Coauthored by Stephen B. Brauerman
Managing a creditor of a Delaware corporation became more treacherous this May when the Delaware Supreme Court slammed the door on a potential remedy for the creditors of insolvent or potentially insolvent Delaware corporations.
In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, the court clarified for the first time that creditors cannot assert direct claims for breach of fiduciary duties against the directors of corporate debtors. With more than half of the Fortune 500 and countless other companies incorporated in Delaware, this ruling will undoubtedly impact the rights of thousands of creditors. However, with a little knowledge, competent counsel, and a creative business plan, creditors can still control their own destiny and reduce their transaction risks.
While outwardly unappealing, in that it shuts off a potential means of holding directors accountable to creditors for the decisions that make it impossible to collect valid debts, the Gheewalla ruling represents the Delaware judiciary’s consistent approach to business litigation and does recognize the fundamental right of creditors to protect themselves. By forcing corporate actors to become more self-sufficient, Gheewalla encourages creditors to negotiate safeguards uniquely tailored to circumstances of a given transaction.
This article will briefly review Gheewalla, discuss its impact on corporate directors and then suggest how creditors can protect themselves in its aftermath.
Clearwire Holdings, Inc. entered into an agreement with North American Catholic Educational Programming Foundation, Inc. to purchase the foundation’s microwave signal transmission licenses for approximately $23.4 million, as part of its effort to create a national system of wireless internet connections. In June 2002, when the market for wireless spectrum bottomed out in the wake of the WorldCom accounting scandal, Clearwire informed NACEPF that it could no longer perform its obligations pursuant to the agreement because it could not obtain financing, as planned.
NACEPF then filed a lawsuit against several Clearwire directors, all of whom worked for Goldman Sachs, for breach of fiduciary duties for pursuing Goldman Sachs’ agenda at Clearwire’s expense. NACEPF based its fiduciary claims on the Clearwire directors’ alleged failure to preserve assets for NACEPF’s benefit and their decision to continue the agreement, knowing that Clearwire could not pay for the licenses — thereby depriving NACEPF of the opportunity to find other suitable buyers before the market crashed.
Ordinarily, directors of Delaware corporations owe fiduciary duties only to the corporation and its stockholders. However, when a company is insolvent or approaching insolvency (i.e. the company cannot meet its maturing obligations or has a deficiency of assets below liabilities, with no reasonable prospect of recovery — also known as the “zone of insolvency”), the corporate constituency can change.
Previous court decisions have hinted that when a corporation is insolvent or within the zone of insolvency, management’s priorities and obligations, which normally flow to the stockholders, should run to the creditors.
Shifting the focus of fiduciary duties would ensure that directors of such corporations would have an obligation to maximize the value of the company to repay its debts, and be subject to the threat of litigation and personal liability for failure to do so. It was precisely this issue that the Delaware Supreme Court addressed for the first time in Gheewalla.
Concerned about the risk of hampering an insolvent company’s ability to negotiate in good faith with its creditors and of stifling “effective and proactive” leadership at a crucial time, the Delaware Supreme Court refused to subject directors to the individual liability that could result if corporate creditors were permitted to assert direct fiduciary duty claims against them.
The Court noted that pre-existing safeguards (covenants, liens, and contract rights) and the right to bring a derivative suit on behalf of the company adequately protect creditors in the absence of direct fiduciary duties.
If they are unable to rely on direct fiduciary duties that would hold directors personally liable for unpaid corporate debts, how can deal makers protect themselves in the post-Gheewalla world?
Gheewalla makes clear that creditors must protect themselves, noting that the “existing protections — among which are the protections afforded by their negotiated agreements, security instruments, the implied covenant of good faith and fair dealing, fraudulent conveyance law, and bankruptcy law — render the imposition of an additional, unique layer of protection through direct claims for breach of fiduciary duty unnecessary.”
Delaware courts have observed that creditors, unlike shareholders, are uniquely positioned to negotiate contractual safeguards to apply in the event of default. Now that creditors can no longer rely on generic fiduciary duties for protection and their rights are limited to contractual remedies, directors and other managers of potential creditors must pay careful attention to the contractual provisions they negotiate.
The most obvious contractual protection a creditor can negotiate is a lien over the debtor’s assets. By securing the debt (typically against real estate, intellectual property or other quasi-liquid asset), creditors can ensure at least partial repayment in the event the company does not have the cash to meet its obligations.
