Inside M&A - September/October 2008

Delaware Courts Clarify Fiduciary Duties Owed By Directors Of

Troubled Companies

By Samuel Wales and Emily Garrison

Two recent decisions by the Delaware Supreme Court clarify the

fiduciary duties owed to creditors by directors of Delaware

corporations that are insolvent or operating in the zone of

insolvency. First, in North American Catholic Educational

Programming Foundation, Inc. v. Gheewalla, the Delaware Supreme

Court, in a case of first impression, addressed the ability of

creditors to assert claims for breach of fiduciary duty against

directors of a Delaware corporation that is insolvent or operating

within the zone of insolvency. The Delaware Supreme Court

unequivocally held that, as a matter of law, a creditor cannot

assert a direct claim in either situation and that, when a

corporation is insolvent, a creditor can only assert a derivative

claim for breach of fiduciary duty against the corporation's

directors. See Gheewalla, 930 A.2d 92, 103 (Del. 2007).

Second, in Trenwick America Litigation Trust v. Ernst &

Young, the Delaware Court of Chancery addressed the ability of

creditors to assert a direct tort claim for "deepening

insolvency" against directors of a Delaware corporation that

is insolvent. Deepening insolvency is a judge-made cause of action,

first recognized by the Third Circuit Court of Appeals, that could

be asserted against a corporation's directors, officers,

lawyers, accountants and other professionals for damages resulting

from improper acts that cause the corporation to become insolvent

or more insolvent. In Trenwick, the Delaware Court of Chancery

definitively held, and the Delaware Supreme Court subsequently

affirmed, that Delaware law does not recognize deepening insolvency

as an independent cause of action. See Trenwick Am. Litg. Trust v.

Billet, 931 A.3d 438 (Del. 2007), aff'g Trenwick Am. Litig.

Trust v. Ernst & Young L.L.P., 906 A.3d 168, 174-75, 195, 205

(Del. Ch. 2006).

As a result of these decisions, the Delaware Supreme Court has

effectively eliminated creditors' ability to assert direct

claims against directors of Delaware corporations that are

insolvent or operating in the zone of insolvency.

Unanswered Questions

One of the questions that remains unanswered in the Gheewalla

and Trenwick opinions is whether a creditor can assert derivative

claims for breach of fiduciary duty against directors when the

corporation is operating within the zone of insolvency. While

neither the Delaware Supreme Court nor the Delaware Court of

Chancery specifically address this issue in Gheewalla or Trenwick,

the Delaware Supreme Court in Gheewalla strongly suggested that

creditors are precluded from asserting derivative claims in such a

situation. First, the Delaware Supreme Court observed that, in

questioning whether it was necessary for creditors to have a right

to assert claims for breach of fiduciary duty against directors of

a corporation operating within the zone of insolvency, creditors

already have specific legal protections through "their

negotiated agreements, their security instruments, the implied

covenant of good faith and fair dealing, fraudulent conveyance law,

and bankruptcy law." Gheewalla, supra, at 99 (citing North

American Catholic Educational Programming Foundation, Inc. v.

Gheewalla, 2006 WL 2588971, at *13 (Del. Ch. Sept. 1, 2006);

Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d

772, 790 (Del. Ch. 2004); Big Lots Stores, Inc. v. Bain Capital

Fund VVI, LLC, 2006 WL 846121, at *8 (Del. Ch. Mar. 28, 2006)).

Second, the Delaware Supreme Court pointedly noted that directors

of a Delaware corporation owe their fiduciary duties to the

corporation's shareholders and that such duties do not change

when a corporation begins to operate within the zone of insolvency.

The Delaware Supreme Court stressed that "[w]hen a solvent

corporation is navigating in the zone of insolvency, 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." Id. at 101. Finally, the Delaware Supreme Court

stressed that insolvency, and not the zone of insolvency, is the

dividing line when derivative claims of breach of fiduciary duty

shift from the stockholders of a corporation to its creditors.

"When a corporation is solvent, [directors'] fiduciary

duties may be enforced by its shareholders, who have standing to

bring derivative actions on behalf of the corporation because they

are the ultimate beneficiaries of the corporation's growth and

increased value. When a corporation is insolvent, however, its

creditors take the place of the shareholders as the residual

beneficiaries of any increase in value." Id., at 101 (emphasis

in original).

