Posts Tagged ‘fiduciary duty’

In Quadrant Structured Products v. Vertin et al, the Delaware Court of Chancery held in an opinion issued October 1, 2014, and again confirmed in relevant part on October 28, 2014, that lenders do not have direct claims against directors of a company for breach of fiduciary duty, and the directors do not owe fiduciary duties to the company’s lenders, but if a company is in the zone of insolvency, lenders do have the right to bring a derivative claim, just as a shareholder would under normal circumstances.


When a company is in financial difficulty, its shareholders and lenders often find themselves at odds. This is particularly true when the company has been through several rounds of financing, because holders of preferred stock have first right to the company’s assets in a liquidation, and even though they are shareholders, they are also pseudo-creditors. During the last recession, lender’s lawyers creatively asserted claims against company directors, first claiming that when a company was broke or nearly broke (in the “zone of insolvency”), the directors owed fiduciary duties to the lenders. When that didn’t work, they claimed that directors breached their fiduciary duties to the company by making risky business decisions that put a troubled company deeper in debt. These came to be known as the “zone of insolvency” claims.

Because a large percentage of U.S. companies are incorporated in Delaware, and many other states follow Delaware law on matters of corporate governance and fiduciary duties, Delaware courts addressed these arguments frequently from 2004 through 2010.

Company Directors or Mangers do NOT Owe Fiduciary Duties to Lenders

First, Delaware courts made it clear that directors (corporations), managers (LLCs), and general partners (partnerships) owe fiduciary duties to the entity, not to its owners, and not to its creditors. Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772, 792 (Del. Ch. 2004); North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007). It has long been law that shareholders cannot sue directors for breach of fiduciary duty, because fiduciary duties are owed to the company, not to individual shareholders. Instead, they must bring a “derivative” action – a law suit against the company, to cause the company to sue its directors. When lenders tried to sue directors for breach of fiduciary duty, Delaware courts turned them away also – in Gheewalla the court held: “The directors of Delaware corporations have the legal responsibility to manage the business of a corporation for the benefit of its shareholder owners,” and denied creditors the right to sue directors for breach of fiduciary duty. However, the court also held that once a company is broke, its creditors also have the right to bring a derivative suit for breach of fiduciary duty – like shareholders, lenders can sue the company to cause the company to sue its directors for breach of fiduciary duties.

Insolvency Does Not Expand the Usual Fiduciary Duties

Based on the decisions in Production Resources and Gheewalla, lenders next brought derivative claims asserting that if a company is in financial trouble (in the zone of insolvency), the directors have a duty to manage the company for the benefit of its creditors, and not make risky decisions that could lead to the company going broke, or “deepening its insolvency.” The argument goes like this: When a company is in trouble, the directors often take big risks, entering into questionable deals that, if successful will save the company, but have a high risk of failure. A risky deal that destroys the company leaves little for the creditors, but if the directors instead act to preserve the remaining assets for the creditors, they will at least get some if not all of their money back. If a company has significant debt, shareholders of troubled companies support taking bet-the-company risk – they have already lost their investment to the lenders, who get first pick. Thus, they have nothing to lose.

Delaware courts do not support the lenders argument that fiduciary duties shift to benefit the lenders: “…if 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.” Gheewalla, 930 A.2d at 101, See also Trenwick American Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 202-203 (Del. Ch. 2006) affd., 931 A.2d 438 (Del. Supr. 14 Aug 2007). The business judgment rule, as developed and refined over the years, particularly in Delaware, encourages risk and protects directors from risky decisions that do not work out, so long as they are taken properly and fairly.

Quandrant Structured Products v. Vertin

The Delaware Court of Chancery addressed this issue again recently. In Quadrant Structured Products v. Vertin et al, Athilon Capital, a company that sells credit protection to large financial institutions, guaranteed credit default swaps on collateralized debt obligations sold by its wholly-owned subsidiary. During the 2008 financial crisis, Athilon was deep into the zone of insolvency. Another company, EBF, bought all of the Athilon’s Junior Subordinated Notes and all of its equity, gaining control over Athilon. Thereafter, Quadrant Structured Product bought Athilon’s Senior Subordinated Notes.

EBF, now in control of Athilon, but in a junior security position, decided (1) not to exercise its right to defer interest payments to itself on the junior notes, (2) to pay above-market service and licensing fees to its own affiliate, and (3) to adopt a new, riskier business strategy instead of dissolving Athilon, which would have benefited other creditors like Quadrant. Since EBF’s notes were junior to Quadrant’s notes, EBF would get nothing in a liquidation, but could benefit if the risky strategy worked – they already had nothing, so all of the risk of EBF’s strategy fell on Quadrant. In short, a junior lender was able to improve its position over a senior lender by taking over the company and making decisions to its benefit. Quadrant, the senior creditor, sued the new directors, claiming that since the company was in the zone of insolvency, the directors breached their fiduciary duties by not making business decisions to benefit the senior lenders.

The Delaware court held that the directors’ decision to try to increase the value of the insolvent corporation by adopting a highly risky investment strategy was allowed under the “business judgment rule,” even though Quadrant and other senior creditors bore the full risk if the strategy failed. Vice Chancellor Laster held: “In the case of an insolvent corporation, board decisions that appear rationally designed to increase the value of the firm as a whole will be reviewed under the business judgment rule, without speculation as to whether those decisions might benefit some residual claimants more than others.”

