FIDUCIARY DUTIES IN CASE OF A TROUBLED START UP COMPANY PRESENTATION TO CORONADO VENTURES FORUM March 18, 2004 1. Fiduciary Duty to Creditors. Craig M. Tighe Gray Cary Ware & Freidenrich LLP a. General Rule. Creditors only owed contractual duties; no fiduciary relationship. No duties will be imposed, beyond those articulated in contracts, by use of good faith and fair dealing covenant implied in the contracts. This is true even in the case of debt that is convertible into equity, as courts generally hold that a creditor s right to become an equity holder does not give the creditor the fiduciary protection afforded to shareholders. b. Insolvency Rule. Creditors are owed fiduciary duty if: i. Insolvency. Corporation is insolvent; ii. iii. Vicinity of Insolvency. Corporation is in vicinity of insolvency; or Cause Insolvency or Bring to Vicinity of Insolvency. If an action corporation takes would cause insolvency or bring it to vicinity of insolvency. This insolvency trigger appears to be limited to actions, such as leveraged buyouts, that, upon their completion, would clearly result in corporation being insolvent or in vicinity of insolvency. Delaware courts apply all three of these fiduciary duty triggers. Problem. Courts have yet to articulate standard for determining when a corporation is in vicinity of insolvency. c. Insolvency Test. Courts employ multiple insolvency definitions: i. Balance Sheet Definition. Corporation is insolvent when its liabilities exceed the reasonable market value of its assets. 1
ii. Cash Flow Definition. Corporation is insolvent when it is unable to pay its debts as they become due in the ordinary course of business. iii. Unreasonably Small Capital Test. If corporation has unreasonably small capital, that is, it has a balance sheet that indicates insolvency is reasonably foreseeable, then creditor fiduciary duties arise. Corporation does not need to be the subject of bankruptcy, liquidation or similar proceedings for these tests to apply. Delaware courts employ all three insolvency definitions. Problem. Determining whether a corporation is insolvent under the balance sheet or the cash flow tests is often difficult and subject to second guessing (For example, ascertaining whether a corporation is insolvent under the balance sheet test could be problematic, as the courts, in the fiduciary duty cases, have not indicated whether assets should be valued on a going-concern or a liquidation basis, and these bases can yield significantly different numbers). This is particularly true in the case of early stage technology companies whose business plans are predicated on their ability to raise multiple equity rounds to grow and survive. For such companies, a narrow reading of the cash flow test would suggest that they are insolvent if, prior to achieving positive cash flow under their business models, they will need to raise additional equity and they do not have the commitments for such equity in hand. d. Parties Owing Duty. There is a split of judicial authority, as some courts hold directors and officers both owe creditors the fiduciary duty. Others, though, limit duty to directors. Delaware courts hold that only directors are fiduciaries of creditors. Note: Officers could nevertheless have creditor liability for fiduciary breach if held to have aided and abetted director breach. Although not all jurisdictions recognize aiding and abetting cause of action, Delaware courts have done so. Also, a creditor, such an investor that provides a bridge loan to the corporation, could have aiding and abetting liability in the jurisdictions that recognize such causes of action. Aiding and abetting liability would exist if (1) the directors breached their fiduciary duty to the creditors, (2) a officer or creditor is aware of the breach, and (3) the officer or creditor materially assists or encourages the breach and obtains some benefit from the breach. e. Legal Basis for Fiduciary Duty. i. Trust Fund Doctrine. Once a corporation is insolvent, all of its assets become a trust fund for the benefit of its creditors. 2
ii. Equitable Interest Theory. Once a corporation is insolvent or verging on insolvency, its creditors are its residual owners, and decisions that the directors then make can have a pronounced impact on the creditors and therefore their interests need to be taken into account. Delaware courts generally analyze director creditor fiduciary duties in terms of equitable interest theory. They also apply the trust fund doctrine on occasion. f. Impact of Creditor Fiduciary Duty on Shareholder Duties. The courts are divided on the question whether directors and officers continue to owe shareholders fiduciary duties once they stand as fiduciaries in relation to creditors. Some hold that they cease to be shareholder fiduciaries, while others view them as having fiduciary duties to both constituencies. Delaware courts hold that directors are fiduciaries to both creditors and shareholders, and owe their duties to the corporate enterprise and more specifically that the expanded fiduciary duty is to maximize the value of the corporate enterprise. g. Nature of Fiduciary Duty Owed to Creditors. There is no judicial consensus as to the scope of the fiduciary duties owed to creditors. In some cases, it