Opinion ID: 1057564
Heading Depth: 1
Heading Rank: 5

Heading: Direct Cause of Action by Creditor of Insolvent Corporation for Breach of Fiduciary Duty

Text: Mr. Sanford brought a direct claim for breach of fiduciary duty against the Waughs, as officers and directors of the insolvent corporation, SecureOne. The trial court dismissed the claim and the Court of Appeals reversed, holding that a creditor of an insolvent corporation could bring a direct claim for breach of fiduciary duty against corporate officers and directors. Sanford, 2009 WL 1910957, at -14. The question of whether an individual creditor of an insolvent corporation may bring a direct cause of action against the directors and officers for breach of fiduciary duty has not been directly addressed by the courts in Tennessee. This determination presents an issue of law, and therefore we view the trial court's decision de novo with no presumption of correctness. Madden v. Holland Grp. of Tenn., Inc., 277 S.W.3d 896, 898 (Tenn.2009). We begin with a brief review of the role and responsibilities of corporate officers and directors. A corporation is governed by its directors and officers. Tennessee Code Annotated section 48-18-101 (2002) establishes the position and general role of a corporate director, stating as follows: (a) Except as provided in subsection (c), each corporation must have a board of directors. (b) All corporate powers shall be exercised by or under the authority of, and the business and affairs of the corporation managed under the direction of, its board of directors, subject to any limitation set forth in the charter. (c) A corporation having fifty (50) or fewer shareholders may dispense with or limit the authority of a board of directors by describing in its charter who will perform some or all of the duties of a board of directors; provided, that any such person or persons shall be subject to the same standards of conduct that this chapter imposes on directors in the performance of their duties. Similarly, Tennessee Code Annotated section 48-18-401 (2002) governs corporate officers by stating that [a] corporation has the officers described in its bylaws or designated by its board of directors in accordance with the bylaws; provided, that every corporation shall have a president and a secretary. The corporation's officers are appointed or elected by the board of directors unless its charter or bylaws provide otherwise. Id. In a solvent corporation, there is a clear distinction between the fiduciary duty the officers and directors owe to shareholders of the corporation and the duty the officers and directors owe to creditors. The directors and officers of a corporation owe a fiduciary duty to the corporation and to its shareholders. Deadrick v. Bank of Commerce, 100 Tenn. 457, 45 S.W. 786, 788 (1898) (observing that a corporation's officers or agents stand in a fiduciary relation to both the corporate entity and shareholders); Neese v. Brown, 218 Tenn. 686, 405 S.W.2d 577, 581 (1964) (observing that a director, or other officer, of a corporation, although not responsible for errors of judgment[,] is a fiduciary charged with the duty of caring for the property of the corporation and managing its affairs honestly and in good faith) (internal quotation marks omitted); Knox-Tenn Rental Co. v. Jenkins Ins., Inc., 755 S.W.2d 33, 36 (Tenn. 1988) (stating [a] corporate officer must at all times be loyal to his trust and act in good faith and unselfishly toward the corporation and its stockholders) (quoting Hayes v. Schweikart's Upholstering Co., 55 Tenn. App. 442, 402 S.W.2d 472, 483 (1965) (citing 19 C.J.S. Corporations § 761b)). A fiduciary is a person holding the character of a trustee who bears the duty to act primarily for the benefit of another. See McRedmond v. Estate of Marianelli, 46 S.W.3d 730, 738 (Tenn.Ct.App.2000). As fiduciaries, corporate officers and directors must act in good faith, as observed by the McRedmond court: With respect to directors in a close corporation, They are required to act in the utmost good faith, and ... they impliedly undertake to give to the enterprise the benefit of their care and best judgment and to exercise the powers conferred solely in the interest of the corporation ... and not for their own personal interests. A fiduciary is not an insurer, but is bound to exercise good faith and due diligence. Id. (internal citations omitted). Tennessee Code Annotated section 48-18-301 (2002) (pertaining to directors) and section 48-18-403 (2002) (pertaining to officers) require that directors and officers discharge all duties under their discretionary authority: (1) In good faith; (2)With the care an ordinarily prudent person in a like position would exercise under similar circumstances; and (3) In a manner the director [or officer] reasonably believes to be in the best interests [2] of the corporation. Id. Although shareholders, as owners of the corporation, cannot exercise any control over the corporation's