Directors of the financially troubled company: guidance for a thankless job.

Directors of the financially troubled corporation face a difficult and thankless job. As leaders of a failing enterprise, directors must deal with unhappy creditors and disappointed shareholders, make the most of diminishing resources, and determine the course of the company's future. As an additional complication, once the corporation enters what is referred to as the "vicinity of insolvency," directors' obligations and the standards by which they are measured change. This article discusses the fiduciary duties applicable to directors of corporations in the "vicinity of insolvency" under Florida law and provides practical guidance for counsel to advise directors of these general legal principles, many of which remain unsettled, as they contemplate the available alternatives.

Fiduciary Duties of Directors Generally

Under Florida law directors oversee the management of the business and affairs of the corporation, (1) and their actions are governed by a mixture of statutory and common law principles. (2) The corporate director's fiduciary duties are generally expressed in terms of the "duty of care" and the "duty of loyalty" which have been codified in F.S. [section] 607.0830 (2001):

(1) A director shall discharge his or her duties as a director, including his or her duties as a member of a committee:

(a) In good faith;

(b) With the care an ordinarily prudent person in a like position would exercise under similar circumstances; and

(c) In a manner he or she reasonably believes to be in the best interests of the corporation. (3)

To satisfy the duty of care, directors must follow a reasonable and informed deliberative process. The directors should attend the meetings, ask questions, review written materials, and otherwise inform themselves of relevant information reasonably available to them. (4) In performing their duties, directors should seek the input of experts, such as investment bankers, attorneys, and accountants, (5) and should, if possible, consider and discuss important issues at more than one meeting. (6)

The duty of loyalty requires directors to act in good faith in the best interests of the corporation and its shareholders and to refrain from engaging in activities which would permit them to receive an improper personal benefit from their relationship with the corporation. The duty of loyalty prohibits misappropriation of corporate opportunities, bad faith, and self-dealing. (7)

Except in extraordinary circumstances, the "business judgment rule" acts as a judicial presumption that directors have fulfilled these duties, unless a challenger can affirmatively demonstrate a breach. The business judgment rule gives directors "wide discretion in the exercise of business judgment in the performance of their duties" and when it applies, courts will not "pass upon questions of mere business expediency or the mere exercise of business judgment, which is vested by law in the governing body of the corporation." (8)

Fiduciary Duties in the "Vicinity of Insolvency"

* To Whom is the Duty Owed--to Shareholders and Creditors or to Creditors Exclusively?

Directors of solvent Florida corporations owe fiduciary duties exclusively to the corporation's shareholders and not to its creditors. (9) It is well-settled law that once a company has entered statutory insolvency proceedings, fiduciary duties are owed to creditors. (10) However, in the landmark case of Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. 1991), the Delaware Chancery Court held that this duty to creditors begins earlier, at the point the corporation enters "the vicinity of insolvency."

The reasoning of Credit Lyonnais was explained in In re Ben Franklin Retail Stores, Inc., 225 B.R. 646 (Bankr. N.D. Ill. 1998) (aff'd 1999 WL 982964 (N.D. Ill. 1999); 2000 WL 28266 (N.D. Ill. 2000): When a corporation is solvent, satisfaction of creditors' claims requires only compliance with the contracts that create them. However, once the corporation enters financial distress, "the value of the creditors' contract claims against an insolvent corporation may be affected by the business decisions of managers" and "at the same time, the claims of the shareholders are (at least temporarily) worthless." (11) In this period of distress, creditors need protection beyond the scope of their contracts in the form of fiduciary duties from directors.

