Globally, businesses have been impacted by the novel coronavirus (COVID-19) pandemic. Some businesses have been disrupted or disappeared altogether, while others are hanging on for dear life. In these precarious times, directors and officers are placed in the unenviable position of managing financially troubled corporations. The corporation’s financial “temperature” will determine the fiduciary duty of a director and so it is important to pay attention to the numbers. A director must know when a corporation is approaching insolvency, also known as the “zone of insolvency,” versus when the corporation is insolvent.
1. A director’s fiduciary duty is to the shareholders when a corporation is approaching insolvency.
It is well established law, that a director’s fiduciary duty is to the shareholders of the corporation. A director must manage a solvent corporation for the benefit of the shareholders. As a corporation approaches the zone of insolvency, the director’s fiduciary duty does not change. In the seminal case of North American Catholic Educational Programming v. Gheewalla, 930 A.2d 92 (Del. Supr. 2007), the Supreme Court of Delaware stated that a director’s fiduciary duty does not shift from the shareholders to the creditors when a corporation is approaching insolvency. The Court noted that directors must continue to operate a corporation according to their business judgment in the best interest of the corporation and for the benefit of the shareholders. The Court observed that when a corporation is solvent, or in the “vicinity” of insolvency, only shareholders have the standing to bring derivative actions on behalf of the corporation, not creditors.
2. A director’s fiduciary duty is to the residual claimants when a corporation is insolvent.
When a corporation is insolvent, as determined by cash flow or the balance sheet, a director’s fiduciary duty shifts from the shareholders to the residual claimants. The residual claimants of an insolvent corporation include both the creditors and the shareholders. At this juncture, a director must still make decisions in the best interests of the corporation but must now consider the interests of the creditors as well as the shareholders. In Gheewalla, the Supreme Court of Delaware stated that once a corporation is insolvent, creditors can bring derivative action claims against a director for breach of fiduciary duty. This does not mean that a director needs to immediately shut down an insolvent corporation or start marshalling assets for dispersal to creditors – although in some instances, this may be the best option – but rather, that directors must exercise their best business judgment given the circumstances.
It may not always be clear whether a corporation is insolvent or not. Courts have not developed a bright-line test, but rather, they generally rely on one of three tests: the cash flow test, the small capital test, and/or the balance sheet test. Since there is no bright-line test, directors of corporations must closely monitor their company’s finances to determine if a business is approaching insolvency or is insolvent. When making decisions, directors should always use their best judgment and take into account their fiduciary duties to the shareholders versus their fiduciary duty to residual claimants (shareholders and creditors). A creditor can only file a derivative claim against a director or officer post-insolvency. Keeping these associated risks in mind, it is imperative that directors or officers of corporations facing financial troubles immediately seek the counsel of an experienced bankruptcy attorney to guide them through these murky waters.
About the author
Augusta Massey, Esq. is the Managing Partner of Massey & Associates Law Firm, PLLC and serves as the President of the Las Vegas Chapter of the National Bar Association.
About this article
This article was originally published in the “Bankruptcy Law” issue of Communiqué, the official publication of the Clark County Bar Association, (April 2021). See https://clarkcountybar.org/about/member-benefits/communique-2021/communique-april-2021/.
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