has been limited to the duty of loyalty, while in others, the duty of care has been implicated as well. Delaware courts, in applying the creditor fiduciary label to directors, require them to observe both the duty of care and the duty of loyalty. i. Duty of Loyalty. (a) (b) Description of Duty. This duty requires directors and officers to act in good faith and in the reasonable belief that their actions are in the corporation s best interests. This duty prohibits self-dealing, such as misappropriation of corporate opportunities. The vast majority of cases in which a breach of fiduciary duty to creditors has been found have involved self-dealing and similar violations of the duty of loyalty. Standard for Determining Compliance. If a director has a personal interest in a transaction, the director s conduct will be judged under the entire or intrinsic fairness standard and the director will bear the burden of proving the overall fairness of the transaction to the corporation. As a practical matter, this means that the court is more likely to second guess the director s actions than it would when the business judgment rule, as described below, governs the analysis of 3
the director s conduct. However, if the transaction is approved by a disinterested majority of the board (or committee of the board), the burden of proof in litigating the transaction would shift to the creditors or other parties challenging the insider transaction. ii. Duty of Care. (a) Description of Duty. This duty requires directors and officers to: carefully monitor the corporation s operations; and act in an informed and thoughtful manner when making decisions, exercising the degree of care that an ordinarily careful and prudent person would use in similar circumstances. (b) (c) Fulfilling the Duty. Based on the judicial pronouncements that the objective, once a corporation is insolvent or on the lip of insolvency, is to maximize the value of the corporate enterprise, it appears that directors conduct, for duty of care purposes, will be measured against this goal. As shown on the worksheet Maximizing the Value of the Corporate Enterprise (Exhibit A to this outline), directors, to fulfill their duties, and to balance the interests of creditors and shareholders, may or may not be obligated to pursue strategies that favor creditors as against shareholders the appropriate course of action turns on expected enterprise values, not likelihood of creditor claims being paid. Standard for Determining Compliance. There has been some judicial controversy regarding the standard by which director and officer actions are to be evaluated in terms of compliance with the duty of care. Some courts (generally those applying the trust fund doctrine) evaluate them under a mere negligence standard, which could easily result in liability being imposed. Others state that the business judgment rule, as in the case of evaluating observance of the duty of care owed to shareholders, is to be applied. This rule presumes that in making a business decision, directors and officers act on an informed basis, in good faith and in the honest belief that it was taken in the corporation s best interest. It largely shields directors and officers from judicial second-guessing. 4
Delaware courts evaluate director conduct, for duty of care purposes, under the business judgment rule. The business judgment rule might not provide as broad protection for directors in shielding them from liability to creditors, as it does in limiting exposure to shareholder liability, as the courts, in applying fiduciary duty to creditor concepts, have been willing to broaden the definition of an interested director transaction. In one case, the court, in evaluating a director s decision to vote in favor of a leveraged buyout (an LBO ) of the corporation, stated that the director, as the representative of a substantial stockholder that would benefit from the LBO, was interested in the LBO, and therefore had to demonstrate the LBO s entire fairness, unless it was approved by a majority of disinterested directors. Thus, the director was labeled an interested party, even though he did not have any interest in the proposed buyer in the LBO. A further issue with the rule is that it only protects actions taken by directors; it does not shield inaction. As a Delaware court has stated, [t]echnically speaking, [the business judgment rule] has no role where directors have either abdicated their functions, or absent a conscious decision, failed to act. Thus, unless directors are vigilant in monitoring a corporation s financial condition and prospects, so that they can ascertain when they may become fiduciaries to the corporation s creditors, and based on such change in duties, make decisions about the corporation s actions, they could be exposed to creditor liability for breach of duty of care. Specifically, their failure to make specific decisions (even if they would have been to stay the course), by depriving them of the business judgment rule s protection, could result in a court closely examining the corporation s operations under the duty of care and concluding that they failed to maximize the corporation s long-term value. Finally, it is possible that a court would discard the business judgment rule in favor of close scrutiny of directors actions if they are selling the insolvent corporation. Under the Revlon doctrine, directors of a Delaware corporation, once they decide to sell the corporation, are obligated to maximize the sales price for the shareholders benefit, and their actions will be judged for their reasonableness in achieving this goal. 5
