Opinion ID: 145387
Heading Depth: 3
Heading Rank: 1

Heading: The Duty of Loyalty

Text: 21 Under Delaware law, “[t]he essence of the duty of loyalty is that ‘corporate officers and directors are not permitted to use their position of trust and confidence to further their private interests.’” 1-4 Corporate Governance: Law and Practice § 4.03 (quoting Guth v. Loft, 5 A.2d 503, 510 (Del. 1939)). The duty of loyalty requires a fiduciary to act in the best interests of the corporation. Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993) (“the duty of loyalty mandates that the best interest of the corporation and its shareholders take precedence over any interest possessed by a . . . controlling shareholder and not shared by the stockholders generally.”) A claim for breach of the duty of loyalty under Delaware law exists where (1) the company is harmed or (2) a fiduciary personally profits from a corporate opportunity. See Oberly v. Kirby, 592 A.2d 445, 463 (Del. 1991) (holding a breach of the fiduciary duty of loyalty can exist where either the beneficiary is harmed or the fiduciary uses knowledge gained from his position to advance his independent interests). The Amended Complaint alleges that the Individual Defendants and Wellspring breached the duty of loyalty by favoring the interests of Wellspring over those of the Debtor. In short, the Amended Complaint alleges that the Individual Defendants managed Far & Wide for the benefit of a majority 22 shareholder and that Far & Wide obtained a loan from Wellspring in October 2002, which allowed the company to continue to run its troubled businesses rather than preserving its value for the creditors. As a threshold matter, the conclusory allegations concerning breach of the duty of loyalty in both complaints are not supported by the necessary factual allegations “to state a claim to relief that is plausible on its face.” Twombly, 550 U.S. at 570. Moreover, the Trustee alleges injury only to the Debtors’ creditors. For example, the Amended Complaint alleges that the decision to accept the loan from Wellspring in 2002 and continue operating the business “resulted in the diminution in value of Far & Wide’s assets to a point where Far & Wide did not have any ability to pay its liabilities to its creditors when bankruptcy protection was finally sought....” In order to state a claim for breach of the duty of loyalty, the Trustee must allege facts that indicate either Far & Wide or its minority shareholders, not Far & Wide’s creditors, were injured by the action of the Individual Defendants. See Cede & Co., 634 A.2d at 361 (stating that a breach of the duty of loyalty can exist where a fiduciary pursues his own interest over that of the shareholders). Neither the Complaint nor the Amended Complaint contain sufficient factual allegations to support such a claim. The Trustee does not allege facts demonstrating that the 23 majority shareholders were preferred in any way over the minority shareholders. No allegations indicate that the loan could have been obtained on more favorable terms, that the Individual Defendants personally benefitted, or that Wellspring benefitted at all since the loan was never repaid. The only injury alleged in the Amended Complaint was to the Debtors’ creditors as a result of Far & Wide staying in business longer and deepening its insolvency, when it would have been in the best interest of the creditors for Far & Wide to cease business and liquidate. Delaware law, however, does not recognize a cause of action for “deepening insolvency.” Trenwick Am. Litig. Trust v. Ernst & Young, LLP, 906 A.2d 168, 174, 204 (Del. Ch. 2006). Even when a firm is insolvent, its directors may, in the appropriate exercise of their business judgment, take action that might, if it does not pan out, result in the firm being painted in a deeper hue of red. The fact that the residual claimants of the firm at that time are creditors does not mean that the directors cannot choose to continue the firm's operations in the hope that they can expand the inadequate pie such that the firm's creditors get a greater recovery. Id. at 174. The Trustee alleges that the actions taken by the board of directors were done so that the company could continue operating in an attempt to facilitate a sale of the corporation to a third party. The sale, however, would have 24 maximized the value to all shareholders. Recent Delaware cases hold that officers and directors do not breach the duty of loyalty by exercising their business judgment and continuing to operate an insolvent corporation rather than entering bankruptcy and preserving assets to pay creditors. Trenwick, 906 A.2d at 174; Gheewalla, 930 A.2d at 99 (explaining that the general rule is that directors of a corporation do not owe creditors duties beyond the relevant contractual terms). In fact, Gheewalla presents an analogous factual situation. In Gheewalla, a creditor of Clearwire Holdings, Inc. (“Clearwire”) sued several directors of Clearwire for breach of fiduciary duty. Gheewalla, 930 A.2d at 94. The creditors alleged that the directors breached their fiduciary duties once Clearwire became insolvent and effectively went out of business because the directors allowed the corporation to continue holding certain licenses. Id. at 97-99. Holding onto these licenses required large expenditures of cash each month, which otherwise would have been available for creditors had the corporation liquidated. Id. at 97-99 The Delaware Supreme Court stated: It is well established that the directors owe their fiduciary obligations to the corporation and its shareholders. While shareholders rely on directors acting as fiduciaries to protect their interests, creditors are afforded protection through contractual agreements, fraud and fraudulent conveyance law, implied covenants of good faith and fair 25 dealing, bankruptcy law, general commercial law and other sources of creditor rights. Id. at 99. All these remedies are available to the creditors in the present situation, and they continue to pursue some in the district court. If they were wronged, they have ample recourse, but the remedies do not include bringing a claim for breach of fiduciary duty where the only alleged injury is a deepening insolvency which harmed only creditors. Since Delaware law does not recognize a duty to liquidate, and the Amended Complaint fails to allege sufficient facts to demonstrate the necessary elements of a claim for breach of the duty of loyalty to the Debtors, the district court did not err in dismissing Appellant’s claim for breach of the fiduciary duty of loyalty.