Advising the Corporation Operating in the Vicinity of Insolvency: Directors' Fiduciary Obligations and Creditors' Rights

*Michael D. Goldman, Peter J. Walsh, Jr., Stephen C. Norman, and Michael A. Pittenger are partners in the law firm of Potter Anderson & Corroon, Wilmington, Delaware.  Potter Anderson & Corroon has appeared in several of the cases discussed in this paper.  The opinions expressed here are those of the authors and not of Potter Anderson & Corroon or its clients.

INTRODUCTION

It is a bedrock principle of Delaware law that the directors of a Delaware corporation owe fiduciary duties to the corporation and its shareholders.  E.g., Mills Acquisition Co. v. McMillan, Inc. , Del. Supr., 559 A.2d 1261, 1280 (1989).  However, corporate directors typically do not owe fiduciary duties to the corporation's creditors.  E.g., Simons v. Cogan , Del. Ch., 542 A.2d 785, 788, 790-91 (1987), aff'd , Del. Supr., 549 A.2d 300 (1988); Katz v. Oak Industries, Inc. , Del. Ch., 508 A.2d 873, 879 (1986).  Rather, the obligations of a corporation to its creditors are contractual in nature and are determined under principles of contract law.  See Simons , 542 A.2d at 787-88; Katz , 508 A.2d at 879.  In fact, under certain circumstances, a corporation's directors may be held liable to the corporation's shareholders for favoring the interests of creditors over those of the shareholders.  See Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. , Del. Supr., 506 A.2d 173, 182-84 (1986) (holding that directors breached fiduciary duty to shareholders by entering into auction-ending lock-up agreement for primary purpose of shoring up market value of senior subordinated notes, instead of obtaining highest price for benefit of shareholders).

As with any general rule, there are exceptions to the rule respecting fiduciary duties (or the lack thereof) owed to corporate creditors.  The most noteworthy of these exceptions may be those arising in connection with corporate insolvency.  The Delaware Court of Chancery has held that the directors of a Delaware corporation owe fiduciary duties to creditors upon insolvency of the corporation. See Geyer v. Ingersoll Publications Co. , Del. Ch., 621 A.2d 784, 787, 790 (1992) (holding that fiduciary duties to creditors arise upon fact of insolvency).  The Court of Chancery has also held that the focus of directors' fiduciary duties changes when the corporation "is operating in the vicinity of insolvency," but stopped short of holding that the directors owed fiduciary obligations directly to creditors under such circumstances.  See Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp. , Del. Ch., C.A. No. 12150, mem. op. at 83-85, Allen, C. (Dec. 30, 1991).

Although there is ample authority, in Delaware and elsewhere, indicating that the nature of the fiduciary duties of corporate directors changes upon the insolvency (or near insolvency) of the corporation, the parameters of the directors' duties under such circumstances are not well defined.  This uncertain state of the law is apt to provide fertile ground for both shareholders and creditors (and possibly other corporate constituencies) to challenge, through litigation, the decisions of the directors of financially troubled companies.  Moreover, due to the uncertain state of the law and the conflicts likely to arise between the interests of a corporation's creditors and those of its stockholders, advising the board of a corporation operating in the vicinity of insolvency has become a matter of great concern to corporate counsel.  The law respecting directors' fiduciary obligations, however, is not the only body of law with which counsel should be familiar.  Other bodies of law may impact the nature of the advice rendered to the corporation's board, including federal bankruptcy law and the law of fraudulent conveyances.

FIDUCIARY DUTIES OF DIRECTORS

As noted above, the Delaware courts have suggested that the nature and focus of the fiduciary duties of corporate directors may differ depending upon the financial condition of the corporation.  Specifically, a board of directors may need to refocus its fiduciary obligations once a corporation enters the vicinity of insolvency and again if it actually becomes insolvent.  Counsel advising the board of a financially troubled corporation should be familiar with the effect of each of these financial conditions on the fiduciary duties of corporate directors.

A. The Vicinity Of Insolvency.

In Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp. , Chancellor Allen briefly addressed the duties of directors of a company "operating in the vicinity of insolvency."  Credit Lyonnais , mem. op. at 83-85.  Therein, MGM-Pathe Communications Company (MGM) agreed to grant certain concessions to Credit Lyonnais Bank, N.V. (the Bank) as a condition to obtaining financing to allow MGM to emerge from an involuntary bankruptcy.  Among the concessions was that an executive committee comprised of the Bank's designees would assume operating control of MGM.  The Bank also agreed that should Pathe Communications Company (PCC), MGM's majority stockholder, reduce MGM's indebtedness to a certain level, control of MGM would be returned to PCC.  Soon thereafter, the executive committee refused PCC's request to sell two MGM assets, which would have allowed MGM to begin to pay down its debt.  The executive committee refused to sell the assets because it believed the proposed sale price was too low. PCC complained that the executive committee had breached its fiduciary duty to PCC, the majority stockholder.

Chancellor Allen held that the executive committee did not breach its fiduciary duty under the circumstances. Chancellor Allen explained:

At least where a corporation is operating in the vicinity of insolvency, a board of directors is not merely the agent of the residu[al] risk bearers, but owes its duty to the corporate enterprise.

