April 24th 2020
While management of a company generally has no duty to creditors of the company, there is one big exception: when the company is insolvent or in the “qons of insolvency.” Here is a look at three states analysis of the issue.
In Texas, the fiduciary duty owed to creditors when a corporation is insolvent is well-settled and has been consistently held in the state since 1893. See Lyons-Thomas Hardware Co. v. Perry Stove Mfg. Co., 86 Tex. 143, 156 (Tex. 1893) (holding that the assets of an insolvent corporation which has ceased to carry on business with no intent to resume, is a fund from which all unsecured creditors have the right to be paid on equal terms). In more modern times, courts have continued to hold that officers have a fiduciary duty to the creditors of a corporation when a corporation becomes insolvent. See Fagan v. La Gloria Oil & Gas Co., 949 S.W.2d 624, 628 (Tex. Civ. App. 1973) (holding that when a corporation “(1) becomes insolvent and (2) ceases doing business…[t]he officers and directors hold the corporation assets in trust for the corporate creditors. They are placed in a fiduciary relation to and owe a fiduciary duty to the creditors”); see also Dyer v. Shafer, Gilliland, David, McCollum & Ashley, Inc., 779 S.W.2d 474, 477 (“[C]reditors may challenge the breach if the transaction is made to defraud creditors or while the corporation is insolvent”).
Not only does a fiduciary duty to creditors exist during “the zone of insolvency,” but creditors also have proper standing to bring a claim in these situations. Similar to Delaware law, Texas courts recognize that when a company enters the “zone of insolvency,” creditors have standing to bring a breach of fiduciary care claim against the officers. See In re VarTec Telecom, 2007 WL 2872283, *2-3 (Bankr. N.D. Tex. September 24, 2007) (recognizing that under Texas Law, a corporation’s creditors are able to bring a cause of action against a corporation’s officers when the corporation enters a zone of insolvency); see also Carrieri v. Jobs.com Inc., 393 F.3d 508, 534 (5th Cir. 2004) (“When a corporation reaches the ‘zone of insolvency’, as with actual insolvency, the officers and directors have an expanded fiduciary duty to all creditors of the corporation, not just the equity holders”) (interpreting Texas law).
Since Delaware is a powerhouse of corporate law interpretation and litigation, many states look to the Delaware Court of Chancery for guidance on complex issues, such as the issue at hand. Delaware courts believe that officers owe a fiduciary duty to creditors when the corporation enters the “zone of insolvency.” Quadrant Structured Products Company, Ltd. v. Vertin 115 A.3d 535, 546 (Del. Ch. 2015). In addition, Delaware courts agree that creditors have standing to bring breach of fiduciary duty claims against directors and officers when the corporation enters the “zone of insolvency.” See North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92, 101-02 (Del. 2007) (holding that creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duty, since the corporation’s state of insolvency makes the creditors the principal constituency injured by any breach of fiduciary duty that would decrease the firm’s value) (emphasis added). It is important to note here that creditors of an insolvent corporation can bring a derivative suit against the corporation, but not a direct suit. Id.
Delaware has shed some light on the confusing lexicon employed by many courts when they refer to the “zone of insolvency.” Delaware sees insolvency in-of-itself as the marker of when the fiduciary duties of directors and officers extend to creditors. See North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92, 101 (Del 2007); Quadrant Structured Products Company, Ltd. v. Vertin 115 A.3d 535, 546 (Del. Ch. 2015). In doing so, the Court in Quadrant held that “[t]he only transition point that affects fiduciary duty analysis is insolvency itself.” 115 A.3d at 546. Additionally, Delaware courts due not require corporations to satisfy statutory filing to be classified as “insolvent,” but rather recognize that corporations can become insolvent “in-fact.” See generally Geyer v. Ingersoll Publications Co., 621 A.2d 784, 787 (Del. Ch. 1992) (“[I]nsolvency means insolvency in fact rather than insolvency due to a statutory filing in defining insolvency for purposes of determining when a fiduciary duty to creditors arises”).
New York Courts rely heavily on the “trust fund doctrine” when analyzing fiduciary duties once a corporation becomes insolvent. The doctrine states that “persons in control of an insolvent corporation must hold the corporation’s remaining assets in trust for the benefit of its creditors.” Aldoro, Inc. v. Gold Force Intern. Ltd., 52 A.D.3d 223, 224 (1st Dept. 2008). The doctrine cannot be invoked by a simple contract creditor before they “exhaust legal remedies.” Credit Agricole Indosuez v. Rossisyskiy Kredit Bank, 94 N.Y.2d 541, 550 (N.Y. 2000).
However, New York courts appear to follow the lead of Delaware courts that creditors have the standing to bring derivative suits against directors and officers of an insolvent corporation. See generally OFSI Fund II, LLC v. Canadian Imperial Bank of Commerce, 82 A.D. 537 (1st Dept 2011). Further, New York courts appear to be less accepting of the idea that creditors who bring derivative claims will actually get substantive results. See Acacia Investments, B.S.C.(C) v. West End Equity I, Ltd., 2020 WL 809721 at *9 (N.Y. Sup. Ct. Feb. 18, 2020) (stating that creditors can bring a case against officers and directors of an insolvent corporation based on standing, but does not create a guarantee that the claims will work). In addition, New York courts have noted that the “trust fund doctrine” similarly does not “automatically create…an equitable interest as such in corporate assets upon insolvency [for creditors].” Credit Agricole Indosuez v. Rossisyskiy Kredit Bank, 94 N.Y.2d 541, 549-50 (N.Y. 2000).
Assisted by Samuel Hines