Executives and board members have always known that angry shareholders could attack, filing a flurry of lawsuits if the stock price or sales plummeted. But executives and boards also face an assault from another corner – suits on behalf of creditors.
While board members’ fundamental fiduciary responsibility has long been to shareholders, the Delaware courts in the 1990s changed all that with rulings holding that they also must look out for creditors in certain circumstances. And the courts in recent years have been refining and limiting, but not eliminating, the risk of creditor suits.
The sea change in the 1990s spawned suits from trustees and creditor committees going after not only companies, but executives and board members for decisions leading to defaults and bankruptcies.
Delaware courts ruled that when a company is in what’s known as a “zone of insolvency,” executives and boards must consider creditor and shareholder interests.
Executives who took risks designed to save companies could be held accountable if they were perceived to be risking both shareholders’ and creditors’ money.
“When a company is doing well, a corporate fiduciary owes a duty to shareholders only,” said Thomas Slome, a partner at Meyer, Suozzi, English & Klein in Garden City.
When firms fall on hard times, companies by law must look out for creditors. Bankruptcy and defaults can trigger litigation.
“They’re looking for a recovery somewhere and if it means going after directors and officers, they’re going to find a way to do it,” said Joseph Gitto, a senior associate at Nixon Peabody in Manhattan and Jericho. “They have to be taking their steps and actions in good faith and not with the intent to harm shareholders or defraud creditors.”
David Sterling, chief executive of Woodbury-based insurance brokerage Sterling & Sterling, said suits often are filed before anyone knows whether directors have been negligent.
“Everybody sues when they lose money,” Sterling said. “Then they try to figure out if the reason they lost money is due to mismanagement and negligence.”
The first problem in creditor cases, Slome said, is defining when a firm enters a zone of insolvency, something still being refined by the courts.
“It’s one of these things where the court says, ‘You know it when you see it,’” Slome said. “The best definition is that it’s when a company has a substantial risk of becoming unable to pay its creditors.”
He said well-intentioned acquisitions or divestures by companies already at risk can prompt litigation on behalf of creditor committees.
“Whenever they make a corporate decision, they have to keep the best interest of creditors in mind,” Slome said of firms at risk. “The theory is that if the company is solvent, it has enough money to pay creditors and can make decisions only with shareholder interests in mind. Once there’s a substantial risk that the creditors aren’t going to get paid, the officer has to think about their best interest.”
The Delaware courts have begun to narrow director and officer liability in recent years, including a 2004 Delaware Court of Chancery decision that limited claims that state officers waived their obligations for what’s known as “duty of care.” A suit in 2007 further chipped away at individual creditor rights, finding creditors lack standing to bring direct actions against directors alleging breach of duty owed by directors and officers.
“It limited actions somewhat,” said Slome who added that suits can still be brought by trustees or committees on behalf of creditors collectively. “It’s a continuously evolving area.”
Directors and officers may be protected by companies’ director and officer insurance, but it depends on the amount and breadth of coverage.
“The amount has to be enough,” Slome said. “It should be commensurate with the amount of indebtedness the company has.”
Sterling said policies also may exempt directors and officers sued by trustees who take over firms in receivership. He said companies should make sure their policies cover this possibility.
“We add that coverage,” Sterling said. “That was made necessary because of the prevalence of creditor lawsuits.”
Sterling said director and officer coverage has become cheaper in recent years for many industries, as more insurers compete for customers.
“That’s industry specific,” Sterling said. “If you’re a hedge fund or a securities firm or a bank, you’re not likely to see that type of reduction.”
But directors and officers may face greater risks as banks demand “greater protections, including guarantees by officers and directors who are owners,” Slome said. And recent Wall Street meltdowns could lead creditors to file suit against directors and executives as well as advisory firms such as lawyers and accountants.
“We really haven’t experienced the numbers of defaults that are coming down the pike and at the same level of dollars,” Slome said. “People are talking these days more and more often in terms of billions of dollars rather than millions, and as a result, I think you’re going to see these claims asserted aggressively and at a rate never seen before.”