The [directors were] not disloyal in not immediately facilitating whatever asset sales were in the financial best interests of the controlling stockholder.  In managing the business affairs of MGM, [the executive committee] owed [its] supervening loyalty to MGM, the corporate entity....  [T]he MGM board or its executive committee had an obligation to the community of interest that sustained the corporation, to exercise judgment in an informed, good faith effort to maximize the corporation's long-term wealth creating capacity.

Id. at 83-85 (footnotes omitted).

In a lengthy footnote, the Chancellor offered a hypothetical to demonstrate his conception of the duty owed to the corporate enterprise when the corporation is faced with the possibility of insolvency.  See id. at 83-84 n.55.  The hypothetical assumed that a solvent corporation had a single asset, a judgment for $51 million against a solvent debtor.  The judgment is on appeal and subject to modification or reversal.  The only liabilities of the corporation are to bondholders in the amount of $12 million.  The Chancellor assumed that the array of probable outcomes on appeal is as follows:

Chancellor Allen then analyzed the standards by which directors would evaluate the fairness of settlement offers of $12.5 million and $17.5 million.  The bondholders would be in favor of accepting either offer because in either event they would avoid the 75 percent risk of modification or reversal, which would lead to insolvency and default.  However, stockholders clearly would be opposed to the 12.5 million offer, under which they would get practically nothing.  Furthermore, the stockholders may well oppose the $17.5 million offer, under which the residual value of the corporation would be $5.5 million, because the litigation alternative presents a possibility of a $39 million residual value, even though the chance of affirmance is only 25 percent.

The Chancellor explained that, under these circum-stances, if the entire community of interest that the corporation represents (stockholders, creditors, employees, and any other groups interested in the corporation) is considered, the directors should accept the best settlement offer above $15.5 million and reject any offer below that amount.  This result, the Chancellor explained, will be reached only by directors capable of conceiving of the corporation as a legal and economic entity. Id. at 84 n.55. He continued:

Such directors will recognize that in managing the business affairs of a solvent corporation in the vicinity of insolvency, circumstances may arise when the right (both the efficient and the fair) course to follow for the corporation may diverge from the choice that the stockholders (or the creditors, or the employees, or any single group interested in the corporation) would make if given the opportunity to act.

Id.  The Chancellor's hypothetical makes clear that, in his view, when a corporation is operating in the vicinity of insolvency, the duty owed to the corporate enterprise supervenes any duties owed to shareholders, creditors, or other constituencies. See also id. at 84-85.

Based on the Chancellor's ruling in Credit Lyonnais, it appears that the directors of a corporation operating in the vicinity of insolvency owe fiduciary obligations not only to the corporation's stockholders, but to the corporate entity as a whole.  Under this formulation, directors of a nearly insolvent corporation are permitted (and perhaps required) to consider the interests of creditors and other corporate constituencies in addition to the interests of stockholders, even if such consideration would require the board to pursue an option contrary to the best interests of the stockholders.

Interestingly, the obligation enunciated in Credit Lyonnais is similar to the standard of conduct for corporate directors articulated by the Delaware Supreme Court in Paramount Communications, Inc. v. Time, Inc. , Del. Supr., 571 A.2d 1140 (1990).  In Paramount , the Supreme Court held that a corporation's board of directors is generally obligated to chart a course that is in the best interests of the "corporate enterprise," and that, except in a limited set of circumstances[1], the board is not under any per se duty to maximize stockholder value in the short term.  Id. at 1150, 1154.  In other words, as a general rule, corporate directors may pursue the best interests of the "corporate enterprise," even if such action does not comport with the short term interests of the stockholders.  The difference, if any, between the standard enunciated in Credit Lyonnais and that articulated in Paramount, is that directors of a corporation operating in the vicinity of insolvency may be required to consider the interests of the corporate enterprise first and the interests of the stockholders second, while the directors of a corporation not in the vicinity of insolvency may, but need not, consider the interests of the corporate enterprise as a whole, rather than the short-term interests of the stockholders.

Importantly, in Credit Lyonnais, the Chancellor did not address whether creditors would have standing to assert a claim for breach of fiduciary duty to the corporate enterprise under circumstances in which the corporation is operating in the vicinity of insolvency.  On the one hand, much of the Chancellor's language and reasoning in Credit Lyonnais suggests that the obligations of the directors of a nearly insolvent corporation to the corporate enterprise as a whole are mandatory and not merely discretionary[2].  Absent standing for creditors to sue on the corporation's behalf, the corporation could face the prospect of suffering an injury for which there may be no remedy.   It could be argued that if creditors are not permitted to take legal action on behalf of the corporation under such circumstances, the corporation's directors would have little incentive to carry out their "supervening" duties to the corporate enterprise.

On the other hand, a test predicated on the corporation entering the vicinity of insolvency would be fraught with uncertainty and would likely create a dilemma for directors of financially troubled corporations.  Thus, although it may be wise under such circumstances to permit directors at least to consider the interests of creditors, granting standing to creditors to assert breach of duty claims against directors for failure to consider creditors' interests may be too harsh.  Moreover, given the potential for inherently irreconcilable conflicts among the interests of various corporate constituencies, Delaware courts have steadfastly refused to expand the fiduciary duties of corporate directors to constituencies other than stockholders, except in a narrow set of circumstances, such as actual insolvency, dissolution, or violation of a statute.[3]  This may be indicative of a general policy disfavoring suits by creditors alleging breaches of fiduciary duties except in those narrow circumstances.

