With the increased number of derivative actions against directors for breach of fiduciary duty, corporate directors now realize that the business judgment rule no longer stands as an impenetrable shield against personal liability. Recent Delaware opinions alerting directors of their fiduciary duties to corporations and shareholders should not be taken lightly. A fiduciary must act with loyalty and honesty in a manner consistent with the best interests of its beneficiary at all times. In the world of corporate governance, this means that the trustworthy performance of a corporation's officers and directors, as carried out through their fiduciary duties, ensures the survival and stability of a corporation. One Colorado court aptly recognized, "By [the directors'] efforts, the institution operates; only through their diligence, loyalty, care and candor may it prosper."² In today's rocky economy and unpredictable market, directors of corporations are beginning to think twice when considering whether to accept or remain in their positions of both solvent and insolvent corporations. And as current Delaware decisions indicate, corporate directors must always proceed cautiously to avoid the imposition of personal liability because the rules by which directors must abide change once a corporation is no longer financially healthy.³ This article will address the fiduciary duties of directors of: (1) solvent and insolvent corporations, (2) public and private companies, and (3) limited liability companies.

Duties of Directors of Solvent Corporations

Directors are expected to maintain the utmost fidelity in their dealings with and on behalf of the corporation. In determining if a director has violated the duty of loyalty, the threshold inquiry involves consideration of whether the director has a conflict of interest in the transaction. Directors are considered "interested" if they "appear on both sides of a transaction" or expect to derive any personal financial benefit from the transaction through self-dealing.⁴

In many instances, however, the business judgment rule shields directors from liability where plaintiffs have brought actions on the issue of breach of fiduciary duty. The business judgment rule serves as a standard of judicial review, not as a standard of business conduct.⁵ Therefore, the business judgment rule is not a guide for directors to follow, but rather a defense against judicial scrutiny if certain standards are met. In solvent corporations, there exist two significant ways to rebut the business judgment rule: the "self-interested" option, where the plaintiff must demonstrate that the decision was a product of the directors' self-interest, and the "uninformed director" option, where the plaintiffs must prove that the directors failed to adequately inform themselves of necessary facts regarding the decision.⁶

Accordingly, if the plaintiff challenges the decision under the "self-interested option," the burden then shifts to the defendants to prove that the decision was fair. Burden-shifting does not necessarily create liability on the part of the defendants, but the defendants must still demonstrate the decision was the product of both fair dealing and fair price. If, however, the plaintiff proceeds under the "uninformed director" option, the burden does not shift to the defendants, and the plaintiff is allowed to present proof that the defendants breached their duties of loyalty or care. Delaware courts use the standard of gross negligence to determine whether a business judgment reached by a board of directors is an informed decision.⁷

Shareholders of corporations voluntarily enter into a contractual relationship with the corporation (through direct or indirect stock purchase) in order to receive voting rights, dividends, rights to inspect books and records, rights to distributions on liquidation, and rights to sell, assign or pledge these interests in contractual or commercial transactions. By contracting in this manner, shareholders relinquish direct control over the corporation to the board of directors, who manage the corporation according to their fiduciary duties of care and loyalty. Therefore, shareholders are limited to equitable remedies where directors breach their fiduciary responsibilities.

In solvent corporations, the fiduciary duties of care and loyalty do not extend to a corporation's creditors. Courts do not allow the fiduciary duties to extend to creditors because they do not have an existing property right or an equitable interest that support these duties when a corporation is solvent; creditors, in fact, have only a contractual relationship with the corporation.⁸ In other words, their rights and duties are typically negotiated through arm's-length bargaining and are governed by contract principles. Creditors who fear insolvency or dissolution of the corporation may negotiate a security interest in unencumbered corporate assets, seek limited proxy rights, or negotiate representation on the board for the term of their contract.⁹

Duties of Directors of Insolvent Corporations

The Model Business Corporation Act defines insolvency as "the inability of a corporation to pay its debts as they become due in the usual course of business," Model Bus. Corp. Act §6.40(c)(2) (1985), while the U.S. Bankruptcy Code defines insolvency as "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." 11 U.S.C. §101(32)(A). The Delaware Chancery Court routinely opts to use the Model Business Corporation Act definition because it better reflects the dynamics of the corporate culture.¹⁰

