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Following record-breaking financial scandals and the enactment of the Sarbanes-Oxley Act, corporate directors have become more independent, more vocal and more likely to challenge, rather than rubber-stamp, management. As directors rise to the challenges of the post-Enron era, so have the Delaware courts risen to their aid by waging a silent, persistent battle to reinvigorate the business-judgment rule and protect directors and officers of troubled and failed companies. Of particular interest to bankruptcy and restructuring practitioners, these courts have brought clarity and considerable intellectual rigor to the often nebulous “zone of insolvency”-where the risk for even the most responsible directors is greatest. In a string of decisions, the Delaware courts have clarified the scope and derivative nature of creditor claims in the zone of insolvency. The courts in Trenwick America Litigation Trust v. Ernst & Young LLP, 906 A.2d 168 (New Castle Co., Del., Ch. 2006), and In re Scott Acquisition Corp., 344 B.R. 283 (Bankr. D. Del. 2006), recently upheld and strictly enforced the business-judgment rule and eliminated deepening insolvency as a cause of action under Delaware law. All in all, these cases seem to be pushing case law to a tipping point, where the liability of directors and officers of troubled companies can no longer be established by simply pointing to the failure of a business, but must instead be the result of grossly negligent decisions. Perhaps the first principle these cases have emphasized is that claims by creditors in the zone of insolvency are still derivative-the fact that a company is in the zone of insolvency does not magically empower creditors to sue directors and officers directly. The spark for this recent wave of cases is certainly Production Resources Group v. NCT Group Inc., 863 A.2d 772 (New Castle Co., Del., Ch. 2004). In a lengthy opinion by Vice Chancellor Leo Strine, the court shored up the theoretical underpinning of claims against directors, noting that “regardless of whether they are brought by creditors when a company is insolvent, these claims remain derivative, with either shareholders or creditors suing to recover for a harm done to the corporation as an economic entity.” Id. at 792. Consistent with this intellectual position, In re Scott Acquisition ruled that, under Delaware law, directors and officers of insolvent subsidiary companies owe fiduciary duties to both its creditors and the subsidiary itself. Before this, leading cases on this issue held that fiduciary duties were owed only to creditors and the single-shareholder, parent companies. In that case, Scott Acquisition Corp. and its subsidiary, Scotty’s Inc., filed for bankruptcy protection on Sept. 10, 2004. Their case was later converted to Chapter 7 and a trustee was appointed. The trustee sued the officers and directors of Scotty’s Inc., alleging that the directors and officers breached their duties of loyalty and care in connection with Scotty’s prebankruptcy workout with its lenders. The directors and officers moved to dismiss on several grounds, arguing that, under Delaware law, they could not have violated their fiduciary duties because the directors of a wholly owned subsidiary owe their fiduciary duties solely to the single shareholder and not to the subsidiary corporation itself, even when the corporation becomes insolvent. The court rejected that contention and ruled that Delaware law would recognize that the directors of an insolvent, wholly owned subsidiary owe fiduciary duties to both the subsidiary and its creditors. Under Delaware law, it reasoned, creditors of insolvent corporations are owed fiduciary duties, but these duties are typically derivative of those owed to the subsidiary corporation itself. So, if a subsidiary’s creditors are said to be owed a fiduciary duty upon insolvency, the subsidiary itself must also be owed such a duty. The Scott court also noted that its conclusion benefited from the Production Resources decision, which clarified that a director’s fiduciary obligations in the zone of insolvency are still to the corporation itself: “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 to the company’s creditors. This is an uncontroversial proposition and does not completely turn on its head the equitable obligations of the directors to the firm itself.” In re Scott Acquisition Corp., 344 B.R. at 289. Thus, the court held that the more natural reading of Delaware law is that upon insolvency, directors of a wholly owned subsidiary owe fiduciary duties to the subsidiary and its creditors. The chancery court recently furthered this point again in North American Catholic Educational Programming Foundation Inc. v. Gheswalla, No. Civ. A. 1456-N., 2006 WL 2588971 (New Castle Co., Del. Ch. Sept. 1, 2006). There, a creditor directly sued a company’s directors, alleging breaches of fiduciary duty while in the zone of insolvency. Citing Production Resources, the court held that no direct claim for breach of fiduciary duties may be asserted by creditors of a corporation operating in the zone of insolvency, noting that directors of companies “in the zone” were in most need of the certainty that they would not be subject to individual liability from direct creditor claims. Business-judgment rule Although these opinions seem to focus on obscure intellectual points, their effect is far more than academic. If claims by creditors are derivative, then they are certainly subject to the business-judgment rule defense and any exculpation clauses in a business’ formation documents. Again, this exact point was first brought home strongly by Production Resources. But more recently, Strine again waded into the breach of fiduciary duty and zone of insolvency arena with his decision in Trenwick America Litigation Trust, which strongly upholds the business-judgment protection for directors and officers who appropriately exercise their duties, even in the face of subsequent and complete business failure. A publicly traded holding company, the Trenwick Group Inc. was primarily in the business of reinsurance. Trenwick embarked on a growth strategy by acquiring three other insurance companies, all in arms’-length transactions approved by a majority of Trenwick’s