Another issue that the court in Credit Lyonnais did not have occasion to address is whether the business judgment rule, and the presumption it creates, are applicable to directorial decision making once the corporation has entered the vicinity of insolvency.  Certainly, the Chancellor's statement that the board of a nearly insolvent corporation has an obligation to exercise its judgment "in an informed, good faith effort to maximize the corporation's long-term wealth creating capacity," suggests that he viewed the guiding principles to be similar to those applicable to directorial decisions made while the corporation is not operating in the vicinity of insolvency; in other words, when the prerequisites to business judgment deference apply.  However, whether the rule itself or a variant thereof applies in the context of near insolvency remains an open issue.

B. Insolvency In Fact.

As noted above, with few exceptions, corporate directors do not owe fiduciary duties to the corporation's creditors.  E.g., Simons v. Cogan , Del. Ch., 542 A.2d 785, 788, 790-91 (1987), aff'd , Del. Supr., 549 A.2d 300 (1988).  One of the exceptions to this general rule is that corporate directors may owe fiduciary duties to creditors upon insolvency of the corporation.  See Geyer v. Ingersoll Publications Co., Del. Ch., 621 A.2d 784, 787, 790 (1992). The exception relating to insolvent corporations has its origins in the so-called "trust fund doctrine."[4]

1. The Development of the Trust Fund Doctrine.

The trust fund doctrine has its roots in two decisions by United States Supreme Court Justice Story:  Wood v. Drummer , 30 Fed. Cas. 435 (C.C.D. Me. 1824) (No. 17,944) and Mumma v. The Potomac Company , 33 U.S. (8 Pet.) 281 (1834).  In Wood, certain note holders sought to recover a cash dividend of capital stock that had been paid to the defendant stockholders while the bank was allegedly insolvent.  The stockholders moved to dismiss the complaint, apparently contending that the note holders had no cause of action against them.  Justice Storey found that, although the note holders had not specifically so pleaded, an action did lie against the stockholders under a trust fund theory.  In reaching this conclusion, the court reasoned that the capital stock of a bank is deemed to be a pledge or trust fund for the payment of debts.  Accordingly, "[i]f the capital stock is a trust fund, then it may be followed by the creditors into the hands of any persons, having notice of the trust attaching to it.  As to the stockholders themselves, there can be no pretence to say, that, both in law and fact, they are not affected with the most ample notice."  Wood , 30 Fed. Cas. at 437.  Justice Storey made no mention of any fiduciary duties running from the directors to the creditors.  Instead, the relief followed the improperly transferred assets — the res of the trust — into the hands of the stockholders.

In Mumma , a creditor that had obtained a judgment against the defendant corporation sought to revive the corporation after it had dissolved.  Although the Court concluded that plaintiff could not execute a judgment against a dissolved corporation, it held that the obligations of the corporation survived and therefore the creditor could pursue any remaining assets of the dissolved corporation.  "[T]he creditors may enforce their claims against any property belonging to the corporation, which has not passed into the hands of bona fide purchasers; but is still held in trust for the company...."  Mumma , 33 U.S. at 286.

Since Wood and Mumma, the trust fund doctrine has been subject to differing and often conflicting interpretations.  As historically formulated, the trust fund doctrine provided that upon insolvency, the assets of the corporation are impressed with a trust for the benefit of the corporation's creditors who can trace corporate assets into the hands of the stockholders. See In re RegO Co., Del. Ch., 623 A.2d 92, 95 (1992).  Thus, the trust fund doctrine as formulated in Wood, Mumma, and other early cases appears to have been little more than a rule of priority as between creditors and stockholders of a dissolved corporation.  The rule provided creditors with an equitable right to impress a constructive trust upon corporate assets in the hands of the stockholders.  See Hollins v. Brierfield Coal & Iron Co., 150 U.S. 371, 383 (1893) (pursuant to trust fund doctrine, corporate assets are impressed with a "condition of trust, first, for the creditors, and then for the stockholders"); New York Credit Men's Adjustment Bureau, Inc. v. Weiss , 110 N.E.2d 397, 402 (N.Y. 1953) (Desmond, J., dissenting) (Under trust fund doctrine, as historically formulated, corporate property is trust for payment of all debts, and creditors have equitable lien thereon and right to priority payment over stockholders).

Some jurisdictions, however, have construed the doctrine strictly and literally, holding that upon a corporation's insolvency, the directors owe fiduciary duties directly to corporate creditors, rather than to the shareholders.  See, e.g., FDIC v. Sea Pines Co., 692 F.2d 973, 976-77 (4th Cir. 1982) (holding that directors of insolvent corporation owe duty to creditors only), cert. denied, 461 U.S. 928 (1983); Davis v. Woolf, 147 F.2d 629, 633 (4th Cir. 1945) (same).  Under a strict application of the "trust fund" doctrine, the directors of an insolvent corporation become trustees, in the literal sense, who are duty-bound to preserve the corporation's assets for the benefit of creditors.  See New York Credit Men's Adjustment Bureau v. Weiss, 110 N.E.2d 387, 398, 400 (N.Y. 1953) (holding that directors of insolvent corporation have strict duty of trustees to protect corporation's assets for benefit of creditors).