As a result, the Delaware Supreme Court's highlighting of

the existing legal protections available to creditors, strong focus

on the fiduciary duties owed by directors to the corporation's

shareholders, and emphasis on creditors' ability to enforce

derivative claims only after a corporation's insolvency all

strongly suggest that the Delaware Supreme Court views creditors as

having no right to bring derivative claims for breach of fiduciary

claims against directors of a corporation that is operating within

the zone of insolvency.

Advising Directors

The opinions in Gheewalla and Trenwick provide guidance to

boards of Delaware corporations that are insolvent or operating

within the zone of insolvency, including those considering whether

to incur additional indebtedness or those considering a sale or

comparable transaction involving a change of control of the

corporation. While a Delaware corporation is operating within the

zone of insolvency, directors owe fiduciary duties to the

corporation's stockholders and must exercise their business

judgment in the best interests of the corporation and its

stockholders. After a Delaware corporation becomes insolvent,

directors continue to owe the same fiduciary duties, but the

corporation's creditors replace its stockholders as the primary

constituency affected by any breach of such duties. As a result, as

long as directors of an insolvent corporation continue to make good

faith business judgments on an informed basis that they believe are

in the best interests of the corporation and its creditors, such

creditors will have difficulty successfully asserting any claim of

breach of fiduciary duty.

Important Ninth Circuit Decision Narrowly Interprets Survival

Clause

By Amar Murugan

Parties to acquisition agreements typically agree to limit the

survival of certain or all of the representations and warranties

made in the agreement to a period shorter than the applicable

jurisdiction's statute of limitations. Generally, such

provisions governing the survival periods of representations and

warranties are also understood by the parties to limit the period

during which a claim may be brought for a breach or failure of a

representation or warranty. However, the U.S. Court of Appeals for

the Ninth Circuit recently held in Western Filter Corp. v. Argan,

Inc. (9th Cir. August 25, 2008) that contractual language limiting

the survival period of representations and warranties may not be

construed to also limit the period during which a claim may be

brought for a breach of the same in the absence of explicit

language intended to shorten the claims period. Although it remains

unclear whether the court's decision in Western Filter will be

followed by other courts, practitioners should ensure that any

acquisition or other agreement governed by California law

explicitly states the parties' intentions with respect to both

the survival period for representations and warranties and whether

such period shall also constitute the period during which a party

may file a claim relating to a breach of the same, notwithstanding

any applicable statute of limitations.

Background

On October 30, 2003, Western Filter Corporation and Argan, Inc.,

entered into a Stock Purchase Agreement (the Purchase Agreement)

pursuant to which Western Filter acquired all of the outstanding

shares of Puroflow, Inc., a wholly owned subsidiary of Argan, for

$3.5 million. Section 8.1 of the Purchase Agreement provided that

"[t]he representations and warranties of [Western Filter] and

[Argan] in this Agreement shall survive the Closing for a period of

one year, except the representations and warranties contained in

Section 3.1(a), (b), (c) and (f) and 3.2(a) and (b) shall survive

indefinitely."

Following the consummation of the acquisition, Western Filter

allegedly discovered that the value of Puroflow's inventory was

substantially less than had been represented. In September 2004,

Western Filter sent written notice to Argan claiming that Argan had

grossly misrepresented the financial condition of Puroflow and

claiming damages in the amount of $2,002,850. In its notice,

Western Filter offered to immediately settle its claims for

$700,000 in order to avoid protracted litigation. In late September

2004, Argan responded to Western Filter's notice and indicated

that the issues could be solved without the involvement of counsel,

and in late October 2004 Western Filter confirmed with Argan that

the $300,000 escrow would be retained pending resolution of the

dispute. However, six months later, on March 22, 2005, Western

Filter filed suit in Los Angeles County Superior Court against

Argan, claiming, among other things, breach of contract and

intentional misrepresentation. The case was later moved to federal

court, upon which Argan filed for summary judgment.

The federal district court granted Argan's motion for

summary judgment, holding that Western Filter's claims were

barred by the survival period limitations set forth in the Purchase

Agreement. The court concluded that the plain meaning of the

provisions of Section 8.1 of the Purchase Agreement clearly

indicated that a claim could only be filed for the...