Two recent decisions by the Delaware Supreme Court clarify the fiduciary duties owed to creditors by directors of Delaware corporations that are insolvent or operating in the zone of insolvency. First, in North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, the Delaware Supreme Court, in a case of first impression, addressed the ability of creditors to assert claims for breach of fiduciary duty against directors of a Delaware corporation that is insolvent or operating within the zone of insolvency. The Delaware Supreme Court unequivocally held that, as a matter of law, a creditor cannot assert a direct claim in either situation and that, when a corporation is insolvent, a creditor can only assert a derivative claim for breach of fiduciary duty against the corporation’s directors. See Gheewalla, 930 A.2d 92, 103 (Del. 2007).

Second, in Trenwick America Litigation Trust v. Ernst & Young, the Delaware Court of Chancery addressed the ability of creditors to assert a direct tort claim for “deepening insolvency” against directors of a Delaware corporation that is insolvent. Deepening insolvency is a judge-made cause of action, first recognized by the Third Circuit Court of Appeals, that could be asserted against a corporation’s directors, officers, lawyers, accountants and other professionals for damages resulting from improper acts that cause the corporation to become insolvent or more insolvent. In Trenwick, the Delaware Court of Chancery definitively held, and the Delaware Supreme Court subsequently affirmed, that Delaware law does not recognize deepening insolvency as an independent cause of action. See Trenwick Am. Litg. Trust v. Billet, 931 A.3d 438 (Del. 2007), aff’g Trenwick Am. Litig. Trust v. Ernst & Young L.L.P., 906 A.3d 168, 174-75, 195, 205 (Del. Ch. 2006).

As a result of these decisions, the Delaware Supreme Court has effectively eliminated creditors’ ability to assert direct claims against directors of Delaware corporations that are insolvent or operating in the zone of insolvency.

Unanswered Questions

One of the questions that remains unanswered in the Gheewalla and Trenwick opinions is whether a creditor can assert derivative claims for breach of fiduciary duty against directors when the corporation is operating within the zone of insolvency. While neither the Delaware Supreme Court nor the Delaware Court of Chancery specifically address this issue in Gheewalla or Trenwick, the Delaware Supreme Court in Gheewalla strongly suggested that creditors are precluded from asserting derivative claims in such a situation. First, the Delaware Supreme Court observed that, in questioning whether it was necessary for creditors to have a right to assert claims for breach of fiduciary duty against directors of a corporation operating within the zone of insolvency, creditors already have specific legal protections through “their negotiated agreements, their security instruments, the implied covenant of good faith and fair dealing, fraudulent conveyance law, and bankruptcy law.” Gheewalla, supra, at 99 (citing North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2006 WL 2588971, at *13 (Del. Ch. Sept. 1, 2006); Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772, 790 (Del. Ch. 2004); Big Lots Stores, Inc. v. Bain Capital Fund VVI, LLC, 2006 WL 846121, at *8 (Del. Ch. Mar. 28, 2006)). Second, the Delaware Supreme Court pointedly noted that directors of a Delaware corporation owe their fiduciary duties to the corporation’s shareholders and that such duties do not change when a corporation begins to operate within the zone of insolvency. The Delaware Supreme Court stressed that “[w]hen a solvent corporation is navigating in the zone of insolvency, directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.” Id. at 101. Finally, the Delaware Supreme Court stressed that insolvency, and not the zone of insolvency, is the dividing line when derivative claims of breach of fiduciary duty shift from the stockholders of a corporation to its creditors.

“When a corporation is solvent, [directors’] fiduciary duties may be enforced by its shareholders, who have standing to bring derivative actions on behalf of the corporation because they are the ultimate beneficiaries of the corporation’s growth and increased value. When a corporation is insolvent, however, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.” Id., at 101 (emphasis in original).

As a result, the Delaware Supreme Court’s highlighting of the existing legal protections available to creditors, strong focus on the fiduciary duties owed by directors to the corporation’s shareholders, and emphasis on creditors’ ability to enforce derivative claims only after a corporation’s insolvency all strongly suggest that the Delaware Supreme Court views creditors as having no right to bring derivative claims for breach of fiduciary claims against directors of a corporation that is operating within the zone of insolvency.

Advising Directors

The opinions in Gheewalla and Trenwick provide guidance to boards of Delaware corporations that are insolvent or operating within the zone of insolvency, including those considering whether to incur additional indebtedness or those considering a sale or comparable transaction involving a change of control of the corporation. While a Delaware corporation is operating within the zone of insolvency, directors owe fiduciary duties to the corporation’s stockholders and must exercise their business judgment in the best interests of the corporation and its stockholders. After a Delaware corporation becomes insolvent, directors continue to owe the same fiduciary duties, but the corporation’s creditors replace its stockholders as the primary constituency affected by any breach of such duties. As a result, as long as directors of an insolvent corporation continue to make good faith business judgments on an informed basis that they believe are in the best interests of the corporation and its creditors, such creditors will have difficulty successfully asserting any claim of breach of fiduciary duty.