United States: Are you in the Zone? Additional Duties Imposed on Directors of a Corporation in the "Zone of Insolvency"

Directors of a public or private corporation know very well that they serve in a fiduciary capacity to shareholders of the corporation and must, at all times, fulfill duties of care, loyalty, and good faith for the benefit of the corporation and its shareholders. In most instances, a director’s fiduciary obligations begin and end with the shareholders.

The obligations shift once a corporation becomes insolvent and their fiduciary duties extend to the creditors of the corporation. Courts reason that once the corporation becomes insolvent, or enters the "vicinity of insolvency," the corporate assets are held in trust for the benefit of creditors, causing the directors to become trustees with a fiduciary duty the creditors. The economic rationale for the "insolvency exception," also known as the "trust fund doctrine" or the "zone of insolvency," is that the value of creditors’ contract claims against an insolvent corporation may be affected by the directors’ business decisions.

The fiduciary duty owed by a director or controlling shareholder of an insolvent corporation requires that the controlling shareholder/director of the debtor maximize the value of the assets for unsecured creditors. Directors or officers of an insolvent corporation may be held strictly accountable or liable to the general creditors if the corporate funds or property are wasted or mismanaged.

The vast majority of cases that have held a director or officer liable for breaching the fiduciary duty to creditors involve some form of self-dealing, fraudulent conveyances, or preferences. However, the risk of liability is not limited to such situations.

The Eighth Circuit and Minnesota courts have taken a narrow view of the "trust fund doctrine" by limiting the extent of the directors’ fiduciary duties to creditors to prohibit self-dealing or insider preferences. Although these cases characterize the preferential transfers or encumbrances as a breach of the insider’s fiduciary duty to creditors of an insolvent corporation, the analysis is no different than a garden-variety preferential transfer analysis. See e.g., Helm Fin. Corp v. MNVA Railroad, Inc., 212 F. 3d 1076. 1081 (8th Cir. 2000).

Other courts have extended the directors’ fiduciary duty to creditors of an insolvent corporation to minimize loss upon insolvency. The court in New York Credit Men’s Adjustment Bureau v. Weiss, 110 N.E. 2d 397 (NY Ct. App. 1951) imposed on directors the burden of going forward to show that their action in selling inventory at a public auction at a time when the corporation was insolvent resulted in obtaining full value under the circumstances and did not occasion an improper or improvident depletion of creditor property. Similarly, the court in In re Ben Franklin Retail Stores, Inc., 225 B.R. 646 (Banter N.D. Ill. 1998) indicated that causing unwarranted claims to assets is a way of diverting them from appropriate corporate uses and that directors who cause debt to be incurred may be in breach of their duties to creditors.

Finally, one important Delaware decision has taken an expansive view of a director’s fiduciary duties to creditors of an insolvent corporation to "maximize the corporation’s long-term wealth-creating capacity." See Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613, at *34 (Del. Ch. Dec. 30, 1991). The board or executive committee had an obligation to exercise judgment in an informed, good faith effort because, where a corporation is operating in the vicinity of insolvency, a board of directors is not merely the agent of the risk bearers, but owes its duty to the corporate enterprise.

The business judgment rule protects directors by preventing courts from "second guessing" directors’ actions, and its effect is to require a showing of more than simple negligence to establish recovery for a breach of the duty of care. Under this rule, it is presumed that 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. Where that presumption is rebutted, the rule will not protect a director. Those cases that apply the "trust fund" theory of liability generally do not recognize the protections afforded directors by the business judgment rule.

As an alternative basis for liability, creditors may be able to argue that directors are liable for causing the "deepening insolvency" of a company. The Third Circuit has recognized the "deepening insolvency" theory as a viable basis for liability against directors and officers of an insolvent corporation. See Official Committee of Unsecured Creditors v. R.R. Lafferty & Co., Inc. ("Lafferty"), 267 F.3d 340 (3d Cir. 2001). This theory is based upon the premise that a corporate body may seek damages resulting from an injury to the corporation arising from the wrongful expansion of the debtor’s debt out of all proportion of the debtor’s ability to repay, which ultimately forces the debtor to seek bankruptcy protection. Thus, creditors may be able to assert a claim against officers or directors for causing the corporation to incur unwieldy debt, which undermines the corporation if the directors or officers conceal the true financial condition of the corporation or otherwise act in a fraudulent manner for their personal gain.

Application of any of the legal approaches to the scope of fiduciary duties will be highly case specific.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.