Much has been written, but few useful cases decided, defining the role of corporate directors of a company which is insolvent or within the “zone of insolvency.” A deep dive into that debate is beyond the scope of this post, but counselors to corporations under financial stress might want to take a look at the October 1st decision in Quadrant Structured Products decided by Delaware Chancery Court.
You don’t have to be a lawyer to understand the broad teaching here: directors do not owe any direct duty at any time to creditors; creditors can only make a claim against directors on a derivative basis which is to say, where they hold the position of the stakeholders in the corporation and the directors have breached their obligation to the corporation.
What is the standard for determining if a director is liable to a creditor for having managed an insolvent company in a manner which ultimately reduces the enterprise value to the creditors?
Directors should be comforted to know that, generally speaking, the “business judgment rule” applies. Even if a company is insolvent, if directors in good faith believe that by taking risk, spending money, etc. they can increase the value of the enterprise as a whole, then they are entitled to try and they are protected from liability if they have taken reasonable (and not self-interested) steps in that effort. (I do not here deal with issues created by director self-dealing, but there is even good news in the decision on that front.)
Globally, there is much discussion as to the duty of directors to creditors, but in the long run seldom resulting in any strategic adjustment. Typically: directors and management at all times want to build value, not waste it; strategic decisions in that context involve risk; many decisions will prove to have negative impact on value; good faith rational judgment by boards, even when a company is underwater, will be protected (at least in Delaware) from derivative claims asserted by creditors who have ended up short. Insolvency “does not mean that the directors cannot choose to continue the firm’s operations in the hope they can expand the inadequate pie such that the firm’s creditors get a greater recovery.”