When a shift from solvency to insolvency occurs, the director's fiduciary duties also shift from the shareholders to the corporation's creditors. Essentially, an officer or director of an insolvent corporation has a duty to the corporation's creditors to be loyal, to act solely for the financial benefit of the creditors in all matters, and to enhance the financial interest of the insolvent corporation.¹¹ The directors should manage the insolvent corporation as trustees for the corporate creditor-beneficiaries and not attempt, in an effort to forgive debts, to improperly transfer corporate property or make preferential payments to the detriment of the corporation's creditors.¹² Directors may continue to operate a corporation during insolvency, provided that the purpose of the continued operation is not solely to benefit the directors at the expense of the corporation and its creditors.¹³

Courts allow the fiduciary shift during insolvency because, in essence, creditors become the equitable owners of the corporation; after all, upon insolvency of a corporation they are the sole interested parties in the corporation's assets.¹⁴ Seemingly, the directors no longer represent the shareholders due to the insolvency. Instead, they become trustees of the corporation's assets for the benefit of its creditors and are charged with the responsibility of assuring that the creditors are either paid in full or pro rata from the remaining assets.¹⁵ In doing so, directors cannot give preference to themselves or particular creditors by transferring corporate property.

However, shareholders are sometimes given preference over creditors in limited circumstances. In Helm Financial Corp. v. MNVA Railroad Inc., et al., 212 F.3d 1076. (8th Cir. 2000), a Minnesota federal court found that the directors of the nearly insolvent MNVA Railroad Inc. did not breach their duty under Minnesota law when they distributed the stock of an MNVA subsidiary to MNVA shareholders for free, even though MNVA failed to pay its creditors shortly thereafter. The district court dismissed the claims after finding that the law did not create a fiduciary duty to creditors for a distribution in which the officers and directors did not personally benefit. The court ruled that the simple act of preferring shareholders over creditors was not a breach of duty. Further, the court noted that while officers and directors of a nearly insolvent corporation may not prefer themselves over creditors, they have no duty to favor creditors over shareholders.

Directors must act cautiously to safeguard themselves against a creditor's claim of breach of fiduciary duty. Some protective strategies that directors could employ include strictly maintaining board minutes and clearly addressing the competing concerns among interested parties, providing detailed explanations as to steps taken to search out other buyers in the event that the sales of assets are made to insiders, and even abstaining from voting if board members are also creditors and shareholders.¹⁶

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Although the business judgment rule continues to be the first defense in derivative suits, the rule does not apply where directors fail to inform themselves of all information reasonably available to them or where they fail to exercise the requisite level of care...

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Liability of Directors of Public Companies: In re The Walt Disney Co. Derivative Litigation

The May 2003 ruling of In re The Walt Disney Co. Derivative Litigation has many corporate directors concerned about their own personal liability when making decisions on behalf of their corporations. The chancery court of Delaware warned that directors who take a "we don't care about the risks" attitude regarding material corporate decision-making face serious legal and financial repercussions.¹⁷ Consequently, the Walt Disney decision serves as a warning to corporate directors that state courts are now willing to allow plaintiffs to prove that directors who fail to exercise due care in carrying out their fiduciary duties should be liable to the shareholders of the corporation, even without the suggestion of self-dealing.

The facts of Walt Disney make it an easy case for "conscious indifference" by corporate directors, according to the court. The chief executive officer of Disney, Michael Eisner, unilaterally made the decision to hire Michael Ovitz, a long-time personal friend. Throughout Ovitz's hiring process, no employment agreement drafts were presented to the compensation committee or board for review, the board did not raise any questions concerning Ovitz's hiring, the board approved Ovitz's hiring even though the employment agreement was still being negotiated, and the final employment agreement was negotiated and signed without any further input from the board.¹⁸ Further, Ovitz and his attorneys negotiated the employment contract with Eisner instead of an impartial entity, such as the compensation committee, allowing him to devise a severance package worth over $140 million after barely a year of mediocre to poor job performance.¹⁹ The court found that the shareholders sufficiently alleged that the directors' conduct in executing the employment contract and no-fault termination clause fell outside of the business judgment rule and that the directors breached their fiduciary duties. In short, the plaintiffs will now be allowed to prove all of the allegations that they have asserted.

