Delaware Supreme Court rejects theory that creditors may directly sue Boards of insolvent corporations for breach of fiduciary duty

A strong decision last week by the Delaware Supreme Court, NACEPF v. Gheewalla et al., protecting the boards of insolvent companies from creditor claims, may be another significant reason to incorporate in Delaware.

"Zone of insolvency"... Ahh. Makes me wistfully think back to the days of F*ckedCompany.com, circa 2002, sitting in scores of board meetings of companies that were soon to meet their maker. You all know the typical scenario. Company X raises %10-15M of venture capital in one or more rounds, market adoption slows and investors decide that another investment is probably not prudent. So they gently get out of the way, letting the management know that they won't lead the next round but would follow another lead. Burn rate is at a pretty good pace, and management ignores the VC body language, assuming that the cache of their past investors will help find new ones quickly, and that a follow is just as good anyway.

When things don't work as planned, and cash starts to get real tight, a board meeting is called where a new lawyer from your corporate law firm appears - their bankruptcy guy - and tells you that you probably need to shut the company down, or face potential claims from creditors because you are now in the "zone of insolvency". What is that, you say? Well, generally, the "zone" is when a company cannot pay its debts when they become due, such as payroll or vendor payables, etc. So now, he claims, you will face claims from creditors who don't get paid unless you shut the company down now, while there is still money left to pay. You shrug because that state probably describes the company from day one, so that just cannot be case. Otherwise, how do companies get started?

Unfortunately, this issue has plagued startups for the last decade, and probably has resulted in a good share of startups being shut down, when they may have made it in the end. Last week, the Delaware Supreme Court put an end to the dilemma by holding, in no uncertain terms, that "the creditors of a Delaware corporation that is either insolvent or in the zone of insolvency have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against the corporation’s directors."

The Court agreed with the Chancery Court in its reasoning that “an otherwise solvent corporation operating in the zone of insolvency is one in most need of effective and proactive leadership—as well as the ability to negotiate in good faith with its creditors—goals which would likely be significantly undermined by the prospect of individual liability arising from the pursuit of direct claims by creditors.”

Because this has been such an important issue for academics and practioners alike, the Court noted that "the need for providing directors with definitive guidance compels us to hold that no direct claim for breach of fiduciary duties may be asserted by the creditors of a solvent corporation that is operating in the zone of insolvency. " When a solvent corporation is navigating in the zone of insolvency, the Court emphasized that 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."

It is important to note that this decision does not completely eliminate Board liability for any claims, but just those claims that are "direct" claims brought by the creditors. In general, claims against a Board can be direct or derivative, depending on a myriad of factors, including how and to whom the harm occurs. A derivative claim is a claim brought by the corporation that has suffered from the misconduct of directors, and typically must be reviewed by an independent committee as to whether the claim is a valid one. Therefore, while the NACEPF decision does leave room for creditors to bring derivative claims, the risk is diminished that the threat of such an action would chill board members from continuing to serve and from making hard decisions in distressed circumstances.

Best state for incorporation

The folks for www.askthevc.com have a good post on best state for incorporation if you are thinking about venture capital. I agree that Delaware is really the best choice, but there are variations. I also am not a huge fan of Massachusetts, which, unlike Delaware, still has the annoying procedural requirement that they need original signatures for an effective filing. Another issue with Massachusetts is that you have to opt in, in a written provision in your charter, that shareholder consents do not have to be unanimous to be effective. If you forget to do this when you form the Company, you have to chase every shareholder, or call a meeting - which creates additional issues at closing that people don't always plan.

I think another interesting topic is choice of entity. Most vcs dont favor LLCs, and yet that may be the right structure. Perhaps I will take that on in a future post.

When is consent unreasonably withheld?

Consent provisions in contracts and leases become hot issues in the context of an acquisition. Landlords and licensors don't always have to play nice and a badly drafted consent provision in a key contract could kill an entire deal.

In negotiating these provisions, lawyers often try to soften the impact by requiring that the consenting party (such as a landlord, bank, licensor, etc.) does not "unreasonably withhold consent". What does this clause really mean?

A couple of recent decisions help interpret what protection this clause may actually provide to the party seeking consent in the future. They also provide guidance as to the type of information that a consenting party may reasonably request in order to evaluate whether or not to grant its consent.

A recent Massachusetts Supreme Judicial Court decision, Chapman v. Katz, 448 Mass. 519, 862 N.E.2d 735 (Mass. Mar 16, 2007) restates the law in Massachusetts on when it is reasonable to withhold consent in the context of a commercial lease.

• In a commercial context, only factors which relate to a landlord's interest in preserving the property or in having the terms of the prime lease performed should be considered. Among the factors properly considered are the financial responsibility of the subtenant, the legality and suitability of the proposed use, and the nature of the occupancy. A landlord's personal taste and convenience, on the other hand, are not factors properly considered. . . .
• [I]t is unreasonable for a landlord to withhold consent to a sublease solely to extract an economic concession or to improve its economic position.

