This article was originally published in the March 2005 issue of The Bankruptcy Strategist, which is published by Law Journal Newsletters, a division of ALM Production Resources: ARetreat from the Law on Fiduciary Duties to Creditors of Insolvent Companies or Merely an Explanation of Standing Requirements? By Russell C. Silberglied and Kimberly D. Newmarch 1 In the current environment of increasing scrutiny of corporate behavior after corporate scandals such as Enron and Worldcom, lawsuits brought by creditors for breach of the fiduciary duties owed to them by officers and directors have increased significantly. The suits are taking center stage on the dockets of bankruptcy courts and state courts alike, and receive much public attention across the country. Against this backdrop, the Delaware Court of Chancery s November opinion in Production Resources Group, L.L.C. v. NCT Group, Inc. 2 is likely the most important pronouncement on the nature of fiduciary duty claims brought by creditors since the Court of Chancery s 1991 opinion in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp. 3 Certain to be widely cited, this lengthy and scholarly opinion also is likely to be misconstrued by many bankruptcy practitioners as signaling a retreat from settled law that directors and officers of insolvent Delaware corporations owe fiduciary duties to creditors. This article demonstrates that such a reading of Production Resources is incorrect. The article also discusses the holding of Production Resources that directors of a Delaware corporation can be exculpated from personal liability pursuant to section 102(b)(7) of the Delaware General Corporation Law even in suits commenced by creditors. This holding, which has already been followed by the United States District Court for the District of Delaware in Continuing Creditors Comm. of Star Telecommunications Inc. v. Edgecomb, 4 is the first such holding in Delaware and is contrary to cases from other jurisdictions.
A. Fiduciary Duties Owed to Creditors and Standing to Maintain Suit. Ordinarily, a corporation s directors and officers only owe fiduciary duties to the company s stockholders. 5 However, it is well established that once a Delaware corporation becomes insolvent, regardless of whether the corporation has filed for bankruptcy protection, the fiduciary duties of the corporation s directors expand 6 and allow them to take into account the interests of the company s creditors as well as the interests of stockholders. 7 Moreover, in its famous passage in Credit Lyonnais, the Court of Chancery stated that even if a company is not insolvent, directors can consider the interests of creditors if a company is in the zone or the vicinity of insolvency. 8 Armed with this case law, creditors, as well as Chapter 7 trustees, creditors committees and Chapter 11 liquidating trusts, have increasingly begun to second guess the actions of fiduciaries, arguing that directors or officers breached their duties to creditors while the company was insolvent or in the zone of insolvency. When these suits are commenced as adversary proceedings in a pending bankruptcy case, the question of who gets to control the suit rarely, if ever, is an issue: either the trustee, the debtor in possession (usually through new management) or the liquidating trust pursues the action directly, or the creditors committee -- often with the consent of the debtor in possession -- moves the bankruptcy court for permission to prosecute the litigation. However, where an aggrieved creditor of an allegedly insolvent, but not yet bankrupt company wants to challenge the decisions of the current management of the corporation, struggles for control of the litigation -- including whether it should be pursued -- are likely to follow. It was with this backdrop that Production Resources was filed by a creditor of non-debtor, but allegedly insolvent, NCT Group, Inc. in the Delaware Court of Chancery. In 2
