Difficult economic times frequently generate unanticipated questions and challenges for a corporation and its creditors. One unanticipated question may include if or when fiduciary duties should be extended to a corporation’s creditors.
While it is well-recognized that officers and directors owe fiduciary duties to shareholders and the corporation, whether those fiduciary duties extend to a corporation’s creditors is less certain. Generally, the law extends fiduciary duties to creditors when a corporation becomes insolvent—commonly meaning the corporation cannot pay its debts as they become due. What if, however, the corporation is not yet insolvent but heading towards insolvency, also known as operating in the “zone of insolvency?”
Currently, the law regarding whether fiduciary duties are owed to creditors when a corporation is operating in the “zone of insolvency” is less settled. A large concern held by creditors and generated by the “zone of insolvency” is that shareholders and directors who are about to wind up with nothing because they know the corporation is heading towards insolvency may take unreasonable gambles with corporate assets that otherwise would have gone to the creditors upon dissolution of the corporation. If fiduciary duties are owed to creditors while a corporation is operating in the “zone of insolvency,” the theory is that a corporation will be less likely to gamble big. While many courts have hinted that fiduciary duties exist when a corporation enters the “zone of insolvency,” the issue remains largely undecided.
Creditors can take steps to protect themselves from the risks presented when a corporation operates in the “zone of insolvency.” For example, creditors can negotiate and implement safeguards by placing limitations on corporate behavior, such as restricting the types of projects in which the firm may invest or conditioning when it may invest. Similarly, a creditor could negotiate for a share of the up-side that may be realized in various projects, such as through convertible debt securities. In addition, corporate governance restrictions could be applied, such as limits on certain expenditures.
Just as creditors can take steps to protect themselves, corporations also can initiate steps to protect themselves. For example, a corporation can document in minutes and memoranda the corporation’s good faith exercise of its business judgment in all actions designed to prolong the life of the corporation, increase its debt, or extend terms. Likewise, before decisions are made, officers and directors can and should become thoroughly educated on the corporation’s financial condition.
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