Real Estate Strategies Update – The Importance of Creditors to Officers and Directors of Restructuring Companies

    By Real Estate Strategies Group

    As many companies shift and restructure to adjust to changing market conditions, it is important for officers and directors of such companies to consider to what extent they may owe a fiduciary duty to creditors of the company. Virginia is one of several jurisdictions, including New York, in which courts will apply the Trust Fund Doctrine, which refers to the principle that assets of an insolvent corporation are held in trust for the benefit of shareholders and creditors by corporate officers.

    In insolvency, Virginia directors may owe fiduciary duties of care and loyalty to their creditors, in addition to their shareholders. These fiduciary duties must impact decisions made, and a creditor’s best interests must be considered. This is counter-intuitive for many directors, as in the normal course of a company’s business operations a director’s duty is to its shareholders. In insolvency, a director has a duty to manage the company and its assets in ways that will protect creditors in addition to shareholders. The resulting joint duty necessarily creates an environment where directors must operate with extraordinary care in fulfilling their fiduciary duties. For example, actions and decisions to protect assets may conflict with the goal of increasing the value of a company, a director’s duty to the shareholders under normal operating conditions.

    It is important to note that in many jurisdictions, including Delaware, courts have been reluctant to apply the Trust Fund Doctrine. The Supreme Court of Delaware recently found that ‘[i]t is well established that the directors owe their fiduciary obligations to the corporation and its shareholders’, and ‘the general rule is that directors do not owe creditors duties beyond the relevant contractual terms.’ N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A. 2d 92 (2007). The Gheewalla decision held that the creditors of a Delaware company operating within the zone of insolvency have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against a corporation’s directors.’ Therefore, under Gheewalla the focus for directors does not change. Their duty to the company and its shareholders is to exercise their business judgment in the best interests of the company for the benefit of the shareholders.

    In Delaware and in Virginia, courts may find that when a company is insolvent, a creditor has the standing to maintain derivative claims against directors for breach of their fiduciary duties of care and loyalty. The good news is that, in these instances, a well-established doctrine known as the business judgment rule applies, shielding a company’s officers and directors from liability for business decisions made in good faith. A good illustration of a court’s treatment of the business judgment rule can be found in In re Bear Stearns Litig., 2008 NY Slip Op 28500 (N.Y. Sup. Ct. 2008), where Bear Stearns shareholders claimed that the directors breached their fiduciary duties in their actions relating to a merger with JPMorgan. Citing a host of established law, the court explained that under the business judgment rule, there is a presumption that the directors of a corporation act on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Decisions will be upheld if they can be attributed to any rational business purpose. The burden is on a plaintiff to rebut the presumption by proving that the directors breached their fiduciary duty of care or loyalty or acted in bad faith.

    The duties of loyalty and care generally are met when a director acts in good faith. A lack of loyalty may be evidenced by a showing that the directors are interested or lack independence relative to the decision. A lack of care may be evidenced by the establishment that the use of a grossly negligent process that includes the failure to consider all material facts reasonably available. Bad faith is not simply bad judgment or negligence, but may be shown where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the company.

    While it is important for officers and directors of an insolvent company to be aware of their duty to balance the good of the company with the good of the creditors of the company, a good faith effort to exercise business judgment for the benefit of the company and its creditors is likely all that is required.

    Hazel C. Wong is an associate in Kaufman & Canoles’ Richmond office. Her practice involves all aspects of the acquisition, development, financing, leasing and sale of commercial properties and businesses. Hazel can be reached at (804) 771.5782 or

    The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2024.