The Rights of Creditors With Regard to Corporate Debts

Obtaining financing is a crucial part of most companies’ growth and success, and many lenders advance money in hopes of it being repaid at a profit. Even with financing, however, businesses often fail, making it difficult for lenders to get their money back. Most creditors’ rights are contractual, but Minnesota law provides a few other protections to creditors attempting to have their loan repaid. This article describes the legal rights of creditors, both under Minnesota and Delaware law, with regard to making corporations retain the assets necessary to pay their debts. First, it discusses terms likely to be included in loan agreements.

Contractual Obligations to Creditors

The vast majority of creditors’ rights in regards to repayment of debt are contractual. When a lender agrees to loan money to a company, the two sides negotiate the terms of the agreement. At the most basic, a lender will require the repayment of the funds plus interest. Usually, there will be some sort of collateral, either provided by the borrower itself or by a related third party. For example, an affiliated company might agree to pay the debt if the borrower cannot, or might agree to invest a certain amount of money into the defaulting company to keep it afloat. Also, a lender might demand preference rights—a guarantee that the lender will get its money back before subsequent creditors (or, a lender might charge a higher rate in exchange for subordinating its payment rights). Still another option for lenders is to require a covenant to engage in or to not engage in specific acts, resulting in creditors having some element of control over the decisions of the business. Truly, the range of options available to creditors is extremely broad, and a full discussion is well outside the scope of this article. Suffice it to say that creditors are usually able to protect themselves by contract if they plan ahead. Still, Minnesota law provides further safeguards to defend against debtor misbehavior.

Limitations on Paying Dividends

Although it doesn’t specifically create a right for creditors, the Minnesota Business Corporations Act protects creditors to a very limited degree in regards to dividends paid to shareholders. Under § 302A.551 Subd. 1, the board may pay dividends only if it determines that the corporation will be able to pay its debts in the ordinary course of business after making the distribution. It’s important to note that the board’s determination is what is considered by the statute, not the actual financial situation of the corporation as proven by a third party. As the general comments to the statute make clear, the board’s decision is protected by the “Business Judgment Rule”—so long as directors acted in good faith and had a reasonable basis for their decision, the courts will defer to their judgment. Failure to meet this standard results in potential liability for directors.

Delaware corporate law provides creditors with a little bit more protection. Section 170 of the DGCL, Delaware corporations can only pay dividends to stockholders out of surplus or out of its profits for the current or prior fiscal year. This requirement is more distinct than that of Minnesota—“surplus” is defined by the Delaware statute—and is also somewhat stronger. A profitable corporation in either state, however, has no need to worry about creditors’ rights when paying dividends.

In fact, the law shields creditors from abusive dividends only in extreme circumstances. These statutes prevent a corporation with extensive debt from distributing all its assets to its shareholders, leaving nothing for its creditors to take and essentially avoiding liability. Still, the business judgment rule goes a long way in defending the decisions of directors, and anything short of such an explicit situation likely wouldn’t offend the statute. As such, these statutes stop short of creating any real protection to creditors.

Duties Owed to Creditors When Approaching Insolvency

Minnesota case law makes clear that corporate directors do owe some sort of duty to creditors when a corporation nears insolvency. According to Helm Financial Corporation v. MNVA Railroad, Inc., 212 F.3d 1076, 1081 (8th Cir. Minn. 2000), “when a corporation is insolvent, or on the verge of insolvency, its directors and officers become fiduciaries of the corporate assets for the benefit of creditors.” Although the court uses the term fiduciary, it only goes so far as to prohibit self-dealing and preferential treatment; this obligation falls well short of the fiduciary duty directors owe to the corporation and its shareholders. Better understanding of this case can be found by examining what constitutes self-dealing, preferential treatment, and the verge of insolvency.

  • Self-Dealing – Self-dealing transactions involve one person being on ‘both sides’ of the exchange, and can be damaging when that person ends up paying far less for an item than it is worth. A simple example would be a car salesman selling himself an automobile for a dollar. In the corporate setting, self-dealing would take the form of a director approving the sale of some corporate asset to that director at a discount. The self-dealing side of this fiduciary duty contemplates a scenario where an insolvent corporation owes debts to outside creditors, but instead of preserving its assets to pay the creditors it sells the assets to officers or directors at a very low price. When creditors attempt to obtain payment, the corporation would have no assets with which to pay. A corporation’s directors and officers owe a duty to creditors not to engage in self-dealing once the corporation becomes close to insolvent.
  • Preferential Treatment – Especially in closely held corporations, directors and officers often make loans to the entity just like outside lenders might. As opposed to a contribution which becomes part of their equity, these loans are expected to be paid back, giving the director or officer the same rights to this money as third party creditors. The court’s prohibition on preferential treatment, then, deals with giving preference in the paying back of these loans, as compared to self-dealing which questions whether fair value was paid. The prohibition is more fully described in Snyder Electric Co. v. Fleming, 305 N.W.2d 863 (Minn. 1981), at 869:
    • “As fiduciaries, they cannot by reason of their special position treat themselves to a preference over other creditors. . . By ‘preference’ we here mean generally a transfer or encumbrance of corporate assets made while the corporation is insolvent or verges on insolvency, the effect of which is to enable the director or officer to recover a greater percentage of his debt than general creditors of the corporation with otherwise similarly secured interests.”

