Directors’ Duties In and Around the Zone of Insolvency

by Zack A. Clement, Travis Torrence

Apr 13, 2010

(TMA Global)  

During these challenging economic times, as publicly traded and private companies face cash-flow problems, operational issues, and other financial difficulties, individuals serving as directors and officers must be cognizant of the issues associated with their roles as fiduciaries and must keep abreast of the evolving legal landscape of corporate governance.

It is well-settled that directors of solvent Delaware corporations generally owe fiduciary duties to the corporation and its shareholders and that those of insolvent corporations owe fiduciary duties to exercise their business judgment in the best interest of the insolvent corporation. However, a grey area exists for directors of corporations that are solvent but operating within the zone of insolvency. This article examines the fiduciary duties that directors owe to shareholders and creditors when a company is solvent, insolvent, or in the vicinity of insolvency.      

Solvent Corporations

It is well-settled that the directors of a solvent corporation owe a fiduciary duty to the corporation and its shareholders. N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 99 (Del. 2007). Further, under Delaware law, directors owe no such duty to the corporation’s creditors. Id. In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, the Delaware Supreme Court recently emphasized that:

While shareholders rely on directors acting as fiduciaries to protect their interests, creditors are afforded protection through contractual agreements, fraud and fraudulent conveyance law, implied covenants of good faith and fair dealing, bankruptcy law, general commercial law and other sources of creditor rights. Delaware courts have traditionally been reluctant to expand existing fiduciary duties. Accordingly, “the general rule is that directors do not owe creditors duties beyond the relevant contractual terms.” 

A director’s fiduciary duty to the corporation and its shareholders consists of two components—the duty of care and the duty of loyalty. The business judgment rule customarily protects directors from judicial scrutiny in their performance of these duties.

Duty of Care. The duty of care requires a director of a corporation to exercise the degree of care that an ordinarily careful and prudent person would exercise under the same or similar circumstances, such that the director’s actions do not constitute gross negligence. See Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984) (“While the Delaware cases use a variety of terms to describe the applicable standard of care, our analysis satisfies us that under the business judgment rule director liability is predicated upon concepts of gross negligence.”); Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985) (“Representation of the financial interests of others imposes on a director an affirmative duty to protect those interests and to proceed with a critical eye in assessing information of the type and under the circumstances present here.”).

Courts generally follow the business judgment rule in their review of directors’ decisions. “The rule operates to preclude a court from imposing itself unreasonably on the business and affairs of a corporation.” Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 360 (Del. 1994). Accordingly, Delaware courts have articulated the business judgment rule as follows:

The rule operates as both a procedural guide for litigants and a substantive rule of law. As a rule of evidence, it creates a “presumption that in making a business decision, the directors of a corporation acted on an informed basis [i.e., with due care], in good faith and in the honest belief that the action taken was in the best interest of the company.” The presumption initially attaches to a director-approved transaction within a board’s conferred or apparent authority in the absence of any evidence of “fraud, bad faith, or self-dealing in the usual sense of personal profit or betterment.” Id. (citations omitted). 

“Therefore, under the business judgment rule, directors have a duty to inform themselves of all material information reasonably available to them before making a business decision and then to act with the requisite care in discharging their duties.” John W. Butler, Jr., Harvey R. Miller, and J. Ronald Trost, "Managing the Managers: Chapter 11 Counsel and the Board of Directors," American College of Bankruptcy 2002 Induction Ceremony, at 3 (March 16, 2002) (citing Aronson v. Lewis, 473 A.2d at 812). If directors have taken these steps, courts presume that their actions were made on an informed basis, in good faith, and in the honest belief that the action was in the best interests of the corporation and will accordingly allow the directors’ decisions to stand. Id.

Duty of Loyalty. The duty of loyalty generally prohibits self-dealing and the usurpation of corporate opportunities by directors. Delaware courts have defined the duty of loyalty as follows:

Corporate officers and directors are not permitted to use their position of trust and confidence to further their private interests. . . . A public policy, existing through the years, and derived from a profound knowledge of human characteristics and motives, has established a rule that demands of a corporate officer or director, peremptorily and inexorably, the most scrupulous observance of his duty, not only affirmatively to protect the interests of the corporation committed to his charge, but also to refrain from doing anything that would work injury to the corporation, or to deprive it of profit or advantage which his skill and ability might properly bring to it, or to enable it to make in the reasonable and lawful exercise of its powers. The rule that requires an undivided and unselfish loyalty to the corporation demands that there be no conflict between duty and self-interest. Guth v. Loft, Inc., 5 A.2d 503, 510 (Del. 1939).

