Creditor standing to bring derivative claims when corporation is insolvent

05/07/2015

Creditor standing to bring derivative claims when corporation is insolvent

Francis Pileggi blogs about Quadrant Structured Products Company, Ltd. v. Vertin, C.A. No. 6990-VCL (Del. Ch. May 4, 2015), which he predicts "is destined to be cited as a seminal ruling for its historical and doctrinal analysis of important principles of Delaware corporate law, including the following:

The reasons why creditors can pursue derivative claims on behalf of insolvent corporations against corporate officers and directors.
The reasons why the traditional balance sheet test is the proper standard for determining when a creditor has standing to bring a derivative claim and why insolvency is only determined at the time of filing as opposed to the irretrievable insolvency test used for the appointment of a receiver under DGCL § 291.
Basic principles: reviewing the two fundamental fiduciary duties owed by directors of loyalty and care. In addition to describing the component of loyalty that includes the requirement to act in good faith, which is a condition of the duty of loyalty, the Court also explains what must be shown in order to establish a claim that a director breached the duty of loyalty and failed to act in good faith: for instance, where the fiduciary intentionally acts with a purpose other than that of advancing the best interest of the corporation. See footnotes 21-23."

Go read the whole thing. As counselor Pileggi kindly points out, the opinion indirectly cites yours truly by quoting (p.18 n.19) from Leo Strine's opinion in Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P.:

Professor Bainbridge‘s views regarding the substantive effect the question of insolvency should have on directors‘ ability to rely upon the business judgment rule . . . is identical to mine—short answer none. . . .

Strike is referring to my analysis in Much Ado about Little? Directors' Fiduciary Duties in the Vicinity of Insolvency. Journal of Business and Technology Law, Forthcoming; UCLA School of Law, Law-Econ Research Paper No. 05-26. Available at SSRN: http://ssrn.com/abstract=832504:

Where the contract between a corporation and one of its creditors is silent on some question, should the law invoke fiduciary duties as a gap filler? In general, the law has declined to do so. There is some precedent, however, for the proposition that directors of a corporation owe fiduciary duties to bondholders and other creditors once the firm is in the vicinity of insolvency.

Courts embracing the zone of insolvency doctrine have characterized the duties of directors as running to the corporate entity rather than any individual constituency. This approach is incoherent in practice and insupportable in theory. Courts should focus on whether the board has an obligation to give sole concern to the interests of a specific constituency of the corporation.

Concern that shareholders will gamble with the creditors' money is the principal argument for imposing a duty on the board running to creditors when the corporation is in the vicinity of insolvency. On close examination, however, this argument proves unpersuasive. It is director and manager opportunism, rather than strategic behavior by shareholders that is the real concern. Because bondholders and other creditors are better able to protect themselves against that risk than are shareholders, there is no justification for imposing such a duty.

This article also argues that the zone debate is much ado about very little. The only cases in which the zone of insolvency debate matters are those to which the business judgment rule does not apply, shareholder and creditor interests conflict, and a recovery could go to directly to those who have standing to sue. In those cases, as this Article explains, there is a strong policy argument that creditors should be limited to whatever rights the contract provides or might be inferred from the implied covenant of good faith.

Posted at 12:09 PM in Corporate Law, Dept of Self-Promotion | Permalink

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The reasons why creditors can pursue derivative claims on behalf of insolvent corporations against corporate officers and directors.
The reasons why the traditional balance sheet test is the proper standard for determining when a creditor has standing to bring a derivative claim and why insolvency is only determined at the time of filing as opposed to the irretrievable insolvency test used for the appointment of a receiver under DGCL § 291.
Basic principles: reviewing the two fundamental fiduciary duties owed by directors of loyalty and care. In addition to describing the component of loyalty that includes the requirement to act in good faith, which is a condition of the duty of loyalty, the Court also explains what must be shown in order to establish a claim that a director breached the duty of loyalty and failed to act in good faith: for instance, where the fiduciary intentionally acts with a purpose other than that of advancing the best interest of the corporation. See footnotes 21-23."

Professor Bainbridge‘s views regarding the substantive effect the question of insolvency should have on directors‘ ability to rely upon the business judgment rule . . . is identical to mine—short answer none. . . .

Where the contract between a corporation and one of its creditors is silent on some question, should the law invoke fiduciary duties as a gap filler? In general, the law has declined to do so. There is some precedent, however, for the proposition that directors of a corporation owe fiduciary duties to bondholders and other creditors once the firm is in the vicinity of insolvency.

Courts embracing the zone of insolvency doctrine have characterized the duties of directors as running to the corporate entity rather than any individual constituency. This approach is incoherent in practice and insupportable in theory. Courts should focus on whether the board has an obligation to give sole concern to the interests of a specific constituency of the corporation.

Concern that shareholders will gamble with the creditors' money is the principal argument for imposing a duty on the board running to creditors when the corporation is in the vicinity of insolvency. On close examination, however, this argument proves unpersuasive. It is director and manager opportunism, rather than strategic behavior by shareholders that is the real concern. Because bondholders and other creditors are better able to protect themselves against that risk than are shareholders, there is no justification for imposing such a duty.

This article also argues that the zone debate is much ado about very little. The only cases in which the zone of insolvency debate matters are those to which the business judgment rule does not apply, shareholder and creditor interests conflict, and a recovery could go to directly to those who have standing to sue. In those cases, as this Article explains, there is a strong policy argument that creditors should be limited to whatever rights the contract provides or might be inferred from the implied covenant of good faith.