2. The Delaware Experience.

The early Delaware cases suggest that the "trust fund" doctrine is not to be applied strictly and literally in Delaware, with the exception, perhaps, of cases of clear fraud.  The first Delaware case to address the doctrine was MacKenzie Oil Co. v. Omar Oil & Gas Co., Del. Ch., 120 A. 852 (1923).  In MacKenzie, the Court of Chancery ruled that, absent an insolvency statute, no trust was created for the benefit of creditors upon insolvency.  Id. at 857.  The court, however, went on to conclude that the existence of a statute permitting creditors to seek the appointment of a trustee or receiver for an insolvent corporation was evidence of an intent on the part of the legislature to create an equitable remedy on behalf of the creditors of an insolvent corporation.  As the Chancellor explained, the right to such an equitable remedy "is to be gathered ... from what appears to be the evident and manifest purpose of the statute.  That right, I conceive, is that the assets of a corporation upon the event of insolvency may be regarded by creditors and stockholders as impressed with somewhat of the nature of a trust to be administered for their benefit."  Id. at 857.

Following MacKenzie Oil Co., the Court of Chancery in Asmussen v. Quaker City Corp., Del. Ch., 156 A. 180 (1931), rejected the contention that the trust fund doctrine prevented directors from preferring one creditor over another.  In so ruling, Chancellor Wolcott recognized the almost universal acceptance by the courts of the trust fund doctrine in some form or another.  The Chancellor, however, expressed concern about the resulting risk of liability for directors who, in good faith, prefer certain creditors over others.  Thus, the Chancellor held that "as among creditors, no trust exists which prevents directors of an insolvent corporation from preferring some over others, notwithstanding the corporation is in failing circumstances and manifestly headed for disaster."  Id. at 181.

In reaching his conclusion, the Chancellor relied upon the fact that individual debtors are not prohibited from preferring certain creditors over others, and upon the absence of any apparent reason to treat corporations differently.  Id. at 181-82.  The Chancellor also rejected the suggestion that the failure to provide equal protection for all creditors would leave creditors at the mercy of directors who might be inclined to prefer a favored few.  He found that the right to seek the appointment of a receiver or trustee provided adequate protection against such risk.  Id. at 182.  The Chancellor thus left it to the creditors to take action to protect their interests.

Importantly, while recognizing the fundamental principles underlying the trust fund doctrine, the Court of Chancery in Asmussen declined to apply the doctrine strictly by refusing to impose upon directors of insolvent corporations the duties of "trustees," in the technical sense of the term.  The Court explained that the designation "trust fund doctrine" is merely descriptive and should not be applied literally:

The risks of liability on the part of honest directors, which inhere in the contentions of the complainant if they be accepted, are so great and hazardous, that I think the courts should not subject them to it by so carrying to its extreme length the logic of a catchy phrase that it eventuates in special indulgences to creditors whose debtors happen to be corporations, greater than the indulgences that the phrase was originally designed to express.

Id. at 182.  The court, however, did recognize the principles underlying the trust fund doctrine to the extent that the doctrine provides a rule of priority as between creditors and stockholders of an insolvent corporation:

If an insolvent corporation should undertake to turn its assets over to stockholders, leaving creditors unpaid, I think no dissent can be found to the proposition that the law would condemn the effort.  As against stockholders, it is universally conceded that the assets of a corporation will be regarded in such a case as "a trust for the benefit of creditors."

Id. at 181.

Unresolved by the holding in Asmussen was whether directors could prefer themselves as creditors over other creditors.  This issue was subsequently resolved by the Court of Chancery in Pennsylvania Co. for Insurance v. South Broad Street Theatre Co. , Del. Ch., 174 A. 112 (1934), wherein an insolvent corporation transferred funds to a creditor controlled by its president, who was also a director.  The court found that the general rule permitting directors to favor certain creditors does not apply where such preferential treatment is afforded to a director-creditor, and thus held that the transfer was an illegal preference.  The court expressly declined to base its decision on the trust fund doctrine, but relied on the fundamental principle "that men should act in honesty and fairness," which principle the court found to underlie the trust fund doctrine in any event. Id. at 116.  Thus, the court stated that "a director of an insolvent corporation should not be allowed as it sinks to take advantage of his position by rushing ahead to a place in the life boat ... ahead of his fellow passengers."  Id.

The only Supreme Court of Delaware opinion to address the trust fund doctrine is Bovay v. H.M. Byllesby & Co. , Del. Supr., 38 A.2d 808 (1944).  In dictum, the court noted that the assets of an insolvent corporation may be administered in equity as a trust fund for the benefit of the corporation's creditors.  Id. at 813.  The court further explained that when the fact of insolvency is established, a trust is created and the legality of actions thereafter taken "will be decided by very different principles than in the case of solvency." Id.

