Creditors Can’t Directly Sue Officers and Directors of an Insolvent Corporation in Tennessee

By Robert J. Mendes

On December 17, 2010, the Tennessee Supreme Court held "that a creditor of an insolvent corporation may not bring a direct claim, only a derivative claim, against officers and directors for breach of fiduciary duties they owe to the corporation." Sanford v. Waugh, 2010 WL 5139496 (Tenn. 2010). With this holding, the Supreme Court reversed the Court of Appeals and instead adopted the reasoning of the Delaware Supreme Court.

This case can be seen as part of a national trend to pare back the sort of "deepening insolvency" theories that gained favor in the late 1990s and early 2000s. This article describes the decisions by the Court of Appeals and Supreme Court, and then suggests where the next hot spots for further litigation will be in Tennessee.

I.  Court of Appeals

Until 2009, no Tennessee state court decision had squarely addressed whether a creditor may bring a direct claim for breach of fiduciary duty against the officers and directors of an insolvent corporation. In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92, 99 (Del. 2007), the Delaware Supreme Court had already held 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." 930 A.2d at 94. That Court explained that "the general rule is that directors do not owe creditors duties beyond the relevant contractual terms." Id. at 99 (citations omitted). However, the Court continued, the creditors of an insolvent corporation do have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties. Id. at 101.

When the issue came before the Tennessee Court of Appeals, in Sanford v. Waugh, 2009 WL 1910957 (Tenn. Ct. App. 2009), the Court of Appeals generally agreed with Gheewalla's holding that a creditor can assert only derivative actions against insiders of an insolvent corporation. However, the Court of Appeals took the analysis a step further by holding that a creditor of an insolvent corporation (or on the verge of insolvency) can bring a direct action against the corporation's insiders for breach of fiduciary duty if the insiders have engaged in self-dealing or preference.

The plaintiff in Waugh was a creditor of an insolvent corporation that owed him on a promissory note. After suing the corporation and its owner to enforce the note, the officers and directors of the corporation began winding down the corporation and disposing of assets in which the plaintiff claimed a security interest. Believing the officers and directors were acting for their own benefit and to avoid paying him under the note, he sued them for breach of fiduciary duty, among other things. The trial court dismissed the breach of fiduciary duty claim on summary judgment. The trial court had relied on Gheewalla in determining that the plaintiff could only proceed against the insiders through a derivative action.

In reversing summary judgment on the breach of fiduciary claim, the Court of Appeals relied on Intertherm, Inc. v. Olympic Homes Sys., Inc., 569 S.W.2d 467 (Tenn. Ct. App. 1978), for the proposition that "officers and directors of an insolvent corporation owe a fiduciary duty to creditors." Id. at 11-12. The Court of Appeals then added:

a creditor to an insolvent corporation or a corporation on the verge of insolvency may assert an action for breach of fiduciary duty against officers or directors who are also creditors to the corporation when they have been given preference in their preexisting debt or have engaged in self-dealing conduct.

Id. at 13. The rationale behind this ruling was that insiders cannot be allowed to use their position and superior inside knowledge to benefit themselves at the expense of third-party creditors. The Court of Appeals acknowledged Gheewalla's concern that recognizing direct fiduciary duties to creditors could create uncertainty and conflicts of interest for directors. The Court of Appeals explained that its holding avoided those concerns, however, because it is limited to cases involving self-dealing or preference. The Court of Appeals distinguished Gheewalla, in part, by pointing out that the defendant-directors in Gheewalla were not accused of self-dealing.

II.  Supreme Court

The Supreme Court rejected the Court of Appeals' position that Gheewalla could be distinguished, and instead adopted the Delaware Supreme Court's reasoning. Before doing that, the Supreme Court described the basis under Tennessee law for its decision.

According to the Court, "[i]n 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." Sanford v. Waugh, 2010 WL 5139496, at 5 (Tenn. 2010). "The directors and officers of a corporation owe a fiduciary duty to the corporation and to its shareholders," but the same "[o]fficers and directors... do not owe a fiduciary duty to creditors of a solvent corporation." Id. at 5-6. Tennessee law has been clear that "creditors may not directly sue officers and directors of a corporation because they allegedly failed to properly manage corporate affairs." Id. at 6. Importantly, for this last proposition, the Supreme Court cited a passage from Deadrick v. Bank of Commerce, 100 Tenn. 457, 45 S.W. 786, 788 (Tenn.1898), that says "[t]o enable the creditors to sue the defendants directly, they must have some independent right of action, either legal or equitable."

The Supreme Court then explored existing Tennessee law regarding insolvent corporations. The Court noted "additional protection is afforded to corporate creditors, including the power to initiate a derivative action on behalf of the corporation" upon a corporation's insolvency. Id. at 7.

After this review of Tennessee law, the Supreme Court adopted the reasoning from Gheewalla. First, like in Delaware, the existence of a derivative action by creditors on behalf of a corporation makes a direct cause of action unnecessary. Id. at 7-8. Second, allowing directors to be sued directly would create uncertainty for directors as corporations reached the "zone of insolvency" - "[d]irectors 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 8. With that, the Supreme Court held "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." Id. at 8.

III.  Where the case law goes from here

After this decision, creditors are still going to want to apply leverage by suing officers and directors. There are two windows that remain open after Waugh. First, the Supreme Court's reference to its 1898 Deadrick decision reminds us that officers and directors are fair game if they have engaged in otherwise tortious conduct. Depending on the facts, a range of business torts like fraud, conversion, or theft of trade secrets may be available to creditors. Second, Waugh is clear that derivative actions are available to creditors of insolvent corporations. This approach has not been commonly used in Tennessee, but perhaps we may see an upswing in creditors attempting this avenue to recovery.