ordinary business operations, they are properly protected by the fiduciary duty owed to them and the corporation by the directors and officers. [A]lthough the shareholder bears the risk, it is the director and officer who, through their decisions, can directly affect the value of the firm. Thus directors must act as custodians entrusted with the management of the shareholders' assets. Cory Dean Kandestin, Note, The Duty to Creditors in Near-Insolvent Firms: Eliminating the Near-Insolvency Distinction, 60 Vand. L.Rev. 1235, 1242 (2007) (internal quotation marks omitted). Officers and directors, however, do not owe a fiduciary duty to creditors of a solvent corporation. Deadrick, 45 S.W. at 788; Merriman v. Smith, 599 S.W.2d 548, 555 (Tenn.Ct.App.1979). Unlike shareholders, creditors are able to protect their interests by contracts, including loan and security agreements, before lending money to the firm. Creditors have fixed claims against the corporation, entitling them to receive repayment of their principal, with interest, at a specified time. Shareholders have the right to participate in firm profits through dividends ... and to share in residual assets ... upon dissolution. J. William Callison, Why a Fiduciary Duty Shift to Creditors of Insolvent Business Entities is Incorrect as a Matter of Theory and Practice, 1 J. Bus. & Tech. L. 431, 431 (2007). The directors of a corporation or a majority of its shareholders, acting for the corporation, are the proper parties to bring a claim on behalf of a corporation. House v. Estate of Edmondson, 245 S.W.3d 372, 381 (Tenn.2008). Also to protect their rights, corporate shareholders may bring a derivative action. A derivative action is a suit brought by one or more shareholders on behalf of a corporation to redress an injury sustained by, or to enforce a duty owed to, the corporation. Id. at 381-82. In contrast, creditors may not directly sue officers and directors of a corporation because they allegedly failed to properly manage corporate affairs. In Merriman, the court observed the general rule that to become directly liable to a creditor, a statutory duty must devolve upon the director or there must be some conduct which creates privity of contract between them or which results in tortious injury to the creditor for which an action ex delicto [3] will lie. 599 S.W.2d at 555; accord Schlater v. Haynie, 833 S.W.2d 919, 924 (Tenn.Ct.App.1991). The Merriman court cited and applied the following general principles observed by this Court in Deadrick: That directors are liable in an action at law to their principal, the corporation, for losses resulting to it from their malfeasance, misfeasance, or their failure or neglect to discharge the duties imposed by their office, and, in equity, to the stockholders for these losses, the corporation declining to bring suit, is clear.... Though the corporation is the legal entity, yet the stockholders are interested in the operations of the corporation while in a state of activity, and, upon its dissolution, in the distribution of its property, after all debts are paid; and so its officers or agents stand in a fiduciary relation to both. But it is otherwise as to creditors.... It is true that the creditors may extend credit upon the faith that the company has assets to pay its debts, and that these assets are prudently managed; yet they are strangers to the directors; they maintain no fiduciary relation with them; there is a lack of privity between the two. . . . To enable the creditors to sue the defendants directly, they must have some independent right of action, either legal or equitable. 45 S.W. at 788-89. The Deadrick Court emphasized that we are not now dealing... with a case where directors have unlawfully or fraudulently appropriated to their own use, or otherwise wrongfully devested the assets of the bank, but only with allegations of ordinary negligent mismanagement of the corporation. Id. at 787. When a corporation becomes insolvent, additional protection is afforded to corporate creditors, including the power to initiate a derivative action on behalf of the corporation, because upon a corporation's insolvency, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value. N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del.2007); cf. Intertherm, Inc. v. Olympic Homes Sys., Inc., 569 S.W.2d 467, 468 (Tenn.Ct. App.1978) (derivative action by certain creditors on behalf of all creditors against directors of insolvent corporation). Creditors are further protected by the application of the trust fund doctrine which allows creditors of an insolvent or dissolved corporation to collect payment of their debts before distributions to shareholders, as noted by this Court as follows: Under this doctrine, as it has been applied in Tennessee, the creditors of an insolvent or dissolved corporation are entitled in equity to payment of their debts before any distribution of corporate property is made among stockholders, and these