Considerations for directors and officers in the expected wave of fiduciary duty litigation in bankruptcy cases

In many bankruptcy cases, disappointing recoveries lead creditors to look for deep pockets as targets. This scrutiny is frequently directed at a bankrupt company’s directors and officers (D&Os or fiduciaries) in so-called D&O suits. These lawsuits are most often brought by bankruptcy trustees, creditors’ committees, liquidating trusts, and other bankruptcy estate representatives. Typically, these estate representatives claim that the D&Os acted negligently in overseeing the corporation’s operations and caused it to become insolvent to the detriment of the corporation’s stakeholders, whom the estate representatives represent. Often these cases are merely an attempt to access the proceeds of company’s D&O insurance policy, which is often the debtor’s last or most substantial remaining asset.

The combination of the impact of lower company valuations resulting from the current pandemic together with the fact that many troubled companies entered the current economic crisis with highly levered balance sheets is likely to result in lower recoveries for unsecured creditors. These lower recoveries will likely result in increased litigation against D&Os by representatives of disappointed creditors and bankruptcy estates.

In this article, we review a couple of key considerations for D&Os to keep in mind when anticipating and preparing for D&O suits.

Fiduciary duty claims

D&O suits are rooted in theories relating to D&Os’ breach of their fiduciary duties to their stakeholders. Fiduciaries owe their stakeholders two basic types of fiduciary duties, the duty of loyalty and duty of care. The duty of loyalty prohibits a D&O from engaging in self-dealing or usurping a corporate opportunity. A fiduciary’s material financial interest that conflicts with his interest in the company invokes this duty. The duty of care requires D&Os to act in a diligent and informed manner. The duty arises in two scenarios: (i) so-called Caremark claims that challenge a fiduciary’s decision-making process, typically couched in their failure to consider necessary information in making their decision and (ii) a challenge to the D&O’s oversight and investigation of corporate employees’ conduct.

An estate representative bringing a D&O suit bears the burden of establishing that the fiduciary breached a fiduciary duty. In addition to complex legal and factual defenses, there are common defenses and presumptions that are generally available to facilitate a defense of these claims. Although standards vary by state, D&Os are typically afforded great deference in their business judgment. The so-called business judgment rule is an automatic presumption that fiduciaries act independently, in good faith, and with due care in making a business decision. Indeed, it is a fundamental principal of corporate law that, barring any wrongdoing, a company’s D&Os are not personally liable for the company’s losses. This is the case even when a court believes their decision, in hindsight, was “wrong,” “stupid,” “egregious,” or “irrational.” Further, many states, including Delaware, have enacted a statute authorizing corporations and LLCs to include an exculpation clause in their certificates of incorporation or operating agreements immunizing directors (for corporations) and managers and controlling members (for LLCs) from personal liability “to the corporation or its stockholders” for monetary damages for the breach of duty of care. While such an exculpation clause provides virtually limitless protection to directors from duty of care claims, it does not protect them from duty of loyalty claims and is inapplicable to a corporation’s officers.

Some states have suggested that D&Os’ fiduciary duties are owed to different stakeholders depending on their company’s solvency. While requirements vary by state, when a corporation is solvent, fiduciaries generally only owe fiduciary duties to the corporation itself and, by proxy, the corporation’s owners: its shareholders. When a corporation is entering the “zone of insolvency,” ie, when its liabilities exceed its assets or its cashflow is insufficient to satisfy its obligations as they come due, some courts have suggested that D&Os’ duties expand to include creditors’ interests. Including creditors as entities whose interests fiduciaries must take into account in the “zone of insolvency” is based on a recognition that creditors take the place of shareholders as the residual beneficiaries of an increase in value of an insolvent corporation. That being said, most courts now follow the lead of Delaware courts that recently rejected that view and held that the company’s presence in the zone of insolvency has no legal significance as to whom directors owe a duty to. Put differently, under the Delaware rubric, fiduciaries’ duty remains the obligation to maximize value for all constituents when the company enters the “zone of insolvency.”

D&O insurance

The existence of a D&O insurance policy is typically the unstated motivation that drives estate professionals’ prosecution of D&O claims. While D&O insurance policies vary and may be complex to interpret, their proceeds can be a source of funds to pay for D&Os’ defense costs as well as a source of funds to pay any settlement or judgment amount. Frequently, estate professionals argue the entire proceeds of a D&O policy are property of the bankruptcy estate and, thus, should not be made available to fund fiduciaries’ defense costs. However, most courts have determined that in the context of a bankrupt corporation, D&Os are entitled to access the policy’s proceeds to indemnify them for their defense costs and any liability – the specific purpose for which D&Os insist that their corporations obtain such policies in the first place.

Looking forward and takeaways

In the anticipated wave of D&O suits, estate professionals will likely claim that a bankrupt corporation’s failure was due to D&Os’ failure to implement and oversee procedures to identify and mitigate significant operational risks associated with the coronavirus disease 2019 pandemic. While the theory that fiduciaries should have predicted and appropriately responded to an unprecedented and unpredictable global pandemic is absurd, estate professionals will undoubtedly attempt to pursue the claims in hopes of accessing substantial D&O insurance policy proceeds.

Some D&Os, with the support of willing D&O insurers, may be inclined to settle these claims and move on with their lives. However, some insurers have made a point to “take a stand” against what they perceive as extortionary suits and would prefer to pay D&Os’ attorneys to defend these suits instead in an effort to stem the flow of these suits. Further, many D&Os may prefer to fight it out and be exonerated – something that may be critical to their reputation and future employment with other companies.

In any case, D&Os are urged to take steps now to further insulate themselves from liability for D&O claims. Fiduciaries may examine and take immediate active measures minimize their corporation’s legal and operational risks. At a minimum, D&Os are encouraged to consider the corporation’s: (i) financial outlook and contingency plans; (ii) access to capital, including cash on hand; (iii) key personnel plans; and (iv) supply chain, customer, and distributor financial health. Fiduciaries may increase the frequency of their meetings to consider these increased risks and adequately document their discussions, plans, and decisions. While these steps will not guarantee that a fiduciary will be insulated from a D&O suit, these actions may bolster the fiduciary’s defense of any such claims down the road.


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This information does not, and is not intended to, constitute legal advice. All information, content, and materials are for general informational purposes only. No reader should act, or refrain from acting, with respect to any particular legal matter on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction.