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Defending Directors and Officers Against Breach of Fiduciary Duty Claims in Bankruptcy

Thursday, September 27, 2012

By Jeffrey Baddeley, Ulmer & Berne LLP

When a company files for bankruptcy protection, the search for scapegoats is nearly inevitable. If the company has failed, someone must have breached a duty. And if the company fails, someone will get less than they want. As “bankruptcy protection” becomes synonymous with “orderly liquidation,” creditors will start to investigate claims against officers and directors. When the auction comes up short, directors and officers become targets.

One increasingly prevalent pattern in Chapter 11 cases is:

1. The lenders and the company management agree to a series of forbearance agreements;

2. The lenders strengthen their collateral positions;

3. The debtor's collateral will not repay the debt;

4. The debtor and the lenders agree that the debtor will file for bankruptcy to sell the debtor's assets as a going concern;

5. The assets are sold; and

6. Avoidance claims held by the debtor are left for the creditors' committee to pursue.

In this scenario, it is inevitable that creditors will pursue director and officer claims.

If the debtor had alternatives, the creditors' committee (or the trustee) will seek to hold the officers and directors liable for the economic train wreck. Counsel for the committee (or the trust acting for the creditors) are 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.

This article reviews the history of breach of fiduciary claims in bankruptcy, with an emphasis on the history of such claims in Delaware. The article then reviews the recent Third Circuit decision in Official Committee of Unsecured Creditors v. Baldwin (In re Lemington Home for the Aged), No. 10-4456 (3d Cir. 2011)(23 BBLR 1215, 10/6/11), which revives (or perhaps reaffirms) the theory of “deepening insolvency” against directors and officers.

The Fiduciary Duties of Directors and Officers

Outside of bankruptcy, officers and directors owe duties of care and loyalty1 to the corporation they serve.

Duty of Loyalty: Officers and directors owe undivided and unqualified loyalty to the corporation they serve.2 They must act in good faith and with the reasonable belief that their actions are in the company's best interest. They cannot personally profit at the expense of the corporation, or place their personal concerns ahead of those of the corporation. 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.3

Claims for breach of the duty of loyalty may also arise when directors fail to act. Delaware courts have held: “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.”4 To hold a disinterested director liable for a breach of loyalty under Delaware law (i.e., for indolence in monitoring the company's affairs), the plaintiff must make a strong showing of misconduct.5

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.”6 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: (1) subjective bad faith, motivated by actual intent to do harm; (2) lack of due care, consisting of actions taken without malice, but as the product of gross negligence; and (3) 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.7 Gross negligence, without more, is not 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.”8 To rebut the presumption 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.”9

To obtain the protections of the business judgment rule, the officer or director must diligently and reasonably inform him or herself of all relevant facts, and cannot passively approve important transactions without undertaking any examination of the facts.10 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.11

Entering the “Zone of Insolvency ”

The foregoing rules seemed well established and widely accepted until the 1991 Delaware Chancery Court decision in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp.12 There, Chancellor Allen appeared to expand the director's duties to protect not only the corporation, but also its creditors: “[a]t 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.13

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 of an art than science. Boards, officers, and their counsel were often confused as to when their duties began to expand.

Courts in Delaware and elsewhere developed different interpretations of when the “zone of insolvency” arose—and how duties might change. After several years, however, the courts 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. 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, L.L.C. v. NCT Group, Inc.,14 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 rejected the notion that Credit Lyonnais had held that new duties arose in the “zone of insolvency.” “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.”15

Even though the Production Resources court did not reject the idea that directors owe 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.” 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, L.L.P.16 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 “deepening insolvency” as a cause of action under Delaware law. In doing so, the Court emphasized that directors 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.


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

In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla,17 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.18

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.”19

Not so Fast

A more 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), No. 10-4456 (3d Cir. 2011)(23 BBLR 1215, 10/6/11), the Third Circuit announced that: (1) while “deepening insolvency” may not be a viable cause of action under Delaware law, it is a viable cause of action under Pennsylvania law; (2) directors owe fiduciary duties to the creditors of an insolvent entity; and (3) 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 revitalize 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 the goal of transferring Lemington Home's principal charitable asset to an affiliate whose board was comprised 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: (1) the business judgment rule precluded the Committee's claims of breach; and (2) the Committee would be unable to show the fraud necessary to support a claim of deepening insolvency.

Liability for Negligence, not Just Gross Negligence.

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 held that directors could only be held liable for gross negligence.20 “Pennsylvania, however, recognizes directors' and officers' liability for negligent breach of fiduciary duty.” 21

Liability to Creditors, Not Just to Corporation.

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.” 22 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.

The Rebirth of Deepening Insolvency.

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.”23

Failure to Disclose May Amount to Fraud.

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 tending to 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; 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, that their actions would cause further insolvency, but 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. This language implies that a debtor which is insolvent, approaching insolvency, or 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.

Advising Directors and Officers Post-Lemington.

What should directors and officers do when faced with possible claims of deepening insolvency?

1. Stay current on the company's financial condition. Directors must have current financial data to make competent decisions. Failing to obtain that data may give rise to claims for breach of the duty of care.

2. Maintain records. Directors and officers should be able to demonstrate that they were thorough and diligent in reviewing the company's financial options. If advisors present alternative plans, directors should keep records of those presentations.

3. Communicate with key creditors. Lenders, employees, and critical vendors should hear regularly from directors and management about the company's prospects. One defense to a Lemington type fraud claim is disclosure.

4. Maintain strict neutrality. Avoid favoring one constituency over another. What is good for the employees must also be good for the lenders.

5. Avoid conflicts of interest. Insider deals—particularly when the company is in financial distress—will be closely scrutinized. Directors should avoid financial dealings with the company, or at least have those deals reviewed by a disinterested board.

6. Retain counsel and financial advisors. Dispassionate expert advice is the best defense against prior decisions. It will also provide defense against post-failure lawsuits.

7. Stay on board. A director who remains, even when time gets tough, will be able to influence the outcome, to earn goodwill, and possibly resolve or avoid personal liability claims. Leaving the company means losing input to the claims resolution process.

Jeffrey Baddeley is a partner in Ulmer & Berne's Cleveland office. He can be reached at jbaddeley@ulmer.com or 216.583.7036.

Disclaimer

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