Since this article focuses on issues that pertain only to directors and managers of businesses that are insolvent or nearing insolvency (referred to in this article as being “financially troubled”), I hope that you will never need to use this information. That being said, if you ever serve as a director of a corporation or a manager of a limited liability company that is financially troubled, the information contained in this article may prove to be useful as you make financial decisions about how to direct the business’s scarce resources. Serving as a director of a corporation or a manager of a limited liability company that is financially troubled is stressful enough, but the situation can become even more stressful if you make a wrong decision that allows a creditor of the business you serve to reach into your own wallet to satisfy the business’s debts.
While North Carolina corporate law provides that certain executive officers of a corporation (president, chief executive officer, etc.) owe fiduciary duties to the corporations they serve, this article is limited to the fiduciary duties owed by members of a corporation’s board of directors and does not address the fiduciary duties owed by such corporate officers. Further, because limited liability companies are the creatures of very recent legislation as compared to the relatively ancient laws allowing the creation of corporations, the law of potential manager responsibility and liability is not as fleshed out by statute or case law as the law applicable to corporate directors. Thus, while some of the references in this article are to well-developed principles of law governing corporations and their directors, this article explains how these principles could be extended to apply to limited liability companies and their managers.
This article discusses two distinct types of fiduciary duties. The first type is the category of fiduciary duties that, by North Carolina statute and case law, are owed by the business’s governing body (e.g., the board of directors of a corporation and the managers of a limited liability company) to the business as an entity. These fiduciary duties will be referred to in this article as the “traditional” fiduciary duties.
The second type of fiduciary duty is the fiduciary duty that a director of a financially troubled corporation owes to corporate creditors. This fiduciary duty generally is described as the duty to treat all similarly-situated corporate creditors equally. Currently, North Carolina courts have not had an occasion to apply this fiduciary duty to managers of financially troubled liability companies. However, as discussed in more detail below, it is likely that North Carolina courts, when faced with the appropriate case, will extend this fiduciary duty to limited liability company managers. Therefore, limited liability company managers need to be aware of this additional fiduciary duty and act accordingly.
Part I of this article provides general information on the traditional fiduciary duties that apply to both corporate directors and limited liability company managers. Part II of this article discusses the additional fiduciary duty owed by directors of financially troubled corporations and provides guidance to corporate directors on how to avoid personal liability in that situation. Part II of this article also discusses why it is likely that North Carolina courts will extend this additional fiduciary duty to limited liability company managers.
Part I: A General Overview of the Traditional Fiduciary Duties
The traditional fiduciary duties generally are defined as the obligations that members of a corporation’s board of directors and managers of limited liability companies owe to the businesses they serve. The traditional fiduciary duties provide the general standards of conduct to which directors and managers must adhere in making decisions on behalf of their businesses in order to avoid facing personal liability. Like other states, North Carolina law imposes the traditional fiduciary duties on directors and managers in order to balance two competing demands: (1) the need for directors and managers to have sufficient discretion to take risks in managing the business without the fear of personal liability, and (2) the need to hold directors and managers personally liable when they take certain extraordinary actions that are not in the best interests of the business.
When a corporation or limited liability company is solvent, its directors or managers owe the following traditional fiduciary duties to the business:
- Duty of Care – The duty to direct the affairs of the business using the level of care that an ordinarily prudent person in a position similar to that of the director or manager would exercise under conditions similar to those the director or manager faces – For example, a director or manager is under a duty to stay reasonably informed about the financial condition and management of the business.
- Duty of Loyalty – The duty to act in a manner that the director or manager reasonably believes is in the best interests of the business, not the best interests of the director/manager or any third party – For example, a director of a corporation that develops heart-related biomedical devices cannot personally purchase a valuable heart-related biomedical device patent without first providing the corporation with the opportunity to purchase the patent.
- Duty of Good Faith – The duty to discharge the director’s or manager’s duties in good faith – While some states provide that the duty of good faith is part of the duty of loyalty, North Carolina delineates the duty of good faith separately from the other fiduciary duties owed by directors and managers.
It should be noted that, as a general rule and unlike corporate officers and directors and limited liability company mangers, shareholders of a corporation and members of a limited liability company do not owe any fiduciary duty to one another or to the business. However, North Carolina courts have held that a corporation’s majority shareholders owe a fiduciary duty to the corporation’s minority shareholders. This fiduciary duty is described generally as a duty not to misuse corporate control for the majority shareholders’ personal benefit and to the minority shareholders’ disadvantage. This exception to the general rule stated above also applies to majority members in a limited liability company.
Part II: The Expansion of Fiduciary Duties When a Business Nears Insolvency
In addition to the traditional fiduciary duties corporate directors owe to the corporations they serve, corporate directors owe an additional duty to corporate creditors when the corporation is financially troubled. As mentioned above, North Carolina law has not extended this fiduciary duty to managers of financially troubled limited liability companies, but it is likely that North Carolina courts will apply this additional fiduciary duty to limited liability company managers when the opportunity arises.
The Additional Fiduciary Duty Owed by Directors of Financially Troubled Corporations
When a corporation is financially troubled, the fiduciary duties of corporate directors expand to include the duty to treat all of the corporation’s similarly-situated creditors equally. For example, upon insolvency or the entry of a corporation into the so-called “zone of insolvency,” as that phrase is explained below, all similarly-situated secured creditors should be treated equally and all similarly-situated unsecured creditors should be treated equally, although the secured creditors may be treated differently from the unsecured creditors. This additional duty, however, raises three primary questions:
- When does this additional fiduciary duty arise,
- What does this additional fiduciary duty require of directors, and
- How can a creditor enforce its rights under this additional duty?
