[210] William David Levine, St. Clair and Levine, Huntington, West Virginia, for plaintiff-appellant.

D.C. Offutt, Jr., argued (John M. Poma, on brief), Jenkins, Fenstermaker, Krieger, Kayes & Farrell, Huntington, W.Va., for defendant-appellee.

Before HALL, Circuit Judge, CHAPMAN, Senior Circuit Judge, and WARD, Senior District Judge for the Middle District of North Carolina, sitting by designation.

OPINION

CHAPMAN, Senior Circuit Judge:

Plaintiff-appellant Kinney Shoe Corporation ("Kinney") brought this action in the United States District Court for the Southern District of West Virginia against Lincoln M. Polan ("Polan") seeking to recover money owed on a sublease between Kinney and Industrial Realty Company ("Industrial"). Polan is the sole shareholder of Industrial. The district court found that Polan was not personally liable on the lease between Kinney and Industrial. Kinney appeals asserting that the corporate veil should be pierced, and we agree.

I.

The district court based its order on facts which were stipulated by the parties. In 1984 Polan formed two corporations, Industrial and Polan Industries, Inc., for the purpose of re-establishing an industrial manufacturing business. The certificate of incorporation for Polan Industries, Inc. was issued by the West Virginia Secretary of State in November 1984. The following month the certificate of incorporation for Industrial was issued. Polan was the owner of both corporations. Although certificates of incorporation were issued, no organizational meetings were held, and no officers were elected.

In November 1984 Polan and Kinney began negotiating the sublease of a building in which Kinney held a leasehold interest. The building was owned by the Cabell County Commission and financed by industrial revenue bonds issued in 1968 to induce Kinney to locate a manufacturing plant in Huntington, West Virginia. Under the terms of the lease, Kinney was legally obligated to make payments on the bonds on a semi-annual basis through January 1, 1993, at which time it had the right to purchase the property. Kinney had ceased using the building as a manufacturing plant in June 1983.

The term of the sublease from Kinney to Industrial commenced in December 1984, even though the written lease was not signed by the parties until April 5, 1985. On April 15, 1985, Industrial subleased part of the building to Polan Industries for fifty percent of the rental amount due Kinney. Polan signed both subleases on behalf of the respective companies.

Other than the sublease with Kinney, Industrial had no assets, no income and no bank account. Industrial issued no stock certificates because nothing was ever paid in to this corporation. Industrial's only income was from its sublease to Polan Industries, Inc. The first rental payment to Kinney was made out of Polan's personal funds, and no further payments were made by Polan or by Polan Industries, Inc. to either Industrial or to Kinney.

Kinney filed suit against Industrial for unpaid rent and obtained a judgment in the amount of $166,400.00 on June 19, 1987. A writ of possession was issued, but because Polan Industries, Inc. had filed for bankruptcy, Kinney did not gain possession for six months. Kinney leased the building until it was sold on September 1, 1988. Kinney then filed this action against Polan individually to collect the amount owed by Industrial to Kinney. Since the amount to which Kinney is entitled is undisputed, the only issue is whether Kinney can pierce the [211] corporate veil and hold Polan personally liable.

The district court held that Kinney had assumed the risk of Industrial's undercapitalization and was not entitled to pierce the corporate veil. Kinney appeals, and we reverse.

II.

We have long recognized that a corporation is an entity, separate and distinct from its officers and stockholders, and the individual stockholders are not responsible for the debts of the corporation. See, e.g., DeWitt Truck Brokers, Inc. v. W. Ray Flemming Fruit Co., 540 F.2d 681, 683 (4th Cir.1976). This concept, however, is a fiction of the law "`and it is now well settled, as a general principle, that the fiction should be disregarded when it is urged with an intent not within its reason and purpose, and in such a way that its retention would produce injustices or inequitable consequences.'" Laya v. Erin Homes, Inc., 352 S.E.2d 93, 97-98 (W.Va.1986) (quoting Sanders v. Roselawn Memorial Gardens, Inc., 152 W.Va. 91, 159 S.E.2d 784, 786 (1968).

Piercing the corporate veil is an equitable remedy, and the burden rests with the party asserting such claim. DeWitt Truck Brokers, 540 F.2d at 683. A totality of the circumstances test is used in determining whether to pierce the corporate veil, and each case must be decided on its own facts. The district court's findings of facts may be overturned only if clearly erroneous. Id.

Kinney seeks to pierce the corporate veil of Industrial so as to hold Polan personally liable on the sublease debt. The Supreme Court of Appeals of West Virginia has set forth a two prong test to be used in determining whether to pierce a corporate veil in a breach of contract case. This test raises two issues: first, is the unity of interest and ownership such that the separate personalities of the corporation and the individual shareholder no longer exist; and second, would an equitable result occur if the acts are treated as those of the corporation alone. Laya, 352 S.E.2d at 99. Numerous factors have been identified as relevant in making this determination.^[1]

[212] The district court found that the two prong test of Laya had been satisfied. The court concluded that Polan's failure to carry out the corporate formalities with respect to Industrial, coupled with Industrial's gross undercapitalization, resulted in damage to Kinney. We agree.

It is undisputed that Industrial was not adequately capitalized. Actually, it had no paid in capital. Polan had put nothing into this corporation, and it did not observe any corporate formalities. As the West Virginia court stated in Laya, "`[i]ndividuals who wish to enjoy limited personal liability for business activities under a corporate umbrella should be expected to adhere to the relatively simple formalities of creating and maintaining a corporate entity.'" Laya, 352 S.E.2d at 100 n. 6 (quoting Labadie Coal Co. v. Black, 672 F.2d 92, 96-97 (D.C.Cir.1982)). This, the court stated, is "`a relatively small price to pay for limited liability.'" Id. Another important factor is adequate capitalization. "[G]rossly inadequate capitalization combined with disregard of corporate formalities, causing basic unfairness, are sufficient to pierce the corporate veil in order to hold the shareholder(s) actively participating in the operation of the business personally liable for a breach of contract to the party who entered into the contract with the corporation." Laya, 352 S.E.2d at 101-02.

