September 18, 2020

Directors & Officers May Face Personal Liability in Subsequent Litigation for Actions Taken During Company Insolvency

by Christopher Tackett, Roetzel & Andress

To varying degrees, the Covid-19 pandemic has imposed revenue losses, economic uncertainties, and unique new challenges on many industries. Adding to the list of challenges is that many of the vendors and suppliers that companies are working with and relying on are also facing new challenges, including supply chain disruption, revenue drops, and cash flow problems.

These difficulties can tend to create ripple effects and lead to increases in litigation, as cash-strapped companies more harshly feel the impacts of contract breaches by their vendors and business partners. Amidst all of this, company directors and officers will continue to feel mounting pressure while weathering Covid-19’s unprecedented challenges. Unfortunately, in many companies directors should also be cognizant that they will face a different standard for personal liability in their roles if the company nears insolvency.

When a company is solvent, the directors and officers owe their fiduciary duties of due care and loyalty to the corporation and its stockholders. The Delaware Chancery Court—a leader in development of corporate law throughout the country—introduced the terms "vicinity of insolvency" and "zone of insolvency" into the legal and business lexicon in a case called Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. 1991). Since then, the Delaware Chancery Court has examined many times whether creditors can sue directors of insolvent corporations, or those in the zone of insolvency, for breach of fiduciary duty. In the seminal case of North American Catholic Educational Programming v. Gheewalla (Del. Supr. 2007), the Delaware Supreme Court was emphatic that directors’ fiduciary duties do not shift from shareholders to creditors when a corporation is operating in the “vicinity” or the “zone” of insolvency.

When a company is insolvent and will not be able to pay its creditors in full, directors and officers still owe their fiduciary duties of due care and loyalty to the corporation. But, upon insolvency, the creditors have the right to bring derivative (but not direct) claims for breach of fiduciary duty against directors and officers. Furthermore, discharging fiduciary duties when a company is insolvent requires a focus on maximizing enterprise value.

What Can a Director Do for Protection?
Directors of a corporation in the zone of insolvency should make a good faith balancing of benefits and losses, recognizing that any loss to creditors may well be more significant than the corresponding benefit derived by stockholders. Directors of a corporation in the zone of insolvency should note the following suggestions:

  • Actions that increase stockholder return by impairing creditors’ claims should be thoroughly scrutinized.
  • Stockholders should not be given preference at the expense of creditors (e.g., directors should not authorize and fund a dividend or a stock redemption at such time)
  • Directors should make reasonable efforts to learn all facts before taking actions, and should genuinely believe that any decisions made are in the best interests of the corporation in its entirety.
  • Transactions that would constitute a fraudulent conveyance (e.g., a transfer for less than fair value) or a preferential payment to one creditor should not be approved.
  • To avoid appearances of violating their duty of loyalty, directors should not engage in any self-dealing.
  • To avoid the appearance of a conflict of interest, directors should fully disclose any personal or business relationships with parties on the other side of transactions.
  • In evaluating potential sales of assets of the troubled corporation, directors should be aware that these transactions may be scrutinized later in light of expanded fiduciary duties to include creditors. While a director is always free to resign under state law and under the corporation’s charter and by-laws, resignation does not provide total protection. A director will continue to have liability for pre-resignation acts and omissions.
  • Review your Director and Officer Liability Policy (“D&O Policy”). A typical D&O Policy will: (1) directly reimburse the corporation for any amounts that it pays to indemnify officers and directors for covered losses; and (2) cover the officers and directors to the extent that there is no corporate indemnification or the available indemnification does not cover the loss incurred.

There is no bright-line test used by courts to determine if a corporation is in the zone of insolvency. In general, if a corporation is in dire financial straits, a court will likely find that the corporation is in the zone of insolvency. Accordingly, when a corporation is in financial distress, its directors and officers should assume that they are in the zone of insolvency, and should be making decisions and taking actions on the basis that they may owe fiduciary duties to creditors as well as stockholders. But, by ensuring that all transactions involving the corporation are entered in good faith and without self-dealing or favoritism toward any group of stakeholders, directors can limit their excess exposure when the company is near insolvency.