Delaware Supreme Court Limits Scope of “Zone of Insolvency” Fiduciary Duties
In a significant Delaware law decision regarding creditors’ ability to sue corporate fiduciaries, the Delaware Supreme Court recently addressed the issue of whether a corporate director owes fiduciary duties to the creditors of a company that is insolvent or in the “zone of insolvency.” In North American Catholic Educ. Programming Found., Inc. v. Gheewalla, the court concluded that directors of a solvent Delaware corporation that is operating in the zone of insolvency owe their fiduciary duties to the corporation and its shareholders, and not creditors. The court also ruled that the fiduciary duties of directors of an insolvent corporation continue to be owed to the corporation. In the case of an insolvent corporation, however, creditors, as the true economic stakeholders in the enterprise, have standing to pursue derivative claims for directors’ breaches of fiduciary duty to the corporation.
North American Catholic Educational Programming Foundation, Inc. (the “Foundation”) held certain radio-wave spectrum licenses. The Foundation then joined with other license holders and, in March 2001, all of them entered into a master agreement with Clearwire Holdings, Inc. (“Clearwire”), a Delaware corporation. Goldman Sachs & Co. (“Goldman Sachs”) provided funding to Clearwire and appointed three directors to Clearwire’s board of directors. Each of these three directors worked for Goldman Sachs.
Under the master agreement, Clearwire agreed to acquire the spectrum licenses of the Foundation and the other license holders for $24.3 million. In June 2002, however, the market for wireless spectrum collapsed, making available a surplus of spectrum. Clearwire entered into negotiations with the Foundation and the other license-holders to rid itself of its obligations under the master agreement. Eventually, Clearwire reached an agreement with all of the license holders except for the Foundation. By October 2003, Clearwire had been unable to obtain any further financing and effectively went out of business.
The Foundation sued the Goldman Sachs directors, alleging, among other things, that the directors had breached their fiduciary duties to the Foundation. According to the Foundation, because Clearwire was either insolvent or in the zone of insolvency, the Goldman Sachs directors owed fiduciary duties to the Foundation, as a substantial creditor of Clearwire. Notably, the Foundation’s complaint asserted a “direct” cause of action — i.e., one alleging particularized harm to the Foundation individually — for breach of fiduciary duty. In fact, the Foundation waived any claims it could have pursued derivatively.
The Goldman Sachs directors moved to dismiss the complaint on the ground that, among other things, as a matter of law, creditors of a Delaware corporation that is insolvent or within the zone of insolvency are unable to assert direct claims against directors for breach of fiduciary duty. The Delaware Chancery Court agreed with the directors and dismissed the complaint, although it dismissed one of the claims for failure to satisfy pleading requirements.
The Delaware Supreme Court’s Ruling
On appeal, the Delaware Supreme Court affirmed the decision of the Delaware Chancery Court. The court first turned its attention to whether Delaware law recognizes a creditor’s right to bring direct fiduciary-duty claims against the directors of a corporation operating in the zone of insolvency. In holding that Delaware law does not recognize such a right, the court explained:
When a solvent corporation enters the zone of insolvency the focus for Delaware directors does not change: Directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.
The court also noted that creditors, unlike shareholders, already have a host of protections available to them, including contractual agreements, security instruments, the implied covenant of good faith and fair dealing, and fraudulent conveyance laws, that “render the imposition of an additional, unique layer of protection through direct claims for breach of fiduciary duty unnecessary.” The court also agreed with the Chancery Court’s reasoning that:
[A]n otherwise solvent corporation operating in the zone of insolvency is one in most need of effective and proactive leadership — as well as the ability to negotiate in good faith with its creditors — goals which would likely be significantly undermined by the prospect of individual liability arising from the pursuit of direct claims by creditors.
The court also closed the door on a creditor’s right to bring a direct breach of fiduciary duty claim against directors of an insolvent corporation. The court reasoned that such a right would create uncertainty for directors who have a fiduciary duty to exercise their business judgment in the best interests of an insolvent corporation. According to the court, a direct right of action would create a conflict between the duty of the directors to “maximize the value of the insolvent corporation for the benefit of all of those having an interest in it, and the newly recognized direct fiduciary duty to individual creditors.” The court explained that it is important to allow a director to “engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation.” The court did not, however, leave creditors without recourse for a breach of fiduciary duty by a director. It made clear that creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for a breach of fiduciary duty.
Gheewalla provides important guidance to directors, creditors and their professionals. It establishes that, irrespective of whether a Delaware corporation is within the zone of insolvency or insolvent, individual creditors cannot assert direct claims for breach of fiduciary duty against directors. In the case of an insolvent corporation, however, creditors can assert derivative claims on behalf of the corporation against directors. It should be noted that the ruling is limited to breach of fiduciary duty claims: it does not restrict other kinds of claims or rights that may be asserted by creditors directly against a corporation under a contract, agreement or applicable law. Also, the ruling may engender increased litigation over when a corporation becomes “insolvent” and which parties should have the right to prosecute derivative claims.
North American Catholic Educ. Programming Found., Inc. v. Gheewalla, 2007 WL 1453705 (Del. May 18, 2007).