In this case, Polan bought no stock, made no capital contribution, kept no minutes, and elected no officers for Industrial. In addition, Polan attempted to protect his assets by placing them in Polan Industries, Inc. and interposing Industrial between Polan Industries, Inc. and Kinney so as to prevent Kinney from going against the corporation with assets. Polan gave no explanation or justification for the existence of Industrial as the intermediary between Polan Industries, Inc. and Kinney. Polan was obviously trying to limit his liability and the liability of Polan Industries, Inc. by setting up a paper curtain constructed of nothing more than Industrial's certificate of incorporation. These facts present the classic scenario for an action to pierce the corporate veil so as to reach the responsible party and produce an equitable result. Accordingly, we hold that the district court correctly found that the two prong test in Laya had been satisfied.

In Laya, the court also noted that when determining whether to pierce a corporate veil a third prong may apply in certain cases. The court stated:

When, under the circumstances, it would be reasonable for that particular type of a party [those contract creditors capable of protecting themselves] entering into a contract with the corporation, for example, a bank or other lending institution, to conduct an investigation of the credit of the corporation prior to entering into the contract, such party will be charged with the knowledge that a reasonable credit investigation would disclose. If such an investigation would disclose that the corporation is grossly undercapitalized, based upon the nature and the magnitude of the corporate undertaking, such party will be deemed to have assumed the risk of the gross undercapitalization and will not be permitted to pierce the corporate veil.

Laya, 352 S.E.2d at 100. The district court applied this third prong and concluded that Kinney "assumed the risk of Industrial's defaulting" and that "the application of the doctrine of `piercing the corporate veil' ought not and does not [apply]." While we agree that the two prong test of Laya was satisfied, we hold that the district court's conclusion that Kinney had assumed the risk is clearly erroneous.

Without deciding whether the third prong should be extended beyond the context of the financial institution lender mentioned [213] in Laya, we hold that, even if it applies to creditors such as Kinney, it does not prevent Kinney from piercing the corporate veil in this case. The third prong is permissive and not mandatory. This is not a factual situation that calls for the third prong, if we are to seek an equitable result. Polan set up Industrial to limit his liability and the liability of Polan Industries, Inc. in their dealings with Kinney. A stockholder's liability is limited to the amount he has invested in the corporation, but Polan invested nothing in Industrial. This corporation was no more than a shell — a transparent shell. When nothing is invested in the corporation, the corporation provides no protection to its owner; nothing in, nothing out, no protection. If Polan wishes the protection of a corporation to limit his liability, he must follow the simple formalities of maintaining the corporation. This he failed to do, and he may not relieve his circumstances by saying Kinney should have known better.

III.

For the foregoing reasons, we hold that Polan is personally liable for the debt of Industrial, and the decision of the district court is reversed and this case is remanded with instructions to enter judgment for the plaintiff.

REVERSED AND REMANDED WITH INSTRUCTIONS.

[1] The following factors were identified in Laya:

(1) commingling of funds and other assets of the corporation with those of the individual shareholders;

(2) diversion of the corporation's funds or assets to noncorporate uses (to the personal uses of the corporation's shareholders);

(3) failure to maintain the corporate formalities necessary for the issuance of or subscription to the corporation's stock, such as formal approval of the stock issue by the board of directors;

(4) an individual shareholder representing to persons outside the corporation that he or she is personally liable for the debts or other obligations of the corporation;

(5) failure to maintain corporate minutes or adequate corporate records;

(6) identical equitable ownership in two entities;

(7) identity of the directors and officers of two entities who are responsible for supervision and management (a partnership or sole proprietorship and a corporation owned and managed by the same parties);

(8) failure to adequately capitalize a corporation for the reasonable risks of the corporate undertaking;

(9) absence of separately held corporate assets;

(10) use of a corporation as a mere shell or conduit to operate a single venture or some particular aspect of the business of an individual or another corporation;

(11) sole ownership of all the stock by one individual or members of a single family;

(12) use of the same office or business location by the corporation and its individual shareholder(s);

(13) employment of the same employees or attorney by the corporation and its shareholder(s);

(14) concealment or misrepresentation of the identity of the ownership, management or financial interests in the corporation, and concealment of personal business activities of the shareholders (sole shareholders do not reveal the association with a corporation, which makes loans to them without adequate security);

(15) disregard of legal formalities and failure to maintain proper arm's length relationships among related entities;

(16) use of a corporate entity as a conduit to procure labor, services or merchandise for another person or entity;

(17) diversion of corporate assets from the corporation by or to a stockholder or other person or entity to the detriment of creditors, or the manipulation of assets and liabilities between entities to concentrate the assets in one and the liabilities in another;

(18) contracting by the corporation with another person with the intent to avoid risk of nonperformance by use of the corporate entity; or the use of a corporation as a subterfuge for illegal transactions;

(19) the formation and use of the corporation to assume the existing liabilities of another person or entity.

Laya, 352 S.E.2d at 98-99 (footnote omitted).

Norbert Ruttenberg and Stephen A. Cohen for appellant.

Lawrence Lauer and John Winston for respondent.

Chief Judge DESMOND and Judges VAN VOORHIS, BURKE and SCILEPPI concur with Judge FULD; Judge KEATING dissents and votes to affirm in an opinion in which Judge BERGAN concurs.

[416] FULD, J.

This case involves what appears to be a rather common practice in the taxicab industry of vesting the ownership of a taxi fleet in many corporations, each owning only one or two cabs.

The complaint alleges that the plaintiff was severely injured four years ago in New York City when he was run down by a taxicab owned by the defendant Seon Cab Corporation and negligently operated at the time by the defendant Marchese. The individual defendant, Carlton, is claimed to be a stockholder of 10 corporations, including Seon, each of which has but two cabs registered in its name, and it is implied that only the minimum automobile liability insurance required by law (in the amount of $10,000) is carried on any one cab. Although seemingly independent of one another, these corporations are alleged to be "operated * * * as a single entity, unit and enterprise" with regard to financing, supplies, repairs, employees and garaging, and all are named as defendants.^[1] The plaintiff asserts that he is also entitled to hold their stockholders personally liable for the damages sought because the multiple corporate structure constitutes an unlawful attempt "to defraud members of the general public" who might be injured by the cabs.

