We Don’t Talk About Insolvency (No, No, No …)

As a parent of three young children, Disney’s excellent new movie, Encanto, has been on heavy rotation in my household. It’s a story of an extended family whose members possess unique magical gifts. Through several humorous songs, the film reveals that the family has ostracized one member, Bruno, whose mystical visions of future calamities upset the rest of the family. Rather than confront the unpleasant aspects of the future, the family finds it easier to simply “not talk about” them, or Bruno.      

This is typical human behavior. It’s easiest to simply avoid difficult topics. For these reasons, directors of struggling businesses may feel reluctant to raise the topic of potential insolvency. Directors of public companies, in particular, may be wary of broaching the topic for fear it would be recorded in board minutes or draw increased scrutiny from the company’s auditor. Social forces may also be at play; management or fellow directors may become defensive and see it as critical of their performance.

But the truth is that businesses can – and do – fail. And avoiding the topic doesn’t make it any less likely to occur. While fear of failure shouldn’t paralyze business leaders, corporate directors should nonetheless educate themselves on the basics of insolvency: what it is, why it matters, and its impact on their fiduciary duties.  

What is insolvency?

Defining exactly when a failing company becomes insolvent can be deceptively tricky. Courts in most jurisdictions identify insolvency using either the balance sheet test or the cash flow test. The balance sheet test asks if the company’s assets exceed its liabilities, while the cash flow test asks if the company is able to pay its debts as they come due. A third (less common) test—the adequate capital test—assesses whether the company possesses adequate capital to continue future operations.

Despite these tests’ seeming simplicity, there is enough subjectivity involved in valuing a company’s assets, liabilities, or future operational costs that even experts can disagree on whether a company is insolvent. This is particularly true with respect to companies teetering on the brink of insolvency (often referred to as in the “zone of insolvency”).

If directors are in doubt about whether their company is insolvent, they should seek professional advice and not rely exclusively on their or management’s best guess. A professional solvency analysis can help directors understand the company’s options, including potential bankruptcy or restructuring, and protect their decisions from being criticized as uninformed.

Does insolvency affect a director’s fiduciary duties?

Before 2007, courts and commentators frequently stated that once a corporation enters the “zone of insolvency,” directors’ fiduciary duties shift from shareholders to creditors. Some courts found that these fiduciary duties to creditors implied an obligation to manage the corporation conservatively as a trust fund for the creditors’ benefit.

But much of this changed in 2007, as a result of the Delaware Supreme Court opinion in N. American Catholic Educ. Programming Found. v. Gheewalla, 930 A.2d 92 (2007) (“Gheewalla”). There, creditors of a company operating in the “zone of insolvency” brought direct claims against the company’s directors for breach of fiduciary duty. The court dismissed these direct claims, holding that “[t]he creditors of a Delaware corporation that is either insolvent or in the zone of insolvency have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against its directors.” Id. at 103.

The Gheewalla court went on to clarify at least two other important points. First, while creditors of an insolvent company do not have standing to bring direct claims, they may assert derivative claims on behalf of the company. The court explained that “when a corporation is solvent, [directors’ fiduciary duties] may be enforced by its shareholders, who have standing to bring derivative actions on behalf of the corporation because they are the ultimate beneficiaries of the corporation’s growth and increased value.” Id. at 101. But when a corporation is insolvent, “its creditors take the place of the shareholders as the residual beneficiaries of any increase in value” and, accordingly, “have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties.” Id. 

Second, the point at which creditors replace shareholders as residual beneficiaries of the company—and gain standing to assert derivative claims—is actual insolvency, not the so-called zone of insolvency. The court explained that “[w]hen a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.” Id. at 101. Thus, the oft-used term “zone of insolvency” no longer had significance under Delaware law; only actual insolvency mattered. 

Gheewalla has proven influential. In 2015, a Delaware Chancery court discussed the sea change Gheewalla represented in Quadrant Structured Products Co. v. Vertin, 115 A.3d 535 (2015). The Quadrant court observed that Gheewalla represented a “regime” change in which the following “principles” are now true:

• There is no legally recognized “zone of insolvency” with implications for fiduciary duty claims. The only transition point that affects fiduciary duty analysis is insolvency itself.
• Regardless of whether a corporation is solvent or insolvent, creditors cannot bring direct claims for breach of fiduciary duty. After a corporation becomes insolvent, creditors gain standing to assert claims derivatively for breach of fiduciary duty.
• The directors of an insolvent firm do not owe any particular duties to creditors. They continue to owe fiduciary duties to the corporation for the benefit of all its residual claimants, a category which now includes creditors. They do not have a duty to shut down the insolvent firm and marshal its assets for distribution to creditors, although they may make a business judgment that this is indeed the best route to maximize the firm’s value.

Id. at 546-47.

While some jurisdictions haven’t embraced Gheewalla, it is still binding precedent under Delaware law. And that’s significant given the State of Delaware’s claim that more than half of all U.S. publicly traded companies are incorporated under Delaware law. Thanks to Gheewalla, directors of companies incorporated under Delaware law can rest assured that, upon insolvency, their fiduciary duties continue to run to the company itself (not creditors) and that the business judgment rule continues to protect their decisions. Directors of companies incorporated under another state’s laws should consult their attorneys to determine if that state adopts Gheewalla and, if not, how insolvency impacts directors’ fiduciary duties under that state’s laws.   

The takeaway

When navigating potential insolvency, professional advisors can be invaluable. Not only can professionals help diagnose insolvency, but they can explain the associated risks and help directors make informed decisions about the company’s best options. Of course, none of this is possible unless directors are aware of and communicate with each other about potential insolvency. Take it from Disney, putting off difficult conversations or avoiding them altogether doesn’t solve anything. Talk about insolvency, ask questions, and seek professional input when in doubt.