3.7.2.2 Creditors suits in bankruptcy

The potential for a suit to be brought by bankruptcy trustees or creditors' committees if the company is insolvent makes litigation based on an allegation of a breach of duty by directors technically more difficult for the defendants. These are suits based on a breach of fiduciary duty to the corporation and are brought in the name of the corporation. The recovery, if any, goes to the corporate estate for the ultimate benefit of creditors. The Delaware Courts have ruled that, in these cases, outside directors have the protection of exculpatory charter provisions, authorised by Section 102(b)(7) of the Delaware GCL, and of the business judgment rule, just as they do in shareholder derivative suits. Consequently fiduciary duty suits initiated by creditors on behalf of the bankrupt estate do not differ greatly from derivative suits brought by shareholders. Outside directors sued on the basis of a breach of loyalty face the risk of having to pay out of their own pockets, but those being sued for a failure to exercise sufficient oversight face hardly any danger.

In the procedure, outside directors have less protection in creditors' cases than they do in suits brought by shareholders. There is no demand requirement of and no possibility to ask for the institution of a special litigation committee in creditor suits. If the merits of a case against outside directors are strong, creditor-initiated fiduciary duty cases pose a greater threat of at least nominal liability than do shareholder derivative suits where the company is solvent. Nevertheless, only in one case, Credit Lyonnais v. Pathé of 1991, did an outside director have to make an out-of-pocket payment in such a litigation.1 Bankruptcy cases are usually dealt with in Federal Courts. In Gheewalla the creditor did not win against the directors.2 Both the Court of Chancery and the Supreme Court of Delaware ruled that if a company was in the zone of insolvency the directors owe fiduciary duties to the company and shareholders. Creditors do not have a derivative action in the period before insolvency. The facts must be very special.

Most cases against directors in insolvency cases are started by receivers in the federal bankruptcy courts, but these cases are rare.