commenting about the nature of this type of suit, Vice Chancellor Leo Strine stated that Credit Lyonnais and its progeny were not intended to create a new body of creditors rights law, or a sword to be wielded against corporate decision makers for making unfavorable decisions. 9 Rather, those cases which permit directors to consider creditors interests were intended to provide directors with a shield when sued by stockholders for breach of fiduciary duties. 10 In essence, without a body of case law acknowledging that directors of a troubled corporation can weigh the interests of creditors and stockholders, disgruntled stockholders would be able to argue that directors of troubled companies should always choose highly risky strategies that gamble away creditors recoveries in potentially vain hopes of recovering even a pittance for stockholders. Vice Chancellor Strine stated that Credit Lyonnais protects directors from such suits by acknowledging that in these circumstances, directors may consider and weigh the interests of stockholders and creditors alike, and are immune from liability under the business judgment rule so long as the decision they reach was informed and made in good faith without considering personal or outside interests. According to Vice Chancellor Strine, that same body of case law should not be turned on its head to create further risk for directors operating in this already perilous environment: a risk that if they choose a course of action favorable to stockholders, the creditors will sue, and if they conversely choose a course of action favorable to creditors, the stockholders will sue. However, Production Resources by no means stands for the proposition that Delaware courts no longer recognize any recourse for creditors if directors of an insolvent corporation breach their fiduciary duties. To the contrary, the Production Resources decision denied in relevant part a motion to dismiss a complaint filed by a creditor claiming breach of fiduciary duties. Instead, the Court of Chancery held that these are not claims that individual 3
creditors can assert, but rather are the corporation s claims. Thus, creditors of an insolvent company may obtain standing to sue directors derivatively for breach of fiduciary duties if they can meet the familiar demand-refused or demand-excused standards of Chancery Court Rule 23.1. Importantly, Vice Chancellor Strine seems to imply that such derivative standing should not be granted to creditors when a company is not actually insolvent, but only in the zone of insolvency. 11 He notes that since the zone of insolvency is hard to define, it would be impossible for directors to determine with any certainty when their fiduciary duties had expanded to include the interests of creditors. Further, as the applicable standard for a motion to dismiss such a fiduciary duty suit under Chancery Court Rule 12(b)(6) is permissive, granting creditors standing to sue during the nebulous zone of insolvency would open the proverbial floodgates for suits of this nature. 12 Production Resources is likely to be misconstrued by bankruptcy practitioners who do not focus on the main thrust of the opinion -- who has standing to control a breach of fiduciary duty suit -- and the fact that standing to maintain these types of suits is rarely an issue in bankruptcy cases. Although some will argue that Production Resources (i) is a retreat from the longstanding law that directors owe a fiduciary duty to creditors, as well as stockholders, once a company is insolvent and (ii) limits a trustee s or debtor-in-possession s ability to sue for abreach of fiduciary duties because the opinion states that the expansion of fiduciary duties is to be used as a shield rather than a sword, a careful reading of the opinion reveals that the opinion supports neither of these arguments. Indeed, Vice Chancellor Strine states that [w]hen a firm has reached the point of insolvency, it is settled that under Delaware law, the firm s directors are said to owe fiduciary duties to the company s creditors. 13 In light of this unambiguous statement, and the fact that the 4
court denied in relevant part a motion to dismiss, any argument that Production Resources represents a sea change in the law of fiduciary duties of directors of an insolvent Delaware corporation to creditors must be rejected. Additionally, the Court of Chancery s holding that these types of suits are derivative in nature should have little impact on the litigation of such suits once a bankruptcy case has been filed. After a company has filed its bankruptcy petition, a trustee or a debtor in possession (or a post-confirmation liquidation trust) unquestionably has direct standing to bring causes of action for breach of fiduciary duties. Further, pursuant to Official Comm. Of Unsecured Creditors of Cybergenics Corp. v. Chinery, 14 the creditors committee can also move to obtain standing to pursue derivative claims. In either case, the issue outside of bankruptcy -- certain disgruntled creditors attempting to challenge the ongoing conduct of a board of directors that remains in control of the company and to receive damages resulting from