iii. Applying the Fiduciary Duty. (a) (b) Liquidation. The courts have held that the expansion of directors fiduciary duties to include creditors does not, in and of itself, require the directors to immediately take action to liquidate the corporation s assets and pay the creditors claims, if they reasonably believe that the corporation will be worth more as a going concern. Payment of Creditor Claims. As fiduciaries of creditors, directors are not barred from favoring certain creditors over others when paying claims. They are, however, prohibited from preferring insider creditors (e.g., a creditor affiliated with a director or officer) at the expense of other creditors. This prohibition extends to barring directors and officers from having their insolvent corporation pay third party creditor claims that they have personally guaranteed in preference to non-guaranteed obligations. This prohibition on favoring insider claims and insiderguarantied claims should not apply, though, in terms of favoring insider-related claims that are secured in relation to unsecured third party claims. Note: Directors and officers could be liable for payments on their claims while the corporation is insolvent through invocation of the Uniform Fraudulent Transfer Act (the UFTA ), rather than fiduciary duty principles. Under Section 5(b) of the UFTA, which has been adopted by most states, a payment that an insolvent corporation makes on an insider claim, when the insider has reasonable cause to believe that the corporation is insolvent, can be avoided by any creditor of the corporation with a claim outstanding on the payment date. For a director or officer to escape liability under Section 5(b), he or she would need to demonstrate that the payment was made in the ordinary course of business or financial affairs of the [corporation] and the [director or officer]. (c) Restructuring of Creditor Claims. Although the courts do not appear to have addressed this issue, it should not be a breach of the fiduciary duty to creditors, if an insolvent corporation negotiates with its creditors, to extract concessions, such as debt forgiveness, debt conversions into equity and payment extensions, if the board reasonably believes that such debt adjustments, by reducing current 6
demands on cash flow or otherwise, is what is best for the corporate enterprise. (d) Obtaining Goods and Services on Credit. Directors and officers can breach their fiduciary duty to creditors by having the corporation acquire goods and services on credit when they know there is a significant possibility that the corporation will be unable to pay for them. (e) (f) (g) (h) Shareholder Distributions. Distributions to shareholders, even if they would be lawful under applicable corporate law, cannot be made while creditor claims are outstanding. Resigning as Director. A director might not be able to escape liability to the company s creditors by resigning from the board. If the director, by remaining on the board, could have stopped a course of action that a court determines was a breach of the board s fiduciary duty to creditors, it could hold the resignation was part and parcel of the breach. Assignment for the Benefit of Creditors. In an assignment for benefit of creditors (an ABC ), the corporation s assets are transferred to a trustee, who then liquidates them and pays creditor claims from the proceeds. Once the trustee assumes control, directors no longer have any operational role, and therefore should not have any fiduciary duty liability exposure arising from the liquidation process. However, the directors could incur liability in approving the ABC, if initiating the ABC, rather than another course of action, is a breach of fiduciary duty. Fraudulent Transfers. Directors approving a fraudulent conveyance while the corporation is insolvent have been held to breach their fiduciary duty to the creditors. h. Availability of Statutory and Contractual Protections from Liability. It is unclear whether the provisions in a corporations articles or certificate of incorporation that limit directors and officers liability for breaches of fiduciary duty would be available to shield directors and officers from liability to creditors for fiduciary breaches. While some courts have applied those provisions to creditor fiduciary breaches, others have ruled that they apply only to liability to the corporation or its shareholders, and therefore are not binding on creditors who were not parties to such contractual provisions. Even if a court holds that such indemnification provisions are enforceable, they are likely to have little, if any, value in a 7
