In an area of the law that continues to be active, the federal bankruptcy court in Delaware has once again issued a detailed ruling on the actions of directors and officers leading up to a company's insolvency. Among the notable conclusions are: (1) failure to conduct due diligence before obtaining a loan may support a claim for breach of duty of care; and (2) there is no cause of action for "improvident lending" in Delaware or New Jersey. Official Comm. of Unsecured Creditors of Fedders N. Am., Inc. v. Goldman Sachs Credit Partners L.P. (In re Fedders N. Am., Inc.), 405 B.R. 527 (Bankr. D. Del. 2009).
The Delaware Supreme Court has long held that directors and officers of a Delaware corporation owe the corporation and its shareholders the duty of care, the duty of loyalty, and the duty to act in good faith. A breach of the duty of care cannot be proved unless there is a showing of gross negligence. To the extent that the decision made by the directors or officers was an informed decision, made in the good-faith pursuit of a legitimate corporate interest, the directors and officers are protected by the "business judgment rule."
The Delaware Supreme Court also has held that the fact that a company is insolvent does not mean that the company's officers and directors "cannot choose to continue the firm's operations in the hope that they can expand the inadequate pie such that the firm's creditors get a greater recovery." Trenwick American Litig. Trust v. Billett, 931 A.2d 438 (Del. 2007). See CR&B Alert, "Delaware High Court Affirms Deepening Insolvency Ruling," (November 2007) p. 1.
The above principles recently were applied in In re Fedders North America, Inc., an adversary proceeding wherein a creditors' committee was granted derivative standing to challenge the actions of the debtors' pre-petition lenders, and former officers and directors. The committee asserted claims for, inter alia, breach of fiduciary duty, aiding and abetting breach of fiduciary duty, fraudulent transfer, aiding and abetting fraudulent transfer, improvident lending, tortuous interference with contractual relations, and tortuous interference with prospective business advantage (the "Complaint").
Fedders had been a successful business for many years. Between 1996 and 2006, Salvatore Giordano, Jr. became the executive chairman and embarked on new product lines, and moved much of its operations overseas, financed by the incurrence of substantial debt. By February 2007, Fedders was in default of its obligations with its lenders, which led to an inability to access new cash. By March 2007, Fedders obtained new financing with new lenders ("Lenders") that paid off the old debt, and increased its debt by 20 percent.
By May 2007, Fedders was in default of certain covenants pertaining to its earnings under the new loans. A chapter 11 was filed in August 2007, the operating companies were sold, and a plan of liquidation was filed.
The creditor's complaint was met with a motion to dismiss by the Lenders and the former officers and directors (collectively, the "Defendants"). The Third Circuit has summarized the pleading standard created by Federal Rules of Civil Procedure, Rule 8 and Rule 12(b)(6) as follows:
Stating... a claim requires a complaint with enough factual matter (taken as true) to suggest the required element. This does not impose a probability requirement at the pleading stage, but instead simply calls for enough facts to raise a reasonable expectation that discovery will reveal evidence of the necessary element.
In re Fedders, at 537, citing Phillips v. County of Allegheny, 515 F.3d 244, 234 (3d Cir. 2008).
Delaware law requires that a plaintiff plead facts supporting an inference that officers and directors committed a cognizable breach of duty. Fedders summarizes the applicable law as follows:
- Duty of Care: A plaintiff cannot prove a breach of duty of care without showing gross negligence, which generally requires directors and officers to fail to inform themselves fully and in a deliberate manner.
- Duty of Loyalty: The duty of loyalty mandates that the best interest of the corporation and the shareholders take precedent over any interest possessed by a director, officer or controlling shareholder, and not shared by the stockholders generally.
- Duty to Act in Good Faith: The duty to act in good faith is a subsidiary element of the duty of loyalty. The Delaware Supreme Court has identified three examples of conduct that may establish a failure to act in good faith: intentional acts with a purpose other than that of advancing the best interest of the corporation; acts with the intent to violate applicable positive law; or intentional failure to act in the face of a known duty to act demonstrating a conscious disregard for the director's duties.
Having reviewed the applicable law, the bankruptcy court made a number of key findings in Fedders with respect to the Defendants' Motion to Dismiss the Complaint, as summarized below.
Breach of Fiduciary Duty – Directors
Simply alleging that a corporation was insolvent and took on more debt is not enough to plead a breach of fiduciary duty.
The fact that officers and directors continued to work and take compensation, standing alone, is not sufficient to plead a breach of fiduciary duty.
Because the directors approved the new loan without due diligence—Fedders never obtained a financial assessment verifying that it would be able to comply with the covenants contained in the financing agreements—the Complaint pleaded sufficient facts to support a claim for breach of duty of care with respect to the loan.
Aiding and Abetting Breach of Fiduciary Duty—Lenders
Because the court found a claim for breach of duty of care with respect to the loan, the court held that the Complaint pleaded sufficient facts to support a claim for aiding and abetting a breach of fiduciary duty of care asserted against the Lenders.
The court acknowledged that the claim against the directors for breach of duty of care with respect to the loan would be dismissed because the Fedders' certificate of incorporation exculpates them from monetary liability. Nonetheless, the court determined that the exculpation of the directors does not necessarily prevent the Lenders from being liable for aiding and abetting the directors' breach of duty of care.
Fraudulent Conveyance: Actual Fraud
Change of Control provisions that would have given several directors large severance payments were not sufficient to support a cause of action for fraudulent conveyance because a change of control never occurred, and hence the payments were never made.
Revisions to Giordano's employment agreement that resulted in a potential release of a $6 million no-interest loan he had taken from Fedders was sufficiently pleaded to state a claim for a fraudulent transfer against Giordano.
Fraudulent Transfer – Constructive Fraud
Because the new loan was drawn down when made—i.e., consideration was received—the Complaint did not state a claim for constructive fraud against the Lenders.
The Complaint did state a claim against Giordano wherein it alleged that Fedders received less than reasonably equivalent value from Giordano in exchange for an interest-free loan, and that Fedders made the transfer to or for the benefit of an insider not in the normal course of business.
Aiding and Abetting Fraudulent Transfers
The plaintiff did not have standing to bring a state law cause of action for aiding and abetting a fraudulent transfer in the bankruptcy proceeding. Furthermore, there is no federal cause of action for aiding and abetting a fraudulent transfer.
No Delaware or New Jersey (jurisdictions of applicable law) has recognized a cause of action for "improvident lending," so the court considered whether the Delaware and/or New Jersey Supreme Court would recognize such as cause of action. After reviewing decisions from other courts, the federal bankruptcy court in Delaware concluded that a cause of action for improvident lending does not exist.
The court concluded that other remedies exist to address the issues involved (e.g., aiding and abetting a breach of fiduciary duty, lender liability premised on contractual rights, and common law fraud and fraudulent transfers), and any attempt to create a new remedy of "improvident lending" would be wholly duplicative.
Particularly in the current economic climate, businesses and their counsel should be acutely aware of the developing law surrounding D&O liability for corporations experiencing financial difficulties.
A regular review of the principles involved in Trenwick, and its progeny, which now includes Fedders, is essential in advising companies teetering on insolvency, and their officers, directors and lenders. The principles involved in this line of cases also are important in contemplating actions to seek recovery for the losses suffered as a result of such insolvency.