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Defending Against Breach of Fiduciary Duty in Bankruptcy

By Jeffrey Baddeley – February 29, 2012

 

“Victory has a thousand fathers; failure is an orphan.” The quote is attributed to John F. Kennedy in the wake of the failed Bay of Pigs invasion, though it appears to have been first used by Count Galeazzo Ciano, son-in-law of Benito Mussolini. The sentiment aptly characterizes the plight of directors and officers of bankrupt companies.


When a company files for bankruptcy, creditors and their counsel often look for scapegoats. Wiser directors or more capable managers would have avoided the economic calamity that now confronts the disappointed creditor constituency. The increasing reality in Chapter 11 bankruptcy cases is that very few companies emerge from bankruptcy intact. Sales of substantially all of a debtor’s assets under Bankruptcy Code Section 363 have become an overwhelmingly common approach to Chapter 11 “reorganization” cases. David Dragatt, “363(b) Sales: News, Views and Increased Use,” and cases cited therein, 18th Annual Southwest Bankruptcy Conference. Often the corporate debtor’s claims against its directors and officers, usually arising out of whatever actions put the debtor into bankruptcy, constitute a significant asset of the bankruptcy estate.


Moreover, the claims against directors and officers are often pursued by a trust established for the benefit of the unsecured creditors. Those trustees and their constituents are more likely to have a hostile view of managers’ conduct. Therefore, lawyers representing corporate officers and directors must understand the duties of officers and directors when the company is in financial difficulty and the impact a bankruptcy filing may have on otherwise available defenses and protections.


The Fiduciary Duties of Directors and Officers
Outside of bankruptcy, officers and directors owe duties of care and loyalty to the corporations they serve. Case law now seems to hold that the duty of good faith, once thought to be an independent duty, is subsumed in the duty of loyalty or the duty of care. See In re Citigroup, Inc. S’holder Derivative Litig., 964 A.2d 106, 122 (Del. Ch. 2009).


Duty of Loyalty
Officers and directors owe undivided and unqualified loyalty to the corporation they serve. Pepper v. Litton, 308 U.S. 295 (1939). Thus, they must act in good faith and with the reasonable belief that an action taken is in the best interest of the corporation. They cannot personally profit at the expense of the corporation or place their personal concerns ahead of those of the corporation. Corporate directors and officers may be seen as trustees for the benefit of shareholders or as their agents. Most “breach-of-loyalty” cases involve a claim that a director’s conflict of interest led the company to enter into a contract that benefited the director, rather than the company. See, e.g., Cede & Co. v. Technicolor, 634 A.2d 345 (Del. 1993). “[A] director is considered interested where he or she will receive a personal financial benefit from a transaction that is not equally shared by the stockholders.” Rales v. Blasband, 634 A.2d 927, 936 (Del. 1993).


Claims for breach of the duty of loyalty are not limited to cases of conflict of interest. Delaware courts have held that the


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.


Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006). To hold a disinterested director liable for a breach of loyalty under Delaware law (such as for indolence in monitoring the company’s affairs), the plaintiff must make a strong showing of misconduct. In re Lear Corp. S’holder Litig., 967 A.2d 640 (Del. Ch. 2008).


Duty of Care
Officers and directors of a corporation must exercise the care that a careful and prudent person would use in similar circumstances and consider all material information reasonably available to them. A breach of the duty of care, without allegations of self-dealing or breach of loyalty, “is possibly the most difficult theory in corporation law upon which a plaintiff might have to win a judgment.” In re Caremark Int’l, Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996). Only a sustained or systematic failure of the board to exercise oversight will establish the lack of good faith necessary to hold directors liable.


Delaware courts have identified three categories of bad-faith corporate fiduciary conduct: subjective bad faith, motivated by actual intent to do harm; lack of due care, consisting of actions taken without malice, but as the product of gross negligence; and a conscious disregard of the director’s duties, such as acting with a purpose other than the corporation’s best interest, or failing to act in the face of a known duty to act. Brehm v. Eisner (In re Walt Disney Co. Derivative Litig.), 906 A.2d 27 (Del. 2006). The Delaware Supreme Court has rejected the notion that gross negligence, without more, is a breach of the duty to act in good faith.


