Director Fiduciary Duties: Additional Risks in Times of Financial Distress

In the face of deteriorating financial conditions for a business, directors should revisit the fiduciary duties they owe to the business and be particularly attuned to the question of which parties are the proper beneficiaries of those duties. Those beneficiaries can change quite significantly in times of distress, exposing directors to potential liability. This alert is intended to provide practical guidance for directors of companies incorporated under Delaware law, particularly in the context of a business that is or may become insolvent.

Core Fiduciary Duties

The fiduciary duties owed by directors to a Delaware corporation are well known.¹ The two core fiduciary duties are:

• The duty of care - requires directors to make informed decisions after considering all important and reasonably available information; and
• The duty of loyalty - requires directors to act in a disinterested and independent manner with the good faith belief that such actions are in the best interest of the corporation.

Under Delaware law, courts generally evaluate transactions and decisions approved by directors under the deferential “business judgment rule” and will not second guess the board if directors’ actions can be attributed to a rational business purpose. However, in certain circumstances, particularly if directors have conflicts of interests or are approving related party transactions, courts may apply the much more rigorous standard of “entire fairness,” which puts the burden of proof on directors to demonstrate affirmatively that the transaction or decision is “entirely fair” from both a procedural and a substantive point of view.

Beneficiaries of Fiduciary Duties Before and After Insolvency

Directors owe fiduciary duties of care and loyalty to the corporation. So long as a corporation remains solvent, these duties are to be exercised for the benefit of the common equity holders of the corporation and not for holders of preferred interests or creditors. Under Delaware law, this is true even as a corporation approaches the “zone of insolvency” but is not yet insolvent.

However, once a Delaware corporation becomes insolvent, the same fiduciary duties owed to the corporation must take into account both the corporation’s common equity holders and its creditors. Importantly, this does not necessarily mean that when a corporation enters insolvency its directors must only consider creditor-focused alternatives. Rather, directors are still able to pursue strategies that are in the best interest of the corporation as a whole.

When does insolvency occur?

Under Delaware law a corporation is considered to be insolvent if its liabilities exceed the value of its assets or if the corporation is unable to meet its obligations as they become due. In a deteriorating situation, the point in time at which either of these types of insolvency occurs is often not clear and is difficult to ascertain. To complicate matters, a solvency (or insolvency) determination is more likely to be challenged by an interested party with the benefit of hindsight, often during bankruptcy or litigation proceedings. Therefore, as a practical matter, fiduciaries should be increasingly aware of the interests of the corporation’s creditors as the corporation’s situation deteriorates and the line between solvency and insolvency begins to blur.

Tips for Properly Discharging Fiduciary Duties in a Distressed Situation

The following practical considerations and actions are intended to help directors properly discharge their fiduciary duties and reduce potential individual liability for breaches of fiduciary duties. However, given the fact-intensive nature of fiduciary obligations, directors should consult with counsel about their fiduciary duties in the context of their company’s specific circumstances. In general, directors should:

• Take actions on a reasonable and informed basis and avoid self-interest;
• More so than ever, remain vigilant in maintaining proper formalities, board processes and corporate recordkeeping in order to document each decision-making process, which can be important factors in litigation proceedings;
• Ensure that the company has available at all times sufficient unencumbered cash to fund its payroll and related obligations as they become due. Directors can be personally liable for shortfalls in such payments;
• Seek to maximize value of the corporation while taking into consideration the interests of both common equity holders and creditors, which may differ in times of financial distress;
• Regularly monitor all aspects of the business’ performance, its ability to meet contractual obligations and its need for, and the availability of, additional funding (including federal, state and local government assistance programs);
• Seek input and expert opinions from financial and legal advisors (including in order to navigate potential insolvency, track when insolvency may occur and obtain third-party valuations before engaging in significant transactions);
• Make use of special committees of disinterested and independent board members to evaluate and negotiate conflict of interest transactions;
• Re-assess any planned dividends and equity repurchases;
• Maintain detailed corporate records; and
• Assess the need to engage with existing lenders to renegotiate credit facilities for debt service extensions or other relief.

Additional Tips for Protecting Directors

In order to minimize the potential for individual director liability, companies should also:

• Review coverage amounts and terms of director and officer insurance policies and understand whether there are exclusions that would eliminate coverage in the event that the company ceases operations or files for bankruptcy protection; and
• Review exculpation clauses in corporate charters and limited liability company agreements to understand the liability protections that may be afforded under such provisions.

LLC Fiduciary Duties & Creditor Remedies

In general, the same fiduciary duties that are owed by directors to a Delaware corporation are also owed by managers to a Delaware limited liability company, unless the LLC agreement contains an express waiver of such fiduciary duties.

It is well established that a creditor of a Delaware corporation may gain standing to assert a derivative claim for alleged breaches of fiduciary duties against directors if the corporation becomes insolvent. However, this is not necessarily true of Delaware LLCs and other alternative entities such as limited partnerships. Some courts have held that, even when an LLC is insolvent, creditors of an LLC do not have standing to bring a derivative claim for alleged breaches of fiduciary duties. These courts have ruled that, due to the specific language of the Delaware LLC statute, only the members of the LLC or their assignees have standing to bring a derivative claim. This could effectively leave creditors with a right but not a remedy.

Further complicating matters, where the LLC agreement contains an express waiver of fiduciary duties – as permitted by Delaware law – this may create an additional obstacle when creditors seek remedies for alleged breaches of fiduciary duties. The entire area of creditor rights and remedies in an LLC setting is likely to be the subject of controversy and litigation in the coming months and years.

Conclusion

Although parts of the world begin to slowly emerge from stay-at-home orders driven by the COVID-19 pandemic, companies of all sizes across a wide range of industries may continue to see economic headwinds. Directors faced with leading companies through these challenging times will benefit from a clear understanding of their fiduciary duties - for the benefit of various constituencies - before, during and after times of financial distress.

 

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¹Private equity funds and other investors should also note that, under Delaware law, stockholders who are either (1) majority owners or (2) minority owners with additional contractual or other rights giving them unusual levels of influence over the corporation may be deemed to be “controllers” of the corporation and, as such, may themselves also have fiduciary duties. Officers also have fiduciary duties under Delaware law.