Company Law

Traditional concept of fiduciary duties

As a general rule, the directors of a solvent corporation owe fiduciary duties to the equity security holders, rather than to creditors. LaSalle National Bank v Perelman (D Del 2000) 82 F Supp 2d 279; In re Schepps Food Stores (Bankr SD Tex 1993) 160 BR 793; Advising & Defending Corporate Directors and Officers §10.22 (Cal 1998). If the company is definitely balance-sheet insolvent, however, the directors’ fiduciary duty is owed to the corporation and its creditors because the equity security holders by definition have nothing of value to protect. In re Mortgage & Realty Trust (Bankr CD Cal 1996) 195 BR 740, 750; Advising & Defending Corporate Directors and Officers §10.22.

Balance sheet insolvency versus insolvency

Although the rule is simply stated, it is often difficult to apply, because balance-sheet solvency versus insolvency can be difficult to determine. See 11 USC §101(32); Grey v Ingersol Publications Corp. (Del Ch 1992) 621 A2d 784; Credit Lyonnais Bank v Pathe Communications Corp. (Del Ch, Dec. 30, 1991, Civ A No 12150) 1991 WL 277613, 1991 Del Ch Lexis ¶215; 7 Collier on Bankruptcy ¶1108.09[4] [b]. It is therefore recognized that a fiduciary duty on the part of the directors arises in favor of creditors when a corporation enters the "zone of insolvency."

May directors be charged with a fiduciary duty to creditors while the corporation is solvent?

This question was recently faced by the directors of Silicon Valley based Covad Communications Group, Inc., as reported in the August 8, 2001 Wall Street Journal. According to the Wall Street Journal article, " . . . [b]ondholders grew so alarmed about the rate at which companies were burning through cash that they moved to test a gray area in corporate law: When does a board’s fiduciary obligation broaden from just shareholders to include all creditors?" There was no question of Covad’s current solvency, but its board was so concerned about possible exposure to creditors that it agreed to the bondholders’ demand for early retirement of the bonds.

The Healthco decision

Recently, a bankruptcy court rendered a decision that may justify such concerns. In Brandt v Hicks, Muse & Co (In re Healthco Int’l) (Bankr D Mass 1997) 208 BR 288, 300 (Bankr D Mass 1997), the bankruptcy court considered the situation of a solvent company’s directors’ fiduciary obligations to creditors and held that directors of a solvent corporation may breach their fiduciary duties when they vote in favor of a transaction that benefits shareholders to the detriment of creditors, if the transaction leaves the corporation insolvent or with unreasonably small capital. See Barnett, Healthco and the "Insolvency Exception:" An Unnecessary Expansion of the Doctrine?, 16 Emory L Bankr Dev J 441 (2000).

A key point in the Court’s legal analysis in Healthco was that it saw the fiduciary duty of the directors to creditors as something " . . . similar to the concept of negligence, which is conduct that creates an unreasonable risk of harm to another’s person or property." Brandt v Hicks, Muse & Co (Bankr D Mass 1997) 208 BR 288, 302.

The element of "foreseeability"

By analogy to concepts of negligence sounding in tort, the court reasoned that the directors’ fiduciary duty is one that exists in favor of creditors at all times, and is anticipatory in nature, involving an element of foreseeability. A director with such a duty therefore would need to consider at all times whether a corporate action could ultimately injure not only shareholders, but also creditors.

A leap beyond traditional concepts

Such an extension of directors’ fiduciary responsibilities would certainly amount to a leap beyond traditional concepts of directors’ fiduciary duties and seems problematical. See, 16 Emory L Bankr Dev J at 461. However, as explained by Professor Barnett, the doctrine enunciated in Healthco might perhaps be understood where a board is considering action that will dramatically alter the financial picture of the corporation from comfortable balance-sheet solvency to a highly leveraged condition. In this situation, solvency will become relatively marginal after the contemplated corporate action is implemented.

Even so, Professor Barnett concludes that imposing a fiduciary duty on directors of a solvent corporation whose finances are outside a "zone of insolvency" is unwarranted and fraught with unacceptable risks for directors. Instead, he concludes that corporate actions that are manifestly egregious may, in appropriate cases, be checked through actions by creditors for injunctions or receiverships.

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