Although the court did not further expound on the nature of the different principles and duties applicable in the case of insolvency, the court did mention several cases in which Delaware courts had referred to corporate directors as "trustees."  The court was quick to point out that use of the term should be interpreted "in light of the situations presented," and that in the prior cases "it was not meant that directors of a corporation are trustees, in a strict and technical sense."  Id.  However, the court explained that corporate directors would be treated as "trustees," in the technical sense, "when they have unlawfully profited through breach of duty, and at the expense of the corporation," which the court believed was true of the case before it.  Id.  Because the Bovay court viewed the case as one to "undo a fraud," it is unclear whether the court relied upon trust fund principles or simply applied traditional tools of equity to remedy a clear fraud.

The Delaware courts have had little opportunity to discuss the trust fund doctrine since Bovay, and recent Delaware cases addressing the fiduciary obligations of directors of insolvent corporations are little more revealing than Bovay and its predecessors.  In Geyer v. Ingersoll Publications Co., Del. Ch., 621 A.2d 784 (1992), the Court of Chancery held that the directors of a Delaware corporation owe fiduciary duties to creditors upon insolvency of the corporation.  Id. at 787, 790 (1992).[5]  In Geyer, a creditor brought an action against the corporation and one of its directors, claiming that certain assets were fraudulently transferred.  The basis for the assertion of jurisdiction over the director was Delaware's director consent statute,[6] which permits suits in Delaware against directors of Delaware corporations for actions taken in furtherance of their fiduciary duties.

The director-defendant moved to dismiss the complaint on the ground that he owed no fiduciary duties to plaintiff, a mere creditor.  The director did not seriously dispute that an insolvency exception exists imposing upon corporate directors fiduciary duties for the benefit of corporate creditors.  However, the director argued that no fiduciary duties arise until a statutory insolvency proceeding, such as a bankruptcy proceeding, is instituted.  Citing Bovay, the court rejected the defendant's position and concluded that fiduciary duties to creditors arise upon the fact of insolvency, not upon the institution of a statutory proceeding.  Id. at 787-90.  The court further ruled that an entity is insolvent when "it is unable to pay its debts as they fall due in the usual course of business" (the equity definition) or "it has liabilities in excess of a reasonable market value of assets held" (the bankruptcy definition).  Id. at 789.

Although Geyer does not shed much light on the nature of the duties owed to creditors upon insolvency, the court did address the issue briefly.  The court reaffirmed that prior to the institution of statutory insolvency proceedings, no fiduciary duties are owed to creditors with respect to claims that the directors unjustly favored one creditor over another.  Id. at 788 (discussing Asmussen ).  However, the court explained that institution of statutory proceedings is not necessary "for the establishment of fiduciary duties via the insolvency exception as to claims against directors for unjustly favoring shareholders over creditors, committing corporate waste or favoring creditors who are also directors over all other creditors."  Id.  According to the court, these aspects of the fiduciary obligations of corporate directors to creditors arise upon the fact of insolvency.

Additionally, the court's opinion indicated that the directors of an insolvent corporation should focus on the best interests of the corporate enterprise, rather than the interests of any individual constituency:

The existence of the fiduciary duties [owed to creditors] at the moment of insolvency may cause directors to choose a course of action that best serves the entire corporate enterprise rather than any single group interested in the corporation at a point in time when shareholders' wishes should not be the directors' only concern.

Geyer, 621 A.2d at 789.[7]  The foregoing language appears to be an endorsement of Chancellor Allen's description in Credit Lyonnais of the "supervening" duty owed to the corporate enterprise when the corporation is operating in the vicinity of insolvency.  See id. (citing Credit Lyonnais ).  Thus, it appears from Geyer that the directors of an insolvent corporation may owe fiduciary duties to all corporate constituencies, or the enterprise as a whole, and not to the creditors exclusively.[8]  At the same time, Geyer reaffirmed the priority aspects of the older trust fund doctrine cases, which make it clear that the directors of an insolvent corporation cannot favor shareholders over creditors with respect to the preservation and distribution of corporate assets.  See id. at 788 (citing Asmussen , 156 A. at 181).

The Court of Chancery also had an opportunity to discuss the trust fund doctrine in In re RegO Co., Del. Ch., 623 A.2d 92 (1992), a case involving a dissolved corporation.  Noting that the trust fund doctrine applies in cases of both insolvency and dissolution, Chancellor Allen explained that the "core concepts" of the doctrine are:

that on dissolution [or insolvency] corporate directors have obligations to creditors and that creditors, at least creditors of whom the corporation [has] reason to know, have an equitable right to follow corporate assets and to impress a constructive trust upon them in the hands of shareholders.

Id. at 95.  The Chancellor's explanation of the trust fund doctrine in RegO appears to affirm the priority aspects of the doctrine — i.e. that creditors have priority over stockholders with respect to the corporation's assets — as well as the remedial aspects of the doctrine, which grants creditors an equitable right to impose a constructive trust upon the corporation's assets in the hands of the stockholders.[9]  Interestingly, the Chancellor avoided the use of the term "fiduciary" in explaining that directors of insolvent and dissolved corporations owe "obligations" to creditors.  This may indicate the Chancellor's preference for viewing the obligations of directors under such circumstances as running to the corporate enterprise as a whole, rather than exclusively to any individual corporate constituency.  Cf. Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp. , Del. Ch., C.A. No. 12150, mem. op. at 83-85, Allen, C. (Dec. 30, 1991) (corporation operating "in the vicinity of insolvency").

