Recent Developments in the Zone of Insolvency
Choosing among the options they must consider has never been easy for directors of corporations facing financial difficulty. In recent years, some court decisions have made the choices that corporate directors must make, and the advice their lawyers must give to them about those choices, even more difficult. That is because some court decisions have suggested or held that if a corporation is in a “zone of insolvency,” although never clearly defined, its officers and directors take on direct fiduciary obligations to the company’s creditors. Some of these decisions have suggested further that if the officers or directors failed to discharge these obligations correctly, they might be liable for “deepening” the company’s insolvency, and thereby decreasing its ability to pay its creditors.
Such decisions threaten directors and officers with a damned if you do, damned if you don’t dilemma. On the one hand, they are charged with trying to save a corporation from its financial perils. On the other hand, if their efforts are unsuccessful, they face possible expanded liabilities as a result of their failure.
In the last year several decisions have taken some of the air out of zone of insolvency and deepening insolvency theories. It is too soon to tell whether the theories are dead and gone forever, but in some jurisdictions at least, the law has been clarified, making life a bit less difficult for officers and directors of a struggling corporation.
Birth of Zone of Insolvency and Deepening Insolvency Theories
The zone of insolvency theory was given currency by a Delaware decision in 1991, Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. Dec. 30, 1991). The Delaware Court of Chancery noted in a footnote in its long opinion that if a corporation was in the "vicinity of insolvency," the directors' perspective on what is best for the company would vary according to whether they considered only the interests of the shareholders, or that of creditors or other groups. The court held that in this situation, the directors owed a "duty to the entire corporate enterprise," which might entail a course of action different from that chosen by the stockholders, given the "community of interests that the corporation represents."
Those statements from the Credit Lyonnais Bank decision were expanded upon by some courts to allow creditors to bring suit against directors directly on their own behalf, on the theory that if a company was in a "zone of insolvency" the directors' decisions affected the company's ability to pay its creditors, and as such, directors’ duties extended to creditors as well as to shareholders. Official Committee of Unsecured Creditors v. Fleet Retail Finance (in re Hechinger Investment Co. of Delaware), 274 B.R. 71, 89–90 (Del. 2002); Miramar Resources, Inc. v. Schultz, 208 B.R. 723, 729 (Bankr. Md. Fla. 1997). Since the acts of directors always have the potential to affect a corporation’s ability to pay its creditors, however, these holdings were suspect.
In addition, some early zone of insolvency theory cases contained language characterizing corporate directors as "trustees" in terms of their relationship to creditors if the corporation was insolvent or threatened with insolvency. See, for example, Thomas v Matthews, 111 N.E. 669, 673 (Ohio 1916). A trustee, of course, is a fiduciary, required to place the interests of the beneficiaries for whom he or she acts, in trust, over his or her own interests, or the interests of other parties. In 2003, a federal court in Ohio relied upon earlier holdings expanding directors’ duties to creditors to deny a motion to dismiss a claim by creditors that directors owed them a fiduciary duty in light of the corporation's insolvency. DeNune III v. Consolidated Capital of North America, Inc., 288 F. Supp. 2d 844, 855 (N.D. Ohio 2003).
The "deepening insolvency" theory was recognized as a valid cause of action under Pennsylvania law by the Third Circuit in a 2001 decision. Official Committee of Unsecured Creditors vs. R.F. Lafferty & Co., Inc., 267 F.3d 340, 349–50 (3rd Cir. 2001). See also OHC Liquidation Trust v. Credit Suisse First Boston (In Re Oakwood Homes Corp.), 340 B.R. 510, 529–531 (Bankr. D. Del. 2006). The Third Circuit held that the deepening insolvency theory was sound because extending a corporation's life in the face of its impending insolvency may cause injury by dissipating the corporation's remaining assets while its debts increased. These harms could be avoided, the Third Circuit reasoned, if the corporation could be dissolved in a timely manner, "rather than kept afloat with spurious debt."