start up company that has wound down its operations, as it unlikely to have the assets to cover indemnification claims when they arise. i. Availability of Insurance Coverage. The typical directors and officers ( D&O ) liability insurance policy will protect directors and officers against creditor breach of fiduciary duty claims. This coverage generally covers both the costs of defending against such claims as well as indemnification for settlements or judgments. D&O policies contain conditions and exclusions that limit coverage. The most typical exclusion asserted by insurers in this context is the so-called insured vs. insured exclusion. While the language of this exclusion varies materially, in its broader form claims by a bankruptcy trustee, or even a creditors committee, arguably may be excluded. Although courts generally have not been receptive to such insurer arguments, many insureds now insist, when negotiating renewal of their D&O policies, that the exclusion be worded to specifically note that claims by bankruptcy trustees and/or creditors committees do not fall within its ambit. Unfortunately, the typical start up company does not maintain D&O coverage, so that the policy coverage issue is likely to be moot. j. General Guidelines for Action. i. Determining When Duty Arises. The uncertainties involved in determining insolvency, and the lack of judicial guidance on what is the vicinity of insolvency for purposes of the fiduciary duty shift or expansion place directors and officers at risk of judicial second-guessing as to when the fiduciary duty to creditors commenced. These uncertainties notwithstanding, certain transactions, if undertaken while a corporation is less than financially robust, would affect the corporation s equity and debt interests differently. Consequently, the prudent course for management is to assume that the fiduciary duties have expanded to protect creditors, and to evaluate and undertake the transactions in light of such expanded duties. Ironically, for early-stage technology companies that must live from round to round of financing, without certainty that next equity raise or debt financing will be successful, this problem is probably ameliorated under one or more of the insolvency tests, they have a high probability of being deemed insolvent, when viewed retrospectively, and therefore their management probably would be best advised to operate as though they owed their duties to the corporate enterprise. 8
Such a cautious course of action should reduce the risk of a successful creditor fiduciary breach claim. However, it may expose the directors to a shareholder fiduciary breach challenge, if the corporation proves to have been solvent and the directors did not pursue a course to maximize shareholder value. While there is case law that directors do not have a per se duty to maximize shareholder value in the short term, it is not certain that the courts would apply such holding in this context. ii. Fulfilling Duty. To fulfill their duty of care, management needs to be attentive and pro-active once the corporation is experiencing financial difficulties. Only in this way will it be possible to obtain the protection afforded by the business judgment rule. Management, before undertaking any major action, should carefully evaluate the alternatives open to it, and should make a record, along the lines of the worksheet attached as Exhibit A, of the expected values and impacts of the alternative courses. All of this information, and the board s deliberations and decisions based on it, should be memorialized in board minutes. To the extent possible and appropriate, the board should have financial advisors and other experts provide input and guidance on the alternatives. While all this analysis is speculative and reasonable minds can differ on the assumptions and modeling embodied in such analysis, it should insulate the board from legal attack, on fiduciary breach grounds, if the analysis and the board s actions are considered under the business judgment rule. 2. Fiduciary Duty to Preferred Shareholders. a. Duty with Respect to Preferences. In general, a corporation s directors and officers do not owe the corporation s preferred shareholders any fiduciary duty with respect to protecting the preferred s rights and privileges (e.g., liquidation preference). Instead, as is the general rule for creditors, preferred shareholders must rely on their contractual rights. Moreover, as in the case of creditors, the courts have refused to use the good faith and fair dealing covenant to expand the preferred s rights and preferences beyond their specific contractual terms-- directors and officers, in making decisions, will not be required, based on the covenant, to take into account preferred shareholder interests beyond those specifically articulated in the preferred s rights and preferences. b. General Fiduciary Duty to Shareholders. The fiduciary duties that directors and officers owe to preferred shareholders as equity holders are the same duties that are owed to the common shareholders. More 9
