Insolvent Corporations And Director Fiduciary Duties To Creditors: A Review Of The Standards In Delaware And Wisconsin

Individuals serving as directors of corporations face the prospect of making difficult decisions when the enterprise experiences financial distress. In fulfilling their fiduciary duties, do the directors of distressed entities owe their duties of loyalty and care to the entity's shareholders, to its creditors, or to both? Do these duties shift from shareholders to creditors at some point? Terms like "zone of insolvency" and "deepening insolvency" have contributed to the uncertainty directors struggle with when attempting to appropriately discharge their duties. Fortunately, the law governing duties of directors of distressed corporations has recently been clarified and, for the time being at least, both Delaware and Wisconsin courts have articulated clear principles which provide guidance to directors grappling with these issues.

Delaware is the state of incorporation for many entities, including companies which operate in Wisconsin. While the Delaware law of director fiduciary duty may apply to Delaware entities, the Wisconsin Supreme Court has applied Wisconsin choice of law principles, resulting in directors of entities chartered in Delaware becoming subject to Wisconsin law. Therefore, it is important for directors of Wisconsin based companies incorporated in Delaware to understand the scope of their duties under both Delaware and Wisconsin law, and for directors of Wisconsin chartered companies operating in Wisconsin to understand the applicable standards for those duties under Wisconsin law.

Delaware

It is generally recognized that in discharging their duties, directors of corporations owe a duty of care (the duty to make decisions in a prudent manner) and a duty of loyalty (the duty to act without personal economic conflict) to the corporation and its shareholders.1 What happens, however, when the enterprise experiences financial distress and is at risk of becoming insolvent? Do creditors have a right to demand that directors protect the creditors' interests in addition to (or instead of) the interests of shareholders?

Zone of Insolvency

The concept of "zone" or "vicinity" of insolvency arose in 1991 in Credit Lyonnaise, an unpublished Delaware Chancery Court decision.2 Under the zone of insolvency construct, directors were cautioned to make decisions which did not favor the shareholders at the expense of creditors.3 Credit Lyonnaise and the concept of zone of insolvency, which spawned numerous commentaries and articles,4 was criticized for inviting claims of breaches of fiduciary duty against directors who were confused about which constituency to serve at any given time.

Fortunately, the specter of competing or perhaps conflicting fiduciary duties when an entity was in the zone of insolvency was put to rest in 2007 in Gheewalla, a case decided by the Delaware Supreme Court. The case involved a failed company in the business of creating a national system of wireless connections to the Internet. The defendants were members of the company's board of directors and were also employees of the company's lender, Goldman Sachs. The complaint was filed by a creditor that asserted that the company was in the zone of insolvency and that the directors breached their fiduciary duties giving creditors a direct (rather than a derivative) right of action against them.

After defining "insolvency" as assets being worth less than liabilities or the entity being unable to pay its obligations as they become due,5 the court held that so long as an entity is solvent under this definition, the directors' fiduciary duties run only to the shareholders. "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."6 Once the corporation becomes insolvent, said the court, the creditors take the place of shareholders as the residual beneficiaries of the value of the corporation. However, the right of creditors to seek redress remains derivative and is not direct.7

Deepening Insolvency

Directors were even more confused by the emergence of the potential cause of action of "deepening insolvency"causing a failing company to worsen its financial condition giving rise to a cause of action in favor of creditors injured by the improvident decisions made. Deepening insolvency8 was first recognized as a potential cause of action by the Third Circuit Court of Appeals in Lafferty,9 (a Ponzi scheme case arising under Pennsylvania law). With Lafferty, the threat of director liability for deepening insolvency was met by dismay by both insolvency and corporate attorneys alike. The decision caused counselors to...