Connecticut Would Not Recognize Fiduciary Duty to Creditors when Corporation Is in Zone of Insolvency — Would Follow Lead of Delaware Supreme Court and S.D.N.Y.

From Master-Halco, Inc. v. Scillia, Dowling & Natarelli, LLC, 2010 U.S. Dist. LEXIS 142036 (D. Conn. April 5, 2010):

The Court agrees with Defendants that Connecticut courts have not recognized a cause of action for breach of fiduciary duty on behalf of creditors against officers and directors of a debtor that is in the zone of insolvency. ***

No Connecticut Supreme Court or Appellate Court decision has addressed this issue. However, at least two Superior Court decisions have rejected the cause of action. See Metcoff v. Lebovics, 51 Conn. Supp. 68, 75 (Conn. Super. Ct. 2007); All Metals Indus., Inc. v. TD Banknorth, No. CV075002464S, 2008 WL 731954, at *5 (Conn. Super. Ct. Feb. 27, 2008). As Master-Halco points out, in the absence of case law from a Connecticut appellate court, this Court is not bound by Connecticut Superior Court decisions on matters of state law. *** Nevertheless, the Court believes that Metcoff's holding is both well-reasoned and suggests the likely trajectory of the Connecticut courts' thinking on this issue.

In Metcoff, Judge Stevens considered, as a matter of first impression in Connecticut, the precise argument advanced here by Master-Halco: that an individual creditor can bring a claim directly against directors for breach of fiduciary duties owed that creditor while the company was in the zone of insolvency. See 51 Conn. Supp. at 73. Judge Stevens, sitting in the Complex Litigation Docket, rejected the argument, finding persuasive a recent ruling of the Delaware Supreme Court, which held (as a matter of Delaware law) that "directors do not owe creditors duties beyond the relevant contractual terms." Id. at 74 (quoting N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 99 (Del. 2007)).

The Delaware Supreme Court rejected such a cause of action for several reasons. First, directors and officers owe their fiduciary obligations to the corporation and its shareholders. Fiduciary duties are imposed on directors to regulate their conduct when they perform their functions for the corporation. Even when a corporation is in the zone of insolvency, the focus of officers and directors should be on what is in the best interests for the corporation and shareholders, not creditors. Gheewalla, 930 A.2d at 101 ("When . . . 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.").

Second, the court recognized that creditors have considerable existing protections and therefore do not need the court to expand directors' and officers' fiduciary duties. In particular, the contractual obligation between corporations and creditors may provide relief. Furthermore, fraudulent conveyance law, bankruptcy law and the implied covenant of good faith and fair dealing "render the imposition of an additional, unique layer of protection through direct claims for breach of fiduciary duty unnecessary." Id. at 100. And as Gheewalla held, though they may not bring direct claims for breach of fiduciary duty against directors, creditors may still be able to bring derivative claims on behalf of the insolvent corporation. Id. at 102.

In Metcoff, Judge Stevens quoted extensively from Gheewalla's reasoning in declining to extend directors' fiduciary duties to creditors:

Recognizing that directors of an insolvent corporation owe direct fiduciary duties to creditors, would create uncertainty for directors who have a fiduciary duty to exercise their business judgment in the best interest of the insolvent corporation. To recognize a new right for creditors to bring direct fiduciary claims against those directors would create a conflict between those directors' duty to maximize the value of the insolvent corporation for the benefit of all those having an interest in it, and the newly recognized direct fiduciary duty to individual creditors. Directors of insolvent corporations must retain the freedom to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation.

Metcoff, 51 Conn. Supp. at 74 (quoting Gheewalla, 930 A.2d at 103). Judge Stevens adopted this reasoning explicitly, and held that, as a matter of Connecticut law, "the general rule" is that "whether a corporation is solvent or insolvent, directors of the corporation do not owe a fiduciary duty to a corporate creditor that would expose them to personal liability to the creditor for an alleged breach of such duty." Id. at 74-75. As Judge Stevens put it, "[t]he officers and directors of a corporation owe their fiduciary duties to the corporation and its shareholders, and corporate creditors are afforded rights and remedies under existing and extensive contract, tort and statutory protections." Id. at 75. ***

A recent decision of the United States District Court for the Southern District of New York is also convincing. In RSI Communications PLC v. Bildirici, 649 F. Supp. 2d 184 (S.D.N.Y. 2009), Judge Richard Sullivan held that New York law would not recognize even a derivative cause of action by creditors against a corporate officer for breach of fiduciary duties when a corporation is in the zone of insolvency. As Judge Sullivan recognized, "adopting Plaintiff's 'zone of insolvency' theory would provide redundant legal protections to creditors, while impeding corporations' ability to recruit qualified directors, generate capital" and serve those who should be their primary focus -- the corporation itself and its shareholders. Id. at 206.

Footnote 2. New York law does permit creditors to bring a derivative cause of action against directors for breach of fiduciary duties once the corporation is actually insolvent; Judge Sullivan's holding rejected the extension of those duties to the pre-insolvency period. See Bildirici, 649 F. Supp. 2d at 202 ("Indeed, [u]nder New York law, creditors are owed a fiduciary duty by officers and directors of a corporation only when the corporation is insolvent.") (citation omitted, alterations and emphasis in original).

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