importantly, if the interests of the preferred and the common diverge, the courts have not applied these duties, such as the duty of loyalty, to require the preferred s interests to be placed ahead of the common s. For example, a court rejected the claim that the directors decision to borrow funds to keep the corporation operating, in hopes that it would successfully complete its product development, amounted to a breach of their fiduciary duty to the preferred, given that the corporation could have liquidated and paid the preferred their full liquidation preference, while the continued product development could result in the corporation s failure and no funds being available to cover the liquidation preference. It stated that generally it will be the duty of the board, where discretionary judgment is to be exercised, to prefer the interests of the common stock as the good faith judgment of the board sees them to be to the interests created by the special rights, preferences, etc. of preferred stock. c. Impact of Insolvency or Vicinity of Insolvency Determination. The fiduciary standard owed to preferred shareholders is not enhanced or otherwise altered if the corporation is insolvent or in the vicinity of insolvency. The duty owed continues to be the same duty owed to the common, with the board and officers continuing to have the right to make decisions that impose greater risks on the preferred, for the potential benefit of the common, so long as the decisions do not breach specific contractual rights that the preferred hold. 3. Fiduciary Duty of Majority Shareholder to Minority Shareholders. A majority shareholder is a fiduciary to minority shareholders, whether the company is solvent or insolvent. This basically means that the majority shareholder cannot use its control of the corporation to obtain an unfair advantage, as an equityholder, at the minority s expense. For example, a majority shareholder was held to have breached this duty when he organized a new entity, sold the corporation s assets to it on terms that were unfair to the selling shareholders and the corporation. This fiduciary duty should not restrict a controlling shareholder or group of shareholders from exercising their rights as non-shareholders, though. For example, if a majority shareholder is also a creditor, it should be able to freely exercise its rights and remedies as such without breaching any fiduciary duty. As one court noted [a] controlling shareholder is not required to give up legal rights that arise in a non-shareholder capacity. For example, a court recently held that a controlling shareholder that purchased a bank s secured loan to the corporation, and then foreclosed it and obtained control of the corporation s operations, did not breach any fiduciary duty to creditors. It further ruled that the directors, since they could not control the foreclosure s terms, did not breach any fiduciary duties. Note, though, that if a controlling shareholder makes a loan to its corporation that a court recharacterizes as disguised equity, the corporation s 10
and majority shareholder s handling of the loan could be subject to scrutiny under the fiduciary duty to minority shareholders standards. 4. Fiduciary Duties of Creditors a. General Rule. A creditor of a corporation generally does not owe any fiduciary duty to other creditors of the corporation. Consequently, normally it does not need to consider the impact of its actions, such as exercise of its rights and remedies against the corporation during a default, on the other creditors. Moreover, a creditor generally does not owe any duty to the corporation or to the other creditors to restructure its claim against the corporation if the corporation is encountering financial difficulties. b. Exceptions. i. Misrepresentations. A creditor could incur liability to other creditors if provides misleading information to them, for example in connection with a restructuring, and the other creditors, in relying on such misrepresentations, are harmed. ii. Unfair Advantage/Imposition of Harm. In a bankruptcy proceeding, a creditor s claim can be equitably subordinated to other creditors claims to the extent that the bankruptcy court determines that the subordinated creditor engaged in improper conduct pre-bankruptcy that conferred an unfair advantage on the creditor or harmed the other creditors. The risk of equitable subordination is greatest for insider claims, as an insider is more likely to be in a position to manipulate the corporation s affairs to its benefit. 11
Assumptions: EXHIBIT A MAXIMIZING THE VALUE OF THE CORPORATE ENTERPRISE Corporation has $10,000 in debts and $8,000 in assets Corporation is insolvent for creditor fiduciary duty purposes Corporation s directors have duty to maximize the value of the corporate enterprise Corporation has option of pursuing Transaction A, B or C Transaction Potential Post- Transaction Value of the Corporation Corporate Enterprise Value Value of Transaction for Creditors Value of Transaction for Shareholders Conclusion/Decision A [ Liquidation Strategy ] 100%=$8,500 $8,500 $8,500 0 Creditors favor this transaction, as provides greatest assurance of full payment. B [ High Risk Strategy ] 10%=$50,000 90%=$200 $5,180 (.10x 50,000 +.90x 200) $1,180 (.10x 10,000 +.90x200) $4,000 (.10x 40,000 +.90x 0) Shareholders favor this transaction, as provides greatest potential return. But it is highest risk strategy, leaving corporation with lowest expected value. C [ Moderate Risk Strategy ] 40%=$15,000 60%=$6,000 $9,600 (.40x 15,000 +.60x 6,000) $7,600 (.40x 10,000 +.60x 6,000) $2,000 (.40x 5,000 +.60x 0) This transaction is optimal from corporate value level, but is NOT best transaction from creditor standpoint. 12