Tcl - Fiduciary Duties of Directors of Financially Troubled Companies - September 2005 - Business Law Newsletter
| Publication year | 2005 |
| Pages | 61 |
2005, September, Pg. 61. TCL - Fiduciary Duties of Directors of Financially Troubled Companies - September 2005 - Business Law Newsletter
September 2005
Vol. 34, No. 9 [Page 61]
Business Law Newsletter
Fiduciary Duties of Directors of Financially Troubled Companies
by Sherri D. Way
This column is sponsored by the CBA Business Law Section to apprise members of current information concerning substantive law. It focuses on business law topics for the Colorado practitioner, including, but not limited to, issues surrounding antitrust, bankruptcy, business entities, commercial law, corporate counsel, financial institutions, franchising, nonprofit entities, securities law, and small business entities.
Column Editors:
David P. Steigerwald of Sparks Willson Borges Brandt & Johnson, P.C., Colorado Springs - (719) 475-0097, dpsteig@sparkswillson.com; Rob Fogler of Kamlet Shepherd & Reichert LLP - (303) 825-4200, rfogler@ksrlaw.com
About The Author:
This month's article was written by Sherri D. Way, Denver, a partner in the law firm of Krendl Krendl Sachnoff & Way, P.C., where she specializes in corporate, insurance, and securities law - (303) 629-2600, sdw@krendl.com.
This article discusses a recent case that addresses whether and to what extent the interests of creditors must be considered in decision-making for nearly insolvent corporations, providing much-needed guidance for those steering corporations through troubled times.
A number of courts have grappled with issues pertaining to the fiduciary duties of corporate directors and officers to the creditors of financially distressed corporations. In November 2004, the Delaware Chancery Court again addressed the issue in Production Resources Group, L.L.C. v. NCT Group, Inc.1 Production Resources provides directors and their counselors with much-needed guidance for steering corporations through troubled times.
The recently retired Chief Justice of the Delaware Supreme Court, Norman E. Veasey, noted the challenging nature of issues involving whether and to what extent corporate directors must consider the interests of creditors when a corporation is in the vicinity of insolvency.2 Colorado courts have yet to publish a decision expressly addressing fiduciary duties of corporate directors to creditors of nearly insolvent entities. However, inasmuch as Delaware law often influences decisions on corporate fiduciary duty in Colorado, as in other jurisdictions, Colorado practitioners may benefit from that jurisdiction's seasoned review of this challenging area.
This article is intended to provide practitioners with a basic understanding of what fiduciary duties may be owed by corporate directors of corporations that either are insolvent or approaching insolvency. It reviews the Production Resources case, where the court conducts a robust discussion of whether: (1) directors must consider the interests of creditors in making decisions for nearly-insolvent corporations; (2) exculpatory provisions typically included in the debtor's articles of incorporation will insulate the directors of insolvent corporations from creditors' claims; (3) the business judgment rule will apply to decisions made; and (4) various claims made by creditors are generally derivative or direct.
Fiduciary Duties to Creditors: Background
The nature of the fiduciary duties owed by directors to a corporation's creditors, whether the corporation is solvent or insolvent, is generally established. Absent special circumstances, directors typically do not owe duties to creditors of a solvent corporation beyond the relevant contractual terms.3 However, when a corporation becomes insolvent, directors become subject to fiduciary obligations to creditors.4 Moreover, under Colorado law, if a corporation is insolvent, its directors are deemed to be trustees for the corporation and its creditors.5
Approximately twelve years ago, the Delaware Court of Chancery first addressed the murky area of the fiduciary duties owed by directors of a Delaware corporation to its creditors when the corporation is in the tenuous "zone" or "vicinity" of insolvency. In Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp.,6 the dispute arose in the context of a leveraged buyout of MGM-Pathe Communications Co. ("MGM"). In an opinion authored by then-Chancellor William T. Allen, the court determined that the corporation had begun to falter financially almost immediately after consummation of the buyout transaction.
