Delaware courts have also recognized a third test, finding that insolvency “occurs at the moment when the entity has liabilities in excess of a reasonable market value of assets held.”10 This test arguably adopts too expansive a view of insolvency – it could render almost any start-up company insolvent. Nonetheless, since a number of courts have applied this test, it would be unwise for a board to entirely ignore the possibility that the nature of its fiduciary duties may shift if a company’s liabilities exceed its assets.
An assessment of whether any of the three insolvency standards have been triggered is an intensely factual matter, to be determined by the company’s officers and directors. However, it should be noted that any future challenge to a determination of solvency or insolvency will invariably be made with the benefit of hindsight. Therefore, it is imperative that all relevant factors be considered and that the directors be as fully informed and well-advised as possible.
Nonetheless, in many instances (for example, in a rapidly changing market), making a solvency determination may be easier said than done. Management and the board cannot spend all their time assessing and reassessing whether the company has crossed into insolvency, particularly since at times of economic stress there are often many difficult issues to which the company must devote its resources and attention. Nor can management and the board simply assume insolvency when the company appears to be close to it; if the company is later found to have been solvent, the board would be exposed to potential claims by shareholders claiming that the directors owed fiduciary duties solely to the shareholders and any consideration given to the interests of creditors violated those duties.
So, what is a board to do? The answer may well be not to concentrate exclusively on the question of a company’s solvency (although the status of a company’s financial viability obviously cannot be ignored), but to focus – at all times, whether the company is insolvent or just on the brink – on protecting the interests of the corporate enterprise as a whole.
As the court in Gheewalla explained, directors’ fiduciary duties are ultimately owed to the corporation. “When a corporation is solvent, those duties may be enforced by its shareholders . . . because they are the ultimate beneficiaries of the corporation’s growth and increased value. When a corporation is insolvent, however, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.”11 Therefore, the most advisable course of action for directors of a distressed company is to focus on protecting the value of the corporation, with the understanding that the constituencies to whom duties are owed may shift depending on the company’s precise financial situation.
•What Is the Scope of Fiduciary Duties in Insolvency?
What exactly is the nature of that shift? When a company is financially healthy, its directors owe their fiduciary duties solely to the company and its shareholders. That does not, however, mean that the obverse is true. When the company’s financial condition is uncertain, directors do not owe their fiduciary duties solely to the firm’s creditors. Rather, directors of an insolvent corporation owe duties to the “entire corporate enterprise rather than any single group interested in the corporation,” and are permitted to balance the interests of the various corporate constituencies, including shareholders and creditors.12
In evaluating those interests, “the business judgment rule remains important and provides directors with the ability to make a range of good faith, prudent judgments about the risks they should undertake on behalf of troubled firms.”13
Those principles provide significant latitude to directors, but they provide little concrete guidance in determining the scope of their fiduciary obligations in insolvency. Unfortunately, neither Gheewalla nor the cases following it shed much light on this issue. However, it is possible to distill certain guidelines from the existing case law:
• A decision that favors one constituency over another is not a per se violation of fiduciary duties. A decision that advances shareholders’ interests at the expense of creditors may be permissible, and vice versa. 14 Again, what matters is that the directors make a good faith business judgment meant to further the interests of the corporation as a whole. However, directors should be mindful that once the continued existence of their company appears unlikely, they may be required to protect the interests of creditors over those of shareholders. 15
• The fact that a strategy runs the risk of prolonging or deepening insolvency does not mean that directors are barred from pursuing that option. Similarly, directors are not required to approve a course of conduct simply because it would make the company “less insolvent.” Rather, it is sufficient that the chosen course of action reasonably offers the potential for improving the corporation’s condition. 16
Douglas H. Flaum is a partner and Shahzeb Lari is an associate in the litigation department of Fried, Frank, Harris, Shriver & Jacobson. David Wei, an associate at the firm, assisted in the preparation of this article.
Endnotes:
1. 930 A.2d 92 (Del. 2007). This article focuses on Delaware law.
2. Id. at 101-03.
3. Id.; see also Torch Liquidating Trust v. Stockstill, 2008 U.S. Dist. LEXIS 19535, at **13-19 (D. La. March 13, 2008) (rejecting claims that the directors of an insolvent corporation had breached their fiduciary duties to the company’s creditors by failing to disclose the company’s true financial condition because the claims were based on the purported existence of a direct fiduciary duty to the creditors, rather than fiduciary duties owed to the company, and no such duty exists) (citing Gheewalla).
4. Gheewalla, 930 A.2d at 101.
5. Id. at 100 (citing Production Resources Group v. NCT Group Inc., 863 A.2d 772, 790 (Del. Ch. 2004)).
6. Id.
7. Id. at 101.
8. Id. at 98; see also, e.g., Siple v. S&K Plumbing and Heating Inc., 1982 Del. Ch. LEXIS 553, at *5 (Del. Ch. April 13, 1982).
9. Gheewalla, 930 A.2d at 98; see also, e.g., Odyssey Partners, L.P. v. Fleming Companies Inc., 735 A.2d 386, 417 (Del. Ch. 1999).
10. Blackmore Partners, L.P. v. Link Energy LLC, Del. Ch. LEXIS 155, at *22 (Del. Ch. Oct. 14, 2005).
11. 930 A.2d at 101 (emphasis in original).
12. Odyssey, 735 A.2d at 417; see also Gheewalla, 930 A.2d at 101.
13. Production Resources, 863 A.2d at 788 n.52; see also Angelo, Gordon & Co. v. Allied Riser Comm. Co., 805 A.2d 221, 229 (Del. Ch. 1999) (“even where the law recognizes that the duties of directors encompass the interests of creditors, there is room for the application of the business judgment rule”).
14. See, e.g., Equity-Linked Investors, L.P. v. Adams, 705 A.2d 1040, 1042 (Del. Ch. 1997) (directors’ decision to choose a transaction that benefited holders of common stock did not violate any duties owed to preferred stock, although “the board in these circumstances could have made a different business judgment”); Odyssey, 735 A.2d at 418-20 (upholding directors’ decision to engage in a foreclosure sale benefiting creditors instead of filing for bankruptcy, which would have been more beneficial to minority shareholders, because directors made a good faith determination that foreclosure was more beneficial to the enterprise as a whole).
15. See In re Bear Stearns Litig., 2008 NY Slip Op 28500, 2008 N.Y. Misc. LEXIS 7075 (N.Y. Sup. Ct. 2008) (applying Delaware law).
16. See Trenwick America Litigation Trust v. Ernst & Young, 906 A.2d 168, 195 (Del. Ch. 2006).
