Is the Tide Turning on D&O Claims

Is the Tide Turning on D&O Claims

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It has been a decade since a Delaware Chancery Court's footnote in Credit Lyonnais Bank Nederland N.V. v. Pathe Communications, 1991 WL 277613 (Del. Ch. 1991), established the "zone of insolvency." That little footnote sent ripples across the legal system, so much so that claims by creditors' committees and trustees against directors and officers for breach of fiduciary duties owed to creditors are now commonplace. Likewise, a passing analysis in In re Investors Funding Corp. of New York Sec. Litigation, 523 F. Supp. 533, 541 (S.D.N.Y. 1980), seems to have given birth to "deepening insolvency" and an ever-growing wave of lawsuits seeking to hold directors, officers and even third parties responsible for a company's deteriorating financial condition.

But the tide may be turning against both of these causes of action. The Delaware Chancery Court has revisited zone-of-insolvency case law and limited this ever-expanding legal theory. In Production Resources Group L.L.C. v. NCT Group Inc., 2004 WL 2647593 (Del. Ch. 2004), that court has held that the zone-of-insolvency theory does not provide direct claims against directors and officers, and further, that directors and officers may be wholly protected from these due-care and mismanagement claims by virtue of charter exculpation provisions duly adopted pursuant to Delaware Code's §102(b)(7). At virtually the same time, the Chief Judge of the U.S. Bankruptcy Court for the Southern District of New York issued his decision in In re Global Services Group LLC, 316 B.R. 451 (Bankr. S.D.N.Y. 2004), which comprehensively reviews and then essentially rejects deepening insolvency as a viable cause of action, at least under New York law.

Production Resources

In 1999, Production Resources Group L.L.C. (PRG) obtained a $2 million judgment against NCT Group Inc. arising from its sale of computer systems. Despite its efforts thereafter, PRG was unsuccessful in collecting on that judgment, and despite the existence of the judgment, NCT continued to operate, due in part to cash infusions by the wife of a former NCT director. NCT's public filings, the court noted, revealed that it was balance-sheet insolvent and that it had been unable to pay several debts as they came due.

In furtherance of its collection efforts, PRG sued NCT Group in the Delaware Court of Chancery seeking the appointment of a receiver, alleging that NCT Group long ago became insolvent and that its board and top officer had committed various breaches of fiduciary duty. Moreover, PRG argued that it had the right to assert these claims as direct claims not subject to the exculpatory charter provisions that protect NCT directors from due-care claims by shareholders.

NCT, its directors and several officers moved to dismiss for failure to state a claim upon which relief can be granted, specifically arguing that PRG had failed to plead facts stating a fiduciary-duty claim. In fact, the defendants argued, the complaint's allegations of breach of fiduciary duty, at most, plead a "duty-of-care claim" that would be exculpated by provisions within NCT's certificate of incorporation. Simply put, fiduciary duty claims belong to the corporation—even if it is insolvent—and fall within the scope of that exculpatory charter clause.

Court's Decision

The court found that PRG pled sufficient facts to survive a motion to dismiss with respect to NCT's insolvency and to support the discretionary appointment of receiver, but indeed found PRG's fiduciary-duty count more problematic. As to that count, the court rejected PRG's reasoning, holding that claims of this type are classically derivative "in the sense that they involve an injury to the corporation as an entity, and any harm to the stockholders and creditors is purely derivative of the direct financial harm to the corporation itself. The fact that the corporation has become insolvent does not turn such claims into direct-creditor claims, it simply provides creditors with standing to assert those claims." That said, §102(b)(7)'s exculpatory provisions still protect directors in these circumstances.

The court started with a fundamental premise: The law limits creditors' ability to assert fiduciary claims against directors because creditors are protected by their contractual agreements and a well-established body of fraudulent-transfer law. Consequently, as long as directors observe their legal obligations to a company's creditors in good faith, they are entitled as fiduciaries to pursue the course of action that they believe is best for the firm and its stockholders.

In the court's view, Credit Lyonnais did not break from these fundamental points but merely held that directors have discretion to temper the risk that they take on behalf of the equity-holders when the firm is in the "zone of insolvency." The holding and spirit of that decision emphasized that the business-judgment rule protects directors if they, in good faith, pursued a less-risky business strategy because they fear that a more risky strategy might render the firm unable to meet its legal obligations to creditors and other constituencies. In the zone of insolvency, a director's duty is to the "corporate enterprise" itself and to maximize its value in order to serve all the entity's constituencies. Therefore, Credit Lyonnais in fact provided a shield to directors from stockholders who claimed that the director had a duty to undertake extreme risk so long as the company did not technically breach any legal obligations. By providing directors with this shield, creditors benefited.

Further, the court found that a right to pursue direct claims against directors and officers was not created by Credit Lyonnais. Insolvency merely placed creditors in the shoes of the shareholders as the typical residual risk-bearers. Some courts, the court noted, have analogized the insolvent-company situation to that of a trust—hence, the development of the "Trust Fund Doctrine" where the directors become trustees tasked with preserving capital for the benefit of creditors that are deemed to have an equity-interest in the firm's assets. In the court's view, the transformation of creditors into residual owners does not change the nature of the harm in a typical breach-of-fiduciary-duty claim. Whether brought by creditors or shareholders, claims for self-dealing or other improper harm to the economic value of the firm remain derivative, with either shareholders or creditors suing to recover for a harm done to the corporation as an economic entity and any recovery logically flowing to the corporation. In addition, creditors may benefit derivatively to the extent of their claim against the firm's assets. "The reason for this bears repeating: The fact of insolvency does not change the primary object of the director's duties, 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 give them standing to pursue these claims to rectify that injury."