These Delaware concepts were adopted in Florida, more or less, in In re Toy King Distributors, Inc., 256 B.R. 1 (Bankr. M.D. Fla. 2000):

Generally, an officer or director owes fiduciary duties exclusively to the corporation's shareholders. When a corporation becomes insolvent, however, the officer or director's fiduciary duties shift to the creditors of the corporation. The shift in fiduciary duties from the shareholders to the creditors that occurs upon the insolvency of the corporation is sometimes referred to as the insolvency exception. (12)

The Toy King decision is not in complete accord with Credit Lyonnais, particularly on the point of to whom the duty is owed. Credit Lyonnais speaks in terms of a duty to the "corporate enterprise," thus encompassing shareholders and creditors. (13) In contrast, Toy King speaks in terms of duties "shifting" from shareholders exclusively to creditors exclusively. (14)

There appears to be no justification for the removal of fiduciary protections from shareholders upon the company's insolvency and none is articulated in Toy King. It may be that language regarding a "shift" in duties is a nod to reality rather than a hard-and-fast rule--often once a company gets into financial trouble, there is nothing left over for shareholders after demands of creditors are satisfied.

* What is the "Vicinity of Insolvency"?

Although an enterprise can enter the "vicinity of insolvency" long before formal bankruptcy proceedings are filed, there is no bright-line test. (15) In other contexts, courts have historically used two definitions of insolvency: balance-sheet insolvency (i.e., liabilities in excess of assets) and cash-flow insolvency (i.e., an inability to pay debts as they come due). Delaware cases appear to favor the cash-flow insolvency definition. (16) However, the Toy King decision primarily focused on the debtor's balance sheet insolvency which was determined after the court "recharacterized" the debtor's financial statements. The Toy King court did, however, also make reference to testimony that the debtor was unable to pay debts as they come due. Other non-Florida cases have found insolvency where a corporation is contemplating a transaction which may render it, upon consummation of the transaction, insolvent under either definition. (17)

* What Standard-Business Judgment Rule or Trust Fund Doctrine?

Courts are divided on the issue of whether the business judgment rule applies in the vicinity of insolvency. In In re Ben Franklin Retail Stores, the court explained the holding in Credit Lyonnais in terms of a business judgment rule analysis:

The chancellor's solution was to shield such directors from liability to shareholders by declaring that their duty is to serve the interest of the corporate enterprise, encompassing all its constituent groups, without preference to any. That duty, therefore, requires directors to take creditor interests into account, but not necessarily to give those interests priority. In particular, it is not a duty to liquidate and pay creditors when the corporation is near insolvency, provided that in the directors' informed, good faith judgment there is an alternative. Rather, the scope of that duty to the corporate enterprise is "to exercise judgment in an informed, good faith effort to maximize the corporation's long-term wealth creating capacity. (18)

The Toy King decision also used a business judgment rule analysis, but determined that the presumption had been overcome by evidence of self-dealing on the part of the defendant directors. (19)

Some authority exists, however, for holding directors to a higher "trust fund" standard. (20) This higher standard appears primarily in situations involving egregious facts, such as self-interested transactions and misappropriation of corporate assets. The trust fund doctrine was applied by a Florida court in In re Shultz, 208 B.R. 723 (Bankr. M.D. Fla. 1997), a decision based on Delaware law. In Shultz, Miramar Resources, Inc., a judgment creditor of the debtor, sought to have its debt excepted from the debtor's discharge under Bankruptcy Code [section] 523(a)(4) which requires, among other things, that the creditor establish that the debtor, a director of the creditor, was acting in a fiduciary capacity toward the creditor. The court concluded that a fiduciary relationship existed to the "corporate enterprise" as a corporation "on the brink of insolvency":

At the July 20, 1991 meeting, the Defendant knew that if the proposed transactions actually came to fruition that Miramar would be rendered insolvent; therefore, he knew that Miramar was at the "brink of insolvency" just prior to the transactions. Thus, pursuant to the Delaware Trust Fund Doctrine at the time of the July 20, 1991 meeting, the Defendant was a trustee of the corporation with the res being the corporate assets, the beneficiary being the other directors and the shareholders, and the affirmative duties being to act in the best interest of the corporation, including the other directors and shareholders. (21)

Although Shultz, in the context of Bankruptcy Code [section] 523(a)(4), would have been resolved differently under Florida law, (22) it is still less than clear whether a director of an insolvent Florida corporation could ever be held to a trustee standard. For example, in Beach v. Williamson, 83 So. 860 (Fla. 1919), the directors of a corporation which represented itself as having "no funds with which to conduct its business or pay its obligations" and which was "to all intents and purposes insolvent" were held to owe a trust fund type-fiduciary duty to creditors:

While the statement that the directors of a corporation are trustees for its creditors may be technically inexact, it is at least correct in the sense that they are bound to exercise diligence and good faith in dealing with the properties of the corporation, to the end that the creditors' interests may be protected. Especially is this true in the case of an insolvent corporation. (23)

This ambiguity makes it imperative that directors of insolvent Florida corporations be vigilant in the vicinity of insolvency.