that conduct -- is rarely encountered in bankruptcy adversary proceedings. Moreover, the opinion states that once a firm becomes insolvent, there is little doubt that creditors can press derivative claims arguing that director s pre-insolvency conduct injured the firm. 15 (emphasis added). Thus, except for those rare cases when a debtor is not insolvent when it files its petition and does not become insolvent thereafter, once the bankruptcy petition is filed, creditors (presumably a creditors committee) can argue that Production Resources provides them with standing not only to sue directors for prepetition actions, but for pre-insolvency conduct which injured the corporate enterprise. B. Exculpation of Directors From Personal Liability. While the Court of Chancery in Production Resources denied a motion to dismiss most counts of the complaint, it granted pursuant to 8 Del. C. 102(b)(7) the motion to dismiss 5
the count which sought damages for breach of the duty of care. Pursuant to section 102(b)(7) of the Delaware General Corporation Law, a corporation may include in its certificate of incorporation a provision that exculpates its directors from personal liability to the corporation or its stockholders, for monetary damages for breach of the fiduciary duty of care. 16 The statute makes no express mention of whether such an exculpation clause in a certificate of incorporation also shields directors from personal liability if the suit for personal liability is filed by a creditor. Prior to the Production Resources decision, three non-delaware federal courts had addressed the issue, and two held that a section 102(b)(7) exculpation clause does not shield directors from personal liability for suits filed by the corporation s creditors for breach of the duty of care or waste of the corporation s assets. 17 Those courts reasoned that the statute did not specifically mention creditors and therefore did not cover suits filed by creditors. 18 Additionally, they held that a certificate of incorporation is a contract between a corporation and its stockholders, and not a contract between the corporation and its creditors. 19 Thus, according to those courts, because creditors never contractually agreed to such a provision, the section 102(b)(7) exculpation clause is not enforceable against such creditors. In Production Resources, the first Delaware opinion to address the issue, the Court of Chancery held that a section 102(b)(7) exculpation clause does protect directors from suits brought by creditors. The holding was guided by the Court s decision that suits by creditors for breach of fiduciary duties by directors are derivative in nature. Thus, even when a creditor derivatively prosecutes such a suit, it is the corporation s claim. Thus, it fits within the literal wording of section 102(b)(7): to the corporation or its stockholders. (emphasis added). In addition to fitting within the literal wording of the section 102(b)(7), the Court of Chancery also held that the legislative policy behind section 102(b)(7) would be frustrated if 6
the Court of Chancery were to follow the Pereira and Steinberg decisions. It has long been noted that the policy behind the enactment of section 102(b)(7) was to encourage talented individuals to serve as directors of Delaware corporations, free from fear that they would be held personally liable if their good faith decisions later turned out to have been poor ones. 20 Thus, if the Court of Chancery were to hold that directors might have to pay out-of-pocket damages to creditors who challenged their good faith, disinterested decision making, a section 102(b)(7) exculpation clause would be essentially gutted and ineffective at the time it is most needed. After all, the court reasoned, suits are most likely to be filed when there is a reason to second guess the directors because the company s fortunes turned out poorly, and therefore that is when directors need the protections of section 102(b)(7) the most. Although Production Resources is a recent decision, its holding with respect to section 102(b)(7) has already been followed by the United States District Court for the District of Delaware (the District Court ). In Star Telecommunications, Judge Jordan 21 held that Production Resources is the law of Delaware that should be followed when deciding issues involving section 102(b)(7) of the Delaware General Corporation Law. 22 Additionally, although neither section 102(b)(7) nor the corporation s charter were mentioned in the complaint filed by the official committee of unsecured creditors, the District Court invoked section 102(b)(7) as a defense on a motion to dismiss the case pursuant to Federal Rule of Civil Procedure 12(b)(6). This holding is for the most part consistent with the Delaware Supreme Court s holding that a case can be dismissed at the pleadings stage by invoking a section 102(b)(7) clause, albeit introducing this outside document converts the motion to dismiss to one for summary judgment; despite the conversion, a plaintiff cannot take discovery on the 102(b)(7) clause unless it has a good faith basis to challenge its authenticity or the propriety of its adoption. 23 7