[417] The defendant Carlton has moved, pursuant to CPLR 3211(a)7, to dismiss the complaint on the ground that as to him it "fails to state a cause of action". The court at Special Term granted the motion but the Appellate Division, by a divided vote, reversed, holding that a valid cause of action was sufficiently stated. The defendant Carlton appeals to us, from the nonfinal order, by leave of the Appellate Division on a certified question.

The law permits the incorporation of a business for the very purpose of enabling its proprietors to escape personal liability (see, e.g., Bartle v. Home Owners Co-op., 309 N.Y. 103, 106) but, manifestly, the privilege is not without its limits. Broadly speaking, the courts will disregard the corporate form, or, to use accepted terminology, "pierce the corporate veil", whenever necessary "to prevent fraud or to achieve equity". (International Aircraft Trading Co. v. Manufacturers Trust Co., 297 N.Y. 285, 292.) In determining whether liability should be extended to reach assets beyond those belonging to the corporation, we are guided, as Judge CARDOZO noted, by "general rules of agency". (Berkey v. Third Ave. Ry. Co., 244 N.Y. 84, 95.) In other words, whenever anyone uses control of the corporation to further his own rather than the corporation's business, he will be liable for the corporation's acts "upon the principle of respondeat superior applicable even where the agent is a natural person". (Rapid Tr. Subway Constr. Co. v. City of New York, 259 N.Y. 472, 488.) Such liability, moreover, extends not only to the corporation's commercial dealings (see, e.g., Natelson v. A. B. L. Holding Co., 260 N.Y. 233; Quaid v. Ratkowsky, 224 N.Y. 624; Luckenbach S. S. Co. v. Grace & Co., 267 F. 676, 681, cert. den. 254 U. S. 644; Weisser v. Mursam Shoe Corp., 127 F.2d 344) but to its negligent acts as well. (See Berkey v. Third Ave. Ry. Co., 244 N.Y. 84, supra; Gerard v. Simpson, 252 App. Div. 340, mot. for lv. to app. den. 276 N.Y. 687; Mangan v. Terminal Transp. System, 247 App. Div. 853, mot. for lv. to app. den. 272 N.Y. 676.)

In the Mangan case (247 App. Div. 853, mot. for lv. to app. den. 272 N.Y. 676, supra), the plaintiff was injured as a result of the negligent operation of a cab owned and operated by one of four corporations affiliated with the defendant Terminal. Although the defendant was not a stockholder of any of the operating [418] companies, both the defendant and the operating companies were owned, for the most part, by the same parties. The defendant's name (Terminal) was conspicuously displayed on the sides of all of the taxis used in the enterprise and, in point of fact, the defendant actually serviced, inspected, repaired and dispatched them. These facts were deemed to provide sufficient cause for piercing the corporate veil of the operating company — the nominal owner of the cab which injured the plaintiff — and holding the defendant liable. The operating companies were simply instrumentalities for carrying on the business of the defendant without imposing upon it financial and other liabilities incident to the actual ownership and operation of the cabs. (See, also, Callas v. Independent Taxi Owners Assn., 66 F.2d 192 [D. C. Ct. App.], cert. den. 290 U. S. 669; Association of Independent Taxi Operators v. Kern, 178 Md. 252; P. & S. Taxi & Baggage Co. v. Cameron, 183 Okla. 226; cf. Black & White v. Love, 236 Ark. 529; Economy Cabs v. Kirkland, 127 Fla. 867, adhered to on rearg. 129 Fla. 309.)

In the case before us, the plaintiff has explicitly alleged that none of the corporations "had a separate existence of their own" and, as indicated above, all are named as defendants. However, it is one thing to assert that a corporation is a fragment of a larger corporate combine which actually conducts the business. (See Berle, The Theory of Enterprise Entity, 47 Col. L. Rev. 343, 348-350.) It is quite another to claim that the corporation is a "dummy" for its individual stockholders who are in reality carrying on the business in their personal capacities for purely personal rather than corporate ends. (See African Metals Corp. v. Bullowa, 288 N.Y. 78, 85.) Either circumstance would justify treating the corporation as an agent and piercing the corporate veil to reach the principal but a different result would follow in each case. In the first, only a larger corporate entity would be held financially responsible (see, e.g., Mangan v. Terminal Transp. System, 247 App. Div. 853, mot. for lv. to app. den. 272 N.Y. 676, supra; Luckenbach S. S. Co. v. Grace & Co., 267 F.2d 676, 881, cert. den. 254 U. S. 644, supra; cf. Gerard v. Simpson, 252 App. Div. 340, mot. for lv. to app. den. 276 N.Y. 687, supra) while, in the other, the stockholder would be personally liable. (See, e.g., Natelson v. A. B. L. Holding Co., 260 N.Y. 233, supra; Quaid v. Ratkowsky, 224 N.Y. 624, supra; [419] Weisser v. Mursam Shoe Corp., 127 F.2d 344, supra.) Either the stockholder is conducting the business in his individual capacity or he is not. If he is, he will be liable; if he is not, then, it does not matter — insofar as his personal liability is concerned — that the enterprise is actually being carried on by a larger "enterprise entity". (See Berle, The Theory of Enterprise Entity, 47 Col. L. Rev. 343.)

At this stage in the present litigation, we are concerned only with the pleadings and, since CPLR 3014 permits causes of action to be stated "alternatively or hypothetically", it is possible for the plaintiff to allege both theories as the basis for his demand for judgment. In ascertaining whether he has done so, we must consider the entire pleading, educing therefrom "`whatever can be implied from its statements by fair and reasonable intendment.'" (Condon v. Associated Hosp. Serv., 287 N.Y. 411, 414; see, also, Kober v. Kober, 16 N Y 2d 191, 193-194; Dulberg v. Mock, 1 N Y 2d 54, 56.) Reading the complaint in this case most favorably and liberally, we do not believe that there can be gathered from its averments the allegations required to spell out a valid cause of action against the defendant Carlton.