In short, directors and officers of a corporation cannot use their power to make sure they get paid back before other creditors. Once a creditor proves that a transaction occurred between the insolvent corporation and a favored party, the burden shifts to the officer or director to show that the transaction was not preferential.

  • “Verge of Insolvency” – Section 302A.551 of the MBCA uses “able to pay its debts in the ordinary course of business” as a basic test of solvency. Yet this definition differs from that provided by the Minnesota Unified Fraudulent Transfer Act (discussed later), which labels a debtor insolvent if the sum of its debts is greater than all of the debtor’s assets, at a fair valuation. The UFTA also presumes insolvency when the debtor is generally not paying debts as they come due. Even avoiding this contradiction by accepting the firmer definition of the UFTA, lots of wiggle room remains as to what constitutes a “fair valuation”. To make matters worse, Minnesota courts hoist duties on corporations “on the verge of insolvency” in addition to those who are deemed insolvent.

Delaware has limited this special treatment to corporations who are actually insolvent; experts believe that Minnesota will soon follow this lead. Still, corporate insolvency is a hazy legal area, and proceeding cautiously seems to be the only prudent course of action for those affected by such a determination.

It’s important to note that a “breach of duty” under these circumstances does not result in director liability like for improper payment of dividends. Here, a breach would result in the transaction in question being reversed—a sort of clawing back of assets. Upon reversal, the creditors would then be able to satisfy their debts as to the same extent they would have had the transaction not occurred.

Minnesota Uniform Fraudulent Transfer Act

Minnesota’s Uniform Fraudulent Transfer Act, codified at Minn. Stat. §§ 513.41-513.51, also governs suspicious transfers. Transfers are fraudulent as to a creditor under § 513.44 of the statute if two prongs are met. First, the debtor must either have made the transfer with intent to hinder, delay, or defraud the creditor, or without receiving reasonably fair value in exchange for the transfer. Second, the debtor must have thought (or should have thought) that the transaction would lead the debtor towards insolvency. As mentioned earlier, insolvency is defined by this statute as having a greater value of debt than of assets. The section goes on to list many factors that support a finding that the debtor knew or should have known that insolvency could result. These factors attempt to guard against a debtor transferring assets to a related party to avoid using them as payment for a debt.

Minnesota case law provides examples of violations of the act, though not all debtors are corporations. In Citizens State Bank v. Leth, 450 N.W.2d 923 (Minn. Ct. App. 1990), the court found a transfer of assets by an individual to be fraudulent under the statute. Erling Leth sold land, receiving payment of only $100,000 even though the land’s fair market value approached $485,000. At the time, Leth owed a large debt to Citizens Bank as a result of a business loan he had guaranteed, and Leth had transferred most of his other assets into a family trust. The court held that the two part test of § 513.44 was passed, because the transfer was not for fair value and because that Leth knew or should have known that he would be unable to pay the debts he was incurring. Since his other assets were in trust and weren’t accessible, they did not count as assets under the statute; his debts were therefore greater than his assets.

As the case law shows, this statute does provide creditors with a realistic defense against a debtor attempting to unload assets rather than use them to pay debts. Section 513.47 allows for creditors to find relief through avoidance of the transfer or through an attachment against the transferred asset. A court also has the discretion to hand down a solution in equity, such as an injunction against further disposition of assets by the debtor.

Summary of Creditor Rights

When a corporation or other entity has extensive debt, it is often tempting to transfer assets to favored parties instead of using them to pay this debt. While creditors are usually able to guard against this with contractual rights, Minnesota law provides a few alternatives as well. Minnesota law limits a corporation’s payment of dividends to those times when it can still pay its debts, creates limited fiduciary duties owed to creditors by corporations when the corporation nears insolvency, and prohibits certain suspicious transactions that result in nonpayment to creditors. As such, a business approaching insolvency must be aware of how its remaining assets are being used.

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