It is well established that when a corporation is insolvent, its officers and directors owe fiduciary duties not only to the corporation and its shareholders, but to the corporation's creditors as well. Under a relatively recent but widely accepted theory, courts have held that the fiduciary duties of directors and officers have been expanded to include the corporation's creditors when the corporation is in a financially troubled situation and approaching insolvency.
The obvious question for corporate officials and those who advise them is: At what point prior to insolvency do the fiduciary obligations of officers and directors shift to include creditors? This article summarizes the circumstances that may give rise to a shift of fiduciary duties to creditors, and describes the duties that may be owed when a corporation is in the vicinity of insolvency.Shifting Fiduciary Duties In the 'Zone' of InsolvencyThe rules regarding fiduciary duties applicable to solvent corporations become more complicated when a corporation is financially troubled. Officers and directors continue to have fiduciary responsibilities, but they are no longer limited to the corporate entity and its shareholders. When a corporation becomes financially troubled, a shift occurs in the fiduciary role of its officers and directors, who must more actively and consciously consider the interests of the corporation's creditors when making decisions.
While it is undisputed that these fiduciary duties to creditors vest when a corporation is insolvent or initiates an insolvency proceeding, many courts have expanded the time when directors and officers owe fiduciary duties to creditors to include the period when the corporation is in the vicinity of insolvency or the "zone" of insolvency. The theory behind expanding the scope of fiduciary duties to include creditors at the pre-insolvency stage is that creditors may no longer be adequately protected by the agreements they negotiated with the corporation and so they need additional extra-contractual protections. As many courts have stated, to impose obligations on the directors and officers to the corporation's creditors only when insolvency is undisputed may be too late, given the critical operational and financial decisions made just prior to being declared officially insolvent.
The doctrine of expanding the fiduciary duties of directors and officers in the pre-insolvency period is relatively young, but has been widely accepted. The genesis of the doctrine is the Delaware Chancery Court's seminal decision in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp ., 1991 WL 277613 (Del. Ch. 1991). The court gave the following explanation for the shift in duties: "[W]here a corporation is operating in the vicinity of insolvency, a board of directors is not merely the agent of the residue risk bearers [the shareholders], but owes its duty to the corporation enterprise. [D]irectors [should] recognize that in managing the business affairs of a solvent corporation in the vicinity of insolvency, circumstances may arise when the right (both the efficient and fair) course to follow for the corporation may diverge from the choice that the stockholder ... would make if given the opportunity to act." Id. at 35. In other words, the duties to creditors may arise even where the corporation is actually solvent but is approaching insolvency.
The Credit Lyonnais decision -- which clearly departed from the prior bright-line insolvency test for imposing a shift of fiduciary duties -- created instant uncertainty for directors and officers in distressed situations. For the past 10 years, directors and officers have wondered whether their corporation has actually entered the "vicinity" or "zone" of insolvency. Despite the serious implication of expanding the scope of the fiduciary duties to creditors into the pre-insolvency status of a corporation, courts have given surprisingly little guidance on defining the "zone" of insolvency.
In other contexts, courts have historically utilized two definitions of insolvency: the so-called equity definition and the balance sheet definition. Under the equity insolvency definition, a corporation is insolvent when it is unable to pay its debts as they become due in the ordinary course of business. See, e.g., Shakey's. Inc. v. Caple, 855 F. Supp. 1035, 1042-43 (E.D. Ark. 1994); Parkway/Lamar Partners, L.P. v. Tom Thumb Stores, Inc., 877 S.W.2d 848, 850 (Tex. Ct. App. 1994), rehearing overruled (July 12, 1994), writ denied (Dec. 1, 1994).
Under the balance sheet insolvency definition, insolvency occurs when liabilities exceed the reasonable market value of assets held. See, e.g., In re Koubourlis, 869 F.2d 1319, 1321 (9th Cir. 1989); Clarkson Co. Ltd. v. Shaheen, 660 F.2d 506, 513 (2d Cir. 1981), cert. denied, 455 U.S. 990 (1982).
