholic Educational Programming Foundation, Inc. (the “Foundation”), held certain radio-wave spectrum licenses. The Foundation then joined with other license holders, and in March 2001, all of them entered into a master agreement with Clearwire Holdings, Inc. (“Clearwire”), a Delaware corporation. Goldman Sachs & Co. (“Goldman Sachs”) provided funding to Clearwire and appointed three directors to Clearwire’s board of directors. Each of these three directors worked for Goldman Sachs.

Under the master agreement, Clearwire agreed to acquire the spectrum licenses of the Foundation and the other license holders for $24.3 million. In June 2002, however, the market for wireless spectrum collapsed, making available a surplus of spectrum. Clearwire entered into negotiations with the Foundation and the other license holders to rid itself of its obligations under the master agreement. Eventually, Clearwire reached an agreement with all of the license holders except for the Foundation. By October 2003, Clearwire had been unable to obtain any further financing and effectively went out of business.

The Foundation sued the Goldman Sachs directors, alleging, among other things, that the directors had breached their fiduciary duties to the Foundation. According to the Foundation, because Clearwire was either insolvent or in the zone of insolvency, the Goldman Sachs directors owed fiduciary duties to the Foundation, as a substantial creditor of Clearwire. Notably, the Foundation’s complaint asserted a “direct” cause of action — i.e., one alleging particularized harm to the Foundation individually — for breach of fiduciary duty. In fact, the Foundation waived any claims it could have pursued derivatively.

Gheewalla provides important guidance to directors, creditors, and their professionals. It establishes that, irrespective of whether a Delaware corporation is within the zone of insolvency or insolvent, individual creditors cannot assert direct claims for breach of fiduciary duty against directors.

The Goldman Sachs directors moved to dismiss the complaint on the ground that, among other things, as a matter of law, creditors of a Delaware corporation that is insolvent or within the zone of insolvency are unable to assert direct claims against directors for breach of fiduciary duty. The Delaware Chancery Court agreed with the directors and dismissed the complaint, although it dismissed one of the claims for failure to satisfy pleading requirements.

The Delaware Supreme Court’s Ruling

On appeal, the Delaware Supreme Court affirmed the decision of the Delaware Chancery Court. The court first turned its attention to whether Delaware law recognizes a creditor’s right to bring direct fiduciary-duty claims against the directors of a corporation operating in the zone of insolvency. In holding that Delaware law does not recognize such a right, the court explained:

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.

The court also noted that creditors, unlike shareholders, already have a host of protections available to them, including contractual agreements, security instruments, the implied covenant of good faith and fair dealing, and fraudulent conveyance laws, that “render the imposition of an additional, unique layer of protection through direct claims for breach of fiduciary duty unnecessary.” The court also agreed with the Chancery Court’s reasoning that:

[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.

The court also closed the door on a creditor’s right to bring a direct breach-of-fiduciary-duty claim against directors of an insolvent corporation. The court reasoned that such a right would create uncertainty for directors who have a fiduciary duty to exercise their business judgment in the best interests

of an insolvent corporation. According to the court, a direct right of action would 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 individual creditors.” The court explained that it is important to allow a director to “engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation.” The court did not, however, leave creditors without recourse for a breach of fiduciary duty by a director. It made clear that creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for a breach of fiduciary duty.

Analysis

Gheewalla provides important guidance to directors, creditors, and their professionals. It establishes that, irrespective of whether a Delaware corporation is within the zone of insolvency or insolvent, individual creditors cannot assert direct claims for breach of fiduciary duty against directors. In the case of an insolvent corporation, however, creditors can assert derivative claims on behalf of the corporation against directors. It should be noted that the ruling is limited to breach of fiduciary-duty claims: it does not restrict other kinds of claims or rights that may be asserted by creditors directly against a corporation under a contract, agreement, or applicable law. Also, the ruling may engender increased litigation over whena corporation becomes “insolvent” and which parties should have the right to prosecute derivative claims.

________________________________

North American Catholic Educ. Programming Found., Inc. v.

Gheewalla, 2007 WL 1453705 (Del. May 18, 2007).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Eric McKay Esq
 
In association with
Related Video
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert
Email Address
Company Name
Password
Confirm Password
Mondaq Topics -- Select your Interests
Accounting and Audit
Anti-trust/Competition Law
Consumer Protection
Corporate/Commercial Law
Criminal Law
Employment and HR
Energy and Natural Resources
Environment
Family and Matrimonial
Finance and Banking
Food, Drugs, Healthcare, Life Sciences
Government, Public Sector
Immigration
Insolvency/Bankruptcy, Re-structuring
Insurance
Intellectual Property
International Law
Litigation, Mediation & Arbitration
Media, Telecoms, IT, Entertainment
Privacy
Real Estate and Construction
Strategy
Tax
Transport
Wealth Management
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.