Business-Judgment Rule
The business-judgment rule protects directors and officers from a claim for breach of the duty of due care. The business-judgment rule is not a substantive rule of law; instead, it creates a presumption “that in making a business decision the director of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interest of the company.” In re Healthco Int’l, Inc., 208 B.R. 288, 306 (Bankr. D. Mass. 1997). To raise a reasonable doubt that the directors’ actions are protected by the business-judgment rule, the plaintiff must allege specific facts that would disprove “(1) that the directors are disinterested and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.” Aronson v. Lewis, 473 A.2d 805, 809 (Del. 1984).


To obtain the protections of the business-judgment rule, the officer or director must diligently and reasonably inform himself or herself of all relevant facts and cannot passively approve important transactions without undertaking any examination of the facts. Smith v. Van Gorkom, 488 A.2d 858, 873 (Del. 1985), overruled on other grounds, Gantler v. Stephans, 965 A.2d 695 (Del. 2009). A board that meets regularly, hires reputable advisors, and informs itself about the company’s affairs is likely to be protected by the business-judgment rule. See In re Lear, 967 A.2d at 655.


Entering the “Zone of Insolvency”
The foregoing rules seemed well established and widely accepted until the Delaware Chancery Court’s decision in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 17 Del. J. Corp. L. 1099, 1991 WL 277613, at *34 (Del. Ch. 1991). There, Chancellor Allen appeared to expand the directors’ duties to protect not only the corporation, but also its creditors, saying, “At least when the corporation is operating in the vicinity of insolvency, a board of directors is not merely the agent of the residual risk bearers, but owes its duty to the corporate enterprise.”


The language of Credit Lyonnais led to considerable confusion as to the duties and liabilities of directors in the “zone of insolvency.” Courts held that directors are trustees or “quasi-trustees” for an insolvent corporation’s creditors. Under this “trust-fund” theory, the corporate assets are held in trust for the benefit of creditors, and therefore the directors and officers have duties analogous to those of a trustee—to preserve the assets for the benefit of creditors. Dianne F. Coffino & Charles H. Jeanfreau, “Delaware Hits the Brakes: The Effect of Gheewalla and Trenwick on Creditor Claims,” 17 Norton J. Bankr. L. & Prac. 63.


Courts have also wrestled with the question of when the zone of insolvency arises. A company may be operating in the zone of insolvency when it is not yet technically insolvent, but is nevertheless experiencing financial difficulties. There are two generally accepted tests for determining insolvency. Under the “balance-sheet test,” a debtor is insolvent when the sum of its debts exceeds the fair value of its property. Under the “equitable-insolvency test,” a debtor is insolvent if it lacks sufficient property to pay debts as they mature. Determining when a corporation is in the zone of insolvency became more art than science—leaving boards, officers, and their counsel confused as to when their duties began to expand.


Not surprisingly, the notion that the duties of officers and directors had changed in an undefined zone of insolvency led to a variety of different interpretations. After several years, however, the courts in Delaware and elsewhere began to question the validity of the theory. A series of Delaware cases beginning in 2004 began to prune back the reach of the zone-of-insolvency cases that emerged after Credit Lyonnais. The current consensus is that the substantive duties of directors and officers do not change, regardless of the solvency of the company or its imminent insolvency.


In Production Resources Group, LLC v. NCT Group, Inc., 863 A.2d 772 (Del. Ch. 2004), a judgment creditor sought the appointment of a receiver because of alleged wrongdoing by the judgment debtor’s management. The creditor alleged breach of fiduciary duties. The Delaware Chancery Court discussed the concept of fiduciary duties in the vicinity of insolvency and the rights of creditors to sue for breach of fiduciary duties.


The Production Resources court recognized that Credit Lyonnais had given rise to the notion that new duties arose in the “zone of insolvency.” That interpretation was incorrect, according to Production Resources, which said:


The Credit Lyonnais decision’s holding and spirit clearly emphasized that directors would be protected by the business judgment rule if they, in good faith, pursued a less risky business strategy precisely because they feared that a more risky strategy might render the firm unable to meet its legal obligations to creditors and other constituencies.


863 A.2d at 788.


Even though the Production Resources court did not reject the idea that directors owe existing duties to creditors in the zone of insolvency, it did state that


even in the case of an insolvent firm, poor decisions that lead to a loss of corporate assets and are alleged to be breaches of equitable fiduciary duties remain harms to the corporate entity itself. . . . The reason for this bears repeating—the fact of insolvency does not change the primary object of the director’s concern, which is the firm itself. The firm’s insolvency simply makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm’s value and logically gives them standing to pursue claims to rectify that injury.