To summarize, it would appear, based upon what little Delaware case law there is on the subject, that the directors of an insolvent Delaware corporation may have a supervening obligation to act in the best interests of the corporate enterprise, but owe a duty directly to creditors not to commit corporate waste, or to favor shareholders or corporate insiders over creditors with respect to the preservation and distribution of corporate assets.  In addition, the "trust fund doctrine" provides creditors with an equitable remedy by which they may follow corporate assets into the hands of the corporation's stockholders and impose a constructive trust upon such assets for their own benefit.

Although it is clear that directors of an insolvent Delaware corporation owe obligations, fiduciary or otherwise, to the corporation's creditors, no Delaware court has addressed whether the business judgment rule is applicable to directorial decision making in the insolvency context.  It is likely, however, that the Delaware courts will eventually conclude that the business judgment rule or a variant thereof is applicable to the actions of the directors of an insolvent Delaware corporation.  In fact, a number of courts outside of Delaware have held that the business judgment rule or a variant thereof is applicable in the insolvency context.  See, e.g., In re Xonics , 99 B.R. 870, 872, 876 (Bankr. N.D. Ill. 1989) (applying variant of traditional business judgment rule); Gluckin v. Ross (In re Specialty Prods., Inc.), 94 B.R. 781, 784 (Bankr. N.D. Ga. 1989) (holding, in context of insolvency, that directors did not breach fiduciary duty to creditors where decision was supported by valid business reasons); Weiboldt Stores, Inc. v. Schottenstein, 94 B.R. 488, 509-10 (N.D. Ill. 1988) (recognizing availability of business judgment rule in insolvency context, but holding that complaint adequately alleged that directors did not meet business judgment rule prerequisites); Henderson v. Buchanan (In re Western World Funding, Inc.), 52 B.R. 743, 770 (Bankr. D. Nev. 1985) (holding that business judgment rule applies in context of insolvency); see also New York Credit Men's Adjustment Bureau, Inc. v. Weiss, 110 N.E.2d 397, 401-02 (N.Y. 1953) (Desmond, J., dissenting) (concluding that director's decisions should have been protected by business judgment rule).  Moreover, the paucity of Delaware law that exists on the subject indicates that Delaware courts will be reluctant to analyze directorial conduct in the insolvency context under the fiduciary principles applicable to trustees, in the strict and technical sense.  See, e.g., Asmussen, 156 A. at 182.

Certainly, the considerations that underlie the business judgment rule continue to be present in the case of an insolvent corporation:  Namely, courts are no better suited to manage a business, even an insolvent business, than are the directors, and the shareholders have elected the directors, not a court, to manage the company.  In re Xonics, 99 B.R. at 876 (deferring to directors' decisions); Meredith M. Brown, When the Corporation Is Financially Troubled, Director's Role Changes, Nat'l L.J. at S10 (May 20, 1991).  Indeed, the policies underlying the application of the business judgment rule (as well as the business judgment presumption) would appear to be even more compelling when the corporation is insolvent due to the complexity of the decision-making process and the conflicting interests of the various corporate constituencies under such circumstances.  See Xonics, 99 B.R. at 876 (stating that, in the insolvency context, application of a strict standard "in assessing breach of fiduciary duty ... would constrain the commercial world in developing means to aid the floundering corporation").

ADVISING THE BOARD OF A CORPORATION

OPERATING IN THE VICINITY OF INSOLVENCY

Because of the uncertain state of the law, determining the nature and scope of the duties owed by the directors of insolvent and nearly insolvent corporations may prove difficult not only for corporate directors but for counsel advising corporate directors.  An even more difficult determination may be presented, however, as a threshold matter: at what point is the financial outlook for the corporation such that the differing standards for directorial conduct are triggered.  As shown above, Delaware case law suggests that the nature of the fiduciary obligations of corporate directors changes when the corporation is operating in the vicinity of insolvency and changes again when the corporation becomes insolvent.  However, the points in time at which a corporation crosses the line into the "vicinity of insolvency" and at which it crosses yet another line, becoming insolvent in fact, are not likely to be ascertained until well after the corporation has crossed each respective line.  Thus, the directors of a financially troubled corporation, as well as counsel advising such directors, may be faced with the dilemma of knowing that the nature of the directors' fiduciary obligations may change at some point, but not knowing precisely when such change will be, or whether such change already has been, triggered.

The directors' dilemma is compounded by the fact that the Court of Chancery has not yet articulated a test for determining when a corporation is "operating in the vicinity of insolvency."  Moreover, even though the Court of Chancery has articulated a test for determining when a corporation is insolvent in fact,[10] such test may be extremely difficult for a board of directors to apply in practice.[11]  One option that may provide the directors some assurance would be to undertake an investigation, either internally or with the assistance of outside financial experts, to determine whether or not the corporation is insolvent or operating in the vicinity of insolvency.  Of course, expending the money that such an investigation is likely to cost may not be the best course of action for a corporation that is experiencing grave financial difficulties.

