Creditors may sue directors of companies that can’t pay their debts, but the board members can protect themselves with the same provision that shields them from certain shareholder lawsuits, Delaware’s Court of Chancery ruled last month.
It’s long been settled in Delaware law that when a company is insolvent, the directors have fiduciary duties to their creditors. What’s been unclear in Delaware and most states is whether the so-called exculpatory provision—Section 102(b)(7) in Delaware’s corporation law—prevents creditors from suing directors for breaching their fiduciary duty claims, or not looking out for what’s in the creditors’ best interest.
The provision, in the charters of most companies incorporated in Delaware, ensures that shareholders can’t sue directors for money lost because the company was poorly managed. These are derivative duty of care claims.
Strine
“One of the primary purposes of 102(b)(7) is to encourage directors to undertake risky, but potentially value-maximizing, business strategies, so long as they do so in good faith,” said Vice-Chancellor Leo Strine in his Nov. 17 opinion.
But it does not protect directors who ignored their duties to the company, who knowingly broke the law, or who acted out of self-interest. Strine ruled that the same protection rules apply to creditors’ claims even though the provision mentions only shareholders’.
Delaware’s Court of Chancery often sets the standards for other states, so Strine’s decision was an important one nationwide.
Limited Protection From Creditors' Claims
Proctor
"The key is that the decision says Section 102(b)(7), which permits directors to be exculpated from shareholder damage claims, does include creditors’ claims as well, even though it doesn’t specifically address them," said Vernon Proctor, a lawyer at The Bayard Firm in Wilmington, Del. Proctor is representing Production Resources Group, which has been trying to collect over $2 million from NCT Group since 1999. Both companies are incorporated in Delaware.
PRG claims that NCT’s individual directors "totally failed to exercise appropriate oversight over NCT and its management and are directly responsible for the deplorable financial condition" of the company.
According to Strine, "Insofar as the complaint explicitly attempts to state a due care claim against the defendant-directors for mismanagement, the exculpatory charter provision bars it."
But Strine did not toss out all the creditor’s fiduciary duty claims. He said PRG included enough details about transactions between NCT and it’s primary creditor—a wife of one of the former directors—to suggest that NCT’s directors had engaged in conscious wrongdoing, and instructed PRG to pursue these claims.
McCarthy
"From the directors’ point of view, Strine’s opinion says: ‘If it’s simple negligence, you’ll be protected pre- and post-insolvency; but if you did something intentionally or engaged in self-dealing, then this provision is not going to protect you,’" said Jim McCarthy, founding partner of Diamond, McCarthy, Taylor, Finley, Bryant & Lee in Dallas.
For the creditor, this means they have a right to bring direct and derivative actions against directors when a company is insolvent, but that derivative claim will be dismissed if it’s a simple duty of care claim.
A derivative claim puts the stockholder, or creditor, in the shoes of the company. A stockholder argues that the majority of directors engaged in self-dealing or other intentional acts of bad faith, causing the company to lose value. If the company’s value sinks, then the stockholder, in turn, loses money.
The case against Michael Eisner, Michael Ovitz, and other former and current directors of Walt Disney is a shareholder derivative suit—one shareholder is suing the directors on behalf of the company. The suit claims that the directors breached their fiduciary duties by not scrutinizing Ovitz’s employment contract, entitling him to a $140 million severance package when he left the company 14 months later.
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