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In the past 10 to 15 years, the evolving law of the duties of a board of directors of an insolvent corporation or a corporation in the “zone of insolvency” has created uncertainties for directors and the professionals that advise them. Beginning in the early 1990s, several decisions have appeared to expand directors’ liabilities and to deprive them of certain defenses to those liabilities that would exist outside of the insolvency/bankruptcy context. For example, Pereira v. Cogan, No. 00 CIV. 619 (RWS), 2001 WL 243537, at 11-12 (S.D.N.Y. March 8, 2001), held that the exculpation provision of the corporation’s charter, authorized under applicable state law, did not bar recovery by creditors for breach of fiduciary duty by directors. See also Growe v. Bedard, No. 03-198-B-S, 2004 WL 2677216 (D. Maine Nov. 23, 2004); Steinberg v. Kendig (In re Ben Franklin Retail Stores Inc.), nos. 97 C 7934, 97 C 6043, 2004 WL 28266 (N.D. Ill. Jan. 11, 2000). Other decisions seem to have questioned the applicability of the business judgment rule in the context of a claim for breach of fiduciary duty brought by a creditor. Needless to say, the apparent expansion of the potential pool of plaintiffs and the modification of normal corporate law principles protecting the decision-making process caused significant concern for directors. Some practitioners have argued that these judicial decisions militated in favor of earlier Chapter 11 filings to obtain protection for the board and senior management. A recent Delaware Chancery Court decision in Production Resources Group LLC v. NCT Group Inc., No. CIV.A. 114-N, 2004 WL 2647593 (Del. Ch. Nov. 17, 2004), addressed and clarified the concepts of liability in the area of creditor litigation asserted against a board. The decision is important in that Vice Chancellor Leo E. Strine Jr. carefully analyzed the doctrinal bases for the imposition of liability against boards of directors and senior management. At bottom, Strine held that the directors’ duties are not fundamentally altered in the insolvency context; rather, the pool of potential plaintiffs is expanded to include creditors. Thus, because the litigation is derivative in nature, the normal corporate principles involving the business judgment rule and, when adopted, exculpation will apply to creditor claims asserted derivatively. DUTY OF CARE PRINCIPLES Delaware law provides that if a director does not breach his duty of loyalty to the company, he is permitted to rely on the business judgment rule or an exculpatory provision to shield him from liability for a breach of the duty of care. Emerald Partners v. Berlin, 787 A.2d 85, 90 (Del. 2001). The business judgment rule operates as a presumption “‘that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.’” Beam ex rel. Martha Stewart Living Omnimedia Inc. v. Stewart, 845 A.2d 1040, 1048-49 n.16 (Del. 2004) (citing Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)). The business judgment rule is an important protection for directors. It creates a strong presumption that is difficult to rebut; consequently, in many cases, courts will dismiss at the pleadings stage complaints against directors when the issue is a disagreement with the decision of the board. Courts will not, absent unusual facts, substitute their judgment for the judgment of the board of directors. Id. In addition to the protection of the business judgment rule, Delaware statutory law allows corporations to grant their directors further protection. Specifically, �102(b)(7) of the Delaware General Corporation Law allows corporations to adopt a charter provision to exculpate directors from breaches of the duty of care. When “the standard of review ab initio is the business judgment rule, properly raising the existence of a valid exculpatory … provision in the corporate charter entitles director [defendants] to dismissal of any claims for [monetary] damages against them that are based solely on alleged breaches of the board’s duty of care.” Emerald Partners, 787 A.2d at 93 (internal citations omitted). Many practitioners would point to the decision of Chancellor William T. Allen in Cr�dit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp., No. CIV.A.12150, 1991 WL 277613 (Del. Ch. Dec. 30, 1991), as articulating the more modern approach to directors’ duties when a corporation is insolvent or in the “zone of insolvency.” Among other things, Cr�dit Lyonnais supports the proposition that directors will be protected by the business judgment rule if they, in good faith, pursued a less risky business strategy that was more consistent with the interests of creditors rather than shareholders. Some courts have read Cr�dit Lyonnais as creating a new set of fiduciary duty claims against directors. See, e.g., LaSalle Nat’l Bank v. Perelman, 82 F. Supp. 2d 279, 290 (Del. 2000); Weaver v. Kellogg, 216 B.R. 563, 582-84 (S.D. Texas 1997); Official Comm. of Unsecured Creditors of Buckhead Am. Corp. v. Reliance Capital Group Inc. (In re Buckhead Am. Corp.), 178 B.R. 956, 968-69 (D. Del. 1994). The recent Delaware Court of Chancery opinion thoughtfully addresses the nature of the fiduciary duties owed to the company’s creditors when the company becomes insolvent and suggests that the above rules apply even within the context of financially troubled companies. Specifically, Strine’s opinion held that exculpation clauses do apply to prevent creditors as well as shareholders from bringing duty of care/mismanagement claims when the firm is insolvent. 2004 WL 2647593, at 13-14. The court made it clear that, contrary to expansive readings of Cr�dit Lyonnais, there is no “new body of creditor’s rights law.” Id. at 12. GUIDANCE FOR DIRECTORS More broadly, the Production Resources opinion provides guidance to the directors of companies within the zone of insolvency that good-faith decisions exercising business judgment as to the best interest of the company as a whole ought not to give rise to liability. As mentioned above, Production Resources rejects those cases that interpreted Cr�dit Lyonnais as authorizing creditors to challenge directors’ business judgments as breaches of a fiduciary duty owed to them. Id. at 12. The Production Resources opinion makes the following significant points: Cr�dit Lyonnais is a “shield to directors” and not a sword for creditors seeking to bring suit. Strine explained that the Cr�dit Lyonnais “holding and spirit clearly emphasized that directors would be protected by the business judgment rule if they, in good faith, pursued a less risky business strategy precisely because … a more risky strategy might render the firm unable to meet its legal obligations