In light of a recent swell of bankruptcies in Oklahoma and surrounding areas – predominantly triggered by the turbulent energy market – directors should fortify their understanding of fiduciary duties owed to companies in times of financial distress.

As a general rule, directors are charged with maximizing the value of the company for its “residual risk-bearers,” which are typically the company’s equity-holders. No direct fiduciary duty is owed to creditors of solvent companies, who instead protect themselves through contractual arrangements governing their relationships with firms.

Interestingly, under Delaware law, once a company is insolvent its directors continue to owe fiduciary duties solely to the company, but the benefit extends to both shareholders and creditors. This is because creditors are the residual risk-bearers of an insolvent company – paid before equity-holders under the applicable priority rules. This principle ensures that directors avoid risks detrimental to residual corporate value on the theory that equity-holders receive nothing without drastic action. Conversely, by factoring in creditors’ interests, directors may make business decisions aimed at preserving company value, even if that means equity-holders receive little to no realized recovery in bankruptcy.

There are two different standards for determining insolvency for such purposes. Some courts determine that creditors’ interests arise sometime before the company becomes insolvent, while in the so-called “zone or vicinity of insolvency.” This concept makes it difficult for directors to know exactly when they must begin considering creditors’ interests, as the beginning of the zone is generally ambiguous. Other courts have moved away from the zone concept in favor of a bright-line rule: fiduciary duties are owed for the benefit of creditors after a company has become insolvent, but not before. Although recent Delaware cases place more emphasis on the bright-line rule, the zone of insolvency remains a useful concept for directors.

Because it is difficult to pinpoint the precise moment a company becomes insolvent, directors should be increasingly mindful of their duties to creditors as a company’s financial wherewithal begins to deteriorate. When evaluating strategic alternatives and responding to financial challenges, directors should keep this practical viewpoint in mind: act in the interest of the company, and never one single constituency. In order to avoid the appearance of preferential treatment toward one constituency at the expense of another, the board’s materials, correspondence, and discussions should be clearly focused on acting in the interest of the company as a whole.

This article appeared in the September 22, 2016, issue of The Journal Record. It is reproduced with permission from the publisher. © The Journal Record Publishing Co.