The better option may be for the directors to choose a course of conduct that is likely to comport with the directors' fiduciary obligations regardless of whether the corporation is insolvent, operating in the vicinity of insolvency, or merely on the threshold of one of these financial conditions.  That course of conduct would be to pursue the best interests of the corporate enterprise as a whole.  Choosing to pursue the best interests of the enterprise would appear to satisfy the directors' fiduciary obligations under both Geyer (insolvency in fact) and Credit Lyonnais (vicinity of insolvency).  See Geyer, 621 A.2d at 789; Credit Lyonnais, mem. op. at 85.  Moreover, choosing the course of action that is in the best interests of the corporate enterprise, rather than a course of action that favors the interests of stockholders over those of creditors, or vice versa, is likely permissible under the Delaware Supreme Court's holding in Paramount Communications, Inc. v. Time, Inc., even if the corporation is neither insolvent nor operating in the vicinity of insolvency.  See Paramount Communications, Inc. v. Time, Inc., Del. Supr., 571 A.2d 1140, 1150, 1154 (1990).[12]

Of course, choosing a course of conduct that serves the best interests of the corporate enterprise as a whole is easier said than done.  Existing case law offers little guidance with respect to what the courts will consider to be in the best interests of the corporate enterprise.  In Credit Lyonnais, Chancellor Allen suggested that the best interests of the corporate enterprise are commensurate with maximizing the corporation's long-term wealth-creating capacity.  Credit Lyonnais, mem. op. at 85.  However, whether long-term wealth maximization is best achieved through filing a petition for bankruptcy, initiating a reorganization or business combination outside of the bankruptcy forum, or some other course of action will depend on the circumstances of each case.  Moreover, maximization of long-term wealth-creating capacity may not be in the best interests of every financially troubled corporate entity.  Certainly, for some corporations, the possibility of emerging from insolvency will be impracticable or otherwise undesirable.  For such corporations, liquidation and dissolution may be the course of action best serving the interests of the enterprise as a whole.

Counsel should be careful to advise the board of a financially troubled corporation that the Delaware courts have not yet determined whether the business judgment rule will be applicable to the board's decisions while the corporation is insolvent or operating in the vicinity of insolvency.  However, counsel should also advise that it is possible (and likely probable) that Delaware courts will eventually conclude that the business judgment rule or a variant thereof is applicable in the context of both the insolvent and the nearly-insolvent corporation.  In fact, the Delaware courts have already indicated that directors' decisions in the insolvency context will not be judged by the principles applicable to trustees, in the strict and technical sense.

As stated above, one alternative that directors may wish to consider when the corporation is operating in the vicinity of insolvency is the filing of a voluntary petition for reorganization under Chapter 11 of the Bankruptcy Code.  Under many circumstances, filing for bankruptcy may provide the corporation's directors with the greatest level of protection, as all significant corporate decisions will be subject to the prior approval of the bankruptcy court.  However, filing for bankruptcy may not always be in the best interests of the corporation, especially in situations where there is a reasonable likelihood that the corporation can work its way out of insolvency without the need for a bankruptcy proceeding and without incurring the numerous administrative costs attendant to such a proceeding.

On a related matter, the implications of the Bankruptcy Code for the financially troubled corporation are many and wide-ranging.  In fact, bankruptcy-related issues are likely to manifest themselves long before the corporation actually enters bankruptcy.  Accordingly, it is imperative that counsel representing the financially troubled corporation familiarize himself or herself generally with the provisions of the Bankruptcy Code likely to impact the decision-making process of a corporation operating in the vicinity of insolvency, such as the Bankruptcy Code's preference provisions and the effect of bankruptcy proceedings on the corporation's existing obligations and on any pending litigation.[13]  Moreover, it is advisable that corporate counsel consult other counsel specializing in bankruptcy matters once bankruptcy-related issues manifest themselves, even if the corporation is not yet formally in bankruptcy.

Another area of law with which the corporate practitioner should be familiar when advising a financially troubled corporation is the law of fraudulent conveyances.  The Delaware Fraudulent Conveyances Act, 6 Del. C. Sections 1301-1312, like similar acts in other states, deems fraudulent as against creditors any conveyance made or obligation incurred by a corporation without fair consideration, regardless of intent, if the corporation is or is thereby rendered insolvent. Id. Section 1304.[14]  A corporation is insolvent when "the present fair salable value of [its] assets is less than the amount that will be required to pay [its] probable liability on [its] existing debts as they become absolute and matured."  Id. Section 1302.  The Fraudulent Conveyances Act provides a remedy to creditors for any conveyance or obligation deemed fraudulent as to creditors.  Under such circumstances, the creditor may, except as against a bona fide purchaser, have the conveyance set aside or the obligation annulled to the extent necessary to satisfy the claim or the creditor may disregard the conveyance and levy execution upon the property conveyed.  Id.  Section 1309.  Accordingly, financially troubled corporations should be careful to assure that all conveyances made and obligations incurred are for fair consideration, either in the form of property or satisfaction of antecedent debt. See id . Section 1303.