Deepening Insolvency Meets Judicial Skepticism
Soon after deepening insolvency theory was first proposed, it began to run into rough sailing in the courts. Several decisions expressed skepticism about whether deepening insolvency was an independent tort for which directors and officers could be sued, as opposed to merely a measure of damages caused by a breach of fiduciary duty or some other claim. Alberts v. Tuft (In Re Greater Southeast Community Hospital Corp. (1), 353 B.R. 324, 337–38 (Bankr. D.D.C. 2006); Amato v. Southwest Florida Heart Group, P.A. (In Re Southwest Florida Heart Group, P.A.), 346 B.R. 897, 898 (Bankr. M.D. Fla. 2006); Del-Met Corp.v. Buergar, 322 B.R. 791, 813 (Bankr. M.D. Tenn. 2005); Kittay v. Atlantic Bank of New York (In Re Global Service Group, LLC), 316 B.R. 451, 458 (Bankr. S.D.N.Y. 2004). Some courts suggested that deepening insolvency was not an independent cause of action because it merely duplicated the traditionally recognized claim for breach of fiduciary duty. Bondi v. Bank of America Corp. (In Re Parmalat), 383 F.Supp. 2d 587, 601-602 (S.D.N.Y. 2005); Official Committee of Unsecured Creditors v. American Tower Corp. (In re Verestar, Inc.), 343 B.R. 444, 475–78 (Bankr. S.D.N.Y. 2006; In Re Fleming Packaging, 2005 WL 2205703 at *7–10 (Bankr. D.D.C. 2005); In Re Greater Southeast Community Hosp., 333 B.R. 506, 517 (Bankr. D.D.C. 2005).
Eventually, even the Third Circuit itself suggested that application of deepening insolvency theory should be limited to cases of fraud, as with the Lafferty case where it was adopted, and that no claim should be allowed for deepening a corporation's insolvency through actions that were only negligent. Seitz v. Detweiler (In re CitX Corp., Inc.), 448 F.3d 672, 680 and n.11 (3rd Cir. 2006).
At roughly the same time, a Delaware Chancery decision criticized deepening insolvency theory as "the kind of stentorious academic ring that tends to dull the mind to the concept's ultimate emptiness." Trenwick American Litigation Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 204 (Del. Ch. 2006).
In Liquidating Trustee v. Baker (Amcast), 2007 Bankr. LEXIS 692, 47 Bankr. Ct. Dec. 263 (Bankr. S.D.Ohio, March 12, 2007), the United States Bankruptcy Court for the Southern District of Ohio considered whether Ohio law would allow claims against a company's officers and directors based upon "zone of insolvency" and deepening insolvency theories. With respect to deepening insolvency, the court agreed that "the concerns raised in these decisions [criticizing the theory] are valid. Deepening insolvency as a cause of action remains vague and convoluted." The court found that the breach of fiduciary duty claims asserted against the former directors and officers involved the same facts and same claim for relief as the breach of fiduciary duty and other claims, and that "the complete redundancy of the deepening insolvency claim provides this court with ample reason, by itself, for dismissing it as a cause of action."
The Amcast court further found that giving validity to a deepening insolvency claim would contravene the business judgment rule, which was codified in particularly strong terms in Ohio’s General Corporation Law, because "if a plaintiff cannot state a claim that directors and officers breached their fiduciary duties in implementing a business strategy, that plaintiff may not cure the deficiency by simply alleging that the strategy made the corporation more insolvent." The court accordingly held that Ohio law would not recognize deepening insolvency as a cause of action, and it dismissed the plaintiffs' claim under Rule 12(b)(6).
No Fiduciary Duty to Creditors Regardless of Zone of Insolvency
Zone of insolvency theory has not encountered the same rapid judicial rebuttal as deepening insolvency theory, but recent decisions have also cast doubt on its continuing viability as the foundation of a direct, as opposed to a derivative, claim asserted by dissatisfied creditors against officers and directors of a distressed or bankrupt corporation.
In Amcast, supra, the corporation had filed bankruptcy under Chapter 11, and its reorganization plan was approved by a bankruptcy court. The Amcast lawsuit arose from changes implemented by the directors and officers to the company's retirement benefits plan one to three years prior to bankruptcy filing. The plaintiff was a Liquidating Trustee representing unsecured creditors, who, under the bankruptcy plan of reorganization, was authorized to pursue claims on behalf of the unsecured creditors, including claims that the former officers and directors had violated their duties through their actions regarding the retirement benefits plan. In particular, the plaintiff alleged that the former officers and directors had improperly approved of changes in the retirement benefits plans to benefit a former company chairman and CEO while the corporation was in a zone of insolvency, and having done such, owed a fiduciary duty to consider the interests of the company's creditors, not just those of the corporation's shareholders.
