May 21, 2007
Zoning in on the Zone of Insolvency
Posted by Fred Tung

On Friday, in North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, the Delaware Supreme Court cleared up some confusion about directors' fiduciary duties in distressed firms.  The most important thing to know about the case is that the court cited me in passing (JK), as well as fellow corporate law bloggers Steve Bainbridge and Larry Ribstein.      

In its principal holding, the court held that for a firm in the zone of insolvency (ZOI), its creditors have no direct breach of fiduciary duty claims against the firm's directors. 

Perhaps more interesting, language in the opinion also casts serious doubt about whether creditors can even bring ZOI derivative claims:

When 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.  (Emphasis supplied).

By contrast, discussing actually insolvent firms later in the opinion, the court confirms the long standing view that creditors replace shareholders as the firm's residual claimants:

Consequently, the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties.  (Emphasis in original).

The opinion suggests, therefore, that the ZOI concept famously described in Credit Lyonnais will no longer have any continuing relevance as a legal concept.  On balance, this is probably the right result.  It's hard for directors to know when they're in an ill-defined "zone" of insolvency.  So for purposes of "providing directors with definitive guidance," as the Gheewalla court attempts to do, doing away with ZOI is probably a good thing.

OTOH, drawing the line at insolvency seems somewhat arbitrary, and ZOI is not without some conceptual basis.  As I wrote in Gap Filling in the Zone of Insolvency,

Insolvency is not some magic event that triggers perverse incentives for managers that do not exist before insolvency. Instead, the agency cost of debt is increasing in the percentage of outside financing comprised of debt versus equity.

Insolvency, then, is just the extreme case of perverse managerial incentives to make inefficient investment decisions on behalf of equity.  What ZOI does--under any reasonable definition--is simply capture a larger share of those states of the world in which managers may have these perverse incentives.  For a legal rule, though, it's pretty vague.  Of course, one might suggest drawing a different line--say, when the debt-equity ratio hits 9:1.  The valuation issues are probably no worse at 9:1 than at insolvency (and the factual issues for equitable insolvency are likely to be even more intractible).  OTOH, the insolvency line may be defensible as a sort of focal point?

Finally, the court held that even for insolvent firms, creditors could not assert direct claims, but only derivative claims.  The court expressly overruled the Chancery Court's Production Resources decision in this regard.

Corporate Law, Delaware, Fiduciary Law | Bookmark

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