Duties Of Directors In The Insolvency Zone

There is growing recognition that the directors of an insolvent corporation owe a duty of care to the corporation's creditors. Although this duty is not a fiduciary duty, the directors, in determining whether the board is acting with a view to the best interests of the corporation, may need to consider the interests of, inter alia, shareholders, employees, suppliers, creditors, consumers, governments and other stakeholders. Until recently, it was believed that the U.S. and U.K. approach to such duties, which involve directors shifting their primary duties from shareholders to creditors as a company approaches the zone of insolvency, would apply in Canada as well.1 The interests of these different constituencies may conflict, and the directors have the difficulty of balancing competing interests, with few clear criteria to guide their decision making.

Fiduciary Duty Is Not Owed It is now clear that the directors of a company, even when the company is facing insolvency, do not owe a fiduciary duty to the creditors of the company. In Peoples Department Stores Inc. (Trustee of) v. Wise,2 the Supreme Court of Canada examined the nature of a director's duties under Canadian law in the context of an insolvency proceeding. The Peoples case involved a claim by the trustee in bankruptcy of the bankrupt corporation against the former directors of the bankrupt corporation. In this case, the directors of Peoples Department Stores had implemented a joint procurement policy with its parent company, Wise Stores Inc. whereby Peoples acquired all of the inventory offered for sale at both Peoples and Wise. As a result of the manner in which the joint procurement arrangement was implemented, Peoples effectively provided free unsecured inventory financing to Wise and, upon Wise's bankruptcy, Peoples itself was placed into a bankruptcy proceeding. The trustee in bankruptcy of Peoples brought an action against the directors of Peoples, alleging that the directors had breached their fiduciary obligations to the creditors of Peoples; however, the trustee in bankruptcy did not pursue any claim against the directors under either the oppression remedy or a derivative action on behalf of Peoples.

At the trial level, the trial judge recognized that British, Australian and New Zealand courts have all held that when a company is near insolvency, the directors owe duties not only to the shareholders of the company but also to its creditors.3 The Quebec Court of Appeal overturned the lower court decision and rejected the concept that the duties of directors shift in favour of the creditors of the corporation as it nears the zone of insolvency.4 In examining the issue whether directors owe a fiduciary duty to the corporation's creditors, the Supreme Court of Canada affirmed the decision of the Quebec Court of Appeal and expressly held:

The principal question raised by this appeal is whether directors of a corporation owe a fiduciary duty to the corporation's creditors comparable to the statutory duty owed to the corporation. For the reasons that follow, we conclude that directors owe a duty of care to creditors, but that duty does not rise to a fiduciary duty. We agree with the disposition of the Quebec Court of Appeal.5

In analyzing where a director's duty falls under Canadian law, the Supreme Court examined both the issue of a director's duty of loyalty and a director's duty of care. In referring to section 122(1)(a) of the Canada Business Corporations Act (the CBCA), which requires that a director "act honestly and in good faith with a view to the best interest of the corporation," the Supreme Court held that the director's duty of loyalty at all times is a fiduciary obligation owed to the corporation itself. The Court held that the duty of loyalty does not extend to other stakeholders beyond the corporation. On the other hand, in examining section 122(1)(b) of the CBCA, which requires directors to "exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances," the Court held that the duty of care is owed to all stakeholders of the corporation. In casting the net for the duty of care widely, the Supreme Court has created a broad group of interested parties, including shareholders, creditors, employees and other similar parties, to whom directors owe a duty of care under Canadian law. On the other hand, by limiting the duty of loyalty to the corporation itself, the Supreme Court has excluded such stakeholders from the scope of a director's fiduciary duties. This distinction is summarized by the Supreme Court as follows:

The various shifts in interest that naturally occur as a corporation's fortunes rise and fall do not, however, affect the content of the fiduciary duty under s. 122(1)(a) ... At all times, directors and officers owe their fiduciary obligation to the corporation. The interests of the corporation are not to be confused with the interests of the creditors or those of any other stakeholders ... In using their skills for the benefit of the corporation when it is in troubled waters financially, the directors must be careful to attempt to act in its best interest by creating a "better" corporation, and not to favour the interests of any one group of stakeholders.6

In the Peoples case, the Supreme Court affirmed that courts should respect the business judgment of the directors of a corporation in reviewing the conduct of these directors. The Court ruled that judges are ill-suited to second-guess the application of a director's business expertise in considerations that are involved in corporate decision making; judges should rather focus their review on determining whether the directors brought an appropriate degree of prudence and diligence to the table.7

In assessing whether or not directors have fulfilled their duties, different considerations apply to the procedural and substantive aspects of their conduct. The procedural aspect requires directors to make reasonable inquiry into all relevant information available to them before making a decision (i.e., directors are required to make informed decisions). This means that directors should take a direct and active role, especially in key matters affecting the corporation. Although directors are not bound to attend all meetings of the board, they should make an effort to attend: it would be a breach of their duty of diligence to deliberately ignore the corporation's affairs.

If a director has fulfilled this duty of care, any substantive decision made should be subject to the "business judgment rule." In other words, if business decisions have been made honestly, prudently, in good faith and on reasonable grounds, the courts will be reluctant to interfere or to substitute their judgment for the director's judgment. In short, directors should not be liable for errors in judgment if they had otherwise acted properly.

The sanctity of the business judgment rule was also recently re-affirmed by the Supreme Court of Canada in Re BCE Inc.8 In the BCE case, which did not involve an insolvency proceeding, the Supreme Court gave an overview of directors' duties, considered the interests that are protected under the oppression remedy available under most Canadian corporate statutes and discussed the test for approval of a plan of arrangement. The Court re-affirmed its earlier decision in Peoples and held that the directors have a duty to act in the best interests of the corporation, which requires directors to consider the interests of all stakeholders and not to equate the interests of the corporation with the interests of shareholders alone. The Court rejected the "shareholder primacy" model derived from U.S. jurisprudence and held that the duties of directors in Canada:

comprehends a duty to treat individual stakeholders affected by corporate acts equitably and fairly. There are no absolute rules. In each case, the question is whether, in all of the...