Counsel: Consider All Alternatives

The ultimate goal for directors of a financially troubled company should be to maximize enterprise value. Sometimes it is possible to return the corporation to profitability; other times all that can be done is to determine the best way to get out.

Directors should be advised of all the various legal options available, including filing bankruptcy under federal law; a state law assignment for the benefit of creditors under F.S. ch. 727; a voluntary dissolution under F.S. [section] 607.1402; informal negotiation with creditors, including the potential voluntary surrender of collateral in exchange for release of debt pursuant to F.S. [section] 679.620; or taking no action at all. In considering the alternatives, directors must consider what is in the best interest of the corporation's creditors.

When directors reach an informed, reasonable, good faith conclusion that the continued operation of the company as a going concern is not economically justified, they frequently choose the certainty and finality of a court-supervised liquidation, either through bankruptcy or through a state law assignment for the benefit of creditors. Although filing bankruptcy would seem to be a choice that would not be second-guessed, it may not be the best business decision from the standpoint of creditors, in fact, a voluntary surrender of collateral to bona fide secured creditors could be a more desirable or cost-effective alternative, given the consequences to the various constituencies. (24)

Directors should consider all relevant factors when deciding whether to surrender collateral voluntarily to a secured creditor, particularly where the result would be to put the company out of business and leave nothing for other creditors. Directors should consider potential conflicts of interest and whether the secured creditor holds bona fide commercial debts and is independent from management. Directors should also consider the potential economic harm which the secured creditors would suffer as a result of the delay, additional expense, uncertainty, and potential deterioration of collateral if the company filed bankruptcy, as well as the company's additional legal expenses.

Conclusion

Directors of a Florida corporation in the "vicinity of insolvency" owe a fiduciary duty to the creditors of the corporation. Arguably, in light of Toy King, this is the only duty directors owe, superseding any previous obligation to the shareholders. To satisfy this duty, directors must be vigilant and carefully consider all of the alternatives available before choosing a course of action. Process is especially important in light of the ambiguity concerning which standard--the business judgment rule or the trust fund doctrine--will be applied. Moreover, directors should be aware that the obvious choice--judicially supervised proceedings--may not be the best one. Often from the creditors' prospective, because of the reduced transaction costs, the voluntary surrender of collateral makes more sense.

(1) FLA. STAT. [section] 607.0801(2) (2001).

(2) See S. Cohn and S. Ames, Florida Business Corporations-Overview, FLA. BUS. LAWS ANN. (2001-02 ed.).

(3) See also Orange Groves Co. v. Hale, 144 So. 674, 677 (1932) ("They are required to act in the utmost good faith, and in accepting the office they impliedly undertake to give the enterprise the benefit of their best care and judgment, and to exercise the powers conferred solely in the interest of the corporation.").

(4) Redstone v. Redstone Lumber & Supply Co., 133 So. 882, 884 (Fla. 1931) ("The directors of a corporation are chargeable with knowledge of such corporate affairs as it is their duty to keep informed of and of the facts which the corporate books and records disclose.").

(5) FLA. STAT. [section] 607.0830(2) (2001).

(6) See, e.g., Smith v. Van Gorkom, 488 A.2d 858,877-78 (Del. 1985).

(7) See, e.g., Federal Deposit Insurance Corporation v. Gonzalez-Gorrondona, 833 F. Supp. 1545, 1549 (S.D. Fla. 1993).

(8) Yarnall Warehouse & Transfer, Inc. v. Three Ivory Brothers Moving Co., 226 So. 2d 887,891-92 (Fla. 2d D.C.A. 1969).