In the recent case of Bridgeport Holdings Inc. Liquidating Trust v. Boyer (In re Bridgeport Holdings, Inc.), 388 B.R. 548, 564 (Bankr. D. Del. 2008), the court emphasized that a claim for breach of loyalty may be premised on the failure of a fiduciary to act in good faith:

The Delaware Supreme Court recently clarified that a claim for breach of loyalty may be premised upon the failure of a fiduciary to act in good faith. . . .

“[T]he fiduciary duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest. It also encompasses cases where the fiduciary fails to act in good faith.. . .

Where directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.” Id. (quoting Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006)).

Therefore, in sum, “the duty of loyalty mandates that the best interests of the corporation and its shareholders takes precedence over any interest possessed by a director, officer or controlling shareholder and not shared by the stockholders generally.” Cede & Co., 634 A.2d 345, 361 (Del. 1994). Generally, the business judgment rule will not apply when there is a breach of the duty of loyalty. See Revlon Inc. v. McAndrews & Forbes Holdings Inc., 506 A.2d 173 (Del. 1986). 


There are two competing approaches to assessing insolvency—”equitable” insolvency and “balance sheet” insolvency. Delaware courts have determined that insolvency may be demonstrated by either of these. Gheewalla, 930 A.2d at 98 (stating that the Chancery Court opined that insolvency may be demonstrated by meeting the definition of equitable insolvency or balance sheet insolvency); Prod. Res. Group v. NCT Group, Inc., 863 A.2d 772, 782 (Del. Ch. 2004) (stating that to meet the burden of sufficiently pleading insolvency, the plaintiff must plead facts that show that the corporation is either equitably insolvent or meets the test of balance sheet insolvency).

Equitable insolvency is “an inability to meet maturing obligations as they fall due in the ordinary course of business.” Gheewalla, 930 A.2d at 98. Prod. Res. Group v. NCT Group, Inc., 863 A.2d at 782 (quoting Siple v. S & K Plumbing & Heating, Inc., No. 6731, 1982 WL 8789, at *2 (Del. Ch. Apr. 13, 1983)). This definition of insolvency ignores the balance sheet and instead focuses on the corporation’s ability to pay its current debts. Butler, Miller and Trost at 7.

Balance sheet insolvency, on the other hand, is “a deficiency of assets below liabilities with no reasonable prospect that the business can be successfully continued in the face thereof.” Gheewalla, 930 A.2d at 98; Prod. Res. Group, 863 A.2d at 782 (quoting Siple, 1982 WL 8789, at *2); McDonald v. Williams, 174 U.S. 397, 403 (1899) (defining an insolvent corporation as an entity with assets valued less than its debts).

In addition to the several Delaware cases that have relied on the balance sheet definition of insolvency, the U.S. Bankruptcy Code uses balance sheet insolvency. Specifically, under the Bankruptcy Code, the term “insolvent” means a “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation,” exclusive of fraudulent transfers and exempt property. 11 U.S.C. Section 101(32).

When a corporation becomes insolvent[1], its directors owe fiduciary duties to the insolvent corporation for the benefit of its creditors, while continuing to bear the task of attempting to maximize the economic value of the firm for any potential residual benefit to the shareholders. Gheewalla, 930 A.2d at 103; Cf. Akande v. Transamerica Airlines, Inc. (In re Transamerica Airlines, Inc.), No. Civ. A. 1039-N, 2006 WL 587846, at *7 (Del.Ch. Feb. 28, 2006) (“When a company becomes insolvent, its directors owe fiduciary duties to the company’s creditors, as well as its stockholders.”).

Therefore, Delaware courts have determined that creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties:

. . . [T]he creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties. The corporation’s insolvency “makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm’s value.” Therefore, equitable considerations give creditors standing to pursue derivative claims against the directors of an insolvent corporation. Individual creditors of an insolvent corporation have the same incentive to pursue valid derivative claims on its behalf that shareholders have when the corporation is solvent.

