In light of current economic conditions, individuals serving as directors of companies may want to refamiliarize themselves with the law concerning the impact of a corporation's financial distress on their fiduciary duties. Decisions in Delaware since the last economic downturn have changed some of the rules of the game.
Corporate directors have two primary fiduciary duties: the duty of care and the duty of loyalty. The duty of care requires that each director exercise the degree of care that an ordinary and prudent person would use in similar circumstances. The duty of loyalty requires that a director act in good faith in the best interests of the corporation and its shareholders and prohibits self-dealing.
In making business decisions, directors are generally protected by the "business judgment rule," which presumes that the directors acted on an informed basis, in good faith and in the honest belief that the decision was in the best interest of the corporation. However, decisions of "interested" directors are subject to the more onerous "intrinsic fairness" test, which examines whether the board action was both substantively and procedurally fair.
In a solvent corporation, the board of directors owes its fiduciary duties to the corporation's shareholders. Creditors are entitled only to the contractual rights set forth in related financing and other agreements. When a corporation is in distress, the focus of the board's obligations expands to include not only the interests of shareholders, but also those of creditors. For many board decisions, this change in focus will not be significant, and directors should consider the best interests of the "community of interests" constituting the corporation. But sometimes the interests of creditors and shareholders diverge. When this occurs, the corporation's directors need not slavishly follow the demands of its creditors. However, the directors should not subject the corporation and its creditors to undue risk in pursuit of a recovery for shareholders.
Until recently, restructuring professionals generally advised clients that the board of directors' fiduciary duties expand to include creditors when the corporation is in the vicinity or "zone of insolvency."
Recent Delaware decisions, however, have moved toward a bright-line test, suggesting a duty to creditors does not arise until the corporation is actually insolvent. Courts in many jurisdictions, such as New York, have not yet spoken clearly on this issue. But the Delaware courts are highly influential in the field of corporate governance, and other jurisdictions are likely to follow Delaware's lead.
This change in Delaware law may mean less in practice than in theory. Determining when a corporation actually becomes insolvent is not easy. The two traditional tests of solvency -- the balance sheet test (i.e., whether the liabilities of the corporation exceed its assets at fair valuation) and the equity test (i.e., whether the corporation can pay its debts as they come due) -- can be difficult to apply. Consequently, in most instances, a board should start thinking in terms of maximizing value for everyone rather than just shareholders once the company is in financial distress.
It is important to remember that in many respects a director's fiduciary duties do not change upon insolvency. As before, the director's principal obligations are the duties of care and loyalty, and most decisions of the board are still protected by the business judgment rule.
Further, since the last economic downturn, the Delaware courts have confirmed that the rules applicable to directors of solvent corporations apply when a corporation is insolvent in other important respects. In recent decisions, the Delaware courts have held that creditors (like shareholders) have no direct right of action against a corporation's directors for breach of fiduciary duty and are subject to provisions in a corporation's charter that limit the liability of directors for breaches of the duty of care. Note, however, that a director's liability for breaches of the duty of loyalty cannot be limited by the corporation's charter.
Richard F. Hahn is a partner and Hilary Sokolowski and Jasmine Powers are associates in the New York office of Debevoise & Plimpton LLP. A version of this article originally appeared in the fall issue of Debevoise & Plimpton Private Equity Report.