November 19, 2007
Delaware Supreme Court Limits Directors' Liability to Creditors
Coauthored by Stephen B. Brauerman
Managing a creditor of a Delaware corporation became more treacherous this May when the Delaware Supreme Court slammed the door on a potential remedy for the creditors of insolvent or potentially insolvent Delaware corporations.
In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, the court clarified for the first time that creditors cannot assert direct claims for breach of fiduciary duties against the directors of corporate debtors. With more than half of the Fortune 500 and countless other companies incorporated in Delaware, this ruling will undoubtedly impact the rights of thousands of creditors. However, with a little knowledge, competent counsel, and a creative business plan, creditors can still control their own destiny and reduce their transaction risks.
While outwardly unappealing, in that it shuts off a potential means of holding directors accountable to creditors for the decisions that make it impossible to collect valid debts, the Gheewalla ruling represents the Delaware judiciary's consistent approach to business litigation and does recognize the fundamental right of creditors to protect themselves. By forcing corporate actors to become more self-sufficient, Gheewalla encourages creditors to negotiate safeguards uniquely tailored to circumstances of a given transaction.
This article will briefly review Gheewalla, discuss its impact on corporate directors and then suggest how creditors can protect themselves in its aftermath.
Clearwire Holdings, Inc. entered into an agreement with North American Catholic Educational Programming Foundation, Inc. to purchase the foundation's microwave signal transmission licenses for approximately $23.4 million, as part of its effort to create a national system of wireless internet connections. In June 2002, when the market for wireless spectrum bottomed out in the wake of the WorldCom accounting scandal, Clearwire informed NACEPF that it could no longer perform its obligations pursuant to the agreement because it could not obtain financing, as planned.
NACEPF then filed a lawsuit against several Clearwire directors, all of whom worked for Goldman Sachs, for breach of fiduciary duties for pursuing Goldman Sachs' agenda at Clearwire's expense. NACEPF based its fiduciary claims on the Clearwire directors' alleged failure to preserve assets for NACEPF's benefit and their decision to continue the agreement, knowing that Clearwire could not pay for the licenses — thereby depriving NACEPF of the opportunity to find other suitable buyers before the market crashed.
Ordinarily, directors of Delaware corporations owe fiduciary duties only to the corporation and its stockholders. However, when a company is insolvent or approaching insolvency (i.e. the company cannot meet its maturing obligations or has a deficiency of assets below liabilities, with no reasonable prospect of recovery — also known as the "zone of insolvency"), the corporate constituency can change.
Previous court decisions have hinted that when a corporation is insolvent or within the zone of insolvency, management's priorities and obligations, which normally flow to the stockholders, should run to the creditors.
Shifting the focus of fiduciary duties would ensure that directors of such corporations would have an obligation to maximize the value of the company to repay its debts, and be subject to the threat of litigation and personal liability for failure to do so. It was precisely this issue that the Delaware Supreme Court addressed for the first time in Gheewalla.
Concerned about the risk of hampering an insolve
Managing a creditor of a Delaware corporation became more treacherous this May when the Delaware Supreme Court slammed the door on a potential remedy for the creditors of insolvent or potentially insolvent Delaware corporations.
In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, the court clarified for the first time that creditors cannot assert direct claims for breach of fiduciary duties against the directors of corporate debtors. With more than half of the Fortune 500 and countless other companies incorporated in Delaware, this ruling will undoubtedly impact the rights of thousands of creditors. However, with a little knowledge, competent counsel, and a creative business plan, creditors can still control their own destiny and reduce their transaction risks.
While outwardly unappealing, in that it shuts off a potential means of holding directors accountable to creditors for the decisions that make it impossible to collect valid debts, the Gheewalla ruling represents the Delaware judiciary's consistent approach to business litigation and does recognize the fundamental right of creditors to protect themselves. By forcing corporate actors to become more self-sufficient, Gheewalla encourages creditors to negotiate safeguards uniquely tailored to circumstances of a given transaction.
This article will briefly review Gheewalla, discuss its impact on corporate directors and then suggest how creditors can protect themselves in its aftermath.
THE RULING
Clearwire Holdings, Inc. entered into an agreement with North American Catholic Educational Programming Foundation, Inc. to purchase the foundation's microwave signal transmission licenses for approximately $23.4 million, as part of its effort to create a national system of wireless internet connections. In June 2002, when the market for wireless spectrum bottomed out in the wake of the WorldCom accounting scandal, Clearwire informed NACEPF that it could no longer perform its obligations pursuant to the agreement because it could not obtain financing, as planned.
NACEPF then filed a lawsuit against several Clearwire directors, all of whom worked for Goldman Sachs, for breach of fiduciary duties for pursuing Goldman Sachs' agenda at Clearwire's expense. NACEPF based its fiduciary claims on the Clearwire directors' alleged failure to preserve assets for NACEPF's benefit and their decision to continue the agreement, knowing that Clearwire could not pay for the licenses — thereby depriving NACEPF of the opportunity to find other suitable buyers before the market crashed.
Ordinarily, directors of Delaware corporations owe fiduciary duties only to the corporation and its stockholders. However, when a company is insolvent or approaching insolvency (i.e. the company cannot meet its maturing obligations or has a deficiency of assets below liabilities, with no reasonable prospect of recovery — also known as the "zone of insolvency"), the corporate constituency can change.
Previous court decisions have hinted that when a corporation is insolvent or within the zone of insolvency, management's priorities and obligations, which normally flow to the stockholders, should run to the creditors.
Shifting the focus of fiduciary duties would ensure that directors of such corporations would have an obligation to maximize the value of the company to repay its debts, and be subject to the threat of litigation and personal liability for failure to do so. It was precisely this issue that the Delaware Supreme Court addressed for the first time in Gheewalla.
Concerned about the risk of hampering an insolve