The Duties of Directors in Uncertain Times
The Business Advisor
October 22, 2008
The current economic uncertainty and financial challenges confronting all businesses heighten even more the already amplified vigilance that is expected of the directors and senior management of corporations. Since creditors and shareholders of troubled companies increasingly look to the directors and senior officers as potential sources of recovery for losses attendant to business failures, individuals serving in such positions need to be well acquainted with their legal duties and, of course, the scope and coverage limits of liability insurance.
This article will review the basic rules of corporate governance, how they change when a company confronts severe financial difficulties, and standards of conduct that, if complied with, should mitigate against the assertion of breach of duty claims or, at least, provide the basis for a sound defense. While the legal principles cited are derived from Delaware law, such principles are generally followed in other jurisdictions.
Basic Rules of Corporate Governance
The board of directors and senior management of a solvent company owe fiduciary duties to the corporation and its shareholders. Generally, no such duties are owed to creditors of a solvent company. Rather, the obligations owed to creditors are defined by the terms of the contract giving rise to the obligation. The fiduciary duties owed to the corporation and its shareholders include the duty of loyalty and the duty of care.
The duty of loyalty imposes an obligation to refrain from conduct that is either harmful to the corporation and its shareholders or is solely in the directors’ or officers’ own interests. The duty of good faith is a subsidiary element of the duty of loyalty and requires that directors and officers act in a manner that they believe to be in the best interests of the corporation.
The duty of care requires that directors and officers act with the care an ordinarily prudent person would exercise under similar circumstances and includes a requirement that, prior to making a business decision, they inform themselves of all material information available to them, including reasonable alternative courses of action.
In discharging the duties of loyalty and care, directors are entitled to rely on management and the advice of professional advisors who are experts in their fields, provided that the directors have no independent basis for not relying on such advice. Directors and officers are entitled to a presumption that in making a business decision they have acted “on an informed basis, in good faith and in the honest belief that the action was taken in the best interests of the company.” Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985). This is the so-called “business judgment” rule.
What Happens when a Corporation Becomes Insolvent?
When a corporation enters the zone of insolvency or actually becomes insolvent, the fiduciary duties expand and extend to creditors, in addition to the corporation and the shareholders. In essence, this means that directors and officers of an insolvent corporation should endeavor to maximize the value of the enterprise, rather than attempt to maximize value for any one particular constituency. When a corporation is insolvent, the creditors’ influence expands as they are the holders of the economic interests most likely to be impacted by decisions of management and the board. However, while the constituencies to whom duties are owed expand, the nature of the duties of loyalty and care and the benefits and requirements of the application of the business judgment rule remain the same.
Indeed, an insolvent company is not required to shut down and liquidate if the company’s directors believe that the continuation of operations will maximize the value of the company. Moreover, in what has been perceived as good news for corporate boards, Delaware courts have recently held that the general rule that fiduciary duties expand to include creditors does not give rise to direct causes of action by creditors against directors and officers if the creditors believe such duties have been breached. Such claims for breach of fiduciary duty belong solely to the corporation, not to any particular corporate stakeholder, and may only be asserted derivatively, in other words on behalf of the corporation, if the corporation does not assert the claim itself.
In addition to the continuing application of the business judgment rule, recent decisions have also made it clear that directors threatened by aggressive creditor groups continue to be protected by exculpatory provisions contained in the corporation’s certificate of incorporation. Under § 102(b)(7) of the Delaware General Corporation Law, a corporation may eliminate personal liability for breaches of the duty of care. Liability may not be eliminated for breaches of the duty of loyalty. The New Jersey Business Corporation Act contains a similar provision at N.J.S.A. 14A:2-7(3).
Recent Lessons from a Delaware Bankruptcy Court Decision
However, Bridgeport Holdings Inc. Liquidating Trust v. Boyer (In re Bridgeport Holdings, Inc.), 388 B.R. 548 (Bankr. D. Del. May 30, 2008) demonstrates that directors and senior management of companies that are either insolvent or in the zone of insolvency must affirmatively make reasonable, deliberate and well-informed decisions to be afforded the protections of an exculpatory charter provision and the business judgment rule.
In Bridgeport Holdings, following a leveraged buyout, the company’s financial position deteriorated and ultimately the company was in a Chapter 11 proceeding. A liquidating trust asserted various breach of fiduciary duty claims alleging that the directors and officers failed to consider potential restructuring or sale alternatives, abdicated decision-making authority to a restructuring advisor and acquiesced to the restructuring advisor’s decision to sell the assets of the company immediately prior to filing for bankruptcy protection, rather than pursuant to a “Section 363” sale under bankruptcy court supervision.
More specifically, the liquidating trust alleged that there were various options to preserve enterprise value including finding a new investor, completing a strategic M & A transaction or restructuring indebtedness with a new lender. The court denied dismissal of breach of duty of loyalty claims stating that “a claim for breach of loyalty may be premised upon the failure of a fiduciary to act in good faith” and that the liquidating trust had sufficiently alleged that the officers and directors had acted in bad faith by abdicating their duties to the company.
Moreover, the court determined that invoking the business judgment rule was insufficient to dismiss plaintiff’s claims because, viewing the allegations most favorable to plaintiff, the directors and officers had failed to inform themselves, prior to approving the sale of assets, of all material information reasonable available to them. They had not hired an investment banker to value the assets or shop the deal. They did not obtain a fairness opinion and they did not seek offers from other potential purchasers.
In sum, failure by a board to discharge its responsibilities or even a delegation of duties to corporate officers may become problematic. Thus, directors and officers of financially distressed companies need to consult with professional advisors and take care in making reasoned decisions after establishing a record of their efforts to maximize enterprise value.