Directors Owe Fiduciary Duties to Creditors of Insolvent Companies

Creditors of a corporation in bankruptcy recently received some good news from a bankruptcy court in California. In re ATWR Liquidation, Inc. clarified that corporate officers and directors owe creditors the same fiduciary duties that they owe to shareholders. Those fiduciary duties include duties of care, loyalty and good faith, and the exercise of business judgement in an informed, good faith effort to preserve and grow the corporation’s value. 

When a corporation is rendered insolvent creditors become “risk bearers”—their interests are affected by management’s business decisions in a way they were not before insolvency. Therefore, these fiduciary duties of officers and directors then extend to creditors in addition to stockholders. The duties to creditors do not supersede or dilute duties to stockholders in any way; but directors need to take creditors’ interests into account as well. It also means that upon insolvency, creditors have the right, like stockholders, to bring a derivative action in the corporation’s name against directors or officers for breaches of fiduciary duties to the corporation that may divert, waste, or unduly risk corporate assets.

The court acknowledged that acting in the best interests of both stockholders and creditors can be difficult given the two constituencies’ different approaches to risk. Stockholders often prefer risky business strategies because they profit from the success of those decisions, but share the loss with creditors if they fail; whereas, creditors prefer corporate decisions that minimize risk because they hold fixed claims. Given this difficult balance of interests, courts defer to the business judgment of corporate directors if they attempt, in good faith, to follow their overall duty to preserve and enhance corporate value (officers, however, do not have the protections of this business judgment rule under California law). 

Therefore, once a debtor corporation becomes insolvent, a creditor has rights not only with respect to the corporation, but also its officers and directors.