independent board and stockholder base. Trenwick then reorganized the entire company into three subsidiary organizations operating in the United States, the United Kingdom and Bermuda. Trenwick America Corp., a wholly owned subsidiary of Trenwick, in turn became the parent of all the U.S. operations. As part of the reorganization, Trenwick America increased its guarantor obligations as to the parent company, Trenwick, adding $190 million of securities debt to its existing $260 million obligation. Trenwick and Trenwick America were forced to seek bankruptcy protection when their business plan failed. The Trenwick America Litigation Trust, spawned by Trenwick’s resulting Chapter 11 reorganization plan, sued the directors and officers of Trenwick (the parent holding company) and Trenwick America (the subsidiary operating the American insurance line), alleging, among other things, that the holding-company board engaged in an imprudent business strategy by acquiring other insurers, at least one of which had underestimated its potential claims exposure. As a result of that strategy, the holding company and its top U.S. subsidiary were eventually rendered insolvent to the detriment of their creditors. Further, because Trenwick America assumed obligations to support its parent’s debt, that top U.S. subsidiary and its creditors suffered even greater injury than the holding company and its creditors. The directors and officers moved to dismiss the complaint for failure to state a claim. The court granted the motion as to the claims of breached fiduciary duty against the directors and officers. Because the litigation trust had the ability to assert a claim only on behalf of Trenwick America, the court stated, the trust would have to show that the directors of a corporate parent-Trenwick-breached fiduciary duties owed to the parent’s wholly owned subsidiary, Trenwick America. But that would be contrary to Delaware law, which holds that a parent corporation does not owe fiduciary duties to its wholly owned subsidiaries or their creditors. See Anadarko Petro. Corp. v. Panhandle Eastern Corp., 545 A.2d 1171 (Del. 1988). The court also noted that, had the claim been brought by Trenwick itself, it would fail to state a claim for breach of fiduciary duty because Trenwick’s Delaware charter contained an exculpatory provision under � 102(b)(7). Thus, neither Trenwick nor its stockholders could bring an action against its directors for damages resulting from the breach of duty of care. Moreover, the trust could not overcome the exculpation provisions because it failed to plead facts supporting a gross negligence claim. To the contrary, the Trenwick board was dominated by independent directors, and all the deals were at arms’ length and supported by a diverse base of shareholders and after more than adequate due diligence. In the chancery court’s view, to allege that a corporation has suffered a loss as a result of a lawful transaction, within the corporation’s powers, authorized by a corporate fiduciary acting in good-faith pursuit of corporate purposes, does not state a claim for relief, no matter how foolish the investment may appear in retrospect: “The business judgment rule exists precisely to insure that directors and managers acting in good faith may pursue risky strategies that seem to promise great profit.” 906 A.2d at 193. Simply put, all the trust did was allege that Trenwick’s strategy was a foolhardy one, but it failed to allege facts that supported a breach of fiduciary duty claim. Further, the trust’s strategy of suing Trenwick’s directors and officers had no legal basis. The trust could only sue Trenwick itself, and not its board of directors, without piercing its corporate veil. If there was a breach of fiduciary duty by conduct at the Trenwick-level toward Trenwick America, then the proper defendant would be Trenwick itself, the parent corporation. To hold otherwise would effectively allow the trust to “end run” Trenwick’s exculpatory provisions. And the court ruled that the mere incantation of the word insolvency does not change the breach of fiduciary duty analysis, referring to the recently decided In re Scott Acquisition Corp. in support of this proposition. Nixing ‘deepening insolvency’ Consistent with this trend to refocus claims against directors and officers as purely derivative, the Trenwick court joined the growing judicial consensus against the very existence of “deepening insolvency” causes of action. These actions are a relatively new form of tort claim against directors and officers for fraudulently or negligently prolonging the life of an insolvent company. Delaware law, the court held, imposes no absolute obligation on the board of a company to cease operations and to liquidate because it is unable to pay its bills. Even when a company is insolvent, its board may pursue, in good faith, strategies to maximize the value of the firm. What is more, the board of an insolvent corporation, acting with due diligence and good faith, may pursue a business strategy that it believes will increase the corporation’s value and even incur additional debt, without becoming a guarantor of that strategy’s success. If deepening insolvency-type claims may be asserted at all under Delaware law, it is as a traditional breach of fiduciary claim. The business-judgment rule continues to protect the board members. Summarizing its cold criticism of the theory, the court noted that “the concept of deepening insolvency has been discussed at length in federal jurisprudence, perhaps because the term has the kind of stentorious academic ring that tends to dull the mind to the concept’s ultimate emptiness.” For bankruptcy practitioners counseling troubled companies or defending directors and officers, these pro-business line cases offer support and reassurance that a client’s actions when managing a troubled company will be judged by their diligence and good-faith efforts, and not merely by hindsight. In the often unpredictable area of insolvency, these decisions offer certainty and predictability. Luis Salazar is a shareholder in the Miami office of Greenberg Traurig, and is a member of the firm’s national business reorganization and bankruptcy department. He can be reached at [email protected].

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