Ruling Makes Bankruptcy Suits Harder

  • United States
  • 06/25/2007
  • U.S. Law

A recent Delaware Supreme Court decision may have undermined cases against directors and officers of companies for actions they take just before they file for bankruptcy, such as increasing the company’s debt or signing major contracts with creditors.

The court ruled last month that creditors of a Delaware corporation that is insolvent or in the so-called “zone of insolvency” have no right to assert direct claims for breach of fiduciary duty against its directors. Some lawyers believe the decision eliminates the threat of suits that seek to recover from directors for actions they took shortly before bankruptcy.

The case was filed by “putative creditor” North American Catholic Educational Programming Foundation Inc. against three directors of the Delaware corporation, Clearwire Holdings Inc., which had agreed to buy the foundation’s Federal Communications Commission-approved licenses for microwave signal transmission to build a national wireless Internet network. North American Catholic Educational Programming Foundation Inc. v. Rob Gheewalla, No. 06-521 (Del.).

But a lawyer involved in a $41.5 million settlement with outside directors reached in March in a separate suit against directors of bankrupt Birmingham, Ala., shoe retailer Just For Feet Inc. said that companies nearing insolvency must still safeguard creditors’ interests to avoid lawsuits.

In the Just For Feet Inc. bankruptcy, the bankruptcy trustee filed a lawsuit in Alabama state court against the company’s directors, officers, accounting firm and independent auditors for breaches of fiduciary duty, fraud and related claims for the company’s actions as it neared bankruptcy or entered the zone of insolvency. There is no legal definition of “zone of insolvency,” but it has been said to refer to when a company nears insolvency or is at the point at which it can’t pay its debts.

The trustee said that the defendants’ decisions to ignore expert advice to file a Chapter 11 restructuring and conceal the company’s shaky financial status for two years led to a $90 million fire-sale liquidation of the company’s assets. Charles R. Goldstein, Chapter 7 Trustee for Just For Feet Inc. v. Harold Ruttenberg, No. 01-06833 (Jefferson Co., Ala., Cir. Ct.).

Some have claimed that Just For Feet could have been reorganized in a healthy way that preserved a substantial amount of value, and the settlement shows that zone-of-insolvency theories are alive and well.

In bankruptcy courts and state courts, lawyers have been testing claims and damages theories involving the duties of a company’s directors as a company nears bankruptcy or enters the zone of insolvency and “deepening insolvency.”

Lawyers disagree about whether the recent Delaware Supreme Court decision rejecting direct creditor claims for breach of fiduciary duty when companies enter the zone of insolvency, or are actually insolvent, shuts the door on director liability in those circumstances.

Courts have also been inconsistent. Cases involving zone-of-insolvency and deepening-insolvency issues have been a developing trend in the past several years. In bankruptcies, it’s incumbent upon trustees to pursue claims against directors, if they exist, for the benefit of creditors and shareholders. Despite the popularity of the theories, courts have been inconsistent on whether zone of insolvency and deepening insolvency are causes of action or a fact pattern.

Court decisions opened the door to such claims a few years ago, but the pendulum has recently shifted. For example, a 3rd U.S. Circuit Court of Appeals decision in 2006 said that only fraud, not negligence, can support a deepening-insolvency claim under Pennsylvania law. In re CitX Corp. Inc., Gary Seitz Ch. 7 Trustee v. Detweiler Hersey & Associates P.C., 448 F.3d 672 (3d Cir. 2006). Later in 2006, a Delaware court of chancery rejected deepening insolvency as an independent cause of action under Delaware law. Trenwick America Litigation Trust v. Ernst & Young LLP, 906 A.2d 168 (New Castle Co., Del., Ch.).

Many are now pointing to the May 18 Delaware Supreme Court decision in the North American Catholic case as a significant milestone in the zone-of-insolvency debate.
The Delaware Supreme Court upheld a Delaware court of chancery decision that dismissed a putative creditor’s case against three directors of wireless Internet company Clearwire Holdings Inc. for breaches of fiduciary duty while the company was in the zone of insolvency or insolvent.

The court said that creditors of a Delaware corporation that is insolvent or in the zone of insolvency “have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against its directors.

“Recognizing that directors of an insolvent corporation owe direct fiduciary duties to creditors would create uncertainty for directors who have a fiduciary duty to exercise their business judgment in the best interest of the insolvent corporation,” wrote Justice Randy Holland.

The Delaware decision erases the threat of direct claims by creditors against directors, but it doesn’t mean zone-of-insolvency issues are dead, Hollin said. Many such lawsuits are already filed as derivative cases on behalf of a corporation by a bankruptcy trustee, an insurance company receiver or a creditor’s committee, said Hollin of Powell Trachtman.

“It doesn’t take away the zone-of-insolvency issues,” Hollin said. “It says they’ve got to be brought in a derivative manner on behalf of the corporation, not by individual creditors.”

While insolvent companies could face derivative suits, the Delaware Supreme Court didn’t directly discuss whether companies in the amorphous zone of insolvency could also face derivative claims.