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Fiduciary Duty to Insolvent / Near Insolvent Corporation Fiduciary Duty to Insolvent / Near Insolvent Corporation

Fiduciary Duty to Insolvent / Near Insolvent Corporation

As we enter this unprecedented time of mandatory social isolation and quarantine, and with it, almost certainly a recession, corporate managers and directors should take a moment to refamiliarize themselves with their fiduciary obligations—especially how those obligations apply when the company is at risk of becoming insolvent.

The Basics: Duties of Loyalty and Care

The basic fiduciary duties that officers, directors, and managers owe to their corporations or limited liability companies are the duties of loyalty and care.[1]
The duty of loyalty requires fiduciaries to act in a disinterested and independent manner, and with the good faith belief that their actions are in the best interest of the company. It requires that fiduciaries avoid self-dealing or improper personal benefits in their actions taken on behalf of their company.

The duty of care requires fiduciaries to act in an informed and considered manner. Fiduciaries should make sure to review all material information reasonably available to them before making decisions and to undertake the decision-making process with the degree of care that a reasonable and prudent person would exercise under the same or similar circumstances.

The Business Judgment Rule

Fiduciaries adhering to their duties of loyalty and care are typically afforded the protections of the “business judgment rule.” Applying the business judgment rule, courts will ordinarily not scrutinize corporate decision-making if the decision was made through a valid exercise of the board’s business judgment. Essentially, corporate fiduciaries who act in good faith, make informed decisions, and do not personally benefit from their corporate actions can rest easier knowing their actions will not be scrutinized after-the-fact with the benefit of hindsight. The business judgment rule facilitates prudent risk-taking and forgives reasonable mistakes in judgment.

Without the protection of the business judgment rule, fiduciaries will need to establish that the corporate action was entirely fair. This may be difficult to prove after the fact, especially if the fiduciaries personally benefitted from the action.

Fiduciary Duties While at Risk of Insolvency

Fiduciary duties are generally owed directly to the company for the benefit of its shareholders.[2] Those duties do not fundamentally change when a company becomes insolvent.[3] However, as a practical matter, when a corporation is distressed because it is insolvent or at risk of becoming insolvent, fiduciaries should be mindful of the interests of both shareholders and the corporation’s creditors. This gives rise to several distinct issues for distressed corporations.

First, actions taken by a company that is insolvent or at risk of becoming insolvent are far more likely to face greater scrutiny. It is especially important to maintain good records of corporate actions and take additional steps, such as obtaining appraisals or legal opinions, to establish the entire fairness of transactions and a fiduciary’s disinterestedness. Moreover, the business judgment rule offers critical protection. As long as fiduciaries of distressed companies act with reasonable care and avoid self-dealing, they are free to make good faith, prudent judgments about the actions their companies should undertake regardless of the ultimate success of the transaction.[4]
Second, when a corporation is distressed, the question of who can sue to seek recompense for breaches of fiduciary duty changes. Claims for breach of fiduciary duty are brought on behalf of the company. A company can sue its own fiduciaries. Shareholders may only sue in a “derivative” action if the company fails to bring the claims directly. When a corporation is insolvent, the company’s creditors also may sue corporate fiduciaries in a derivative action under the theory that the creditors have effectively stepped into the shareholder’s shoes as the corporation’s residual beneficiaries.[5]

The same is not always the case for limited liability companies. Under Delaware law, creditors cannot sue fiduciaries of a limited liability company for breaches of their duties either directly or derivatively unless they contractually bargain for such a right.[6]

Compliance with Fiduciary Duties

First and foremost, a fiduciary should always proceed with the objective of enhancing the wealth generating ability of the corporation. More specifically, a fiduciary should:
  • Avoid conflicts of interests;
  • Fully disclose material aspects of transactions to shareholders and other constituent parties;
  • Base all decisions on sufficient information and deliberation;
  • Maintain corporate records to document the decision making process and compliance with corporate formalities;
  • Obtain independent appraisals and valuations where there is no easily identifiable market value for a transaction; and
  • Obtain legal opinions with respect to the consequences of corporation actions, where appropriate.
Exculpation Clauses

Fiduciaries may also expressly limit their liability by including certain exculpation provisions in the corporate charters and limited liability company agreements.

