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                                                                                                                                        Web address: http://www.nylj.com

VOlUmE 238—NO. 2                                                                                                        TUESDAy, jUly 3, 2007

                                                         Bankruptcy practice
                                                                     By John J. RapiSaRdi


                Direct Creditor Claim for Breach of Fiduciary Duty Nixed


I
      n a recent decision, the Supreme Court                                                                    creditors seeking to avoid the heightened pleading
      of Delaware in North American Catholic                                                                    standard of derivative claims and the exculpation
      Educational Programming Foundation, Inc. v.                                                               provisions of most Delaware charters, have begun
      Gheewalla,1 took a further step in limiting the                                                           to argue that they also have the right to assert
ability of creditors to bring claims against directors                                                          direct claims against directors for breach of
of financially troubled corporations.                                                                           fiduciary duties owed to them individually.8
   In this noteworthy decision, the court held that                                                                • ‘North American Catholic Educational
individual creditors have no right, as a matter of                                                              Programming Foundation Inc. v. Gheewalla’
law, to assert direct claims for breach of fiduciary                                                               Factual Background
duty against the directors of a Delaware corporation,                                                              In Gheewalla, North American Catholic
regardless of whether such corporation is operating                                                             Educational Programming Foundation, Inc.
in the zone of insolvency or insolvent.                                                                         (NACEPF), was a member of an alliance that
                                                                                                                owned telecommunication licenses used for
Fiduciary Duties, Business Judgment                                                                             educational programs. In connection with these
                                                                                                                licenses, the alliance, including NACEPF, entered
   Directors of a solvent corporation owe fiduciary
                                                                                                                into an agreement with Clearwire Holdings Inc.
duties of care and loyalty to the corporation’s
                                                         taken was in the best interests of the company.”3      (Clearwire), a Delaware corporation, pursuant to
shareholders with respect to decisions made on
                                                         The rule serves as a mechanism to prevent              which Clearwire would pay the alliance to obtain
behalf of the corporation. Under the duty of care,
                                                         judicial second guessing of directorial decisions,     rights to such licenses as the licenses became
directors are required to exercise the degree of care
                                                         thereby allowing directors to manage corporations      available. Following the parties’ entry into the
that an ordinarily prudent person would exercise
                                                         without apprehension that their decisions will be      agreement, the market for the licenses collapsed,
under the circumstances. Essentially, directors
                                                         subsequently subject to litigation.                    and as a result, Clearwire began negotiations with
must have been fully informed of all material
                                                                                                                the members of the alliance to be released of its
information available to them prior to making a
business decision and must have not committed
                                                         Enforcement of Directors’ Fiduciary                    obligations under the agreement. Clearwire was
                                                         Duties                                                 ultimately able to reach settlements with all of the
gross negligence when acting on behalf of the
                                                            The shareholders of a solvent corporation may       members of the alliance except NACEPF. Notably,
corporation.2 To comply with their fiduciary duty of
                                                         seek to enforce the fiduciary duties of directors      during that period, Clearwire was in very poor
loyalty, directors must have no conflict of interest
                                                         by asserting derivative suits on behalf of the         financial health.
that would affect their ability to make decisions
                                                         corporation for harm caused thereto. Once a               NACEPF then commenced an action in
that are in the best interest of the corporation.
                                                         corporation becomes insolvent,4 however, the           the Delaware Chancery Court against three
   In analyzing whether directors of a corporation
                                                         principal beneficiary of the directors’ decisions      of Clearwire’s directors alleging, among other
have satisfied these duties, courts review such
                                                         becomes the creditors, who as a result have            things, a direct claim, based on breach of fiduciary
decisions in the context of the business judgment
                                                         standing to pursue derivative claims for breach        duties owed to it as a creditor of an insolvent
rule. The business judgment rule is a “presumption
                                                         of fiduciary duty to redress harm done to              corporation or a corporation operating “in the
that in making a business decision the directors
                                                         the corporation.5                                      zone of insolvency.”9
of a corporation acted on an informed basis, in
good faith and in the honest belief that the action         To maintain a derivative suit, the rules of the
                                                         Delaware Court of Chancery require a plaintiff to      Delaware Court of Chancery’s
                                                         plead with particularity his efforts and failure to    Analysis
John J. Rapisardi is a partner in the financial          cause the directors to take action.6 In addition,         In its decision, the Court of Chancery found
restructuring department of Cadwalader, Wickersham       under Delaware law, corporations can include           that significant contractual protections already
& Taft and is an adjunct professor of law at Pace        exculpatory provisions in their charters that          exist for creditors and any additional protections
University School of Law. Scott Griffin and              limit the personal liability of directors for breach   to be afforded through recognizing a direct claim
Chris Updike, associates of the firm, assisted           of fiduciary duty, which further hinders the           for breach of fiduciary duty would be “outweighed
in the preparation of this article.                      effectiveness of derivative suits.7 Accordingly,       by the disruption of established corporate
NEW yORk lAW jOURNAl                                                                                                                           TUESDAy, jUly 3, 2007