Consistent with the genesis of the doctrine (protecting creditors), it appears that courts analyzing fiduciary duties in troubled companies will apply the equitable insolvency test. At least one court has stated that the concept of "zone" of insolvency refers to the extent of the risk that creditors will not be paid, rather than to balance sheet insolvency. In re Ben Franklin Retail Stores, Inc., 225 B.R. 650, 655 (Bankr. N.D. Ill. 1998). See also Credit Lyonnais, 1991 WL 277613 at 34 n.55 (stating "vicinity of insolvency" exists where corporation was balance sheet solvent, but where there was a risk that creditors would not be paid).
However, unfortunately, virtually no guidance exists in defining the "vicinity" or "zone" of insolvency itself. It does seem evident that a corporation may be in the "zone" of insolvency despite having a functioning solvent operation if the risk of future non-payment to creditors is sufficiently evident. Indeed, the greater the risk to creditors, the more likely a court -- with the benefit of hindsight -- will conclude that the corporation was in the vicinity of insolvency and that fiduciary duties were owed to creditors.
Given the spectrum of financial positions for a company, and the dynamic ongoing processes when a corporation first experiences financial distress, ultimately, the determination of whether a corporation has entered the "zone" of insolvency will depend entirely on the facts and circumstances of a particular situation.Fiduciary Duties in the 'Zone'The directors and officers of a corporation in the "zone" of insolvency typically have the same fiduciary duties to creditors that would exist if the corporation were in fact insolvent. As a general rule, the law provides that directors of the insolvent corporation owe the same duties of loyalty and care to creditors as those that run to shareholders when the corporation is solvent. In re O.P.M. Leasing Servs., Inc., 28 B.R. 740 (Bankr. Del. 1983). In essence, the people to whom the directors and officers owe a duty changes, but as a general proposition, the duties do not. Nevertheless, directors and officers in financially troubled situations face particular challenges in dealing with the business enterprise.
In circumstances of financial distress where a corporation has entered the "zone" of insolvency, there can be a heightening of the existing obligation to attend to corporate affairs. Times of financial distress can call for special diligence and oversight, typically known as the "duty of obedience." Similarly, there can be a heightened duty of care with respect to the financial and operational decisions made by the directors and officers. Managers are obligated to act in good faith, and in a manner reasonably believed to be in the best interests of the enterprise.
In situations where a corporation is financially distressed, directors and officers must be acutely aware of any action that would benefit the shareholders to the detriment of the corporation's creditors, such as funding dividends or redemptions of stock, as well as any action that unnecessarily benefits one creditor over another.
As in situations where a company has not experienced any financial distress, in all circumstances while a corporation is in the "zone" of insolvency, directors and officers are required to exercise at least that degree of judiciousness in performing their duties as a careful and prudent person would exercise under similar circumstances. Careful counseling is a critical component of ensuring that directors and officers meet their fiduciary obligations.
 Courts are divided on the issue of whether directors and officers continue to owe fiduciary duties to shareholders once the corporation becomes insolvent or is in the vicinity of insolvency. Most courts (including those in Delaware) have taken the view that insolvency or near insolvency expands the duties of directors and officers such that they owe fiduciary duties to both creditors and shareholders. See Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613 at 34 (Del. Ch. 1991) (stating that where a corporation is operating the vicinity of insolvency, the directors owe duties not merely to shareholders but to the entire corporate enterprise, including the corporation's shareholders); Geyer v. Ingersoll Publications Co., 621 A.2d 784, 789 (Del. Ch. 1992) ("the existence of the fiduciary duties at the moment of insolvency may cause directors to choose a course of action that best serves the entire corporate enterprise rather than any single group interested in the corporation at a point in time when the shareholders' wishes should not be the directors' only concern").
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This article is reprinted with permission from the April 2001 edition of The Bankruptcy Strategist. c 2001 NLP IP Company