For example, the Delaware General Corporation Law allows Delaware corporations to include an exculpation clause in their charters eliminating or limiting the personal liability of fiduciaries for monetary damages for breach of fiduciary duty, except for: (a) breaches of the duty of loyalty or any transaction in which the fiduciary derived an improper personal benefit, (b) any acts or omissions not in good faith or which involve intentional misconduct or knowing violation of the law, and (c) approving improper dividends. Fiduciaries sued on an exculpated claim may seek immediate dismissal of the suit.

Similarly, under the Delaware Limited Liability Company Act, members of a Delaware limited liability company may expand, restrict, or eliminate the fiduciary duties of members, managers, and officers of the company in the LLC Agreement, so long as they do not eliminate the implied contractual covenant of good faith and fair dealing. Members may also eliminate liability for breach of the LLC Agreement or breach of fiduciary duties of members and managers; provided that they may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing.

Exculpation clauses are extremely helpful for corporate fiduciaries, but they must be carefully crafted to cover all fiduciaries. For example, the Bankruptcy Court for the District of Delaware recently held that under Delaware law, an exculpation clause in a limited liability company agreement that by its terms only applied to the company’s members and managers, did not exculpate officers of the company who were not managers. See In re Sols. Liquidation LLC, 608 B.R. 384, 405–06 (Bankr. D. Del. 2019) (dismissing exculpated breach of fiduciary duty claims against managers while allowing claims against officers that were not managers to proceed).

Frankly, we are in uncharted territory. The COVID-19 pandemic is causing unique economic pain throughout the country. Small and medium businesses are facing novel and difficult challenges. As you address these challenges, be mindful that it is your process for making decisions that truly matters when your actions are scrutinized—not the ultimate outcome.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader’s specific circumstances.
[1] This article primarily highlights fiduciary duties under Delaware law. Because the laws governing fiduciary duties are complex and vary per jurisdiction, it is imperative that the laws applicable to the subject jurisdiction be assessed and applied.    
[2] See N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 103 (Del. 2007) (applying Delaware law).
[3] See Quadrant Structured Prod. Co., Ltd. v. Vertin, 115 A.3d 535, 556 (Del. Ch. 2015) (directors “cannot be held liable for continuing to operate an insolvent entity in the good faith belief that they may achieve profitability, even if their decisions ultimately lead to greater losses for creditors.”).
[4] The Delaware Court of Chancery reaffirmed this with its holding in Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., which limited creditors’ standing to pursue “deepening insolvency” claims against directors of a Delaware corporation. See Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 193-94 (Del. Ch. 2006), aff’d, Trenwick Am. Lit. Trust v. Billett, 931 A.2d 438 (Del. 2007) (“The business judgment rule exists precisely to ensure that directors and managers acting in good faith may pursue risky strategies that seem to promise great profit. If the mere fact that a strategy turned out poorly is in itself sufficient to create an inference that the directors who approved it breached their fiduciary duties, the business judgment rule will have been denuded of much of its utility.”)
[5] See Quadrant Structured Prod. Co., Ltd., 115 A.3d at 556.
[6] CML V, LLC v. Bax, 6 A.3d 238, 242 (Del. Ch. 2010), as corrected (Sept. 6, 2011) (“Read literally, Section 18–1002 denies derivative standing to creditors of an insolvent LLC”); see In re HH Liquidation, LLC, 590 B.R. 211, 284 (Bankr. D. Del. 2018) (applying Bax and holding that a creditors committee lacked the standing to bring a claim for breach of fiduciary duties against the directors and officers of an insolvent debtor because they only derived their standing from that of the creditors the committee represented, and not the LLC itself).
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