Gheewalla, 930 A.2d at 101-02 (emphasis in the original) (concluding that, (i) when the corporation is in the zone of insolvency, creditors may not bring a direct action against the directors for breach of fiduciary duty, (ii) when the corporation is in fact insolvent, creditors have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties, and (iii) even when the corporation is insolvent, creditors have no right to assert direct claims for breach of fiduciary duty against the directors). 

Zone of Insolvency

As the courts have struggled with defining “insolvency,” they have wrestled even more with articulating circumstances that sufficiently demonstrate a “zone of insolvency.” In Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d at 790 n.56, a Delaware Chancery Court explained the difficulty in defining the zone of insolvency as follows:

Defining the “zone” for these purposes would also not be a simple exercise and talented creditors’ lawyers would no doubt press for an expansive view. As our prior case law points out, as discussed above, it is not always easy to determine whether a company even meets the test for solvency. See, e.g., Keystone Fuel Oil v. Del-Way Petroleum, Co., 1977 WL 2572 (Del. Ch. Jun. 16, 1977). Given that reality and the plaintiff-friendly standard that applies to attacks on pleadings, it is not surprising that in the past there have been (and inferably in the future there will be) situations when creditors are accorded standing to assert fiduciary duty claims at the pleading-stage and when, after discovery, courts determine that the companies were not insolvent. Going further and recognizing standing for creditors to bring fiduciary duty claims when a company is in the zone of insolvency would logically require this court to allow creditors standing if the complaint pleads facts that, if true, suggest that a company is within some imprecise and hard-to-define vicinity of insolvency. This means that creditors will be able to get discovery in situations when it is ultimately determined that the relevant company was not only solvent, but never even within the so-called zone of insolvency. Id. 

Since Production Resources, Delaware courts have continued to avoid defining the “zone of insolvency.” See Gheewalla, 930 A.2d 92, 98 n.20 (“In light of its ultimate ruling, the Court of Chancery did not attempt to set forth a precise definition of what constitutes the ‘zone of insolvency.’ Our holding in this opinion also makes it unnecessary to precisely define a ‘zone of insolvency.’”) (citing Credit Lyonnais Bank Nederland N.V. v. Pathe Commc’ns Corp., No. 12150, 1991 WL 277613, at *34 (Del Ch. Dec. 30, 1991) and Prod. Res. Group, L.L.C., 863 A.2d at 789 n. 56); see id. at 99 n.27 and n.28 (stating that although many court opinions and scholarly articles deal with the zone of insolvency, a definition of the zone remains elusive).

In Buckley v. O’Hanlon, No. 04-955GMS, 2007 WL 956947, at *7 (D. Del. March 28, 2007), however, the court determined that a plaintiff had sufficiently pled that a corporation was in the zone of insolvency by explaining that the corporation had great difficulty raising capital, shuffled delinquent accounts to make them appear healthy, could only obtain advances from its line of credit by erroneously certifying impaired loans and leases, and had begun defaulting on its loan obligations. Id.

While there may not be a precise definition for the term “zone of insolvency,” the Delaware Supreme Court in Gheewalla clarified the duties owed by directors of corporations operating in the zone. In that case, the owner of microwave spectrum licenses brought a direct breach of fiduciary duty action against directors of a corporation that had entered into a master agreement regarding the licenses and had allegedly operated in the zone of insolvency. The Chancery Court dismissed the action for failure to state a claim. On appeal, the court wrote:

In this case, the need for providing directors with definitive guidance compels us to hold that no direct claim for breach of fiduciary duties may be asserted by the creditors of a solvent corporation that is operating in the zone of insolvency. When a solvent corporation is navigating in the zone of insolvency, 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. Gheewalla, 930 A.2d at 101 (emphasis added).[2] 

Therefore, for corporations operating in the zone of insolvency, under Delaware law, directors must continue to discharge their fiduciary duties to the corporation and its shareholders.[3]

Prior to Gheewalla, most courts followed the general guidelines set forth by the Delaware Chancery Court in Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp., No. 12150, 1991 WL 277613 (Del Ch. Dec. 30, 1991). At its core, Credit Lyonnais stood for the basic proposition that once a corporation enters the zone of insolvency, directors and officers owe their primary fiduciary duties to the corporate entity as a whole. That is to say, directors of corporations operating in the zone of insolvency were advised to balance the interests of creditors, shareholders, and other corporate constituencies in managing corporate affairs. See id. at *34 n.55 (stating that directors of a nearly-insolvent corporation have “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”). 