Id. at 792 (emphasis added). Production Resources thus made clear that the duties of officers and directors do not change when the company is insolvent or in danger of insolvency. And the protections of the business-judgment rule still apply to officers and directors of insolvent companies.


The retrenchment continued with Trenwick America Litigation Trust v. Ernst & Young, LLP, 906 A.2d 168 (Del. Ch. 2006). In Trenwick, a liquidating trust of an insolvent insurance company sued the parent company’s directors for breach of fiduciary duties, claiming that they had followed an imprudent strategy of acquiring operating subsidiaries and had underestimated their potential claims exposure. That exposure ultimately led to the company’s insolvency. Among other causes of action, the plaintiff pled “deepening insolvency.”


The Delaware Chancery Court rejected the deepening-insolvency cause of action under Delaware law. In doing so, the court emphasized that fiduciaries of an insolvent corporation have no fiduciary duty to choose a conservative approach over an aggressive approach if both are reasonable under the circumstances:


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.


. . . .


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.


Id. at 174–75 .


After Trenwick, corporate counsel had pretty clear direction, at least in Delaware: The tort of deepening insolvency does not exist under Delaware law.


If the board of an insolvent corporation, acting with due diligence and good faith, pursues a business strategy that it believes will increase the corporation’s value but that also involves the incurrence of additional debt, it does not become a guarantor of that strategy’s success. That the strategy results in continued insolvency and an even more insolvent entity does not in itself give rise to a cause of action. Rather, in such a scenario, the directors are protected by the business-judgment rule. To conclude otherwise would fundamentally transform Delaware law.


The rejection of an independent cause of action for deepening insolvency does not absolve directors of insolvent corporations of responsibility. Rather, it remits plaintiffs to the contents of their traditional toolkit, which contains, among other things, causes of action for breach of fiduciary duty and for fraud.


Production Resources and Trenwick left at least one open question: Can creditors bring direct causes for breach of fiduciary duties, or can they only sue for derivative injury to the corporation itself? That question was answered in North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007). There, the Delaware Supreme Court rejected direct claims by creditors in blunt language:


To recognize a new right for creditors to bring fiduciary claims against those directors would create a conflict between those directors’ duty to maximize the value of an insolvent corporation for the benefit of all those having an interest in it, and the newly recognized direct fiduciary duty to individual creditors. Directors of insolvent corporations must retain the freedom to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation.


930 A.2d at 102–3.


So, for a brief moment, the advice to a board was clear, at least under Delaware law: Directors have the benefit of the business-judgment rule; creditors cannot bring direct causes of action; and rational business judgments, even decisions that turn out poorly, are covered under the business-judgment rule. Given the general deference to Delaware law and the rulings of Delaware courts in matters of corporate governance, commentators began to proclaim the death of deepening insolvency. See, e.g., Coffino & Jeanfreau, supra.


Not So Fast
A recent case demonstrates the tenacity of the deepening-insolvency theory. In Official Committee of Unsecured Creditors v. Baldwin (In re Lemington Home for the Aged), 659 F.3d 282 (3d Cir. 2011), the Third Circuit announced that while deepening insolvency may not be a viable cause of action under Delaware law, it is a viable cause of action under Pennsylvania law; directors owe fiduciary duties to the creditors of an insolvent entity; and the business-judgment rule can be overcome by evidence of simple negligence, not only gross negligence. The Third Circuit’s holding, which vacated the district court’s order of summary judgment in favor of the company’s directors and officers, highlights several key differences between Pennsylvania law and Delaware law pertaining to fiduciary duties, the business-judgment rule, and deepening insolvency. Nevertheless, this decision is likely to revive the debate over the zone of insolvency and the progeny of Credit Lyonnais.


Background
In April 2005, Lemington Home filed a voluntary Chapter 11 petition in the Bankruptcy Court for the Western District of Pennsylvania with a goal of transferring Lemington Home’s principal charitable asset to an affiliate whose board was composed of Lemington Home’s directors. In November 2005, the Bankruptcy Court granted the creditors committee’s motion to commence an adversary proceeding in the district court against Lemington Home’s directors and officers.


In its complaint, the committee asserted claims against the directors and officers for breach of the fiduciary duties of care and loyalty and for deepening insolvency. The district court granted the directors’ and officers’ motion for summary judgment, finding that the business-judgment rule precluded the committee’s claims of breach and the committee would be unable to show the fraud necessary to support a claim of deepening insolvency.


