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Many practitioners believe that the next wave of large commercial bankruptcy cases will generate a substantial number of complex litigation claims asserted by creditors who otherwise would recover little or nothing from the debtor’s hard assets. The Delaware Supreme Court, however, recently took a step toward stemming that tide by clarifying – and in most respects, narrowing – those claims that might otherwise be directly available to creditors who believe they have been wronged by a debtor’s management. In a case of first impression, the Delaware Supreme Court in North American Catholic Educational Programming Foundation Inc. v. Rob Gheewalla, et al., not only affirmed a Delaware Chancery Court ruling that creditors of a corporation operating in the “zone of insolvency” may not bring a direct cause of action against its directors for breach of fiduciary duty, but further held that even when that corporation is insolvent, its creditors have nothing more than derivative standing to assert breach of fiduciary duty claims against directors of the insolvent corporation. Through this ruling, the court not only resolved a debate fueled by the Chancery Court’s 1991 decision in Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp., but also further insulated directors of insolvent corporations from direct liability to creditors arising from decisions made while acting on behalf of a troubled company. Plaintiff North American Catholic Educational Programming Foundation Inc. was part of a business alliance that held FCC-approved licenses for microwave signal transmissions used for educational programs. The defendants were directors of Clearwire Holdings Inc. and employed by Goldman Sachs, which appointed them to the Clearwire board. In March 2001, the plaintiff and the other alliance members entered into a master use and royalty agreement with Clearwire, under which Clearwire could attain rights to the licenses upon their expiration. Under this agreement, Clearwire was obligated to pay the plaintiff and other members of the alliance more than $24 million. In June 2002, the wireless communications market collapsed, causing the sudden availability of numerous licenses. Clearwire sought to suspend its obligations under the agreement and in doing so settled with two members of the alliance group who were paid over $2 million. The plaintiff remained as the sole member. By October 2003, Clearwire ceased business operations. The plaintiff company filed a complaint against the defendants in the Chancery Court, alleging, among other things, that because Clearwire was either insolvent or in the “zone of insolvency,” it owed a fiduciary duty to the plaintiff as a substantial creditor of Clearwire, which fiduciary duty was breached by not preserving Clearwire’s assets for its benefit when it became apparent that Clearwire would need to liquidate. The defendants moved to dismiss the complaint for lack of personal jurisdiction and for failing to state a claim upon which relief can be granted. The Chancery Court determined that in order to resolve the issue of personal jurisdiction it had to first address the issue of whether or not the plaintiff’s complaint properly stated a breach of fiduciary duty claim. After initially determining that the complaint properly alleged Clearwire was insolvent and within the “zone of insolvency” during at least a portion of the time alleged in the complaint, the Chancery Court held that the complaint failed to state a claim for relief because the plaintiff attempted to assert a direct claim for breach of fiduciary duty against the defendants while the corporation was operating in the “zone of insolvency,” a claim that does not exist under Delaware law. The Chancery Court did not decide whether or not the plaintiff had a direct claim against the defendants for their breach of fiduciary duty when Clearwire was insolvent, only holding that the complaint itself did not satisfy the specific pleading requirements described in previous decisions of the Chancery Court. The plaintiff company appealed. In its analysis, the Supreme Court first noted that the plaintiff was asking it to recognize a new direct right for creditors to challenge directors’ exercise of business judgment. The court cited favorably to the Chancery Court’s reasoning that creditors have existing protections – including negotiated agreements, security instruments, the implied covenant of good faith and fair dealing, fraudulent conveyance law, and bankruptcy law – that render the imposition of an additional unique layer of protection through direct claims for breach of fiduciary duty unnecessary. Further, the court noted that the Chancery Court correctly recognized that the benefit of such additional direct claims was minimal and would restrict directors at a time when the corporation is in most need of effective and proactive leadership. The court affirmed the Chancery Court’s decision holding that as a matter of law, no such right exists to the extent that the plaintiff attempted to assert a direct claim for breach of fiduciary duty again the defendants while Clearwire was operating in the “zone of insolvency.” The court reasoned that when a corporation is in the “zone of insolvency” the focus for directors in Delaware does not change; directors must continue to discharge their fiduciary duties to the corporation and shareholders in exercising their business judgment. Of greater importance, however, the court next addressed whether creditors had direct claims for breach of fiduciary duty against directors of insolvent corporations. The court noted that the Chancery Court had not directly ruled on this issue in its opinion in this case, and, in previous opinions, in dicta, had left the issue open. The court noted that generally shareholders have standing to bring derivative actions on behalf of the corporation against directors, however, when a corporation is insolvent, the shareholders are replaced by the creditors who then have standing to maintain derivative claims as against directors on behalf of the corporation for breach of fiduciary duty. The court recognized that if directors of an insolvent corporation owe a direct fiduciary duty to creditors, it would create uncertainty for such directors and create a conflict between those directors’ duty to maximize the value of the insolvent corporation and its newly recognized direct fiduciary duty to individual creditors. The court reasoned that directors of insolvent corporations must retain the freedom to engage in vigorous good faith negotiation with individual creditors for the benefit of the corporation and held that individual creditors of an insolvent corporation have no right to assert direct claims for breach of fiduciary duty against corporate directors. Such creditors, however, may bring derivative claims on behalf of the insolvent corporation or any other direct non-fiduciary claim available to individual creditors. Although the court supported its decision, in part, on the existence of other remedies available to creditors, it appears not to have taken into account the structural impediments to creditors that a bankruptcy imposes. By holding that only a derivative claim exists, it provides the debtor-in-possession or a trustee with primary control, thus requiring a motivated creditor to attempt to wrest such control of the claims to ensure aggressive prosecution. It also somewhat clouds the issue of what or whose interests the director must consider when making decisions for an insolvent corporation. The threat of a direct cause of action by a creditor would seem to keep a director’s focus sharp in an insolvency situation as to the interests of general creditors in addition to that of equity. Given the weight Delaware corporate decisions are accorded across the country, it will be interesting to see how many states follow. In any event, if the onslaught of litigation claims many of us expect to see in bankruptcy cases occurs, it looks less likely that direct claims by creditors for breach of fiduciary duty against directors will be part of it. FRANCIS J. LAWALL , a partner in thePhiladelphia office of Pepper Hamilton, concentrates his practice in national bankruptcy and reorganization matters. He routinely lectures to various creditor groups concerning general bankruptcy issues, including preferences, reclamation, the role of creditors’ committees and related issues. THOMAS A. SPRATT, JR. , an associate in the firm’s Philadelphia office, concentrates his practice in national bankruptcy and reorganization matters.

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