New Guidance for Directors of Financially-Distressed Hospitals

Directors of financially-distressed non-profit hospitals may be heartened by new legal developments addressing the scope of their fiduciary duties. Specifically, these developments suggest that the director’s standard of care does not change when the corporation enters the “zone of insolvency” or becomes insolvent. Rather, it appears that courts will measure the director’s performance in times of “prosperity or poverty” under the traditional, deferential “business judgment rule” and not some higher level of scrutiny. These developments also suggest that directors at all times should focus their attention on the needs of the organization without excessive concern with any duties that may be owed to creditors. Given the increasing instances of financial distress among non-profit hospitals nationwide, these developments may come as welcome news to many governing boards.

Business Judgment in the Zone of Insolvency

Courts have traditionally deferred to the business judgment of directors who act in good faith and with the honest belief that the action taken was in the best interest of the corporation. When applicable, the business judgment rule provides directors with a defense to claims of mismanagement and breach of fiduciary duty. The rule has long stood for the proposition that courts should not second-guess the business decisions of directors acting in good faith, who are assumed to be in a better position to understand the corporation’s business and to guide its affairs.

Over the past 15 years, however, a perception has gradually developed that the business judgment rule is of limited utility to directors of insolvent or nearly-insolvent corporations. This perception has been fueled by a spate of director-liability lawsuits filed in the aftermath of high-profile bankruptcies. As a result, the conventional wisdom has for some time held that directors owe heightened duties of care and loyalty to both the corporation and its creditors in times of organizational financial distress. Recently, however, state and federal courts have published well-reasoned opinions that reaffirm the primacy of the business judgment rule irrespective of the financial health of the corporation. As one such court succinctly noted:

“If the board of an insolvent corporation, acting with due diligence and good faith, pursues a business strategy that it believes will increase the corporation’s value…it does not become a guarantor of that strategy’s success…. Rather, in such a scenario the directors are protected by the business judgment rule.^[1]

Fiduciary Duties to Creditors in the Zone of Insolvency

In addition to the positive developments regarding the business judgment rule, a number of recent court decisions have limited the ability of creditors to assert breach of fiduciary duty claims against corporate directors. Previously, several influential courts posited that creditors could bring fiduciary claims for their losses against the directors of insolvent or nearly-insolvent corporations. Fortunately for directors, however, the influential Delaware Supreme Court recently clarified that directors of corporations in the “zone of insolvency” do not owe fiduciary duties to creditors and that creditors may not assert direct fiduciary claims against the directors of insolvent corporations.^[2]

These new judicial decisions provide meaningful guidance on how directors of financially-troubled corporations should discharge their fiduciary duties. By consistently applying the business judgment rule across financial-distress scenarios and limiting directors’ fiduciary obligations to creditors, courts have begun to loosen the perceived restraints upon directors in times of organizational distress to act in a manner they reasonably believe to be in the best interests of the corporate enterprise. It is important to recognize, however, that the business judgment rule presupposes that reasonable diligence has in fact been exercised. The new judicial decisions do not condone inattentiveness or a “business as usual” approach on behalf of the board during a period of financial distress. Clearly, the business judgment rule expects that prudent directors will respond as necessary to address the problems at hand. In this regard, evidence of a clear and deliberate process by which the members of the board evaluate the corporation’s financial distress in good faith and on an informed basis continues to be crucial to achieving the protections of the business judgment rule and deflecting public and regulatory criticism. The value of these new decisions is that, when responding in good faith to financial distress, directors need neither to focus excessive attention on hovering creditors nor to modify their actions for fear of personal liability.

The Governance Institute thanks Michael Peregrine and Miles Hughes, partners with McDermott Will & Emery, for contributing this article. Michael can be reached at (312) 984-6933 or mperegrine@mwe.com. Miles can be reached at (312) 984-6914 or mwhughes@mwe.com

^[1]Trenwick America Litigation Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 204 (Del. Ch. 2006), aff’d, 2007 Del. LEXIS 357 (Del. Aug. 14, 2007).
^[2]North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2007 Del. LEXIS 227 (Del. May 18, 2007).