At the heart of Walt Disney remains the oft-cited business judgment rule, which has traditionally protected corporate decision-making in derivative actions. Although Judge William Chandler III of the chancery court noted that courts are typically hesitant to second-guess the business judgment of disinterested and independent directors, he noted that the facts of Walt Disney "do not implicate merely negligent or grossly negligent decision-making by corporate directors...quite the contrary; the complaint suggests that the Disney directors failed to exercise any business judgment and failed to make any good faith attempt to fulfill their fiduciary duties to Disney and its stockholders."²⁰ The court used as a basis for this analysis the seminal case of Smith v. Van Gorkom,²¹ in which the court applied the standard of gross negligence in determining the validity of a director's decision and held that the board of directors was grossly negligent in approving a merger where the facts indicated that the board's decision was made in a hurried manner, without reading all of the reports or considering the alternatives. Upon first glance, the facts of Walt Disney and Van Gorkom seem to mirror one another. However, as the chancery court has suggested, the directors in Walt Disney did not merely use negligent judgment in their decision-making: They failed to use any judgment at all.

Walt Disney should serve as a wake-up call for corporate directors in public companies. Although the business judgment rule continues to be the first defense in derivative suits, the rule does not apply where directors fail to inform themselves of all information reasonably available to them or where they fail to exercise the requisite level of care, as the court insinuated was the case in Walt Disney. The court refused to accept the defendants' contention that Disney's charter provision based on 8 Del. C. §102(b)(7) protected individual directors from personal damages for any breach of care. Finding that acts or omissions not undertaken honestly and in good faith, or that involve intentional misconduct, do not fall within the protective ambit of the statute, the court refused to dismiss the complaint.²² Moreover, the court implied that the directors consciously ignored their fiduciary duties and knowingly proceeded with indifferent decision-making, thereby causing economic injury to both the corporation and its shareholders.

Liability of Directors of Private Companies: Pereira v. Cogan

In Pereira v. Cogan,²³ the court ruled that the directors of Trace International Holdings owed fiduciary duties of due care, loyalty and good faith to the corporation and its creditors, specifically when the corporation was in danger of insolvency. Further, the best interests of the corporation and its shareholders, the court found, must take precedence over any interests possessed by the director, officer or controlling shareholders. The holding comes as a result of the directors' failure to investigate certain undeclared dividends and blindly voting to ratify compensation set by the corporation's former CEO, Michael Cogan. Over a span of a decade, Cogan earned almost $7 million more than other executives in comparable positions, approved personal loans from the company to his secretary and wife in the amount of $1.7 million and approved $4.2 million in dividends to shareholders of preferred stock, all while he knew that Trace was insolvent. Additionally, Cogan spent more than $1 million of the company's funds for his 60th birthday party, paid his daughter more than $400,000 of company funds for writing a book for which the corporation never received any revenue, and persuaded his secretary not to retire by lending her $300,000 and then forgiving the loan without board approval. The court summed up Cogan's conduct by commenting, "Once Cogan created the cookie jar—and obtained outside support for it—he could not without impunity take from it."²⁴ That impunity resulted in a judgment against Cogan for nearly $44 million.

Particularly, the court found appalling Cogan's blatant disregard for his fiduciary duty to the corporation during the time leading to the corporation's insolvency.²⁵ Cogan and his co-defendants argued that insolvency exists when the corporation's liabilities exceed its assets (which the plaintiffs also agreed upon) or where the corporation is unable to meets its current maturing obligations in the ordinary course of business.²⁶ However, the court rejected the second test by reasoning that by the time a corporation cannot pay its current debts, or is in the vicinity of not being able to pay its current maturing debts, it would be too late to protect a creditor's interest in such a way as to give the fiduciary duty any meaning.²⁷ Consequently, the court found that Trace was in the vicinity of insolvency from 1995 until its bankruptcy filing in 1999 because the corporation did not have enough cash to pay for its projected obligations and fund its business requirements for working capital and expenditures. Therefore, the officers and other directors of Trace owed fiduciary duties of due care, loyalty and good faith to the corporation and its creditors during this four-year period.

Another important issue raised by the court focuses on whether the defendants could be classified as corporate officers for liability purposes. The court found that a defendant may be classified as a corporate officer if he had discretionary authority in the relevant functional area and the ability to cause or prevent the alleged action.²⁸ In this case, Cogan, along with five other directors, did have the ability to make decisions regarding financial decisions of the corporation because they knew about the challenged expenditures, yet unreasonably failed to take action or steps that would have informed them of those expenditures.

Even the business judgment rule could not save the officers and directors from liability in this case, according to the court. Courts typically are reluctant to second-guess the managerial decisions of corporate officers and directors because the court presumes that directors and officers have acted in good faith and in the best interests of the company. In order to determine whether the directors were liable, the court first had to assess if the officers violated their fiduciary duties. Returning to the argument that the officers were well aware of Trace's precarious financial situation, the court ruled that the defendants should have questioned the calculations purporting to find a surplus of company funds. Because the officers and directors failed to question the surplus and act in a situation in which due care would have prevented a loss, the court found that they abdicated their fiduciary duties and breached their duties of loyalty and due care. Thus, the defense of the business judgment rule was of no assistance to the defendants.

