Fairness Opinions and Living in the Zone

Fairness opinions offered for business transactions generally ensure the best interests of the equity holders of a company are protected. Occasionally, at least under current criteria, consideration may also be given to creditors.

The recent restructuring of a publicly traded company involved such circumstances. PCE was engaged to render a fairness opinion that weighed fairness in relation to the equity holders of the company but also evaluated the deal from the perspective of creditors.

That’s unusual, considering a fairness opinion generally answers the question, “is the deal fair to the shareholders?” This particular situation required that same fairness analysis be applied to creditors who would continue to be creditors after the transaction was completed.

Is it fair to creditors?

The development of fairness opinions began after the landmark case Smith v. Van Gorkom. Since that decision, hundreds of boards of directors have commissioned thousands of fairness opinions to help them properly consider transactions and determine the effects on shareholders. More importantly, these outside opinions provided evidence that the boards of directors met their fiduciary duties to the shareholders. In recent years, the scope of the fiduciary duty owed by boards of directors seems to have expanded beyond shareholders and may even apply to creditors, in certain situations.

Applying an analysis that determines if a company has entered the “zone of insolvency,” some courts have expanded the fiduciary duty of boards of directors to include creditors when a company is near insolvency. Applying tests that are very similar to statutory solvency tests used in fraudulent conveyance law, courts have reasoned that a duty to creditors may exist if a board either knew or should have known the company was approaching insolvency, or was “in the zone.” The courts have reasoned that once a company is in the zone of insolvency, creditors have rights more akin to shareholders and the directors’ duty shifts to include those creditors who would suffer from board decisions rendered “in the zone.” Hence, the perceived need for fairness opinions directed toward creditors.

Does it matter if it’s fair to creditors?

A recent case, however, seems to be moving against this current trend. In North American Educational Programming, Inc. v. Gheewalla, 2007 WL 1453705 (Del. 2007), the Delaware Supreme Court held that the creditors of a Delaware corporation that is either insolvent, or in the zone of insolvency, cannot bring direct claims for breach of fiduciary duty against that corporation’s directors. In essence, the ruling states that duties to creditors are negotiated by contract and creditors have additional protection through implied covenants of good faith and fair dealing, general commercial law, and fraud and fraudulent conveyance law.

However, some questions still remain. Can creditors bring derivative claims against a board when it has acted while a company is in the zone of insolvency? We know derivative claims are permitted in actual insolvency. When else can creditors assert derivatively fiduciary claims? Does a different standard apply to a company that is insolvent but still operating? What is the definition of “zone of insolvency?” When does the zone become actual insolvency? How does this affect fraudulent conveyance law?

Until these issues are individually tested and resolved, we anticipate more and more requests for fairness opinions directed toward creditors. After all, for board members who are potentially facing massive personal liability for decisions they make, it is certainly easier to sleep at night knowing an outside independent expert has endorsed the deal.

If you have comments or questions about this article, or would like more information on this subject matter, please contact us.
Tracy Lamb

Valuation
tlamb@pcecompanies.com
Orlando Office

407-621-2100 (main)
407-621-2118 (direct)
407-621-2199 (fax)