The defendant officers and directors contended that their decisions were fair and justifiable under all of the circumstances, and in some cases, were compelled by a contract entered into with the former CEO and chairman years before. They filed a Rule 12(b)(6) motion to dismiss the complaint, arguing, among other points, that the zone of insolvency theory advanced by the plaintiff was contrary to Ohio law. The officers and directors argued that they owed their fiduciary duties to the corporation and its shareholders, not to the company's creditors. In a lengthy and detailed decision, the bankruptcy court agreed.
The defendants in Amcast argued that these decisions were inconsistent with Ohio's General Corporation Law, which provided directors with broad immunity for decisions that they made in the exercise of their business judgment on behalf of the corporation. In particular, O.R.C. § 1701.59, enacted in the 1980s, provided that a director was to perform his or her duties "in good faith, in a manner the director reasonably believes to be in or not opposed to the best interests of the corporation." The statute stated that "a director, in determining what the director reasonably believes to be in the best interest of the corporation, shall consider the interests of the corporation's shareholders," and "in the directors' discretion [he or she] may consider" several other interests, including those of the corporation's employees, suppliers, creditors, and customers. (Emphasis added.)
The statute further provides that a director shall be liable for any actions or failures to act "only if it is proved by clear and convincing evidence . . . that the directors' action or failure to act involved an act or omission undertaken with deliberate intent to cause injury to the corporation or undertaken with reckless disregard for the best interests of the corporation." The defendants argued that these provisions were inconsistent with the notion that because of the corporation's financial position the directors’ fiduciary duties were owed to a different constituency, such as the company's creditors, as opposed to the shareholders, to whom duty was mandatory under the statute.
After evaluating these issues and describing the history by which these decisions and statutes developed, the bankruptcy court ruled that under Ohio's corporate code, the zone of insolvency theory could not be the basis for the creditors' claim, and that the directors and officers owed no fiduciary duty to the corporation's creditors:
The court concludes that while a company operates outside a pending dissolution, receivership, bankruptcy, or similar formal insolvency proceeding the directors' fiduciary obligations remain to the corporation and its shareholders and they are under no obligation to treat the corporate assets as a "trust" that must be liquidated on behalf of creditors.
The court allowed other, more traditional theories to survive the motion to dismiss.
In its holding the court created a high bar for the plaintiff—for the defendants could be found liable only if the court, upon hearing the evidence, concluded that they had acted with deliberate intent to damage the corporation or with reckless disregard for its interests.
Although plaintiffs might be expected to argue that the court’s analysis in Amcast was driven by Ohio statutes and that the court’s reasoning should not be exported to other jurisdictions, such arguments were dealt a blow by another 2007 ruling by the Delaware Supreme Court that came on the heels of the Amcast decision. In North American Catholic Educational Programming Foundation North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2007 WL 1453705 (Del., May 18, 2007) the Delaware Supreme Court affirmed a decision by the Court of Chancery that even if a Delaware corporation is insolvent or in the zone of insolvency, the corporation's creditors have no right to assert direct claims for breach of fiduciary duty against the directors.
The Delaware court's analysis was not as detailed as the Amcast court's, but the decision is important, given the significant role the Delaware courts historically hold in the development of corporate law; Delaware courts’ corporate legal analyses often find their way into decisions of other jurisdictions. The Delaware court reasoned that to recognize this particular new creditors’ right "would create uncertainty for directors who have a fiduciary duty to exercise their business judgment in the best interest of the insolvent corporation." To recognize a new fiduciary duty toward creditors, the court reasoned, would create a conflict with a traditional obligation. The court noted that the rights of creditors are already protected by their negotiated agreements, any security instruments they hold, the implied covenant of good faith and fair dealing inherent in contracts, and fraudulent conveyance and bankruptcy law. The Delaware decision thus implicitly recognized the supremacy of the business judgment rule over the type of claim the creditors sought to assert, even in the absence of the strong statutory recognition of the rule found in the Ohio General Corporation law. The Delaware Gheewalla decision recognized that if a corporation was insolvent—not just in the zone of insolvency—creditors had standing to enforce a derivative claim for breach of fiduciary duty owed by the directors to the corporation. Directors, , however, owe no direct fiduciary duty to creditors as such. The direct fiduciary obligation that the directors owe is to the corporation, and their fulfillment of that duty is subject to the protective shelter of the business judgment rule.