As Pereira cautions, directors of private companies must take their fiduciary duties as seriously as those in the public realm. The significance of the case lies in the court's use of the same criteria for fiduciary responsibility typically used for public corporations. As Elizabeth Warren, a professor at Harvard Law School, remarked, "It is a warning to directors and officers of private companies that they can be held personally liable for failing to manage their businesses properly. A decision like this has powerful ramifications."²⁹ Indeed, the ramifications are powerful because even though the siphoned funds largely benefited Cogan, the controlling shareholder and CEO, the other directors were held liable because of their failure to speak up and against the unilateral decisions made by Cogan.

Liability of Directors of Limited Liability Companies

The emergence of limited liability companies (LLCs) is a relatively new trend in corporate governance. LLCs are often attractive options for new businesses because of the combined features of partnerships and corporations. More notably, LLCs avoid the double-taxation problem because the company is taxed as a partnership, which allows earnings to flow directly to the investors. Typically, the members of the company manage the organization and are not liable to the limited liability company or each other, as long as their management actions are believed to be in good faith and in the best interests of the company. Similar to corporations, LLC managers owe fiduciary duties of loyalty and care to its members, and are held to a "prudent person" standard. The Uniform Limited Liability Company Act³⁰ also provides that fiduciary duties are owed to the LLC and its members. In a member-managed LLC, however, all members owe fiduciary duties, while in a manager-managed LLC, only those members serving as managers owe duties.³¹ Members who are not managers are permitted to bring a derivative suit on behalf of the LLC for a breach of the fiduciary duty. Although there exists limited authority regarding the boundaries of the fiduciary duties owed by LLC managers, the language of the Uniform Limited Liability Company Act suggests that the managers owe a duty directly to the LLC.

An advantage of organizing a business as an LLC is the substantial freedom of contract that members and managers of an LLC may exercise. Parties may expand, restrict or eliminate any duties and liabilities of members or managers, such as indemnifying and holding harmless members or managers from and against any claim or demand arising in connection with the LLC. The exceptions to indemnification usually include that the parties may not indemnify members or managers for intentional misconduct or knowing violations of law, or for transactions triggering the receipt of personal benefits in violation of an existing operating agreement.³²

Because case law is more developed regarding limited partnerships than LLCs, analogous cases in the limited partnership context are often consulted in examining whether directors of limited partnerships have been found personally liable for breach of fiduciary duty to limited partners. For example, in the case of In Re USACafes L.P. Litigation,³³ the Delaware Chancery Court held that corporate directors are fiduciaries for the limited partnership. Although the defendants moved to dismiss for failure to state a claim, the court found that "[T]he assertion by the directors that the independent existence of the corporate general partner is inconsistent with their owing fiduciary duties directly to limited partners is incorrect."³⁴

The court reasoned by analogy that directors of a corporate general partner owe fiduciary duties to the partnership and its limited partners by stating, "...[t]he principle of fiduciary duty, stated most generally, [is] one who controls the property of another may not, without implied or express agreement, intentionally use that property in a way that benefits the holder of the control to the detriment of the property of its beneficial owner."³⁵ Thus, directors of a corporate general partner owe a fiduciary duty to the limited partners because of the directors' control of the partnership's property. Using this rationale, managers or member-managers of LLCs cannot escape personal liability if they knowingly cause the LLC to commit a breach of trust resulting in financial loss.

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Footnotes

¹ Gary W. Marsh is a partner with McKenna Long & Aldridge LLP and is Board-certified in business bankruptcy and creditors' rights law by the American Board of Certification. Petrina Hall was a 2003 summer associate with the firm. Return to article

² In re Bush, 1991 WL 540753 at 5, 6. Return to article

³ The Delaware Chancery Court held in Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp., 17 Del. J. Corp. L. 1099 (Del. Ch. 1991), that the board of a corporation in the vicinity of insolvency is "obligated to act not in the best interests of the shareholders, but rather in accordance with the community of interests that sustain the corporation." Id. at 1157. Return to article

⁴ Bush, supra. Return to article

⁵ Smith v. Van Gorkom, 488 A.2d at 872 (ruling that "[t]he rule itself is a presumption that, in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the corporation."). Return to article