When Does the Additional Fiduciary Duty Arise? North Carolina courts have not provided clear guidance regarding when this fiduciary duty arises. The courts have stated generally that this expanded duty arises when a corporation is on the verge of insolvency and, thus, is within the so-called “zone of insolvency” or is in the dissolution and winding up process. Although the question of whether a corporation is within the zone of insolvency is determined on a case-by-case basis, the North Carolina courts have considered the following factors:
- Whether the liabilities on the corporation’s balance sheet exceed the assets on the corporation’s balance sheet (known as “balance sheet insolvency”);
- Whether the corporation is able to pay its bills as they come due in the ordinary course of business (known as “cash flow insolvency”);
- Whether there are plans for the corporation to cease doing business;
- Whether the corporation is liquidating its assets with a view to going out of business; and,
- Whether the corporation is continuing its business in good faith with a reasonable expectation of continuing to do so.
The only clear principle provided by the North Carolina courts in this area is that balance sheet insolvency, without more, is not sufficient to trigger the additional fiduciary duty. Since there is no clear threshold in North Carolina for determining when a corporation is nearing the zone of insolvency, directors of corporations with balance sheet and/or cash flow issues should be careful to judge their actions in light of the fact that they may owe a fiduciary duty to the creditors of the corporation they serve.
What Does the Expanded Fiduciary Duty Require of Directors? Once a corporation is within the zone of insolvency or, worse, is insolvent, the directors of the corporation must ensure that all payments to similarly-situated creditors are made on a pro-rata basis. North Carolina courts have made it clear that a corporation’s directors can pay more to secured creditors than unsecured creditors, but directors must not treat similarly-situated secured creditors or similarly-situated unsecured creditors differently. For example, the directors of an insolvent corporation would breach the fiduciary duty they owe to the corporation’s creditors if they fully satisfy a secured debt owed to the son of the corporation’s CEO but make no payments on a secured debt owed to a bank.
How Can a Corporate Creditor Enforce Its Rights Against the Directors Personally? If the directors of a corporation that has entered the zone of insolvency breach the fiduciary duty they owe to the corporation’s creditors, each creditor may be entitled to bring an action against the directors either on the creditor’s own behalf or in the form of a derivative action on behalf of the corporation, seeking to hold the directors personally liable. If the creditor brings an action against the directors on the creditor’s own behalf (called a “direct action”), the creditor will be entitled to any proceeds received as a result of the lawsuit. However, in order to bring a direct action, the creditor must suffer an individual injury separate and distinct from any injury suffered by the corporation itself. For example, if one secured creditor is paid nothing while all other similarly-situated secured creditors are paid in full, that creditor would be entitled to bring a direct action against the corporation’s directors.
Alternatively, the creditor may bring an action against the directors on behalf of the insolvent corporation (called a “derivative action”), in which case the insolvent corporation will be entitled to the proceeds received, and the creditor that brought the derivative action will share those proceeds with all other creditors entitled to be paid. While such a derivative action is not expressly authorized by North Carolina’s derivative action statute, North Carolina courts, including the North Carolina Supreme Court, have suggested that a creditor has a non-statutory right to bring such a derivative action. For example, if the directors of an insolvent corporation authorized the payment of an excessive bonus to the corporation’s CEO at a time when the corporation was insolvent, a creditor, or group of creditors, could bring a derivative action on behalf of the corporation against the directors to recover the amount of the excessive bonus. The amount recovered would be returned to the corporation as a corporate asset and then be available to be paid to the creditors as appropriate.
Potential Application to Managers of Financially Troubled Limited Liability Companies
As previously stated, North Carolina courts have not extended this additional fiduciary duty to the managers of limited liability companies that have entered the zone of insolvency. At the same time, North Carolina courts have not ruled that the managers of such limited liability companies are not subject to this duty. There simply has not been a case in North Carolina where the North Carolina courts have been required to answer the question.
Even though there are certain significant differences between corporations and limited liability companies (such as taxation), North Carolina courts likely will apply the additional fiduciary duty to limited liability company managers based on:
- The fact that there is no practical difference between the limited liability status of corporations and limited liability companies,
- The essentially identical roles played by the directors of corporations and the managers of limited liability companies, and
- The fact that directors and managers owe the same traditional fiduciary duties to the businesses they serve.
Consequently, managers of North Carolina limited liability companies need to be aware of this additional fiduciary duty and should conform their conduct to meet its requirements if the limited liability company they serve becomes financially troubled.
Conclusion
Corporate directors and limited liability company managers guiding financially troubled businesses through today’s difficult economic times face an immense amount of pressure and stress. To add to the already mounting pressure caused by a distressed financial situation, directors (and likely managers) need to be aware of their expanded fiduciary duty to treat all similarly-situated creditors equally once their business enters the zone of insolvency. While broadly drafted indemnification provisions and substantial director and officer insurance policies may provide some comfort for directors and managers, the threat of personal liability is real and should not be taken lightly. Consequently, in the event of the insolvency or near insolvency of a business, it becomes even more important for corporate directors and limited liability company managers to maintain communication with the business’s executive officers, obtain competent legal advice, and ensure that the business’s indemnification provisions and director and officer insurance policies are up to date.
For further information regarding the issues described above, please contact Lee C. Hodge .