The individual defendant is charged with having "organized, managed, dominated and controlled" a fragmented corporate entity but there are no allegations that he was conducting business in his individual capacity. Had the taxicab fleet been owned by a single corporation, it would be readily apparent that the plaintiff would face formidable barriers in attempting to establish personal liability on the part of the corporation's stockholders. The fact that the fleet ownership has been deliberately split up among many corporations does not ease the plaintiff's burden in that respect. The corporate form may not be disregarded merely because the assets of the corporation, together with the mandatory insurance coverage of the vehicle which struck the plaintiff, are insufficient to assure him the recovery sought. If Carlton were to be held individually liable on those facts alone, the decision would apply equally to the thousands of cabs which are owned by their individual drivers who conduct their businesses through corporations organized pursuant to section 401 of the Business Corporation Law and carry the minimum insurance required by subdivision 1 (par. [a]) of section 370 of the Vehicle and Traffic Law. These [420] taxi owner-operators are entitled to form such corporations (cf. Elenkrieg v. Siebrecht, 238 N.Y. 254), and we agree with the court at Special Term that, if the insurance coverage required by statute "is inadequate for the protection of the public, the remedy lies not with the courts but with the Legislature." It may very well be sound policy to require that certain corporations must take out liability insurance which will afford adequate compensation to their potential tort victims. However, the responsibility for imposing conditions on the privilege of incorporation has been committed by the Constitution to the Legislature (N. Y. Const., art. X, § 1) and it may not be fairly implied, from any statute, that the Legislature intended, without the slightest discussion or debate, to require of taxi corporations that they carry automobile liability insurance over and above that mandated by the Vehicle and Traffic Law.^[2]

This is not to say that it is impossible for the plaintiff to state a valid cause of action against the defendant Carlton. However, the simple fact is that the plaintiff has just not done so here. While the complaint alleges that the separate corporations were undercapitalized and that their assets have been intermingled, it is barren of any "sufficiently particular[ized] statements" (CPLR 3013; see 3 Weinstein-Korn-Miller, N. Y. Civ. Prac., par. 3013.01 et seq., p. 30-142 et seq.) that the defendant Carlton and his associates are actually doing business in their individual capacities, shuttling their personal funds in and out of the corporations "without regard to formality and to suit their immediate convenience." (Weisser v. Mursam Shoe Corp., 127 F.2d 344, 345, supra.) Such a "perversion of the privilege to do business in a corporate form" (Berkey v. Third Ave. Ry. Co., 244 N.Y. 84, 95, supra) would justify imposing personal liability on the individual stockholders. (See African Metals Corp. v. Bullowa, 288 N.Y. 78, supra.) Nothing of the sort has in fact been charged, and it cannot reasonably or logically be inferred from the happenstance that the business of Seon [421] Cab Corporation may actually be carried on by a larger corporate entity composed of many corporations which, under general principles of agency, would be liable to each other's creditors in contract and in tort.^[3]

In point of fact, the principle relied upon in the complaint to sustain the imposition of personal liability is not agency but fraud. Such a cause of action cannot withstand analysis. If it is not fraudulent for the owner-operator of a single cab corporation to take out only the minimum required liability insurance, the enterprise does not become either illicit or fraudulent merely because it consists of many such corporations. The plaintiff's injuries are the same regardless of whether the cab which strikes him is owned by a single corporation or part of a fleet with ownership fragmented among many corporations. Whatever rights he may be able to assert against parties other than the registered owner of the vehicle come into being not because he has been defrauded but because, under the principle of respondeat superior, he is entitled to hold the whole enterprise responsible for the acts of its agents.

In sum, then, the complaint falls short of adequately stating a cause of action against the defendant Carlton in his individual capacity.

The order of the Appellate Division should be reversed, with costs in this court and in the Appellate Division, the certified question answered in the negative and the order of the Supreme Court, Richmond County, reinstated, with leave to serve an amended complaint.

KEATING, J. (dissenting).

The defendant Carlton, the shareholder here sought to be held for the negligence of the driver of a taxicab, was a principal shareholder and organizer of the defendant corporation which owned the taxicab. The corporation was one of 10 organized by the defendant, each containing [422] two cabs and each cab having the "minimum liability" insurance coverage mandated by section 370 of the Vehicle and Traffic Law. The sole assets of these operating corporations are the vehicles themselves and they are apparently subject to mortgages.^[*]

From their inception these corporations were intentionally undercapitalized for the purpose of avoiding responsibility for acts which were bound to arise as a result of the operation of a large taxi fleet having cars out on the street 24 hours a day and engaged in public transportation. And during the course of the corporations' existence all income was continually drained out of the corporations for the same purpose.

The issue presented by this action is whether the policy of this State, which affords those desiring to engage in a business enterprise the privilege of limited liability through the use of the corporate device, is so strong that it will permit that privilege to continue no matter how much it is abused, no matter how irresponsibly the corporation is operated, no matter what the cost to the public. I do not believe that it is.

Under the circumstances of this case the shareholders should all be held individually liable to this plaintiff for the injuries he suffered. (See Mull v. Colt Co., 31 F. R. D. 154, 156; Teller v. Clear Serv. Co., 9 Misc 2d 495.) At least, the matter should not be disposed of on the pleadings by a dismissal of the complaint. "If a corporation is organized and carries on business without substantial capital in such a way that the corporation is likely to have no sufficient assets available to meet its debts, it is inequitable that shareholders should set up such a flimsy organization to escape personal liability. The attempt to do corporate business without providing any sufficient basis of financial responsibility to creditors is an abuse of the separate entity and will be ineffectual to exempt the shareholders from corporate debts. It is coming to be recognized as the policy of law that shareholders should in good faith put at the risk of the business unincumbered capital reasonably adequate for its prospective liabilities. If capital is illusory or trifling compared with the business to be done and the risks [423] of loss, this is a ground for denying the separate entity privilege." (Ballantine, Corporations [rev. ed., 1946], § 129, pp. 302-303.)

In Minton v. Cavaney (56 Cal. 2d 576) the Supreme Court of California had occasion to discuss this problem in a negligence case. The corporation of which the defendant was an organizer, director and officer operated a public swimming pool. One afternoon the plaintiffs' daughter drowned in the pool as a result of the alleged negligence of the corporation.