In a now well-known footnote - footnote 55 - the Chancellor remarked that the specter of insolvency can do "curious things to incentives" and that creditors could be exposed to "risks of opportunistic behavior."7 To demonstrate, the court constructed a detailed example of how the interests of a corporation's stockholders might differ from those of its creditors. It posed a hypothetical where a corporation with an equity value of $3.55 million and $12 million owing to bondholders had a $51 million judgment (its only asset) currently being appealed by a solvent entity. This judgment had an expected value on appeal of $15.55 million, and an offer to settle was available at $12.5 million.8
In this circumstance, preferences of creditors would differ considerably from those of the stockholders. The court speculated that creditors likely would favor a settlement offer of anything above $12.5 million. However, stockholders probably would oppose anything at or approximating that amount, because they would receive substantially no benefit. In fact, it was surmised that stockholders might even oppose a settlement at $17.5 million.9
The court rationalized that if the corporation's "community of interests" was considered, a settlement offer should be accepted if it were available at $15.55 million or above.10 Under this hypothetical, the court indicated that if the directors were to consider only the interests of the corporation's stockholders, the above result would not be reached. Thus, the court remarked that
[i]n managing the business affairs of a solvent corporation in the vicinity of insolvency, circumstances may arise when the right (both the efficient and the fair) course to follow for the corporation may diverge from the choice that the stockholders (or the creditors, or the employees, or any single group interested in the corporation) would make if given the opportunity to act.11 (Emphasis added.)
Concluding that MGM's chief executive officer was "appropriately mindful" of the potential differing interests between the corporation and its 98 percent stockholder, the court recited that "[a]t least where a corporation is operating in the vicinity of insolvency, a board of directors is not merely the agent of the residue risk bearers, but owes its duty to the corporate enterprise."12
Defining the "Zone" or "Vicinity" of Insolvency
There currently exists no universally accepted test for determining whether a corporation is operating in the "zone" or "vicinity" of insolvency. However, Delaware courts expressly have eschewed the theory that the zone of insolvency commences with the initiation of a proceeding in bankruptcy. Instead, they have opted for a determination based on whether the corporation is "insolvent in fact."13 Two tests have been used to determine insolvency issues: the balance sheet test and the equitable (cash flow) test.14
Balance Sheet Test
In the "balance sheet" test, courts address whether a corporation's liabilities exceed the reasonable market value, or "fair value," of its assets.15 In applying the balance sheet test, courts must consider how fair value will be determined under the applicable circumstances. For example, whether a corporation's assets are valued on a going-concern basis or a liquidation basis can produce significantly different results. Citing In re MFS/Sun Life Trust-High Yield Series,16 the court in Joy Recovery Technology Corp. v. Chang17 remarked that, as a general rule, fair market value (that is, the value a willing buyer would pay for the assets as a going concern) should be used to value assets "unless a company is on its deathbed."18
Even assuming the position articulated in Joy Recovery were to be adopted as the general rule in other jurisdictions, a number of additional factors must be considered in arriving at fair value. These likely would include methods of discounting and adjustments to income - both of which make the determination of when a corporation is insolvent, or in the zone of insolvency, a difficult and uncertain proposition. Moreover, the Delaware Court of Chancery has recognized that it would be impracticable for the sole indication of insolvency to be whether a corporation's liabilities exceeded its assets, particularly when considering the business realities common with start-up companies.19
Equitable (Cash Flow) Test
Courts also have applied an "equitable" test (sometimes referred to as a "cash flow" test) to evaluate whether a corporation is able to pay its debts as they come due.20 Under the equitable test, a company would be deemed to be insolvent if it was unable to pay its debts as they fell due in the usual course of business.21
The Pereira Decisions
Purporting to apply Delaware law, the court in Pereira v. Cogan ("Pereira I")22 applied both a balance sheet test and a cash flow test in determining that the debtor had been operating in the zone of insolvency for nearly all of its existence.23 In applying this cash flow test, the court reviewed: (1) whether the debtor corporation was able to pay its debts as and when they became due; and (2) the debtor corporation's ability to obtain enough cash to pay for its projected obligations and fund its business requirements for working capital and capital expenditures with a reasonable cushion to cover the variability of its...
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