By Neil B. Glassman and Charlene D. Davis

You are the CEO and a director of a company which you know might not be able to pay all its debts. You have managed this business for years in the shareholders' interests, maximising profit and extracting it where you can. But now, your company's enterprise value might never be enough to pay all claims against it. While there are few instances where the duties performed by a director and/or officer can be compared to a tug of war, when the corporation is insolvent, or near insolvency, you may find yourself playing the role of the "rope" in a highstakes game.

The tension on the "rope" is created by the fiduciary duties that directors of financially-distressed companies owe to at least two potentially divergent groups. At one end of the "rope" are the shareholders, the customary beneficiaries of fiduciary duties. They may want the troubled company to take more risk to maximise the return on their investment than the company's creditors, who are at the other end of the rope. Typically, creditors are contract parties to whom fiduciary obligations are owed only when the company is insolvent or in the vicinity of insolvency.

The tug is even stronger when the corporation's enterprise value is "right on the edge" of solvency. Shareholders claim their shares have value, while unsecured creditors contend that the "equity" is "under water" and that unsecured creditors are the "equitable owners" of the company. Whose interests do a director take care of first, especially in today's world where the creditors who are crying foul are often really interested in acquiring the enterprise?

Directors must first understand the fiduciary duties owed before they can properly discharge their obligations to both of these groups. Law libraries are full of cases where directors were unaware of their "dual masters" until it was too late. This chapter describes the fiduciary duties owed to shareholders, identifies instances where the directors' fiduciary duties extend beyond the shareholders to include creditors and provides suggestions on how directors may satisfy their obligations to these often divergent interests. This chapter focuses on the Delaware law of corporations. The laws of other states are mostly similar.

Fiduciary duties defined

Directors of a solvent corporation owe fiduciary duties to the corporation and its shareholders, who have entrusted control and management of the corporation to them. The duties consist of:

(i) the duty of care: directors must exercise care that an ordinary, prudent person would exercise in similar circumstances;
(ii) the duty of loyalty: directors must act with a reasonable belief that an action taken is in the best interests of the corporation; and
(iii) the duty of good faith: directors must act in good faith.

Directors are presumed to have acted in good faith, on a fully informed basis, and with the belief that actions were taken in the corporation's best interests. This presumption is embodied in the "business judgment rule". The business judgment rule is a judicial acknowledgment that when the director is acting in good faith, a court is reluctant to supplant its own judgment for a director's managerial prerogatives. In carrying out their fiduciary duties, directors may rely, in good faith, on the corporation's records and on information, opinions, reports or statements presented to the corporation by its officers, employees, professionals, or committees of the board of directors.

Fiduciary duties to creditors

When a corporation is solvent, it protects creditors' interests by complying with contrac