Justice ROGER TRAYNOR, speaking for the court, outlined the applicable law in this area. "The figurative terminology `alter ego' and `disregard of the corporate entity'", he wrote, "is generally used to refer to the various situations that are an abuse of the corporate privilege * * * The equitable owners of a corporation, for example, are personally liable when they treat the assets of the corporation as their own and add or withdraw capital from the corporation at will * * *; when they hold themselves out as being personally liable for the debts of the corporation * * *; or when they provide inadequate capitalization and actively participate in the conduct of corporate affairs". (56 Cal. 2d, p. 579; italics supplied.)

Examining the facts of the case in light of the legal principles just enumerated, he found that "[it was] undisputed that there was no attempt to provide adequate capitalization. [The corporation] never had any substantial assets. It leased the pool that it operated, and the lease was forfeited for failure to pay the rent. Its capital was `trifling compared with the business to be done and the risks of loss'". (56 Cal. 2d, p. 580.)

It seems obvious that one of "the risks of loss" referred to was the possibility of drownings due to the negligence of the corporation. And the defendant's failure to provide such assets or any fund for recovery resulted in his being held personally liable.

In Anderson v. Abbott (321 U. S. 349) the defendant shareholders had organized a holding company and transferred to that company shares which they held in various national banks in return for shares in the holding company. The holding company did not have sufficient assets to meet the double liability requirements of the governing Federal statutes which provided that the owners of shares in national [424] banks were personally liable for corporate obligations "to the extent of the amount of their stock therein, at the par value thereof, in addition to the amount invested in such shares" (U. S. Code, tit. 12, former § 63).

The court had found that these transfers were made in good faith, that other defendant shareholders who had purchased shares in the holding company had done so in good faith and that the organization of such a holding company was entirely legal. Despite this finding, the Supreme Court, speaking through Mr. Justice DOUGLAS, pierced the corporate veil of the holding company and held all the shareholders, even those who had no part in the organization of the corporation, individually responsible for the corporate obligations as mandated by the statute.

"Limited liability", he wrote, "is the rule, not the exception; and on that assumption large undertakings are rested, vast enterprises are launched, and huge sums of capital attracted. But there are occasions when the limited liability sought to be obtained through the corporation will be qualified or denied. Mr. Justice CARDOZO stated that a surrender of that principle of limited liability would be made `when the sacrifice is essential to the end that some accepted public policy may be defended or upheld.' * * * The cases of fraud make up part of that exception * * * But they do not exhaust it. An obvious inadequacy of capital, measured by the nature and magnitude of the corporate undertaking, has frequently been an important factor in cases denying stockholders their defense of limited liability * * * That rule has been invoked even in absence of a legislative policy which undercapitalization would defeat. It becomes more important in a case such as the present one where the statutory policy of double liability will be defeated if impecunious bank-stock holding companies are allowed to be interposed as non-conductors of liability. It has often been held that the interposition of a corporation will not be allowed to defeat a legislative policy, whether that was the aim or only the result of the arrangement * * * `the courts will not permit themselves to be blinded or deceived by mere forms of law' but will deal `with the substance of the transaction involved as if the corporate agency did not exist and as the justice of the case may require.'" (321 U. S., pp. 362-363; emphasis added.)

[425] The policy of this State has always been to provide and facilitate recovery for those injured through the negligence of others. The automobile, by its very nature, is capable of causing severe and costly injuries when not operated in a proper manner. The great increase in the number of automobile accidents combined with the frequent financial irresponsibility of the individual driving the car led to the adoption of section 388 of the Vehicle and Traffic Law which had the effect of imposing upon the owner of the vehicle the responsibility for its negligent operation. It is upon this very statute that the cause of action against both the corporation and the individual defendant is predicated.

In addition the Legislature, still concerned with the financial irresponsibility of those who owned and operated motor vehicles, enacted a statute requiring minimum liability coverage for all owners of automobiles. The important public policy represented by both these statutes is outlined in section 310 of the Vehicle and Traffic Law. That section provides that: "The legislature is concerned over the rising toll of motor vehicle accidents and the suffering and loss thereby inflicted. The legislature determines that it is a matter of grave concern that motorists shall be financially able to respond in damages for their negligent acts, so that innocent victims of motor vehicle accidents may be recompensed for the injury and financial loss inflicted upon them."

The defendant Carlton claims that, because the minimum amount of insurance required by the statute was obtained, the corporate veil cannot and should not be pierced despite the fact that the assets of the corporation which owned the cab were "trifling compared with the business to be done and the risks of loss" which were certain to be encountered. I do not agree.

The Legislature in requiring minimum liability insurance of $10,000, no doubt, intended to provide at least some small fund for recovery against those individuals and corporations who just did not have and were not able to raise or accumulate assets sufficient to satisfy the claims of those who were injured as a result of their negligence. It certainly could not have intended to shield those individuals who organized corporations, with the specific intent of avoiding responsibility to the public, where the operation of the corporate enterprise yielded profits sufficient to purchase additional insurance. Moreover, it is reasonable [426] to assume that the Legislature believed that those individuals and corporations having substantial assets would take out insurance far in excess of the minimum in order to protect those assets from depletion. Given the costs of hospital care and treatment and the nature of injuries sustained in auto collisions, it would be unreasonable to assume that the Legislature believed that the minimum provided in the statute would in and of itself be sufficient to recompense "innocent victims of motor vehicle accidents * * * for the injury and financial loss inflicted upon them".

The defendant, however, argues that the failure of the Legislature to increase the minimum insurance requirements indicates legislative acquiescence in this scheme to avoid liability and responsibility to the public. In the absence of a clear legislative statement, approval of a scheme having such serious consequences is not to be so lightly inferred.