creditors also possess a right to follow its assets or property into the hands of [anyone] who is not a holder in good faith in the ordinary course of business. See Jennings, Neff & Co. v. Crystal Ice Co., 128 Tenn. 231, 236, 159 S.W. 1088, 1089 (1913). Kradel v. Piper Indus., 60 S.W.3d 744, 756 (Tenn.2001). Mr. Sanford is asking this Court to recognize a new direct, not derivative, cause of action by a single creditor against the corporate directors and/or officers of an insolvent corporation. The trial court dismissed Mr. Sanford's direct claim for breach of fiduciary duty, finding the reasoning of the Delaware Supreme Court in the Gheewalla case to be persuasive. In Gheewalla, the Court addressed as a matter of first impression the same issue presented here and concluded that the creditors of a Delaware corporation that is either insolvent or in the zone of insolvency have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against the corporation's directors. Id. at 94. The Gheewalla Court provided two reasons that we find persuasive in support of its conclusion. First, the Court noted that creditors of corporations are already provided with adequate legal protections and safeguards and observed that an additional layer of protection via a direct claim for breach of fiduciary duty would be unnecessary and problematic: 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 dealing, bankruptcy law, general commercial law and other sources of creditor rights. Id. at 99 (footnotes omitted). The Court, observing that the recognition of a new direct right to assert breach of fiduciary claims by creditors of corporations that are insolvent or in the zone of insolvency may involve `using the law of fiduciary duty to fill gaps that do not exist,' id. at 100 (quoting Production Resources Group L.L. v. NCT Group, Inc., 863 A.2d 772, 790 (Del.Ch.2004)), stated that creditors' existing protectionsamong which are the protections afforded by their negotiated agreements, their security instruments, the implied covenant of good faith and fair dealing, fraudulent conveyance law, and bankruptcy law render the imposition of an additional, unique layer of protection through direct claims for breach of fiduciary duty unnecessary. Gheewalla, 930 A.2d at 100. Secondly, the Gheewalla Court observed that allowing a direct breach of fiduciary duty claim would create problems with corporate governance, causing uncertainty and potential conflicts of interest for officers and directors: Recognizing that directors of an insolvent corporation owe direct fiduciary duties to creditors, would create uncertainty for directors who have a fiduciary duty to exercise their business judgment in the best interest of the insolvent corporation. To recognize a new right for creditors to bring direct fiduciary claims against those directors would create a conflict between those directors' duty to maximize the value of the insolvent corporation for the benefit of all those having an interest in it, and the newly recognized direct fiduciary duty to individual creditors. Directors of insolvent corporations must retain the freedom to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation. Id. at 103. We agree with and adopt the Delaware Supreme Court's reasoning and holding in Gheewalla. [4] Mr. Sanford's rights as an individual creditor of SecureOne were adequately protected by state law and federal bankruptcy law. Although Mr. Sanford did not have a direct breach of fiduciary duty claim, he could have initiated a derivative claim on behalf of all of the insolvent SecureOne's creditors. See Gheewalla, 930 A.2d at 101 (stating that the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties) (emphasis in original); cf. Intertherm, 569 S.W.2d at 468-69 (derivative action on behalf of all creditors against directors of insolvent corporation). Mr. Sanford's rights as a creditor were further protected by his contractual and security agreements with SecureOne, the implied covenant of good faith and fair dealing, see Intertherm, 569 S.W.2d at 471, federal bankruptcy law, Tennessee's version of the Uniform Fraudulent Transfer Act, Tenn. Code Ann. §§ 66-3-301 to -313 (2004), and the trust fund doctrine. Indeed, Mr. Sanford was able to successfully prosecute and obtain a judgment in this case for those transfers made by SecureOne that the jury found to be fraudulent. Mr. Sanford admits in his appellate brief that [o]fficers and directors are already prohibited from self-dealing and from preferring their own debt over the debt of other creditors in the absence of a direct breach of fiduciary duty claim. In summary, we hold that as a matter of law, individual creditors of an insolvent corporation have no right to assert direct claims for breach of fiduciary duty against corporate officers and/or directors. The judgment of the Court of Appeals is therefore reversed, and the judgment of the trial court granting the Waughs summary judgment on this claim is reinstated.