governance mechanism.”10 Thus, the court held             much needed guidance to directors at a very                Court of Chancery has similarly refused to expand
that as a matter of law, no direct claim for breach       critical moment, no direct claim for breach of             creditors’ rights in Trenwick America Litig. Trust v.
of fiduciary duty may be asserted by creditors            fiduciary duties may be asserted by the creditors          Ernst & Young, LLP, where it held that deepening
of a solvent corporation operating in the zone            of a corporation that is operating in the zone             insolvency is not a valid cause of action under
of insolvency.11                                          of insolvency.17                                           Delaware law.24
   In regard to insolvent corporations, the Court             In its discussion of the second issue, the Gheewalla      Although that decision is currently on appeal
of Chancery held that even assuming that a                court affirmed the established principle that when         in the Supreme Court of Delaware, Gheewalla
limited direct claim can be asserted by a creditor,       a corporation is solvent, shareholders may enforce         may be a precursor to the Delaware Supreme
NACEPF had failed to allege facts which set               fiduciary duties through derivative suits on behalf        Court upholding the Trenwick Chancery Court
forth such a claim.12 Accordingly, the Court of           of the corporation; however, when a corporation            decision on appeal. Together, the Delaware
Chancery granted the directors’ motion to dismiss         becomes insolvent, “creditors take the place of the        Supreme Court’s decision in Gheewalla and
and NACEPF appealed the decision to Supreme               shareholders as the residual beneficiaries of any          the Chancery Court’s decision in Trenwick
Court of Delaware.                                        increase in value.”18 Therefore, the creditors of          each appear to reinforce the principle that the
                                                          an insolvent corporation have standing to assert           business judgment rule continues to shield good
Supreme Court of Delaware’s Analysis                      derivative claims against directors for breach of          faith business decisions of directors regardless
                                                          fiduciary duties in a similar fashion to shareholders      of the financial state of the corporation. As a
   In affirming the Chancery Court’s ruling,
                                                          of a solvent corporation.19                                result, directors can retain the freedom to actively
the Delaware Supreme Court in Gheewalla also
                                                              The court, however, found that “[t]he fact that        negotiate in good faith with creditors and to make
divided its analysis into whether a creditor of a
                                                          the corporation has become insolvent does not              those decisions that best maximize the value of
corporation can bring a direct action against its
                                                          turn [derivative] claims into direct creditor claims,      the corporation, solvent or not.
directors for an alleged breach of fiduciary duty
                                                          it simply provides creditors with standing to assert
where the corporation is either (1) in the zone
                                                          those claims” and “[t]o date, the Court of Chancery
                                                                                                                                  ••••••••••••• ••••••••••••••••
of insolvency or (2) insolvent. With respect to
                                                          has never recognized that a creditor has the right
the first question presented, the Supreme Court                                                                         1. 2007 Wl 1453705 (Del. may 18, 2007).
                                                          to assert a direct claim for breach of fiduciary duty
of Delaware noted that directors generally owe                                                                          2. Aronson v. Lewis, 473 A2d 805, 812 (Del. 1984).
                                                          against the directors of an insolvent corporation.”20         3. Id. at 812.
their fiduciary obligations to the corporation
                                                          The court further added that “[a]t all times, claims          4. Insolvency may be defined as either (1) “a deficiency
and its shareholders, and while shareholders rely                                                                    of assets below liabilities with no reasonable prospect that
                                                          of this kind belong to the corporation itself because
on directors to protect their interests, “creditors                                                                  the business can be successfully continued in the face
                                                          even if the improper acts occur when the firm              thereof,” or (2) “an inability to meet maturing obligations
are afforded protection through contractual
                                                          is insolvent, they operate to injure the firm in           as they fall due in the ordinary course of business.” Prod.
agreements, fraud and fraudulent conveyance law,                                                                     Res. Group, L.L.C. v. NCT Group, Inc., 863 A2d 772,
                                                          the first instance by reducing its value, injuring
implied covenants of good faith and fair dealing,                                                                    782 (Del. Ch. 2004).
                                                          creditors only indirectly by diminishing the value            5. Production Resources, 863 A2d at 792.
bankruptcy law, general commercial law and other