Limiting Liability 
If individuals happen to serve as directors on the board of an entity that is in dire financial straits, there are many proactive steps that they can take to limit their exposure to liability. For instance, directors should retain independent counsel to the board (as opposed to the company’s counsel) if there is a potential that the interests of the board and the company may be in conflict.

Further, in many instances, when a corporation is in distress and an imminent action by the board might violate fiduciary duties, directors opposing the action should consider resigning. It is important to note, however, that directors and officers may be able to obtain a release from liability through a plan of reorganization in a Chapter 11 bankruptcy case.

Although courts have left many questions open regarding corporate governance of companies in economic turmoil, recent decisions provide meaningful guidance on how directors of financially troubled corporations should discharge their fiduciary duties.

As a practical matter, if a board ever approaches questions related to the possibility of an entity operating in the zone of insolvency, the most prudent course of action is to act as if the corporation already is in the zone of insolvency and to continue to discharge their fiduciary duties to the corporation and its shareholders diligently. That is, if nothing else, Gheewalla and its progeny have clarified that there is no change in a director’s duties when a solvent corporation begins to operate in the zone of insolvency, thus making the already poignant question of solvency/insolvency even more significant.

[1] As noted earlier there are competing definitions of the term insolvency. While some Delaware courts have stated that balance sheet insolvency connotes insolvency-in-fact, other courts have relied on equitable insolvency. See, e.g., Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 195 n.74 (Del Ch. 2006) (“Insolvency in fact occurs at the moment when the entity ‘has liabilities in excess of a reasonable market value of assets held.’”); but see Odyssey Partners, L.P. v. Fleming Cos., Inc., 735 A.2d 386, 417 (Del. Ch. 1999) (“An insolvent corporation is defined as one that is ‘unable to pay its debts as they fall due in the usual course of business.’”); cf. Geyer v. Ingersoll Publ’ns Co., 621 A.2d 784 (Del. Ch. 1992) (conflating balance sheet insolvency and equitable insolvency).

[2] Delaware courts have warned against using the zone of insolvency as a sword against fiduciaries. In Trenwick America Litigation Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 174-75 (Del Ch. 2006), the Delaware Chancery Court wrote:
The incantation of the word insolvency, or even more amorphously, the words zone of insolvency should not declare open season on corporate fiduciaries. Directors are expected to seek profit for stockholders, even at risk of failure. With the prospect of profit often comes the potential for defeat.The general rule embraced by Delaware is the sound one. So long as directors are respectful of the corporation’s obligation to honor the legal rights of its creditors, they should be free to pursue in good faith profit for the corporation’s equityholders. Even when the firm is insolvent, directors are free to pursue value maximizing strategies, while recognizing that the firm’s creditors have become its residual claimants and the advancement of their best interests has become the firm’s principal objective.

[3] Although Gheewalla and other Delaware cases ignore the issue of whether creditors can bring derivative claims against directors for their actions while corporations operate in the zone of insolvency, some courts have inferred such a right. See, e.g., Hill v. Gibson Dunn & Crutcher, LLP (In re MS55, Inc.), No. 06-cv-01233-EWN, 2008 WL 2358699, at *3 (D. Colo. June 6, 2008); Mims v. Fail (In re VarTec Telecom, Inc.), No. 06-03506, 2007 WL 2872283, at *3 (Bankr. N.D. Tex. Sep. 24, 2007).

Zack A. Clement
Fulbright & Jaworski L.L.P.

Clement is a partner in the Houston office of Fulbright & Jaworski, L.L.P. He represents clients in business restructuring and insolvency litigation matters, including purchasing assets from and lending to troubled companies, investing in companies emerging from bankruptcy, and litigating a broad range of issues involving troubled companies.

Travis Torrence
Senior Associate
Fulbright & Jaworski, L.L.P.

Torrence is an associate in the Houston office of Fulbright & Jaworski, L.L.P., and represents both creditors and debtors in a variety of insolvency- and bankruptcy-related matters.

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