On appeal, the Third Circuit vacated the district court order and remanded the case for trial. The Third Circuit held that the district court had improperly relied on Aronson, which held that director liability could only be premised on gross negligence. 473 A.2d at 812. “Pennsylvania, however, recognizes directors’ and officers’ liability for negligent breach of fiduciary duty.” In re Lemington Home, 659 F.3d at 292 n.5 (citation omitted).


The Third Circuit also held that officers and directors owed fiduciary duties “not only to the corporation and its shareholders, but to the creditors of an insolvent entity.” Id. at 290, citing Citigroup Venture Capital, Ltd. v. Comm. of Creditors Holding Unsecured Claims, 160 F.3d 982, 987–88 (3d Cir. 1998). The Third Circuit’s ruling is diametrically opposed to the Gheewalla decision. While Gheewalla holds that creditors have only derivative claims against directors and officers, Lemington Home holds that directors owe direct duties to creditors.


This holding is disturbing, particularly because it relies on Citigroup Venture Capital as support. In Citicorp Venture Capital, the challenged conduct occurred after the bankruptcy filing. No one seriously disputes that debtors (and their directors and officers) owe fiduciary duties to creditors after a bankruptcy filing. It is far less clear, however, that such duties are owed prior to the filing. The Lemington Home court’s decision, relying on inapposite case law, has given new life to a discredited legal theory.


But the Lemington Home court was not finished. The court first announced a lower standard of liability for directors and officers, and unduly broadened the scope of directors’ fiduciary duties. Then, finding that a cause of action for deepening insolvency “has not been formally recognized by Pennsylvania state courts,” the Third Circuit held that its prior decision in In re Lafferty, 267 F.3d 340 (3d Cir. 2001), compelled a holding that deepening insolvency was a viable cause of action under Pennsylvania law. The Third Circuit acknowledged the growing judicial and scholarly criticism of deepening insolvency, but found that even “if our precedent is erroneous . . . it can only be overturned by this Court en banc.” In re Lemington Home, 659 F.3d at 294 n.6.


Under Pennsylvania law, deepening insolvency is defined as “an injury to [a debtor’s] corporate property from the fraudulent expansion of a corporate debt and prolongation of corporate life.” Id. A plaintiff must show that the directors’ actions were fraudulent, not merely negligent. In Lemington Home, the district court had ruled that the committee would not be able to show the necessary fraud to support a deepening-insolvency claim. The Third Circuit, considering the evidence in the light most favorable to the committee as the nonmoving party, disagreed.


The Third Circuit held that fraud is “anything calculated to deceive, whether by single act or combination, or by suppression of truth” and that the committee had raised a genuine issue of material fact for a finding of fraud, which made summary judgment inappropriate. The facts that might support a finding of fraud included that the directors had delayed the filing of bankruptcy for three months, commingled Lemington Home’s funds with related entities’ funds, let the company continue to do business with vendors despite its insolvency, and transferred some of Lemington Home’s assets to related entities post-petition. The committee therefore had sufficient evidence to bring a claim that the directors knew that Lemington Home was insolvent, that they planned on filing for bankruptcy, and that their actions would cause further insolvency, but they nevertheless failed to inform its creditors of Lemington Home’s insolvency.


Although these facts are arguably consistent with a claim of fraud, the Third Circuit’s ruling may be further proof that “bad facts make bad law.” It is troubling, however, that the court held that “suppression of truth” is the equivalent of fraud in the context of insolvency. That language implies that a debtor that is—insolvent? approaching insolvency? in the zone of insolvency?—owes a fiduciary duty to its creditors to advise those creditors of its financial problems. That kind of candor seems inconsistent with the directors’ duty to preserve value for the corporation and its shareholders.


Directors and officers are often faced with difficult decisions, and awkward communications with vendors and other creditors. Life will not be any easier for them if they are legally obligated to refrain from “suppressing the truth.” The Third Circuit has announced an unrealistic standard of conduct that may give rise to further confusion in a difficult and unsettled area of law.


The Lemington Home decision may have limited impact. After all, far fewer corporations are governed by Pennsylvania law than by Delaware law. It is worth remembering, however, that courts may not find Delaware cases—or Delaware statutes—controlling in deciding issues of director and officer liability.


Keywords: litigation, business torts, director and officer liability, breach of fiduciary duty


Jeffrey Baddeley is a partner with Ulmer Berne LLP in Cleveland, Ohio.


 
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