FOOTNOTES

1. In a limited set of circumstances, a board of directors is required to act reasonably to seek the transaction offering the best value reasonably available to the shareholders.  Such circumstances generally arise when the board pursues a transaction involving a sale of control or a break-up of the corporation.  See Time , 571 A.2d at 1150; see also Paramount Communications, Inc. v. QVC Network Inc. , Del. Supr., 637 A.2d 34, 43-44 (1993).

2. The argument that the duties of corporate directors to the corporate enterprise are mandatory when the corporation is in the vicinity of insolvency is strengthened by the recognition that directors generally may, but need not, consider the interests of the corporate enterprise to the exclusion of the short-term interests of the stockholders, even when the corporation is financially sound. See Paramount Communications, Inc. v. Time, Inc. , Del. Supr., 571 A.2d 1140, 1150, 1154 (1990).

3. E.g., Simons v. Cogan , Del. Ch., 542 A.2d 785, 788, 790-91 (1987), aff'd , Del. Supr., 549 A.2d 300 (1988); Katz v. Oak Industries, Inc. , Del. Ch., 508 A.2d 873, 879 (1986); Harff v. Kerkorian , Del. Ch., 324 A.2d 215, 222 (1974), aff'd in part, rev'd in part on other grounds , Del. Supr., 347 A.2d 133 (1975).

4. A similar exception, which also has its roots in the trust fund doctrine, applies in the case of a dissolved corporation. See In re RegO Co., Del. Ch., 623 A.2d 92, 95 (1992).  Thus, the Court of Chancery has held that directors owe fiduciary duties to creditors upon dissolution of the corporation.  See Kidde Industries, Inc. v. Weaver Corp., Del. Ch., 593 A.2d 563, 564, 565-66 (1991); Gans v. MDR Liquidating Corp. , Del. Ch., C.A. No. 9630, mem. op. at 21-22, Hartnett, V.C. (Jan. 10, 1990).

5. Prior to Geyer, a number of Delaware cases suggested the existence of an insolvency exception to the general rule that corporate directors owe no fiduciary duties to creditors.  See Simons v. Cogan , Del. Ch., 542 A.2d 785, 788 (1987), aff'd, Del. Supr., 549 A.2d 300 (1988); Continental Illinois Nat'l Bank & Trust v. Hunt Int'l Resources Corp., Del. Ch., C.A. No. 7888, Jacobs, V.C. (Feb. 27, 1987); Harff v. Kerkorian , Del. Ch., 324 A.2d 215, 222 (1974), aff'd in part, rev'd in part on other grounds, Del. Supr., 347 A.2d 133 (1975).

6. 10 Del. C. Section 3114.

7. See also Pepper v. Litton, 308 U.S. 295, 307 (1939) (holding that in context of insolvency, fiduciary obligation is designed to protect entire community of interests in corporation, creditors as well as stockholders).

8. The argument that corporate directors do not owe fiduciary duties exclusively to creditors upon insolvency is furthered by the recognition that shareholders continue to have the right to elect directors after the corporation has become insolvent.  See Saxon Indus., Inc. v. NKFW Partners, Del. Supr., 488 A.2d 1298, 1300 (1984).

9. See also Hollins v. Brierfield Coal & Iron Co., 150 U.S. 371, 383 (1893) (pursuant to trust fund doctrine, corporate assets are impressed with a "condition of trust, first, for the creditors, and then for the stockholders"); Bank Leumi-Le-Israel, B.M. v. Sunbelt Indus., Inc., 485 F. Supp. 556, 559 (S.D. Ga. 1980) (holding that in case of insolvent corporation, directors stand as trustees of corporate property for benefit of creditors first and shareholders second).

10. In Geyer v. Ingersoll Publications Co., the Court of Chancery held that an entity is insolvent when "it is unable to pay its debts as they fall due in the usual course of business" (the equity definition) or "it has liabilities in excess of a reasonable market value of assets held" (the bankruptcy definition).  Geyer , 621 A.2d at 789.

11. For example, there are numerous methods to value corporate assets (e.g., as a going concern, individually, etc.), and it is unclear what valuation method will be utilized by the courts in determining the time of insolvency.  In addition, it is unlikely that corporate directors will be able to rely on the corporation's balance sheets because balance sheets typically carry the corporation's assets at historical cost.

12. As stated above, In Paramount , the Delaware Supreme Court held that a corporation's board of directors is generally obligated to chart a course that is in the best interests of the "corporate enterprise," and that, except in a limited set of circumstances, the board is not under any per se duty to maximize stockholder value in the short term. Paramount, 571 A.2d at 1150, 1154.

13. Obviously, the numerous aspects of federal bankruptcy law that may be implicated in the decision making process of the financially troubled corporation are beyond the scope of this paper.

14. Similarly, a conveyance made without fair consideration is deemed fraudulent if the corporation making the conveyance intends or believes it will incur debts beyond its ability to pay as they mature.  6 Del. C . Section 1306.  Moreover, such conveyance is deemed fraudulent to both present and future creditors.  Id.  The statute provides limited rights and remedies for claimants whose claims have not yet matured. See id. Section 1310.