The ruling makes it clear that, at least in Delaware, even though creditors gain the rights of shareholders to bring a derivative action when a company is in the zone of insolvency, that right does not include a shift of fiduciary duty from the company to the creditors. The directors’ duty remains to the company, and decisions normally protected by the business judgment rule do not lose that protection just because a company is going broke.

It should also be noted that the Delaware court remained consistent by holding that the directors’ decisions not to defer interest on the notes held by the junior creditor, and to pay above-market fees to an affiliate of the junior creditor, were conflicting interest transactions subject to entire fairness review, and not purely protected by the business judgment rule. That portion of the decision would have been the same without a “zone of insolvency” situation, and those claims were not dismissed


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In a December 19, 2014 ruling the Delaware Supreme Court confirmed that the “market-check” requirement from the original Revlon decision, and the subsequent QVC decision, do not require a board to run a mandatory auction as part of every change of control transaction. There are other options the board may use to satisfy its Revlon duties in a change of control of transaction, such as a  post-signing market check, so long as there are no material barriers against the emergence of a superior proposal and the company’s stockholders are provided with a non-coercive, fully informed shareholder vote. In the ruling, C&J Energy Services, Inc. et al v. City of Miami General Employees’ and Sanitation Employees’ Retirement Trust, the court held “Revlon does not require a board to set aside its own view of what is best for the corporation’s stockholders and run an auction whenever the board approves a change of control transaction.”  The ruling is discussed in detail on The Harvard Law School Forum on Corporate Governance and Financial Regulation: Delaware Court Reverses Preliminary Injunction Requiring Go-Shop.

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In Gantler v. Stephens, C.A No. 2392, 2009 WL188828 (Del. Jan. 27, 2009), the Delaware Supreme Court held that officers of Delaware corporations owe the same fiduciary duties of care and loyalty to the company and its shareholders as directors owe.  Prior Delaware court decisions have implied that officers might have the same fiduciary duties as directors, but no Delaware Supreme Court case had explicitly applied those duties to company officers before Gantler v. Stephens.  The Court also held that shareholder ratification of director action is limited to approval of matters that are not required to be approved by shareholders in the first place. 

In Gantler the board of directors of First Niles Financial, Inc., a bank holding company, retained a financial advisor to pursue a sale.  Three parties made bids, but company management failed to respond to bidder, and the remaining bidder proposed a stock-for-stock merger, which the board rejected without discussion.  The board then voted to proceed with a going private restructure and reclassification proposed by company management.  The shareholders voted to approve the reclassification.

Normally a board’s decision not to pursue a merger is reviewed under the business judgment standard, which entitles the board to a strong presumption in its favor and prevents a court from second guessing directors’ business decisions.  However, in this case the court found that two directors provided services to the bank that were likely to be terminated in the event of a merger, and that the Chairman failed to communicate with a bidder who he know intended to replace the board. The board’s rejection of the merger was therefore subject to entire fairness review, and was not granted the benefit of the doubt provided by the business judgment rule.  Since the competing offer was made by company management, and because management actions obstructed progress with the outside bidders, the Court then examined the disloyalty claim against the defendant officers, clarifying what had been implied in prior cases:  corporate officers owe the same duties of care and loyalty as directors do.  The Court found that the Chairman may have sabotaged the third-party due diligence process, and the treasurer may have assisted him, for which they each could be liable. 

The Court also clarified that common law shareholder ratification is only valid when the fully informed shareholders vote to approve director action that does not legally require shareholder approval to become effective.  However, this holding applies only to common law ratification and does not affect shareholder ratification under Section 144 of the Delaware General Corporation Law, which provides a process for approving transactions with a corporation in which directors or officers have a conflict of interest.

Gantler is important for several reasons:

  • Disgruntled shareholders who commonly sue directors for breach of fiduciary are now more likely to name officers as defendants in these lawsuits.  However, most state corporate laws protect directors from liability for breach of fiduciary duty, but do not provide any protection for officers.  That is not the case in Colorado.  Colorado Revised Statutes § 7-109-107 states that officers are entitled to the same mandatory indemnification as directors are under § 7-109-103.  Many companies doing business in Colorado are not Colorado corporations, but are formed in Delaware of other states.  I recommend that Companies, particularly those incorporated outside Colorado, review their articles of incorporation and directors and officers liability insurance policy for officer protection. Gantler is likely to result in more fiduciary duty claims against officers.


  •  States whose corporation law is based on the Model Corporate Act, such as Colorado, already impose fiduciary duties on company officers.  Colorado Revised Statutes § 7-108-401 states that directors and officers have fiduciary duties to the company.


  •   If your company seeks a shareholder vote to ratify board action, Gantler permits shareholder ratification only of matters that do not statutorily require shareholder approval to be effected.  For example, shareholder ratification of director action that requires shareholder approval, such as a merger or amendment to the certificate of incorporation, will not provide any additional protection if the shareholders were required to approve the action before it occurred. 


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