Officer and Director Liability After Bankruptcy: 6 Claims a Trustee Pursues

The trustee who takes over a failed company inherits its grievances along with its bank accounts. Section 541(a)(1) places in the estate "all legal or equitable interests of the debtor in property as of the commencement of the case," and the company's claims against the people who ran it are among the things a trustee is expected to find, value, and, where the numbers justify it, pursue.

The duty to look is written down. A chapter 11 trustee must, under section 1106(a)(3) and (4), investigate "the acts, conduct, assets, liabilities, and financial condition of the debtor" and file a statement of "any fact ascertained pertaining to fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the affairs of the debtor, or to a cause of action available to the estate." A chapter 7 trustee's duties under section 704 include investigating the debtor's financial affairs. And in CFTC v. Weintraub (1985) the Supreme Court held that a corporation's trustee may waive the company's attorney-client privilege for communications made before bankruptcy, which means the former managers' conversations with company counsel may be read by the person now deciding whether to sue them. The six claims below are drawn from Delaware law, where the relevant statutes and cases are published and settled; other states differ, sometimes a great deal.

1. Self-Dealing Remains the Claim Charters Cannot Excuse

Delaware lets a corporation's charter eliminate personal liability for money damages for breach of fiduciary duty, but section 102(b)(7) of the General Corporation Law withholds that protection for "any breach of the director's or officer's duty of loyalty," for acts "not in good faith or which involve intentional misconduct or a knowing violation of law," and for "any transaction from which the director or officer derived an improper personal benefit." A manager who sat on both sides of a transaction (a lease from the owner's own real estate company, a supply contract with a relative) cannot rely on the exculpation clause if the arrangement is found to be disloyal or to have delivered an improper personal benefit.

The trustee's case in these matters is built from the same records the company already kept: the lease, the invoices, the minutes approving them, or the absence of minutes.

2. Officers Receive Less Protection Than Directors

The same statute treats officers differently in one respect that matters here. Section 102(b)(7) permits exculpation of officers, but not "in any action by or in the right of the corporation." A trustee pursuing the company's own claim is asserting the company's rights, and so the officer who assumed the charter covered him should have counsel read it again with that exception in mind.

Care claims are harder for a trustee to win. A director protected by an exculpation clause is shielded from money damages for a breach of the duty of care, so a trustee who wants damages must bring the facts within one of the listed exceptions, usually by alleging bad faith or disloyalty, which is a different accusation and a heavier one to prove. There are directors who deserve the harder label, though the pleadings are not where that is decided.

Whether a small LLC's operating agreement contains any comparable protection is a separate question, answered by the document and by the LLC statute of the state that formed it.

3. Unlawful Dividends Carry Personal Liability for Six Years

Section 170 of the Delaware General Corporation Law allows dividends only out of surplus or, where there is none, out of net profits for the current or preceding fiscal year. Section 174 then makes the directors "under whose administration the same may happen" jointly and severally liable for "any wilful or negligent violation," to the corporation "and to its creditors in the event of its dissolution or insolvency," for the full amount paid, with interest, "at any time within 6 years." Stock redemptions made in violation of section 160 are treated the same way.

The statute contains its own exit, and it is a narrow one. A director who was absent, or who dissented, may be exonerated by having the dissent "entered on the books containing the minutes" at the time or immediately after learning of it. The minutes, in other words, are the defense; the director who objected aloud at a meeting nobody recorded has the objection and nothing to show for it.

Limited liability companies run on a different statute with a different trigger. Delaware's LLC Act, section 18-607, forbids a distribution that leaves liabilities exceeding the fair value of assets, and makes a member who received one liable to the company only if the member "knew at the time" that it violated the rule, generally for three years after the distribution. Reasonable compensation for services is not a distribution for this purpose.

Six years is a long time in a small company's life.

4. Money the Officer Received Can Be Recovered as a Transfer

Salary outside the ordinary course, repayments of insider loans, and bonuses paid as the company failed are reached through the avoidance sections rather than fiduciary law: section 547's one-year insider preference period, section 548's provision for insider employment contracts, and recovery from the recipient under section 550. The officer is sued as a transferee, not as a fiduciary, and the defenses are the statute's.

5. "Deepening Insolvency" Is a Theory Delaware Declined

Litigation trusts and trustees have argued that managers who kept an insolvent company borrowing made its creditors' position worse and should answer for the difference. In Trenwick America Litigation Trust v. Ernst & Young, decided in August 2006, the Court of Chancery refused: "Delaware law does not recognize this catchy term as a cause of action, because catchy though the term may be, it does not express a coherent concept." Directors of an insolvent firm may, in the exercise of business judgment, take action that leaves it "painted in a deeper hue of red," and "the directors do not become a guarantor of success." The Delaware Supreme Court affirmed the following year.

Continuing to operate is a judgment. Continuing to operate while moving the company's money to oneself is something else, and Delaware has other names for it.

The court did not immunize the conduct underneath. It pointed trustees to "existing equitable causes of action for breach of fiduciary duty, and existing legal causes of action for fraud, fraudulent conveyance, and breach of contract," which is where Delaware sends a claim about a failing company's last months. An owner who took on merchant cash advances to keep the doors open (which critics of the product will call reckless and which the owner will call payroll) has not, on Trenwick's reasoning, committed a tort by that choice alone.

6. Creditors' Fiduciary Claims Belong to the Estate

The Delaware Supreme Court held in North American Catholic Educational Programming Foundation v. Gheewalla (2007) that creditors of a corporation that is insolvent, or in the zone of insolvency, have no right to assert direct claims for breach of fiduciary duty against its directors. What creditors of an insolvent corporation may bring are derivative claims, on the corporation's behalf.

In bankruptcy the distinction points to the trustee: a derivative claim is asserted on the company's behalf, the company's claims are part of the estate the trustee administers, and an individual funder that believes the owner mismanaged the business is left to its guaranty, its own contract theories, or a dischargeability complaint if the owner files. The trustee, not the loudest creditor, decides whether the fiduciary case is brought.

What Sits Outside the Trustee's Reach

Some personal exposure never passes through the trustee at all. Withheld payroll taxes are pursued by the IRS under 26 U.S.C. 6672, and personal guaranties are enforced by the lenders who hold them. Delancey Street, which is not a law firm, works on the second kind: it negotiates merchant cash advance, SBA and other business debts, often with guaranties attached, and offers a free, confidential review through its website. A trustee's claim against an officer is litigation, and it needs a litigator.

The minutes book is the least read document in most small companies. It is also the one a trustee opens first.