                                                          of the firm and therefore the assets from which               6. See Court of Chancery Rule 23.1.
sources of creditor rights.”13                                                                                          7. See 8 Del. C. §102(b)(7).
                                                          the creditors may satisfy their claims.”21
   Recognizing a reluctance by Delaware courts                                                                          8. To distinguish between derivative and direct actions,
                                                              The court also noted that to recognize that            the court must determine (1) who suffered the alleged
to expand directors’ duties to creditors beyond
                                                          directors of an insolvent corporation owe direct           harm—the corporation or the suing plaintiff individually
relevant contractual terms and applicable law,                                                                       and (2) who would receive the benefit of the recovery
                                                          fiduciary duties to creditors “would create
the Supreme Court of Delaware agreed with the                                                                        or other remedy. Tooley v. Donaldson, Lufkin, & Jenrette,
                                                          uncertainty for directors who have a fiduciary             Inc., 845 A2d 1031, 1035 (Del. 2004).
Court of Chancery that adding another layer of
                                                          duty to exercise their business judgment in the               9. Gheewalla, 2007 Wl 1453705 at *3.
protection for creditors through direct claims for                                                                      10. N. Am. Catholic Educ. Programming Found., Inc. v.
                                                          best interest of the insolvent corporation” by
breach of fiduciary duty would provide minimal                                                                       Gheewalla, C.A. No. 1456-N, 2006 Wl 2588971, *12.
                                                          causing “conflict between those directors’ duty               11. Id. at *13. For the purposes of the motion to dismiss,
benefit and would be “significantly outweighed by
                                                          to maximize the value of the insolvent corporation         the Chancery Court found that NACEPF satisfactorily
the costs to economic efficiency.”14 The Delaware                                                                    alleged facts that permitted a reasonable inference that
                                                          for the benefit of all those having an interest in
Supreme Court also agreed with the lower court’s                                                                     Clearwire operated in the zone of insolvency during at
                                                          it, and the newly recognized direct fiduciary duty         least a substantial portion of the relevant periods.
finding that a solvent corporation operating in
                                                          to individual creditors.”22                                   12. Id. at *18.
the zone of insolvency is one in the most need of                                                                       13. Gheewalla, 2007 Wl 1453705 at *6.
effective decision-making on the part of directors                                                                      14. Id.
who can freely negotiate in good faith with its
                                                          Conclusion                                                    15. Id.
                                                                                                                        16. Id. at *7.
creditors, however, this discretion “would likely            Gheewalla provides comfort to directors presiding          17. Id.
be significantly undermined by the prospect of            over financially distressed corporations. Although            18. Id.
individual liability arising from the pursuit of direct   the Court of Chancery in Production Resources                 19. Gheewalla, 2007 Wl 1453705 at *7.
                                                                                                                        20. Id. at *8 (emphasis in original).
claims by creditors.”15                                   Group, L.L.C. v. NCT Group, Inc., left open                   21. Id.
   The court added that: “[w]hen a solvent                the “possibility” that a creditor of an insolvent             22. Id.
corporation is navigating in the zone of insolvency,      corporation may have a direct claim based on                  23. Production Resources, 863 A2d at 798, 800.
                                                                                                                        24. 906 A2d 168, 218 (Del. Ch. 2006).
the focus for Delaware directors does not change:         breach of fiduciary duty grounds, the Supreme
directors must continue to discharge their fiduciary      Court of Delaware has expressly put an end to a
duties to the corporation and its shareholders by         creditor’s right to assert such claims.23
exercising their business judgment in the best               moreover, the Gheewalla decision is important           Reprinted with permission from the july 3, 2007 edition of
interests of the corporation for the benefit of its       because it represents what appears to be a                 the New york law journal © 2007 Alm Properties, Inc. All
                                                                                                                     rights reserved. Further duplication without permission is
shareholder owners.”16 As a result, the Delaware          trend among Delaware state courts to restrain              prohibited. For information, contact 212-545-6111 or visit
Supreme Court held that, in order to provide              a creditor’s ability to sue directors. Indeed, the         www.almreprints.com. # 070-07-07-0009

				
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