When a company is facing insolvency, the directors and officers of the company have a heightened duty of care to the company and its stakeholders. This is because, when a company is insolvent or in the “zone of insolvency,” the interests of the company’s shareholders and creditors may be in conflict.
In this article, we will explore the fiduciary duties owed by directors and officers in the zone of insolvency under Delaware (where over half of all U.S. publicly traded companies are incorporated due to their corporate law statutes) and Minnesota law. It is worth noting that “zone of insolvency” has not been properly defined, but is commonly referred to as the fair value of assets being less than the liabilities of the company or when the company is unable to pay its debts as they become due.
Delaware’s Laws on Corporate Fiduciary Duties
Under Delaware law, directors and officers of a corporation owe fiduciary duties of care and loyalty to the corporation and its shareholders. The duty of care requires directors and officers to act with the care of an ordinarily prudent person in a like position under similar circumstances. This duty of loyalty requires directors and officers to act in the best interests of the corporation and its shareholders, and to avoid conflicts of interest. When a corporation is in the zone of insolvency, the fiduciary duties owed by directors and officers are heightened to include the interests of creditors as well, and may even result in owing those duties to the creditors over the shareholders.
In the case of the North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, the Delaware Supreme Court held that when a corporation is insolvent or in the zone of insolvency, the fiduciary duties of directors and officers shift from the shareholders to the corporation itself and its creditors. In other words, the directors and officers owe a duty to preserve the remaining value of the corporation for the benefit of its creditors, as well as its shareholders. While the creditors take the place of shareholders as residual beneficiaries of any increases in value, the directors of a corporation do not owe any additional duties beyond the contractual terms of their arrangement. So, the directors’ duties essentially remain the same, but the duty is to the corporation as an enterprise instead of strictly to the shareholders.
Minnesota’s Laws on Corporate Fiduciary Duties
In Minnesota, the fiduciary duties of directors and officers are similar to those in Delaware. Minnesota Statute 302A.251 provides that directors and officers owe fiduciary duties of care and loyalty to the corporation and its shareholders. Similar to Delaware, the MN Statute provides that “a director may, in considering the best interests of the corporation, consider the interests of creditors.”
Similarly to the Delaware case above, in the case of Security Asset Capital Corp., the Bankruptcy Court in Minnesota held that when a corporation is insolvent or in the zone of insolvency, the fiduciary duties of directors and officers shift from the shareholders to the corporation itself and its creditors. The court noted that “when corporations are in the “zone of insolvency,” or actually insolvent, creditors become recognized beneficiaries of the performance of fiduciary duties by directors and officers to their corporations. That is because insolvency expands the risk of corporate loss beyond shareholders to corporate creditors.” Therefore, directors and officers must consider the interests of creditors when making decisions that could impact the corporation’s solvency.
Fiduciary Duties Owed to Shareholders vs. Creditors
In the zone of insolvency, the fiduciary duties owed by directors and officers may conflict with the interests of shareholders. Directors and officers must balance their duty to preserve the remaining value of the corporation for the benefit of its creditors, while also taking into account the interests of shareholders. However, in the event of a conflict between shareholder and creditor interests following insolvency, the interests of shareholders become subordinated to the interests of creditors. This can be a difficult task, especially when the corporation is facing financial distress. It also becomes difficult when directors are themselves shareholders and now owe duties to parties other than themselves.
Contact Legal and Financial Advisors for Assistance
To navigate this difficult situation, directors and officers should consider seeking legal and financial advice. These advisors can help calculate and manage the uncertainties as to how insolvency will be determined and which standards the directors of an insolvent corporation will be held. Generally speaking, corporate directors and officers should review the financial position of the company before taking any adverse actions in regards to shareholders or creditors and should avoid impairing company assets that would otherwise be available to creditors without proper vetting of the action. Additionally, directors and officers should be transparent with shareholders and other stakeholders about the financial situation of the corporation. This can help to avoid claims of breach of fiduciary duty or other legal actions.
If your company is facing insolvency and you’re looking for an attorney to help you navigate the complex situations ahead, contact Avisen Legal today. Our team of partner-level business lawyers and advisors will help you take the correct course of action for your financial and operational circumstances.