Part II: The “Zone of Insolvency” — the Delaware Example

What is a Zone of Insolvency?

(April 26, 2010): This is the second installment of a three-part article by David P. Parker examining the fiduciary duties of officers and directors of insolvent corporations and corporations operating in the so-called “Zone of Insolvency.”

In Gheewalla, a significant Delaware law decision regarding creditors’ ability to sue corporate fiduciaries, the Delaware Supreme Court 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.” The Court ruled 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 to its creditors. The Court also ruled that the fiduciary duties of directors of an insolvent corporation continue to be owed to the corporation. However, with respect to an insolvent corporation, you must have standing in order to pursue derivative claims for directors’ breaches of their fiduciary duty to the corporation.

The Supreme Court of Delaware examined the issue as 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 stated that creditors, unlike shareholders, already have several 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, reasoning 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.

David parker - Senior Health Care Attorney

The ability of a creditor to sue a fiduciary can vary, depending on the specific facts at issue. David Parker has extensive experience in this care of the law and can represent your interests. For a complementary consultation, you may call Mr. Parker or one of our other attorneys at: 1 (800) 475-1906.