Corporate financial uncertainties or troubles frequently require corporate directors to make difficult choices that affect shareholders, creditors and others having an interest in the corporation. In that situation, the question naturally arises: Do directors' duties change when a corporation is experiencing financial difficulties, is nearing insolvency or becomes insolvent? The short answer is that the fiduciary duties of corporate directors under Delaware and Texas corporate law do not change, but that the ultimate beneficiaries of those duties may shift. Under those circumstances, corporate directors should be particularly careful to perform their fiduciary duties and, in performing those duties, should consider the interests of corporate creditors as well as the interests of shareholders.
The fiduciary duties imposed on a corporate director under Delaware or Texas law are primarily two: the duty of care and the duty of loyalty. In general, the duty of care requires that a director exercise the same degree of care as an ordinarily careful and prudent person would use in similar circumstances. The apparent breadth of this duty is mitigated by the business judgment rule, which provides that board decisions made in good faith, on an informed basis and in the belief that the corporate action is in the corporation`s best interest will not be second-guessed by a court. Also, the charter of a Delaware or Texas corporation may (and should) include a provision that exculpates directors from personal financial liability for any breach of their duty of care, other than conduct not in good faith or involving intentional misconduct or a knowing violation of law. Minutes and other corporate records should be prepared so as to reflect the actions taken by the directors to fulfill their duty of care.
In general, the duty of loyalty requires that a director act in good faith in the best interest of the corporation and its shareholders, without deriving any unauthorized or improper personal benefit from his or her relationship with the corporation. This duty encompasses obligations to act honestly toward the corporation and to make full and fair disclosure when dealing with shareholders. But the key obligation is to avoid self-interest or self-dealing, directly or indirectly, regarding the corporation. Unlike situations regarding the duty of care, there is no principle or rule that may mitigate a corporate director`s duty of loyalty. The business judgment rule does not apply if there is any breach of the duty of loyalty, and the permitted charter provisions that exculpate directors from personal financial liability specifically exclude any breach of the duty of loyalty. When any corporate action or transaction may involve any self-interest on the part of a director, that director and the corporation`s other, independent directors should take special precautions to fulfill the duty of loyalty.
These fundamental fiduciary duties apply to directors in the normal situation, when a corporation is financially healthy or solvent. They apply equally if the corporation is facing financial difficulties, when it is nearing insolvency or is insolvent. Neither Delaware nor Texas law imposes any additional fiduciary duty on a director because the corporation is in financial trouble or is insolvent.
Under Delaware or Texas law, a director must perform those fiduciary duties for the benefit of the corporation, whether solvent or insolvent. When the corporation is solvent, its shareholders are also the beneficiaries of those duties. If a corporate director does not perform his or her fiduciary duties, a shareholder of the solvent corporation may file a derivative action, on behalf of the corporation, against the director to enforce those duties. The fiduciary duties are not owed to a solvent corporation`s creditors. When the corporation is insolvent (and, under Texas law, when it has also ceased to operate its business), however, there is a shift in the corporate stakeholders that are the beneficiaries (with the corporation) of the directors` fiduciary duties. The corporation`s creditors replace its shareholders as the primary beneficiaries of those duties; and if a corporate director does not fulfill his or her fiduciary duties, a creditor of the corporation may file a derivative action against the director. A creditor may not enforce fiduciary duties by a direct (non-derivative) action against the director.
Until the corporation is insolvent (and, under Texas law, has also ceased its business), neither Delaware nor Texas law affords corporate creditors any right to enforce fiduciary duties. Therefore, while the corporation is financially troubled or nearing insolvency (sometimes referred to as the ``zone of insolvency``), and not insolvent, the directors owe their fiduciary duties to the corporation and its shareholders. The directors should then continue to manage corporate business and affairs to maximize the value of the corporation for its shareholders, and the directors` decisions, if made consistent with their fiduciary duties, will be protected by the business judgment rule and the exculpation provisions in the corporate charter.
The corporation`s insolvency (and, under Texas law, its cessation of business), causing the shift from shareholders to creditors as the corporate stakeholders to whom fiduciary duties are primarily owed, is an issue of fact. It may, and most often does, occur before any bankruptcy or insolvency filing. Unfortunately, when a corporation becomes insolvent may not be clear for two significant reasons.
The first reason is legal: Under Delaware and Texas law, there are different definitions of, or methods of determining, ``insolvency.`` The two principal methods are the ``equity`` test and the ``balance-sheet`` test. Under the equity test, a corporation is insolvent when it is unable to pay its debts when they become due in the usual course of business. Under the balance-sheet test, a corporation is insolvent when its liabilities exceed the reasonable market value of its assets. The second reason is factual: In each situation, there are different valuation analyses that might be used, and the determinations or calculations of value may well be subjective and uncertain.
Accordingly, as a practical matter, a corporation might be determined to be insolvent only in retrospect, after disputes about the proper definition of insolvency and about the proper valuation of corporate assets and liabilities. Directors of a corporation in financial trouble or nearing insolvency will likely be unable to tell, in ``real time,`` when insolvency occurs. In that circumstance, it would therefore be prudent for directors to consider the interests of corporate creditors even if, strictly speaking, no fiduciary duties may be owed to them. Also, because creditors will then be more keenly concerned about the corporation`s business, directors should anticipate increased scrutiny of their activities and should be more careful than ever to perform their fiduciary duties.