⁶ In re Healthco, 208 B.R. at 302; Van Gorkom, supra (finding no business judgment rule protection for directors who have made an unintelligent or unadvised judgment). Return to article

⁷ Van Gorkom, supra at 873. Return to article

⁸ Simons v. Cogan, 549 A.2d 300, 304 (determining that directors of solvent corporation owed no fiduciary duty to holders of convertible debentures, the Supreme Court of Delaware noted that "before a fiduciary duty arises, an existing property right or equitable interest supporting such a duty must exist."). Return to article

⁹ Stilson, Ann E., "Reexamining the Fiduciary Paradigm at Corporate Insolvency and Dissolution: Defining Directors' Duties to Creditors," 20 Del. J. Corp. L. 1 (1995). Return to article

¹⁰ Francotyp-Postalia AG & Co. v. On Target Tech., 1998 WL 928382 (Del. Ch. 1998). Return to article

¹¹ First Options of Chicago Inc. v. Polonitza, 1990 WL 114740 (N.D. Ill. July 31, 1990). Return to article

¹² First Options, supra.; Bernstein, Donald S. and Sibal, Amit, "Current Developments: Fiduciary Duties of Director and Corporate Governance in the Vicinity of Insolvency," 819 PLI/Comm. 653 (2001). Return to article

¹³ In re Logue Mechanical Contracting Corp., 106 B.R. 436, 440 (holding that directors had violated their fiduciary obligation to the corporation by continuing to operate the business for nine months prior to filing bankruptcy solely for the benefit of themselves when a reasonable person using ordinary skill, care and diligence would have immediately ceased operations and proceeded to liquidate the business to maximize the return to creditors). Most courts, however, have held that corporate officers do not owe a duty to creditors during insolvency unless there is proof of self-dealing or some extraordinary fraudulent or criminal act. Bank of America, et al. v. Musselman, et al., No. 02-253 (E.D. Va., Oct. 7, 2002). Return to article

¹⁴ Gross, Steven R., et al., "Shifting Duties: Directors Face Risks in Workout," Nat'l. L.J., Apr. 15, 1991, at 19. Return to article

¹⁵ In re Mortgag Am. Corp., 714 F.2d 1266, 1271 (5th Cir. 1983). Return to article

¹⁶ Barton, Roger E., "Venture Capitalists as Directors: Avoiding Increased Liability from Serving on the Board of an Insolvent Company," A.C.O.D.L.L.R., March 25, 2002. Return to article

¹⁷ In re The Walt Disney Co., 2003 WL 21267266, pg. 11. Return to article

¹⁸ Walt Disney, supra, pg. 2-6. Return to article

¹⁹ Id. at 7. Return to article

²⁰ Id. at 1. Return to article

²¹ 488 A.2d 858, 872 (Del. 1985) (finding no business judgment rules protection for directors who have made an unintelligent decision or unadvised judgment). Return to article

²² Walt Disney, supra pg. 9. Return to article

²³ 2003 WL 21039976 (S.D.N.Y.). Return to article

²⁴ Id. at 1. Return to article

²⁵ In determining whether a duty attaches, Delaware uses "insolvency in fact" rather than insolvency as defined by statutory filings. Geyer v. Ingersoll Pubs. Co., 621 A.2d 784, 787-88 (Del. Ch. 1992). Return to article

²⁶ See Gibralt Capital Corp. v. Smith, 2001 Del. Ch. LEXIS 68 at 25 (Del. Ch. May 8, 2001). Return to article

²⁷ Pereira, 2003 WL 21039976 at 55. Return to article

²⁸ Gold v. Sloan, 486 F.2d 340, 351 (4th Cir. 1973) (officers who lack "the slightest connection" with events in question or ability to meaningfully participate should not be considered officers for liability purposes.). Return to article

²⁹ Fabrikant, Geraldine, "Private Concern, Public Consequences," The New York Times, Sunday, June 15, 2003. Return to article

³⁰ Uniform Limited Liability Company Act §409, 6A U.L.A. 464 (1995). Return to article

³¹ Id. Return to article

³² See Gotham Partners L.P. v. Hallwood Realty Partners L.P., et. al., 817 A.2d 160, 167-68 (Del. 200); Elf Atochem North America Inc. v. Jaffari, 727 A.2d 286, 290-291 (Del. 1999) (finding the Delaware LLC act to provide substantial contracting freedom for parties). Return to article

³³ 600 A.2d 43 (Del. Ch. 1991). Return to article

³⁴ Id. at 48. Return to article

³⁵ Id. at 48. Return to article