The defendant contends that the court will be encroaching upon the legislative domain by ignoring the corporate veil and holding the individual shareholder. This argument was answered by Mr. Justice DOUGLAS in Anderson v. Abbot (supra, pp. 366-367) where he wrote that: "In the field in which we are presently concerned, judicial power hardly oversteps the bounds when it refuses to lend its aid to a promotional project which would circumvent or undermine a legislative policy. To deny it that function would be to make it impotent in situations where historically it has made some of its most notable contributions. If the judicial power is helpless to protect a legislative program from schemes for easy avoidance, then indeed it has become a handy implement of high finance. Judicial interference to cripple or defeat a legislative policy is one thing; judicial interference with the plans of those whose corporate or other devices would circumvent that policy is quite another. Once the purpose or effect of the scheme is clear, once the legislative policy is plain, we would indeed forsake a great tradition to say we were helpless to fashion the instruments for appropriate relief." (Emphasis added.)

The defendant contends that a decision holding him personally liable would discourage people from engaging in corporate enterprise.

[427] What I would merely hold is that a participating shareholder of a corporation vested with a public interest, organized with capital insufficient to meet liabilities which are certain to arise in the ordinary course of the corporation's business, may be held personally responsible for such liabilities. Where corporate income is not sufficient to cover the cost of insurance premiums above the statutory minimum or where initially adequate finances dwindle under the pressure of competition, bad times or extraordinary and unexpected liability, obviously the shareholder will not be held liable (Henn, Corporations, p. 208, n. 7).

The only types of corporate enterprises that will be discouraged as a result of a decision allowing the individual shareholder to be sued will be those such as the one in question, designed solely to abuse the corporate privilege at the expense of the public interest.

For these reasons I would vote to affirm the order of the Appellate Division.

Order reversed, etc.

---------

[1] The corporate owner of a garage is also included as a defendant.

[2] There is no merit to the contention that the ownership and operation of the taxi fleet "constituted a breach of hack owners regulations as promulgated by [the] Police Department of the City of New York". Those regulations are clearly applicable to individual owner-operators and fleet owners alike. They were not intended to prevent either incorporation of a single-vehicle taxi business or multiple incorporation of a taxi fleet.

[3] In his affidavit in opposition to the motion to dismiss, the plaintiff's counsel claimed that corporate assets had been "milked out" of, and "siphoned off" from the enterprise. Quite apart from the fact that these allegations are far too vague and conclusory, the charge is premature. If the plaintiff succeeds in his action and becomes a judgment creditor of the corporation, he may then sue and attempt to hold the individual defendants accountable for any dividends and property that were wrongfully distributed (Business Corporation Law, §§ 510, 719, 720).

[*] It appears that the medallions, which are of considerable value, are judgment proof. (Administrative Code of City of New York, § 436-2.0.)

Edward M. McNally (argued) and Raj Srivatsan, Morris, James, Hitchens & Williams, Wilmington, DE, for appellant.

Samuel A. Nolen, Richards, Layton & Finger, Wilmington, DE, for appellees.

Before STEELE, Chief Justice, HOLLAND, BERGER, Justices, and ABLEMAN, Judge.^[1]

HOLLAND, Justice:

This is the appeal of the plaintiff-appellant, North American Catholic Educational Programming Foundation, Inc. ("NACEPF") from a final judgment of the Court of Chancery that dismissed NACEPF's Complaint for failure to state a claim.^[2] NACEPF holds certain radio wave spectrum licenses regulated by the Federal Communications Commission ("FCC"). In March 2001, NACEPF, together with other similar spectrum license-holders, entered into the Master Use and Royalty Agreement (the "Master Agreement") with Clearwire Holdings, Inc. ("Clearwire"), a Delaware corporation. Under the Master Agreement, Clearwire could obtain rights to those licenses as then-existing leases expired and the then-current lessees failed to exercise rights of first refusal.

The defendant-appellees are Rob Gheewalla, Gerry Cardinale, and Jack Daly (collectively, the "Defendants"), who served as directors of Clearwire at the behest of Goldman Sachs & Co. ("Goldman Sachs"). NACEPF's Complaint alleges that the Defendants, even though they comprised less than a majority of the board, were able to control Clearwire because its only source of funding was Goldman Sachs. According to NACEPF, they used that power to favor Goldman Sachs' agenda in derogation of their fiduciary duties as directors of Clearwire. In addition to bringing fiduciary duty claims, NACEPF's Complaint also asserts that the Defendants fraudulently induced it to enter into the Master Agreement with Clearwire and that the Defendants tortiously interfered with NACEPF's business opportunities.^[3]

NACEPF is not a shareholder of Clearwire. Instead, NACEPF filed its Complaint in the Court of Chancery as a putative [94] creditor of Clearwire. The Complaint alleges direct, not derivative, fiduciary duty claims against the Defendants, who served as directors of Clearwire while it was either insolvent or in the "zone of insolvency."

Personal jurisdiction over the Defendants was premised exclusively upon 10 Del. C. § 3114, which subjects directors of Delaware corporations to personal jurisdiction in the Court of Chancery over claims "for violation of a duty in [their] capacity [as directors of the corporation]." No other basis for personal jurisdiction over the Defendants was asserted. Accordingly, NACEPF's efforts to bring its other claims in the Court of Chancery fail on jurisdictional grounds unless those other claims are adequately alleged to be "sufficiently related" to a viable fiduciary duty claim against the Defendants.

For the reasons set forth in its Opinion, the Court of Chancery concluded: (1) that creditors of a Delaware corporation in the "zone of insolvency" may not assert direct claims for breach of fiduciary duty against the corporation's directors; (2) that the Complaint failed to state a claim for the narrow, if extant, cause of action for direct claims involving breach of fiduciary duty brought by creditors against directors of insolvent Delaware corporations; and (3) that, with dismissal of its fiduciary duty claims, NACEPF had not provided any basis for exercising personal jurisdiction over the Defendants with respect to NACEPF's other claims. Therefore, the Defendants' Motion to Dismiss the Complaint was granted.

In this opinion, we hold 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. Accordingly, we have concluded that the judgments of the Court of Chancery must be affirmed.

Facts^[4]

NACEPF is an independent lay organization incorporated under the laws of Rhode Island. In 2000, NACEPF joined with Hispanic Information and Telecommunications Network, Inc. ("HITN"), Instructional Telecommunications Foundation, Inc. ("ITF"), and various affiliates of ITF to form the ITFS Spectrum Development Alliance, Inc. (the "Alliance"). Collectively, the Alliance owned a significant percentage of FCC-approved licenses for microwave signal transmissions ("spectrum") used for educational programs that were known as "Instruction Television Fixed Service" spectrum ("ITFS") licenses.