(9) Connolly v. Agostino's Ristorante, Inc., 775 So. 2d 387, 388 (Fla. 2d D.C.A. 2000); Skinner v. Hulsey, 138 So. 769, 773 (Fla. 1931).

(10) Pepper v. Litton, 308 U.S. 295, 307 (1939); see also Andrew Shaffer, Corporate Fiduciary-Insolvent: The Fiduciary Relationship Your Corporate Law Professor (Should Have) Warned You About, 8 AM. BANKR. INST. L. REV. 479, 513 (2000).

(11) Ben Franklin, 225 B.R. at 653.

(12) Toy King, 256 B.R. at 167.

(13) See also Equity Linked Investors, L.P. v. Adams, 705 A.2d 1040, 1042 n.2 (Del. Ch. 1997).

(14) The Toy King court is not alone in this holding. See FDIC v. Sea Pines Co., 692 F.2d 973,977 (4th Cir. 1982), citing Davis v. Woolf, 147 F.2d 629, 633 (4th Cir. 1945) ("[W]hen the corporation becomes insolvent, or in a failing condition, the officers and directors no longer represent the stockholders, but by the fact of insolvency, become trustees for the creditors...."); In re Hoffman Assoc., Inc., 194 B.R. 943, 964 (Bankr. D.S.C. 1995) ("Furthermore, when the Debtor became insolvent, the fiduciary duty owed by Wilber Powers as a director of the Debtor, shifted from the stockholders to all of the creditors of the Debtor.").

(15) Geyer v. Ingersoll Publications Co., 621 A.2d 784,789 (Del. Ch. 1992).

(16) Geyer, 621 A.2d at 789; Credit Lyonnais, 1991 WL 277613 *35.

(17) In re Shultz, 208 B.R. 723, 729 (Bankr. M.D. Fla. 1997) (applying Delaware law); In re Healthco International, Inc., 208 B.R. 288, 300 (Bankr. D. Mass 1997).

(18) Ben Franklin, 225 B.R. at 655. See Equity Linked Investors, 705 A.2d at 1042 n.2 ("Where foreseeable financial effects of a board decision may importantly fall upon creditors as well as holders of common stock, as where the corporation is in the vicinity of insolvency, an independent board may consider impacts upon all corporate constituencies in exercising its good faith business judgment for the benefit of the `corporation.'").

(19) Toy King, 256 B.R. at 128.

(20) See, e.g., New York Credit Men's Adjustment Bureau v. Weiss, 305 N.Y. 1 (N.Y. App. 1953), where a New York court applied the obligations of trustees to the directors of the insolvent corporation. As trustees, the court determined, the directors were assigned "the burden of going forward to show that their action in selling the inventory at public auction resulted in obtaining full value under the circumstances in which they found themselves and did not occasion an improper or improvident depletion of the trust res." Id. at 9. See also Askanase v. Fatjo, 1993 WL 208440 *5 (S.D. Tex. 1993) (applying Delaware law) ("Moreover, the business judgment rule and other rules applicable to solvent corporations are of no effect in the context of insolvency and serve as no defense to a preferential transfer action under the trust fund doctrine.").

(21) Shultz, 208 B.R. at 729.

(22) In re Blackburn, 209 B.R. 4, 9 (Bankr. M.D. Fla. 1997) ("Florida law lacks ... any provision for an express or technical trust for corporate directors."); In re Miceli, 237 B.R. 510, 516 (Bankr. M.D. Fla. 1999).

(23) Beach, 83 So. at 863-64.

(24) Florida courts have approved voluntary surrenders of collateral in preference of some creditors over others. See, e.g., Jacksonville Bulls Football, Ltd. v. Blatt, 535 So. 2d 626, 629 (Fla. 3d D.C.A. 1988) ("An owner of property has the right to dispose of it as he or she sees fit; the only restriction on the right is that no transfer may be made which injures or prejudices existing creditors' rights.")

Gardner F. Davis and Karen Feagle Webb are both graduates of Duke University School Law School and business lawyers in the Jacksonville office of Foley & Lardner.

This column is submitted on behalf of the Business Law Section, John D. Emmanuel, chair, and G. Steven Fender, editor.