Directors’ Duty to Creditors

Directors and officers obviously owe a duty to the corporation and its shareholders. But if the corporation becomes insolvent, directors owe a duty to creditors as well.

Regrettably, the current economic climate suggests that more and more clients will face financial difficulty.

It is well recognized that corporate directors and officers owe a fiduciary duty to corporations they serve, and to the shareholders of those corporations. But if the corporations become insolvent, do directors have a collateral obligation to corporate creditors? That duty has been recognized by Delaware courts, as well as courts in Illinois. Schwendener, Inc v Jupiter Electric Co Inc, 358 Ill App 3d 65, 829 NE2d 818 (1st D 2005).

The BCA

The Illinois Business Corporation Act itself suggests directors’ and officers’ duty to suppliers and customers:

805 ILCS 5/8.85 In discharging the duties of their respective positions, the board of directors, committees of the board, individual directors and individual officers may, in considering the best long term and short term interests of the corporation, consider the effects of any action (including without limitation, action which may involve or relate to a change or potential change in control of the corporation) upon employees, suppliers and customers of the corporation or its subsidiaries, communities in which offices or other establishments of the corporation or its subsidiaries are located, and all other pertinent factors.

(Emphasis added.)

The underlying theory of officer and director liability to creditors in the case of insolvency is based on the assumption that once the corporation is insolvent, the shareholders no longer have anything of value. Their interest has been wiped out. Then the officers’ and directors’ duty shifts to protecting the creditors of the corporation.

Courts, particularly in Delaware, but now in other states as well, have begun to discuss directors’ possible fiduciary duties to creditors when the corporation is operating in the “zone of insolvency.”

Consequently, attorneys advising corporate officers and directors need to know when the corporation is insolvent. Although not directly on point, the Illinois Business Corporation Act (BCA) sheds some light on the subject.

The duty of directors to avoid authorizing distributions to shareholders when the corporation is insolvent was recognized before the BCA of 1983. The 1983 act, at 805 ILCS 5/9.10 (c) and (d), sought to give directors some guidance as to when and how they might determine the solvency of the corporation in making their decisions.

(c) No distribution may be made if, after giving it effect:

(1) the corporation would be insolvent; or
(2) the net assets of the corporation would be less than zero or less than the maximum amount payable at the time of distribution to shareholders having preferential rights in liquidation if the corporation were then to be liquidated.

(d) The board of directors may base a determination that a distribution may be made under subsection (c) either on financial statements prepared on the basis of accounting practices and principles that are reasonable in the circumstances or on a fair valuation or other method that is reasonable in the circumstances.

(Emphasis added.)

This language takes the determination of solvency out of a strict GAAP standard, replacing it with a standard of accounting practices and fair valuation that are reasonable in the circumstances.

The “zone of insolvency”

So corporate officers and directors of insolvent corporations have a fiduciary duty to the creditors. But what’s their obligation if the corporation is operating in the “zone of insolvency”? From this point on, imagine eerie music in the background. We’re approaching that ill-defined area where unintended consequences might occur.

Some argue that the shift in fiduciary obligations occurs not at the moment of insolvency but rather when, and only when, an insolvency proceeding is instituted. This gives the directors, officers, courts and third parties a bright-line standard.

The Delaware courts, however, have rejected this concept. See Geyer v Ingersoll Publications Co, 621 A2d 784 (Del Ch 1992), where the court said “insolvency means insolvency in fact rather than insolvency due to a statutory filing in defining insolvency for purposes of determining when a fiduciary duty to creditors arises.”

In Geyer, the Delaware chancery court wrote as follows:

An entity is insolvent when it is unable to pay its debts as they fall due in the usual course of business….That is, an entity is insolvent when it has liabilities in excess of a reasonable market value of assets held….Although there may be other definitions of insolvency that are slightly different, I am not aware of any authority which indicates that the ordinary meaning of the word insolvency means the institution of statutory proceedings.

This and other rulings gave rise to a theory that there must be a prefiling state called the “zone of insolvency,” or sometimes the “vicinity of insolvency,” where the fiduciary obligation to creditors springs into being. In Illinois, we have a federal district court opinion in Seidel v

Byron, 2008 WL 4411541 (ND Ill 2008) where the court wrote as follows:

Under Delaware law, corporate officers and directors owe creditors no extra contractual duties unless there are special circumstances, including operating in insolvency or in the zone of insolvency [citing Geyer]. The duties owed to creditors may arise before the filing of the bankruptcy petition because a corporation is insolvent when it is in fact insolvent, not when insolvency arises due to a statutory filing like bankruptcy.

A corporation is insolvent when its liabilities far exceed its assets, or when it is unable to pay its debts. Production Resources Group, LLC v NCT Group, Inc, 863 A2d 772, 775-776 (Del Ch 2004). The Delaware Supreme Court has not yet defined “zone of insolvency” precisely. North American Catholic Educ Programming Fund, Inc v Gheewalla, 930 A2d 92, 98 n 20 (Del 2007) (“NACEPF”). In NAECPF, however, the plaintiffs complaint was found to allege that the debtor operated in the zone of insolvency where it stated, among other things, that the debtor could not raise sufficient funds to pay its debts; that it was unable to borrow money from any source other than from one investor; and that it had a certain specific amount of cash on hand that was being spent at a specific rate each month.

The NAECPF case gives us a very clear statement regarding operating in the “zone of insolvency”:

In this case, the need for providing directors with definitive guidance compels us to hold that no direct claim for breach of fiduciary duties may be asserted by the creditors of a solvent corporation that is operating in the zone of insolvency. When a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: 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. Therefore, we hold the Court of Chancery properly concluded that Count II of the NACEPF Complaint fails to state a claim, as a matter of Delaware law, to the extent that it attempts to assert a direct claim for breach of fiduciary duty to a creditor while Clearwire was operating in the zone of insolvency.

(Emphasis added.)

The safest assumption

We have no direct guidance from Illinois courts yet on the zone of insolvency. Delaware suggests that until a corporation is actually insolvent – where its debts far exceed its assets or it is unable to pay debts as they mature – directors and officers owe their duty strictly to the corporation and the shareholders.

The safest assumption is that once a corporation is insolvent, whether or not a formal insolvency filing has occurred, the directors’ duty to creditors arises. We should counsel our director and officer clients accordingly.

Linscott R. “Lin” Hanson <lhanson@dkehq.org> is a member of DiMonte & Lizak, LLC in Park Ridge and the Institute on Illinois Business Laws of Chicago-Kent College of Law, the successor to the Secretary of State’s Business Laws Advisory Committee.