The Defendants were directors of Clearwire. The Defendants were also all employed by Goldman Sachs and served on the Clearwire Board of Directors at the behest of Goldman Sachs. NACEPF alleges that the Defendants effectively controlled Clearwire through the financial and other influence that Goldman Sachs had over Clearwire.

According to the Complaint, the Defendants represented to NACEPF and the other Alliance members that Clearwire's stated business purpose was to create a national system of wireless connections to the internet. Between 2000 and March 2001, Clearwire negotiated a Master Agreement with the Alliance, which Clearwire and the Alliance members entered into in March 2001. NACEPF asserts [95] that it negotiated the terms of the Master Agreement with several individuals, including the Defendants. NACEPF submits that all of the Defendants purported to be acting on the behalf of Goldman Sachs and the entity that became Clearwire.

Under the terms of the Master Agreement, Clearwire was to acquire the Alliance members' ITFS spectrum licenses when those licenses became available. To do so, Clearwire was obligated to pay NACEPF and other Alliance members more than $24.3 million. The Complaint alleges that the Defendants knew but did not tell NACEPF that Goldman Sachs did not intend to carry out the business plan that was the stated rationale for asking NACEPF to enter into the Master Agreement, i.e., by funding Clearwire.

In June 2002, the market for wireless spectrum collapsed when WorldCom announced its accounting problems. It appeared that there was or soon would be a surplus of spectrum available from World-Com. Thereafter, Clearwire began negotiations with the members of the Alliance to end Clearwire's obligations to the members. Eventually, Clearwire paid over $2 million to HITN and ITF to settle their claims and; according to NACEPF, was only able to limit its payments to that amount by otherwise threatening to file for bankruptcy protection. These settlements left the NACEPF as the sole remaining member of the Alliance. The Complaint alleges that, by October 2003, Clearwire "had been unable to obtain any further financing and effectively went out of business."^[5]

NACEPF's Complaint

In its Complaint, NACEPF asserts three claims against the Defendants. In Count I of the Complaint, NACEPF alleges that the Defendants fraudulently induced it to enter into the Master Agreement and, thereafter, to continue with the Master Agreement to "preserv[e] its spectrum licenses for acquisition by Clearwire."^[6] In Count II, NACEPF alleges that because, at all relevant times, Clearwire was either insolvent or in the "zone of insolvency," the Defendants owed fiduciary duties to NACEPF "as a substantial creditor of Clearwire," and that the Defendants breached those duties by:

(1) not preserving the assets of Clearwire for its benefit and that of its creditors when it became apparent that Clearwire would not be able to continue as a going concern and would need to be liquidated and (2) holding on to NACEPF's ITFS license rights when Clearwire would not use them, solely to keep Goldman Sachs's investment "in play."^[7]

In Count III, NACEPF claims that the Defendants tortiously interfered with a prospective business opportunity belonging to NACEPF in that they caused Clearwire wrongfully "to assert the right to acquire NACEPF wireless spectrum," which resulted in NACEPF losing "the opportunity to convey its licenses for spectrum to other buyers."^[8]

Motions to Dismiss

The Defendants moved to dismiss the Complaint on two grounds: first, for lack of personal jurisdiction under Court of Chancery Rule 12(b)(2); and, second, for [96] NACEPF's failure to state a claim upon which relief can be granted under Court of Chancery Rule 12(b)(6). With respect to their first basis for dismissal, the Defendants noted that NACEPF's sole ground for asserting personal jurisdiction over them is 10 Del. C. § 3114. The Defendants argued that personal jurisdiction under § 3114 requires, at least, sufficient allegations of a breach of fiduciary duty owed by director-defendants. With respect to their second basis for dismissal, the Defendants contended that, even assuming that personal jurisdiction was sufficiently alleged, NACEPF's Complaint failed to set forth allegations which adequately supported any of its claims for relief, as a matter of law.

Court of Chancery Rule 12(b)(2)

The Court of Chancery initially addressed the Defendants' motion under Rule 12(b)(2).^[9] It began by examining the exercise of personal jurisdiction over nonresident directors of Delaware corporations under 10 Del. C. § 3114:^[10]

"[T]he Delaware courts have consistently held that Section 3114 is applicable only in connection with suits brought against a nonresident for acts performed in his . . . capacity as a director . . . of a Delaware corporation." Further narrowing the scope of Section 3114, "Delaware cases have consistently interpreted [early cases construing the section] as establishing that [it] . . . appl[ies] only in connection with suits involving the statutory and nonstatutory fiduciary duties of nonresident directors."^[11]

The Court of Chancery limited its Rule 12(b)(2) analysis to whether personal jurisdiction existed over the Defendants with respect to Count II of the Complaint.

Count II alleged that the Defendants breached their fiduciary duties while they served as directors of Clearwire and while Clearwire was either insolvent or in the zone of insolvency. The Court of Chancery concluded that the facts alleged in the Complaint, as supported by the affidavit submitted by NACEPF, constituted a prima facia showing of a breach of fiduciary duty by the Defendants in their capacity [97] as directors of a Delaware corporation. Accordingly, the Court of Chancery held that a statutory basis for the exercise of personal jurisdiction had been established by NACEPF for purposes of litigating Count II of the Complaint.

NACEPF expressly premised its Rule 12(b)(2) arguments for personal jurisdiction over the Defendants regarding Counts I and III (i.e., the non-fiduciary duty claims) on the Court of Chancery's first determining that Count II (i.e., the fiduciary duty claim) survives the Defendants' Rule 12(b)(6) motion to dismiss. Accordingly, the Court of Chancery proceeded on the basis that if it found that Count II must be dismissed under Rule 12(b)(6), then it would be without personal jurisdiction over the Defendants for purposes of moving forward with the merits of Counts I and III. Therefore, to resolve the issue of personal jurisdiction, the Court of Chancery was required to decide whether, as a matter of law, Count II of the NACEPF Complaint properly stated a breach of fiduciary duty claim upon which relief could be granted.

