Periodically courts remind corporate directors that their decisions to act or to refrain from acting during the course of managing the affairs of a corporation are not without limitations. It is well established that corporate directors owe fiduciary duties, and more specifically, a duty of care and a duty of loyalty to corporate shareholders. Those duties should always be at the front of mind of every director when any action or inaction is contemplated, but in particular, when addressing challenging issues facing the corporation. Directors are afforded wide latitude under state corporate law, and by the courts interpreting those laws, to make decisions regarding the management of a corporation that are appropriately within the scope of the directors’ business judgement. But courts, and in particular bankruptcy courts with an interest in protecting a number of different stakeholders, are not shy about reminding corporate directors that the scope of protection provided by the business judgment rule is not unlimited. Such is the case with In re Sportco Holdings, Inc., et al., 2021 WL 4823513 (Bankr. D. Del.), a recent decision by the Bankruptcy Court for the District of Delaware.
Generally, the duty of care requires that directors use the amount of care that an ordinary and prudent person would use in similar circumstances and to consider all material information reasonably available to them when making decisions. A director’s conduct is often not found to violate the duty of care unless such conduct amounts to gross negligence. The duty of loyalty requires, generally, that the best interests of the corporation or its shareholders take precedence over the interests of a director. Actions taken by a director in bad faith or a director receiving a material personal benefit to the detriment of the corporation or its shareholders may form the basis of claims alleging a breach of the duty of loyalty.
Over the years there have been instances where the conduct of directors has made a claimant’s job of proving breach of fiduciary duties fairly simple as the facts giving rise to the breach were in plain sight. See, e.g., Pereira v. Cogan, 294 B.R. 449 (S.D.N.Y. 2003) (two directors who knew that a third director was throwing a lavish birthday party for himself under the guise of a business event and who also knew that the corporation was at minimum paying for part of the event, failed to conduct a reasonable investigation into the plans and costs and were thereby found to have breached both the duty of care and the duty of loyalty).
Other situations are more nuanced and require close scrutiny of the facts leading to director action or inaction. Allegations of breach of fiduciary duty, especially in the context of a financially distressed company, involve a careful assessment of the facts as they existed at the time of the alleged breach. It is not unusual for those facts to first become apparent well after the filing of a bankruptcy and after careful review by new stakeholders with the benefit of hindsight (for example, a bankruptcy trustee). In Sportco, it was not until six months after a liquidating Chapter 11 plan had been confirmed, that the trustee commenced an adversary proceeding against former directors alleging, among other things, breach of fiduciary duties. The defendant directors filed a motion to dismiss, which the Court granted in part and denied in part.
The fiduciary breach counts of the complaint arose out of two factual scenarios: first, a failed and allegedly misguided asset acquisition, and; second, a failed out of court restructuring due to, among other things, the directors’ insistence of releases and indemnitees. The Court initially noted that in order for the party alleging breach of fiduciary duty to prevail in the face of a motion to dismiss, the complaint must plead around the business judgment rule. In re Solutions Liquidation LLC, 608 B.R. 384 (Bankr. D. Del. 2019). “When assessing claims for breach of fiduciary duties, the Court bears in mind that a director does not become ‘a guarantor of success’ by choosing to continue a firm’s operations when it may become insolvent.” In re Sportco at *6 (citation omitted).
In reviewing the facts around the asset acquisition, it was clear that the results fell far short of expectations and indeed far short of the financial performance the director defendants had represented to the company’s secured lenders. The trustee alleged that the directors promoting the asset acquisition benefited by the acquisition as it induced the secured lenders to waive certain interest payments, among other things, and allowed for the continuation of compensation to the CEO and for the reimbursement of travel expenses to the directors. The Court found that the trustee plead sufficient facts, which if true, could lead to a conclusion that the defendants had breached the duty of care by failing to fully inform themselves of all aspects of the acquisition ( defendants’ motion to dismiss duty of care claim denied), but failed to plead sufficient facts to support a claim that the directors were self-interested in violation of the duty of loyalty (defendants’ motion to dismiss duty of loyalty claim granted, but gave the trustee an opportunity to replead).
The Court reached opposite conclusions when addressing the failed out of court restructuring. It found that the complaint did not allege facts sufficient to support a claim that the directors failed to inform themselves adequately of the consequences of rejecting the out of court restructure or that such rejection amounted to gross negligence (defendants’ motion to dismiss duty of care claim granted, but gave the trustee an opportunity to replead). However, the Court also found that allegations addressing the directors’ insistence on releases and indemnifications running to them as a requirement of the out of court restructure were sufficient to support a claim based upon a breach of the duty of loyalty (defendants’ motion to dismiss duty of loyalty claim denied).
For directors, factual and situational awareness of their conduct, or lack thereof, is critical at all times. The business judgment rule is alive and well and thoroughly engrained in American corporate jurisprudence. But stakeholders of an insolvent company, particularly creditors or their proxies, will closely scrutinize director action and inaction for signs of directors having moved beyond the limitations of the business judgment rule to areas where viable claims can be made against directors and those who aid and abet them in order to compensate stakeholders when the assets of an insolvent company fall short.