Thus, Star Telecommunications makes it clear that if a Delaware corporation s certificate of incorporation contains a section 102(b)(7) exculpation clause, the holding of Production Resources is applicable in suits brought in the bankruptcy court. Accordingly, directors are shielded from personal liability for monetary damages for breach of their duty of care regardless of whether such suits are initiated by the corporation, stockholders, creditors or an official committee of unsecured creditors. C. Conclusion. Production Resources is not a retreat from established Delaware law regarding fiduciary duties owed by directors of insolvent corporations to creditors. Rather, the opinion is an explanation of creditors standing to bring fiduciary duty suits. As such, the opinion should have little impact in the bankruptcy arena, since standing to maintain these types of suits is rarely an issue in bankruptcy cases. However, as the opinion is likely to be misconstrued, bankruptcy practitioners must carefully read and understand the opinion s holdings. Once the opinion is understood, its greatest impact on cases brought in bankruptcy courts likely will be its holding that a section 102(b)(7) clause is effective in suits filed by creditors committees. The Delaware District Court has already confirmed in Starr Telecommunications that this includes suits brought by a creditors committee. 1 Russell C. Silberglied is a director of, and Kimberly D. Newmarch is an associate with, Richards, Layton & Finger, P.A. in Wilmington, Delaware. The views expressed herein are those of the authors and not necessarily of Richards, Layton & Finger, P.A., nor its clients. 2 A.2d (Del. Ch. 2004); C.A. No. 114-N, 2004 Del. Ch. LEXIS 174 (Del. Ch. Nov. 17, 2004). 3 C.A. No. 12150, 1991 WL 277613 (Del. Ch. Dec. 30, 1991). 4 No. Civ. A. 03-278-KAJ, 2004 WL 2980736 (D. Del. Dec. 21, 2004). 5 Production Resources, 2004 Del. Ch. LEXIS 174, at *40-41. 6 Some cases and commentators improperly state or imply that upon insolvency, directors and officers of a corporation only owe fiduciary duties to creditors, not stockholders. See, e.g., Federal Deposit Insurance Corp. v. Sea Pines Co., 692 F.2d 973, 976-977 (4 th Cir. 1982); Robert B. Millner, What Does It Mean for Directors of Financially Troubled Corporations to Have Fiduciary Duties to Creditors?, 9J. Bankr. L. & Prac. 201 (Jan./Feb. 2000). That has never been the law in Delaware even before Production Resources. Rather, under Delaware law, the officers and directors duties expand upon insolvency to include the interests of stockholders and creditors. 8
7 Production Resources, 2004 Del. Ch. LEXIS 174, at *50; Credit Lyonnais, 1991 WL 277613, at *34; Geyer v. Ingersoll Publ ns Co., 621 A.2d 784, 787 (Del. Ch. 1992). 8 Credit Lyonnais, 1991 WL 277613, at *34. 9 Production Resources, 2004 Del. Ch. LEXIS 174, at *44. 10 Id. 11 Production Resources, 2004 Del. Ch. LEXIS 174, at *48 n.56. 12 Id. at *24. 13 Id. at *50. 14 330 F.3d 548, 566 (3d Cir. 2003). 15 Production Resources, 2004 Del. Ch. LEXIS 174, at *48 n.56. 16 8 Del. C. 102(b)(7). 17 See Pereira v. Cogan, No. 00 CIV 619 (RWS), 2001 WL 243537 (S.D.N.Y. Mar. 8, 2001); Steinberg v. Kendig (In re Ben Franklin Retail Stores, Inc.), No. 97C7934, 97C6043, 2000 WL 28266 (N.D. Ill. Jan. 12, 2000); but see Brandt v. Hicks, Muse & Co., Inc. (In re Healthco Int l., Inc.), 208 B.R. 288 (Bankr. Mass. 1997). 18 See Pereira, 2001 WL 243537, at *10; Steinberg, 2000 WL 28266, at *8. 19 Id. 20 E. Norman Veasey, Jesse A. Finkelstein and C. Stephen Bigler, Delaware Supports Directors with a Three- Legged Stool of Limited Liability, Indemnification, and Insurance, BUS.LAW. (Feb. 1987). 21 The case was before the District Court because the automatic reference to the bankruptcy court had been withdrawn from the adversary proceeding. 22 Star Telecommunications, 2004 WL 2980736, at *11. 23 Malpiede v. Townson, 780 A.2d 1075, 1091-92 (Del. 2000). 9