Bankruptcy Update

Delaware Supreme Court Rejects Direct Cause of Action by Creditors Against Directors for Breach of Fiduciary Duty

Wednesday, June 20, 2007

For directors guiding a struggling company through the troubled
waters of insolvency, an increasing worry has been the potential for exposure to
creditor lawsuits for breach of some fiduciary duty claimed to be owed directly
to creditors. In a decision that silences the debate on that issue, the Delaware
Supreme Court has ruled, in
North American Catholic Educational Programming Foundation, Inc. v. Gheewalla,
that no direct claim for breach of fiduciary duties may be asserted against
directors by creditors of an insolvent corporation, or by creditors of a solvent
corporation operating in the zone of insolvency. Clarifying dicta from preceding
Court of Chancery opinions that creditors had seized upon to argue for the
existence of such fiduciary duties, the Court recognized as a general rule that
directors do not owe creditors duties beyond the relevant contractual terms.

“When navigating in the zone of insolvency,” the Court ruled,
“the focus for Delaware directors does not change: directors must continue to
discharge their fiduciary duties to the corporation and its shareholders by
exercising their business judgment in the best interests of the corporation for
the benefit of its shareholder owners.” Likewise, in rejecting the notion that
directors of an insolvent corporation assume fiduciary duties directly to
individual creditors, the Court stated that “Directors of insolvent corporations
must retain the freedom to engage in vigorous, good faith negotiations with
individual creditors for the benefit of the corporation.”

While the Court noted in dicta that creditors of an insolvent
corporation do acquire standing to assert
derivative
claims against directors on behalf of the corporation for breach of fiduciary
duties, it did not address whether such standing exists when a corporation is
not insolvent but is in the “zone of insolvency.” The Court also declined to
precisely define “zone of insolvency.”

With this ruling, the Court charts a clearer course for
directors navigating the zone of insolvency, and casts aside one of the two
weapons that creditors have sought to wield against directors of insolvent
Delaware corporations in recent years. The other, being the much-debated theory
of “deepening insolvency” rejected by Vice Chancellor Strine in
Trenwick America Litigation Trust
v. Ernst & Young, L.L.P., is before the Delaware
Supreme Court on appeal from that decision, and a decision is anticipated
imminently.

David M. Fournier

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This article is informational only, and should not be construed as legal advice or legal opinion on specific facts.

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