to creditors and other constituencies.” Id. at 12. In other words, Cr�dit Lyonnais “provided a shield to directors from stockholders who claimed that the directors had a duty to undertake extreme risk so long as the company would not technically breach any legal obligations.” Id. At the same time, however, directors of troubled companies are not required to act solely in the interest of the creditors. Rather, the directors continue to have the “task of attempting to maximize the economic value of the firm” for “the community of interest that sustained the corporation.” Id. at 12-13. Thus, the mere fact that a company may be financially troubled, does not create some sort of “magic dividing line” that profoundly changes a director’s duties. Id. at 21 n.52. As a result, the business judgment rule remains the standard under which directors of a financially troubled company’s conduct will be evaluated. Id. Creditors of insolvent firms have standing to pursue fiduciary duty claims, but the claims are derivative, not direct. The Production Resources court noted, however, that a breach of care claim brought by a creditor for actions that occurred while the company in question was in the “zone of insolvency” was derivative in nature. Id. CLAIM BELONGS TO CORPORATION In explaining why the creditor’s claim was derivative, the Production Resources court stated as follows: “[T]he fact of insolvency does not change the primary object of the director’s duties, which is the firm itself. The firm’s insolvency simply makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm’s value and logically gives them standing to pursue these claims to rectify that injury. Put simply, when a director of an insolvent corporation, through a breach of fiduciary duty, injures the firm itself, the claim against the director is still one belonging to the corporation.” Id. In light of the above, the fact of insolvency, even if the company becomes insolvent after the acts alleged to have been improper, does not transform the nature of the claim; it simply changes the class of those eligible to press the claim derivatively by expanding it to include creditors. Id. at 14. Exculpatory clauses do apply to prevent creditors from bringing duty of care claims. Relying on the fact that any claim held by a creditor is derivative in nature, the Production Resources court held that �102(b)(7) applies to the claims asserted by the company on behalf of its creditors. Id. at 14. The court noted “although �102(b)(7) itself does not mention creditors specifically, its plain terms apply to all claims belonging to the corporation itself, regardless of whether those claims are asserted derivatively by stockholders or by creditors.” Id. In explaining the policy reasons behind this conclusion, the court observed that “[i]t would be puzzling if, in insolvency, the equitable law of corporations expands the rights of firms to recover against their directors so as to better protect creditors, who, unlike shareholders, typically have the opportunity to bargain and contract for additional protections to secure their positions . . . .That is, what right or efficient theory of commercial law would permit creditors, through a bankruptcy trustee or other mechanism, to inherit not only claims belonging to the corporation as an entity but also claims that the corporation has contractually promised it would not bring against its directors?!” Id. at 15. The court held that �102(b)(7) applies to all actions in which a plaintiff alleges duty of care violations and there is an applicable charter exculpation provision, regardless of whether a company is solvent or insolvent. Id. The business judgment rule continues to apply even in the zone of insolvency. Production Resources reaffirms Angelo Gordon & Co. v. Allied Riser Communication Corp., 805 A.2d 221, 229 (Del. Ch. 2002), by holding that the business judgment rule applies to creditors’ suits for breach of the duty of care when the company was insolvent. Production Resources, 2004 WL 2647593, at 21 n.52. In sum, whether a company is in the zone of insolvency or insolvent, the business judgment rule continues to allow directors to make a range of good-faith judgments about risks they should undertake on behalf of troubled firms. In footnote 58 of the Production Resources decision, Strine discussed what this all means as a practical matter to directors within the “zone.” He noted that the real-world decision faced by directors will not involve directors “putting cash in slot machines,” but rather difficult choices between a pursuit of a plausible, but risky, business strategy that might increase the company’s value to the level that the company’s equity holders will receive value, and another course guaranteeing no return for equity, but preservation of value for creditors. Id. at 21 n.58. Thus, absent self-dealing or other indicia of bad faith, Production Resources suggests that these types of tough decisions should be protected by the business judgment rule and not give rise to personal-liability claims by shareholders or creditors. FOLLOWING STRINE’S APPROACH Two recent decisions have cited to Strine’s approach. In Creditor Committee of Star Telecommunications Inc. v. Edgecomb, No. Civ A. 03-278-KAJ, 2004 WL 2980736 (D. Del. Dec. 21, 2004), the Delaware district court applied Production Resources to dismiss claims for the breach of duty of care, including gross negligence, when the company had an exculpatory provision. Id. at 11-12. Similarly, in U.S. Bank National Association v. U.S. Timberlands Klamath Falls LLC, No. Civ. A. 112-N, 2004 WL 3090090 (Del. Ch. Dec. 22, 2004), Vice Chancellor Stephen P. Lamb acknowledged the approach taken by Strine in Production Resources. In sum, the law relating to directors’ duties and liabilities when the corporation is insolvent or in the zone of insolvency has created uncertainty and difficulty for boards of directors, senior management and the professionals advising those boards. Strine’s decision in Production Resources assists practitioners by providing clarity and guidance. Practitioners should be aware of the law applicable to these issues when advising boards, senior management and others in connection with a financially troubled enterprise. Dennis Connolly is a partner at Atlanta’s Alston & Bird. His practice focuses primarily on the representation of debtors and creditors’ committees in commercial Chapter 11 bankruptcy cases. Caroline Keller is an associate in the firm’s securities practice group, where her practice focuses on a variety of securities litigation matters and other business-related and commercial litigation.

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