A lien, however, cannot protect a creditor where the insolvent company does not have assets or where the assets are already encumbered as security for preexisting or higher priority obligations. Lack of collateral at the negotiation stage should alert the future creditor to the increased risk and prompt it to re-structure the transaction to provide for the payment of more cash up-front. In an extreme case, this information would lead the potential creditor to seek alternative opportunities.
In the absence of collateral, potential creditors also can negotiate strong covenants, which coupled with financial disclosures would provide some relief in the event of insolvency.
To use Gheewalla as an example, NACEPF could have required Clearwire to confirm its ability to pay for the licenses, and it could have negotiated pre-payment for certain licenses and established lock-step conditions for the sale, the breach of which would have entitled NACEPF to seek alternate buyers without waiving the damages that would result.
The potential creditor also could place transfer restrictions, akin to a right of first refusal, on the assets of the debtor operating in the zone of insolvency. Such provisions would ensure that the company would preserve its assets for the benefit of its creditors and minimize the creditors’ reliance on the business judgment of the directors of the insolvent corporate debtor.
Finally, creditors should not ignore the possibility of requiring, as a condition of investment, that the debtor’s certificate of incorporation include provisions that create fiduciary duties for certain creditors, such as bondholders. By providing increased access to information, flexibility to mitigate damages prior to default, and greater control over the distribution of corporate assets, a potential creditor can minimize the loss following default.
Another strong contractual protection is the inclusion of a guarantee or indemnification provision. Again, looking at Gheewalla, NACEPF alleged that Clearwire failed to meet its obligations under the agreement because the defendant directors favored Goldman Sachs’ agenda at Clearwire’s expense. Based on Goldman Sachs’ influence over Clearwire, NACEPF could have protected itself by requiring Goldman Sachs’ to guarantee Clearwire’s $23.4 million payment obligation.
Alternatively, potential creditors could seek personal guarantees from the company’s directors or shareholders. These may be difficult to obtain, but if they are obtained, they would protect creditors in the absence of collateral.
Admittedly each of these contractual safeguards presumes that the creditor has bargaining power. But if it does not, the creditor can always walk away from the table and avoid a potentially disastrous deal.
Even in the post-Gheewalla world, creditors have extra-contractual protections, albeit in somewhat limited circumstances.
The law of fraudulent conveyances allows creditors to sue the debtor or attach the distributed asset where the company transfers its property without any legitimate business purpose. (Showing absence of legitimate business purpose may be difficult, however, given Delaware’s deference to the business judgment of corporate directors.)
Additionally, bankruptcy law provides judicial oversight and statutory protection for creditors as the company reorganizes or liquidates and systematically pays its debts. But bankruptcy law applies only to those companies that have actually filed or been forced to file for such protection, and creditors typically receive only pennies on the dollar.
The covenant of good faith and fair dealing offers limited protection against default from the unsuccessful but reasonable business judgments of debtor directors, because the covenant protects only against arbitrary and unreasonable conduct.
In general, it can be said that the dearth of legal protections and Gheewalla’s elimination of direct fiduciary claims against directors underscores the need for creditors to protect themselves by contract.
THE DEBTOR’S VIEW
For corporate actors on the other side of the coin, Gheewalla provides welcome relief: It narrows the obligations and potential liability of the directors of Delaware corporations.
For managers of a company that is insolvent or nearing the zone of insolvency, direct fiduciary duties will run only to the company’s shareholders and not to its creditors. Prior to Gheewalla, case law left open the possibility that directors could owe fiduciary duties directly to several conflicting constituencies: shareholders, creditors and the company itself.
As the Court observed, “[h]aving complied with all legal obligations owed to the firm’s creditors, the board would … ordinarily be free to take economic risk for the benefit of the firm’s equity owners, so long as the directors comply with their fiduciary duties to the firm by selecting and pursing with fidelity and prudence a plausible strategy to maximize the firm’s value.”
Debtor directors should, however, exercise caution when developing and executing such strategies, as existing shareholders may feel emboldened by Gheewalla to pursue fiduciary claims against directors who fail to take sufficient risk to return the company to profitability. Nevertheless, so long as directors comply with their contractual obligations to creditors, their fiduciary duties run only to shareholders and the company itself when crafting a strategy to emerge from the zone of insolvency.
There are two primary lessons from Gheewalla. First, the scope of potential liability for directors of Delaware corporations is more narrow, allowing directors to take more calculated risks to maximize profitability for the company and its shareholders. Second, creditors of insolvent or potentially insolvent corporations have the obligation to protect themselves through contract, because in most instances post-default remedies are limited to negotiated safeguards.
First published in Executive Counsel, November/December 2007. Link to article.