Another decision comes out of California from the auto franchise context . Fladeboe v. American Isuzu Motors Inc., 2007 WL 1191135 (Cal.App. 4 Dist. Apr 23, 2007). Here the court provided as follows:

• [W]ithholding consent to assignment of an automobile franchise is reasonable under California Vehicle Code section 11713.3(e) if it is supported by substantial evidence showing that the proposed assignee is materially deficient with respect to one or more appropriate, performance-related criteria. This test is more exacting than whether the manufacturer subjectively made the decision in good faith after considering appropriate criteria. It is an objective test that requires that the decision be supported by evidence. The test is less exacting than one which requires that the manufacturer demonstrate by a preponderance of the evidence that the proposed assignee is deficient.
• The relevant criteria include, without limitation: (1) whether the proposed dealer has adequate working capital; (2) the extent of prior experience of the proposed dealer; (3) whether the proposed dealer has been profitable in the past; (4) the location of the proposed dealer; (5) the prior sales performance of the proposed dealer; (6) the business acumen of the proposed dealer; (7) the suitability of combining the franchise in question with other franchises at the same location; (8) whether the proposed dealer provides the manufacturer sufficient information regarding its qualifications; and (9) the dealer's honesty and good faith in relations with the manufacturer.
• The initial burden of explaining the basis for the decision is on the manufacturer, but the ultimate burden of persuasion is on the assigning dealer to demonstrate that the manufacturer's refusal to consent is unreasonable.”

Final 409A Regulations

A few weeks ago the Final 409A Regulations were released by the IRS. The proposed regulations have been out for over a year, so this is pretty significant development. The final regs can be found here.

Recent Massachusetts decision on director and shareholder duties

A recent decision by the Massachusetts Superior Court for Suffolk county (Boylan v. Boston Sand & Gravel Co., 2007 WL 836753 (Mass.Super.) has a very good synthesis of duties owed by directors and stockholders of Massachusetts corporations:

"[The defendants] as directors of [the company] , owed a fiduciary duty to the corporation, which included both a duty of care and a duty of loyalty. Demoulas v. Demoulas Super Markets, Inc., 424 Mass. 501, 528 (1997). Since they were both directors and shareholders of [the company] and since [the company]was a closely-held corporation, they owed their fellow shareholders, ..., “substantially the same duty of utmost good faith and loyalty in the operation of the enterprise that partners owe to one another, a duty that is even stricter than that required of directors and shareholders in corporations generally.” Id. at 529; Donahue v. Rodd Electrotype Co. of New England, Inc., 367 Mass. 578, 592-594 (1975).

*7 If [the defendants] wished [the company] to engage in a self-dealing transaction ... they must:
1. make full and honest disclosure of all the known material facts of the proposed transaction, including the details of the transaction and their conflict of interest; Demoulas at 531. See Puritan Medical Ctr. Inc. v. Cashman, 413 Mass. 167, 172 (1992); Dynan v. Fritz, 400 Mass. 230, 243 (1987) (“good faith requires a full and honest disclosure of all relevant circumstances to permit a disinterested decision maker to exercise its informed judgment”); ALI Principles of Corporate Governance § 5.02(a) (1994); and
2. “then either receive the assent of disinterested directors or shareholders, or otherwise prove that the decision is fair to the corporation.” Demoulas at 533. The burden of proving that the assenting directors were disinterested rests with the self-dealing directors, see Houle v. Low, 407 Mass. 810, 824 (1990), as does the burden of proving that the self-dealing was “intrinsically fair, and did not result in harm to the corporation or partnership” if the transaction was approved by self-interested directors. Demoulas at 530-531, quoting Meehan v. Shaughnessy, 404 Mass. 419, 441 (1989).


If the self-dealing directors fail to provide full disclosure of the material facts of their proposed transaction, then they breach their fiduciary duty by proceeding with the transaction, regardless of its approval by the Board or its fairness to the corporation. See Geller v. Allied-Lyons PLC, 42 Mass.App.Ct. 120, 128 (1997) (“full disclosure of all material facts respecting the finder's fee agreement [is] a prerequisite for enforcement”). The Board's approval is vitiated by the failure of full disclosure.

If the self-dealing directors provide full disclosure to the Board and the transaction is approved by the disinterested directors, then the decision enjoys the deference provided by the business judgment rule. See Harhen v. Brown, 431 Mass. 838, 847 (2000). If the self-dealing directors provide full disclosure to the Board and the transaction is approved by self-interested directors, the decision does not enjoy the benefit of the business judgment rule and must be demonstrated to be fair to the corporation. Demoulas at 533."

DC Circuit ruling on broker dealers

The D.C. Circuit Court of Appeals today vacated the 2005 Securities and Exchange Commission rule deeming certain broker-dealers not to be investment advisers (17 CFR 275.202(a)(11)-1). The Court held that the Investment Advisers Act, 15 USC § 80b-2(a)(11)(F), does not authorize the SEC to except from the Investment Advisers Act a group that is already covered in another § 80b-2(a)(11) exception. The decision came in Financial Planning Association v. SEC, Case Numbers 04-1242 and 05-1145.

Brown University Venture Forum for Enterprise Slide Deck

I recently spoke at a program on valuation and term sheets at Brown University put on by the Brown Forum for Enterprise. I discussed the topic of valuation issues surrounding stock options and 409A. The slide deck can be viewed here.