In our prior post, we discussed the standard a creditor must meet to sue an insolvent corporation for breach of fiduciary duties, as laid out in the Quadrant Structured Products Co., Ltd. v. Vertin decision.  Another notable takeaway from the Quadrant decision was the Court’s overview of the “landscape for evaluating a creditor’s breach-of-fiduciary-duty claim” in Delaware, highlighted by the following:

• There is no legally recognized “zone of insolvency” with implications for fiduciary duty claims.  The only transition point that affects fiduciary duty analysis is insolvency itself.

• Regardless of whether a corporation is solvent or insolvent, creditors cannot bring direct claims for breach of fiduciary duty. After a corporation becomes insolvent, creditors gain standing to assert claims derivatively for breach of fiduciary duty.

• The directors of an insolvent firm do not owe any particular duties to creditors. They continue to owe fiduciary duties to the corporation for the benefit of all of its residual claimants, a category which now includes creditors. They do not have a duty to shut down the insolvent firm and marshal its assets for distribution to creditors, although they may make a business judgment that this is indeed the best route to maximize the firm’s value.

• Directors can, as a matter of business judgment, favor certain non-insider creditors over others of similar priority without breaching their fiduciary duties.

• Delaware does not recognize the theory of deepening insolvency. 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.

• When directors of an insolvent corporation make decisions that increase or decrease the value of the firm as a whole and affect providers of capital differently only due to their relative priority in the capital stack, directors do not face a conflict of interest simply because they own common stock or owe duties to large common stockholders. Just as in a solvent corporation, common stock ownership standing alone does not give rise to a conflict of interest. The business judgment rule protects decisions that affect participants in the capital structure in accordance with the priority of their claims.

Some Practical Considerations

Given the current landscape, as a company heads toward insolvency a board should consider retaining professionals to advise the company and the board (but should not abdicate decision-making responsibility to such professionals). Some areas of focus should include:

1. Staying informed and maintaining records.  No action should be taken without reasonable effort to learn all of the facts and alternative options, and such efforts should be thoroughly documented.

2. Maximizing corporate value/ensuring no preferential treatment.  Directors should not give shareholders preferential treatment over creditors.

3. Avoiding conflicts of interest.  Avoid situations of self-dealing and understand that any insider transactions must be entirely fair to the corporation.

4. Closely scrutinizing transactions.  Directors should not approve transfers that could be viewed as an attempt to hinder, delay or defraud creditors or for which the corporation does not receive reasonably equivalent value in exchange.