Summary: Dorsey partners Michael Foreman and Eric Lopez Schnabel consider in The Corporate Board magazine the issue of director fiduciary duties for a company facing insolvency. Boards traditionally owe company shareholders fiduciary duties of care and loyalty. However, when a corporation becomes insolvent, company creditors generally supersede shareholders as the principal constituency injured by any fiduciary breaches that diminish the firm's value.
Historically, the extent of directors' duties in a restructuring has been more complicated than a simple solvency/insolvency test. Many courts have suggested that fiduciary duties were owed to creditors before a company reaches insolvency - when it is in the "zone" or brink of insolvency. Others concluded that once a company became insolvent, acts causing a company to assume greater debt and become more insolvent (or entering "deepening insolvency") were justification for a derivative creditor suit.
Foreman and Schnabel argue that recent Court decisions have now given boards added powers to make tough choices needed for a restructuring or turnaround. Under these rulings, only shareholders may bring suits when a company is in the "zone of insolvency," "deepening insolvency" has been invalidated as a claim by the influential Delaware Supreme Court, and creditors are permitted to bring only derivative suits when a company is in fact insolvent.
"In the Zone: New Insolvency Rules" was published by The Corporate Board magazine, May/June 2008. Republished with permission.