While the fiduciary duties of directors and officers are clearly laid out under applicable state law for solvent companies, there is still a degree of uncertainty surrounding those duties as a company approaches what is known as the “zone of insolvency,” or the point at which insolvency is imminent. For directors and officers of distressed companies, it can be difficult to find definitive answers on precisely what duties are owed to whom at different points in the transition from solvency to insolvency.
An overview of D&O fiduciary duties
In carrying out their responsibilities, directors and officers are governed by two principal duties and one rule. These are determined by relevant state corporate law (Delaware law is typically used in example discussions given that many companies are organized in that state. In addition, many other states follow Delaware law).
The duty of loyalty
Under this duty, directors and officers have an obligation to act in the best interests of both the corporation and its shareholders and to refrain from any conduct that would injure either of these parties or deprive them of any profit or other advantages. A further requirement of this duty for directors and officers is that these obligations be performed in good faith. Some examples of behaviors or situations that constitute a breach of the duty of loyalty include self-dealing, conflicts of interest, disclosure of corporate confidences, misappropriation or other abuse of corporate opportunities, and a disregard for the good-faith performance standards.
The duty of care
This duty deals with the necessary degree of care and prudence that directors and officers must observe in carrying out their responsibilities. In order to properly satisfy the duty of care, directors and officers must ensure that before making a business decision, they are able to act on an informed basis. What this means is that they must consider all reasonably available material on the subject at hand and consult with appropriate advisors, including accountants, financial advisors, and lawyers. Any action taken must also involve the same degree of care.
The business judgment rule
Designed as a protective measure for directors and officers, this rule serves as the standard for judicial review of conduct. Essentially, the rule gives directors and officers the benefit of the doubt by presuming that, when making decisions, they acted in good faith, on an informed basis, and on the belief that their decisions and actions were in the corporation’s best interests. The rule helps to protect disinterested directors and officers in the event that a business decision turns out badly for causes that could not have been reasonably foreseen at the time. If a plaintiff wishes to bring a case against officers or directors for a breach of fiduciary duties, they must bring evidence to show that the business rule should not apply. In other words, the plaintiff must be able to demonstrate that the officers and directors did not act in good faith, did not use the same care that would have been used by any reasonable person, and did not reasonably believe that their actions were in the corporation’s best interests.
Fiduciary duties in times of insolvency
In times of normal operations, that is, when a corporation is solvent, the directors and officers owe the fiduciary duties above to both the corporation and its shareholders. When a company is insolvent, the scope of these duties is extended to include the corporation’s creditors, as well. However, the so-called “zone of insolvency,” wherein a company is financially distressed but not yet actually insolvent, is still a gray area in many cases when determining whether duties are or are not owed to creditors.
In a 2007 case, the Delaware Supreme Court held that creditors of a solvent corporation operating in the zone of insolvency do not have a direct claim against the corporation’s directors for breach of fiduciary duty. In other words, creditors are owed no special duties when a company is financially distressed, as opposed to actually insolvent. Although this ruling would seem to have resolved the issue, a number of questions and concerns remain. One of the principal unsettled points arises from the fact that it can be difficult and contentious to determine the exact state of a corporation – solvent or insolvent at a given point in time. Thus, even though it may be plainly stated that creditors are not owed fiduciary duties unless a corporation is insolvent, legally determining the point of insolvency is not as clear-cut. Further clouding the issue is the fact that other jurisdictions have either not yet opined or have opined affirmatively as to the question of whether fiduciary duties are owed to creditors by a corporation in the zone of insolvency. It is therefore essential for directors and officers of a corporation in financial distress to continue to adhere to good corporate governance practices and to seek additional advice and protective measures as necessary.
In a 2007 case, the Delaware Supreme Court held that creditors of a solvent corporation operating in the zone of insolvency do not have a direct claim against the corporation’s directors for breach of fiduciary duty. In other words, creditors are owed no special duties when a company is financially distressed, as opposed to actually insolvent. Although this ruling would seem to have resolved the issue, a number of questions and concerns remain. One of the principal unsettled points arises from the fact that it can be difficult and contentious to determine the exact state of a corporation – solvent or insolvent at a given point in time. Thus, even though it may be plainly stated that creditors are not owed fiduciary duties unless a corporation is insolvent, legally determining the point of insolvency is not as clear-cut. Further clouding the issue is the fact that other jurisdictions have either not yet opined or have opined affirmatively as to the question of whether fiduciary duties are owed to creditors by a corporation in the zone of insolvency. It is therefore essential for directors and officers of a corporation in financial distress to continue to adhere to good corporate governance practices and to seek additional advice and protective measures as necessary.