On May 18, 2007, in North American Catholic Educational Programming Foundation, Inc. v. Gheewalla (“Gheewalla”),1 the Delaware Supreme Court affirmed the Delaware Court of Chancery’s decision2 in which the Court of Chancery precluded creditors from filing direct suits for breach of fiduciary duty against directors of corporations that are either in the zone of insolvency or are actually insolvent. With its decision, the Delaware Supreme Court has limited creditors’ ability to sue directors for breach of fiduciary duty. The effect of the Delaware Supreme Court’s decision in Gheewalla is to limit the enforcement of fiduciary duties owed to creditors to derivative suits filed on behalf of the corporation. Under Delaware law, directors of solvent corporations do not generally owe fiduciary duties to creditors, meaning that creditors cannot sue them for breach of fiduciary duty.3 Instead, creditors of solvent corporations are protected by contract, fraudulent conveyance and bankruptcy law. When a corporation is insolvent, however, “the fiduciary duty of the directors shifts from the stockholders to the creditors.”4 The reason for the shift in duties is that, upon insolvency,5 the creditors become the equitable owners of the corporation because they are the only parties interested in the corporation’s assets. Creditors are owed fiduciary duties by directors of corporations that have not yet begun statutory proceedings (filed for bankruptcy), but are approaching insolvency or are in the “zone of insolvency.”6
The plaintiff in Gheewalla, the North American Catholic Educational Programming Foundation (“NACEPF”), owned licenses to broadcast in the wireless microwave spectrum used to broadcast educational programs. NACEPF entered into an agreement with Clearwire Holdings, Inc. (“Clearwire”), whereby Clearwire agreed to purchase broadcasting licenses from NACEPF for more than $24.3 million. Following the agreement between NACEPF and Clearwire, the market for wireless spectrum collapsed when WorldCom announced its accounting problems. This made the licenses that Clearwire had agreed to purchase virtually worthless. Clearwire subsequently declared bankruptcy because of a funding deficiency that NACEPF alleged was caused by the defendants7 in breach of their fiduciary duties as directors.
NACEPF filed a direct suit against the defendants, as a substantial creditor of Clearwire, on the following grounds: (1) the defendants breached their fiduciary duty to NACEPF by (a) “not preserving the assets of Clearwire for its [NACEPF’s] benefit…when it became apparent that Clearwire would not be able to continue as a going concern and would need to be liquidated” and (b) “holding on to NACEPF’s license rights when Clearwire would not use them, solely to keep Goldman Sachs’ investment ‘in play,’”8 (2) the defendants fraudulently induced NACEPF to enter into the agreement with Clearwire, and (3) the defendants tortiously interfered with NACEPF’s business opportunities.9 Personal jurisdiction over the defendants was premised solely upon section 3114 of the Delaware Code.10 Under section 3114, directors of Delaware corporations are subject to the jurisdiction of Delaware Courts “for violation of a duty in [their] capacity of [directors of the corporation].”11 NACEPF’s efforts to bring claims other than fiduciary duty violations, therefore, rested upon
(1) the viability of the fiduciary duty claim and
(2) the other claims’ being sufficiently related to the fiduciary duty claim.12
The Court of Chancery rejected NACEPF’s claims mainly on standing grounds, holding that creditors cannot assert direct claims for breach of fiduciary duty against directors. The rationale behind this decision was that corporations in the zone of insolvency are in special need of effective leaders who are able to negotiate with individual creditors on the corporation’s behalf; according to the Court of Chancery, this need would be undermined if the directors had to face the possibility of direct suits against them from creditors.13 The Court of Chancery also held that allowing direct fiduciary duty claims against directors by creditors was unnecessary because of the already-existing protections afforded to creditors. Because the fiduciary duty claim was rejected, NACEPF’s other claims failed on jurisdictional grounds.
The Delaware Supreme Court affirmed the Court of Chancery’s opinion. It held that creditors do not have the right to bring direct claims for breach of fiduciary duty against directors of companies that are either insolvent or operating in the zone of insolvency. The rationale behind the holding was largely the same as that of the Court of Chancery. The Supreme Court reasoned that allowing such direct claims by creditors against directors would create a conflict between a direct fiduciary duty owed to the creditors and the directors’ previously recognized duty to maximize the value of the insolvent corporation for the benefit of all those having an interest in it.14 The Supreme Court also agreed with the Court of Chancery that the existing protections for creditors were sufficient, making the allowance of direct fiduciary duty suits unnecessary.
The Delaware Supreme Court did, however, hold that creditors of insolvent corporations or those operating in the zone of insolvency could bring derivative suits against directors for breach of fiduciary duty. Derivative claims are claims brought on behalf of the corporation to enforce duties owed to the corporation. Normally, only stockholders have standing to bring derivative suits. In Gheewalla, the Supreme Court held that, when a corporation is either insolvent or operating in the zone of insolvency, standing to sue directors derivatively for breach of fiduciary duty is extended to creditors.
Prior to the corporation’s filing for bankruptcy, any damages won through a derivative claim become the property of the corporation. Any damages won through derivative claims after the corporation has filed for bankruptcy become property of the corporate debtor’s bankruptcy estate. Bringing derivative claims is not as advantageous for creditors as bringing direct claims, because damages from direct claims flow directly to the plaintiff, not the corporation or its bankruptcy estate.
In Gheewalla, the Delaware Supreme Court eliminated the possibility of direct creditor fiduciary duty suits against directors of insolvent or nearly insolvent corporations. Following Gheewalla, directors of insolvent or nearly insolvent corporations continue to owe fiduciary duties to creditors; these duties, however, can be enforced only derivatively and not directly. The practical effect of the Gheewalla decision will probably be fewer breach of fiduciary duty suits brought against directors of insolvent or nearly insolvent corporations by creditors because there is less for a creditor to gain from a derivative suit.