Indicative of the extent to which zone of insolvency theory is unsettled, a federal district court in Ohio cited Amcast in passing, but appeared to reach a different result, in In re National Century Financial Enterprises, Inc., 2007 WL 1362695 (S.D. Ohio 2007). That court declined to dismiss fiduciary duty claims against directors, reasoning that under DeNune creditors could assert a breach of fiduciary duty claim if the corporation was alleged to be insolvent. The court did not discuss the Ohio statutes considered in Amcast, or whether a fiduciary duty would be recognized within a zone of insolvency, as opposed to outright insolvency. Based on the facts, the National City court dealt with allegations of outright insolvency, not that the corporation was in a zone of insolvency. The court's opinion, however, vacillates, sometimes stating its holding is based upon the corporation’s insolvency, while at others stating it is based on the corporation’s "on the brink" of insolvency status, —making its precise holding confusing.
In addition, the National City court acknowledges the Amcast court's ruling but describes it as "emphasizing that the scope of the director’s' duty to creditors upon insolvency is not as broad as the duty he owes to the corporation itself." 504 F. Supp.2d at 311. This is hardly an accurate picture of the Amcast court’s holding, since it dismissed the zone of insolvency claim against the former officers and directors. The National City decision’s meaning, consequently, is not at all clear. Its analysis is unlikely to gather a substantial following in future decisions.
The shades of gray in zone of insolvency theory also appeared in two Texas bankruptcy court decisions handed down shortly after Amcast and Gheewalla. In In Re Vartec Telecom, Inc., Bankr. LEXIS 3240 (N.D. Tex., July 17, 2008), the court denied a motion to dismiss a bankruptcy trustee’s claim for breach of fiduciary duty. The Texas court noted the Amcast decision from Ohio only in passing.
The court did mention the Credit Lyonnais case as “seminal,” noting that some more recent Delaware opinions seemed to have retreated from its analysis. But it also found that the Delaware Supreme Court’s Gheewalla decision clarified what had for years been “very muddy legal waters.” The court found that the bankruptcy trustee did have the right to bring a derivative action on behalf of the corporation. The court did not discuss the implication of this holding, but it stands to reason that in asserting a derivative claim, to recover the plaintiff trustee would have to show injury to the corporation— not just injury to the aggrieved creditors. Be that as it may, the In Re Vartec Telecom, Inc. court recognized that “extending officers’ and directors’ duties to creditors when a corporation nears insolvency creates many issues for such officers and directors and the professionals providing them advice. However, this case revolves not around what the law should be, but what the law is.”
This same distinction, between the law as an ideal and the law as it exists, was observed by another bankruptcy court in Texas in Medlin v. Wells Fargo Bank, N.A., 2007 Bankr. LEXIS 3329 (W.D. Tex., July 31, 2007). There the court dismissed a zone of insolvency/breach of fiduciary claim asserted by creditors on the basis that under Gheewalla the right to assert such a claim was derivative only. The bankrupt corporation had already asserted its claim against the defendants and lost, so the court found that the derivative claim that the aggrieved creditors might asserted was barred by res judicata. They had no right to bring a direct action on behalf of themselves.
Conclusion: Where Now?
From the brief discussion above it is clear that the zone of insolvency theory is still in play, at least in some jurisdictions. To a greater extent than was possible a year or two ago, however, lawyers advising directors of a distressed corporation can tell them that their principal focus can and should be upon making decisions that will maximize the value of the company, even if it means incurring expenses that the corporation's creditors might later criticize as deepening the company's insolvency or decreasing their likelihood of being paid. Counsel will obviously need to update their research with respect to the law of the pertinent jurisdictions. Attorneys advising corporations incorporated in Delaware presumably have the benefit of the last word, based on the Gheewalla decision.
Time will tell whether other courts agree with the Amcast court's conclusions with respect to zone of insolvency and deepening insolvency theories. If the Amcast court's decision is followed, directors and officers who are frequently the object of lawsuits following bankruptcy will benefit from significant protection. Corporation creditors have much less potent legal arguments to deploy against such officers and directors in the absence of zone of insolvency and deepening insolvency theories. Creditors can always, like the Liquidating Trustee in Amcast, seek to obtain authorization from the bankruptcy court through a corporation’s plan of reorganization to pursue claims on behalf of the debtor corporation, toward which the officers and directors do have a fiduciary duty. Although, the claims will be limited by the substantial protections provided to directors, and by extension, officers, under the Ohio business judgment rule as codified in the Ohio General Corporation Law. Unless creditors can persuade a court that defendants acted with deliberate intent to harm the corporation, or with reckless disregard for its interests, former directors and officers will have no liability.
*As seen in the Fall issue of DRI In-House Defense Quarterly