Having established this critical point, the court noted that §102(b)(7) authorizes the corporate charter provisions that insulate directors from personal liability to the corporation for breaches of their duty of care. Thus, even creditors asserting derivative claims are subject to these exculpatory charter provisions. In the court's view, this ruling is necessary in order for the statute's evident purpose—encouraging capable persons to serve as directors of corporations by providing them with the freedom to make risky, good-faith business decisions without fear of personal liability—to be implemented.

In fact, these provisions are perhaps most necessary when "a fact-finder, in view of hindsight bias in its knowledge of the fact that the debtor's business strategy did not pan out, will conclude that the directors have acted with less than due care, even if they did not." The mere fact that creditors have standing to pursue an insolvent corporation's claim against directors, or that the corporation's claim has been assigned as an asset to creditors somehow transforms the claim into one excepted from §102(b)(7), would defeat the very purpose of the statute.

Nonetheless, the court concluded that, given the pattern of dealing alleged in the complaint, it could not dismiss PRG's fiduciary duty count, but allowed it to proceed subject to the limitations expressed in its opinion.

Global Services

Echoing the sentiment, if not the substance, of Production Resources, Chief Judge Stewart M. Bernstein's decision in In re Global Service Group LLC deals a possibly crippling blow to "deepening insolvency" claims. In this case, the chapter 7 trustee sued the lender and members and insiders of Global, alleging, among other things, that they artificially prolonged Global's corporate life, resulting in its "deepening insolvency." Defendants moved to dismiss, prompting the court to consider the viability of the deepening-insolvency theory.

In support of his deepening-insolvency claim, the trustee asserted that Global's insiders—its members and owners—allowed Global to do business and incur indebtedness while it was insolvent and under-capitalized. While doing so, they knew that the debtor would be unable to repay its debts based on its financial condition. Similarly, the trustee accused the lender of continuing to finance Global's operations, even though it knew Global was in financial straits. Thus, by prolonging the debtor's corporate life and incurring more debt, both the insiders and the lender deepened Global's insolvency and reduced any potential recovery for creditors.

In granting the motion to dismiss, the court provided one of the most comprehensive and thoughtful analyses of deepening insolvency to date. To start, it reviewed the theory's genesis in In re Investors Funding Corp., 523 F. Supp. 533 (S.D.N.Y. 1980), noting the infamous language in that decision: "A corporation is not a biological entity for which it can be presumed that any act which extends its existence is beneficial to it." Relying on this simple concept, several courts have since accepted the theory that an insolvent corporation suffers a distinct and compensable injury when it continues to operate and incur more debt. Some courts have gone further, treating "deepening insolvency" as an independent cause of action, while others view it as a theory of damages. Investors Funding, the court noted, suggests that deepening insolvency may be considered an independent tort, supporting an independent cause of action for damages.

In the court's view, merely prolonging an insolvent corporation's life, without more, will not result in liability. Instead, one seeking to recover under a deepening-insolvency theory "must show that the defendant prolonged the company's life in breach of a separate duty, or committed an actionable tort that contributed to the continued operation of a corporation and its increased debt."

Given these requirements, the trustee's action failed. With respect to the lender, the court held that it could not be liable merely for making a loan that it knew or should have known Global could never repay ("This may be bad banking, but it isn't a tort"). The court found—rightly so—that if a third party was prohibited from extending credit to an insolvent entity, most companies in financial distress would be forced to liquidate at once.

Likewise, the court granted dismissal on the deepening-insolvency count as to Global's insiders. The court opined that the unspoken premise of the "deepening insolvency" theory is "[t]hat the managers of an insolvent limited-liability company are under an absolute duty to liquidate the company, and anyone who knowingly extends credit to the insolvent company breaches an independent duty in the nature of aiding and abetting the manager's wrongdoing. The assumption is a faulty one."

As in the Production Resources decision, the Global court observed that once insolvency ensues, officers and directors owe duties to multiple constituencies whose interests may diverge. At that point, they 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. Global, 316 B.R. at 460 (citing Credit Lyonnais). In fact, in the exercise of their fiduciary duties, the insiders of an insolvent business might well conclude that the company should continue to operate in order to maximize its "long-term wealth-creating capacity," or more generally, its enterprise value. The entire underpinnings of chapter 11, in the court's view, are based on the notion that an enterprise has more value alive than dead. In contrast to the law of other foreign jurisdictions, such as the United Kingdom, American law simply does not require directors and officers to shut down and liquidate an insolvent corporation.

Thus, in order to overcome the protections of the business-judgment rule, a complaint alleging a cause of action for deepening insolvency must contain specific allegations that the fiduciary acted in bad faith or with fraudulent intent. Because the trustee's complaint lacked such allegations, the court determined that it must be dismissed. Further, the complaint failed to establish any proximate cause between the lender or the insiders' prolongation of the life of the entity and the damage allegedly caused to the corporation or its creditors.


The Production Resources and Global Services cases highlight two prominent voices asserting legal and philosophical opposition to causes of action that have become virtually a given in insolvency circles. In the long run, these cases' greatest impact may be felt by unsecured creditors' committees and trustees seeking to hold directors and officers liable for mismanagement leading to bankruptcy. Among other things, both cases call into question the concept of direct claims against these targets and, in the case of Production Resources, firmly support the viability of "due care" exculpation provisions. The courts' rulings have certainly given strong ammunition to protect lenders, directors and insiders caught in the zone of insolvency.

Journal Date: 
Friday, April 1, 2005