Court of Chancery Rule 12(b)(6)

The standards governing motions to dismiss under Court of Chancery Rule 12(b)(6) are well settled:

(i) all well-pleaded factual allegations are accepted as true; (ii) even vague allegations are "well-pleaded" if they give the opposing party notice of the claim; (iii) the Court must draw all reasonable inferences in favor of the nonmoving party; and (iv) dismissal is inappropriate unless the "plaintiff would not be entitled to recover under any reasonably conceivable set of circumstances susceptible of proof."^[12]

In the Court of Chancery and in this appeal, NACEPF waived any basis it may have had for pursuit of its claim derivatively. Instead, NACEPF seeks to assert only a direct claim for breach of fiduciary duties. It contends that such direct claims by creditors should be recognized in the context of both insolvency and the zone of insolvency. Accordingly, in ruling on the 12(b)(6) motion to dismiss Count II of the Complaint, the Court of Chancery was confronted with two legal questions: whether, as a matter of law, a corporation's creditors may assert direct claims against directors for breach of fiduciary duties when the corporation is either: first, insolvent or second, in the zone of insolvency.

Allegations of Insolvency and Zone of Insolvency

In support of its claim that Clearwire was either insolvent or in the zone of insolvency during the relevant periods, NACEPF alleged that Clearwire needed "substantially more financial support than it had obtained in March 2001."^[13] The Complaint alleges Goldman Sachs had invested $47 million in Clearwire, which "represent[ed] 84% of the total sums invested in Clearwire in March 2001, when Clearwire was otherwise virtually out of funds."^[14]

After March 2001, Clearwire had financial obligations related to its agreement with NACEPF and others that potentially exceeded $134 million, did not have the ability to raise sufficient cash from operations to pay its debts as they became due and was dependent on Goldman [98] Sachs to make additional investments to fund Clearwire's operations for the foreseeable future.^[15]

The Complaint also alleges:

For example, upon the closing of the Master Agreement, Clearwire had approximately $29.2 million in cash and of that $24.3 million would be needed for future payments for spectrum to the Alliance members. Clearwire's "burn" rate was $2.1 million per month and it had then no significant revenues. The process of acquiring spectrum upon expiration of existing licenses was both time consuming and expensive, particularly if existing licenseholders contested the validity of any Clearwire offer that those license holders were required to match under their rights of first refusal.^[16]

Additionally, in the Complaint, NACEPF alleges that, "[b]y October 2003, Clearwire had been unable to obtain any further financing and effectively went out of business. Except for money advanced to it as a stopgap measure by Goldman Sachs in late 2001, Clearwire was never able to raise any significant money."^[17]

The Court of Chancery opined that insolvency may be demonstrated by either showing (1) "a deficiency of assets below liabilities with no reasonable prospect that the business can be successfully continued in the face thereof,"^[18] or (2) "an inability to meet maturing obligations as they fall due in the ordinary course of business."^[19] Applying the standards applicable to review under Rule 12(b)(6), the Court of Chancery concluded that NACEPF had satisfactorily alleged facts which permitted a reasonable inference that Clearwire operated in the zone of insolvency^[20] during at least a substantial portion of the relevant periods for purposes of this motion to dismiss. The Court of Chancery also concluded that insolvency had been adequately alleged in the Complaint, for Rule 12(b)(6) purposes, for at least a portion of the relevant periods following execution of the Master Agreement.

Corporations in the Zone of Insolvency Direct Claims for Breach of Fiduciary Duty May Not Be Asserted by Creditors

In order to withstand the Defendant's Rule 12(b)(6) motion to dismiss, the Plaintiff [99] was required to demonstrate that the breach of fiduciary duty claims set forth in Count II are cognizable under Delaware law.^[21] This procedural requirement requires us to address a substantive question of first impression that is raised by the present appeal: as a matter of Delaware law, can the creditor of a corporation that is operating within the zone of insolvency bring a direct action against its directors for an alleged breach of fiduciary duty?

It is well established that the directors owe their fiduciary obligations to the corporation and its shareholders.^[22] While shareholders rely on directors acting as fiduciaries to protect their interests, creditors are afforded protection through contractual agreements, fraud and fraudulent conveyance law, implied covenants of good faith and fair dealing, bankruptcy law, general commercial law and other sources of creditor rights.^[23] Delaware courts have traditionally been reluctant to expand existing fiduciary duties.^[24] Accordingly, "the general rule is that directors do not owe creditors duties beyond the relevant contractual terms."^[25]

In this case, NACEPF argues that when a corporation is in the zone of insolvency, this Court should recognize a new direct right for creditors to challenge directors' exercise of business judgments as breaches of the fiduciary duties owed to them. This Court has never directly addressed the zone of insolvency issue involving directors' purported fiduciary duties to creditors that is presented by NACEPF in this appeal.^[26] That subject has been discussed, however, in several judicial opinions^[27] and many scholarly articles.^[28]

[100] In Production Resources, the Court of Chancery remarked that recognition of fiduciary duties to creditors in the "zone of insolvency" context may involve:

"using the law of fiduciary duty to fill gaps that do not exist. Creditors are often protected by strong covenants, liens on assets, and other negotiated contractual protections. The implied covenant of good faith and fair dealing also protects creditors. So does the law of fraudulent conveyance. With these protections, when creditors are unable to prove that a corporation or its directors breached any of the specific legal duties owed to them, one would think that the conceptual room for concluding that the creditors were somehow, nevertheless, injured by inequitable conduct would be extremely small, if extant. Having complied with all legal obligations owed to the firm's creditors, the board would, in that scenario, ordinarily be free to take economic risk for the benefit of the firm's equity owners, so long as the directors comply with their fiduciary duties to the firm by selecting and pursuing with fidelity and prudence a plausible strategy to maximize the firm's value."^[29]

In this case, the Court of Chancery noted that creditors' existing protections — among which are the protections afforded by their negotiated agreements, their security instruments, the implied covenant of good faith and fair dealing, fraudulent conveyance law, and bankruptcy law — render the imposition of an additional, unique layer of protection through direct claims for breach of fiduciary duty unnecessary.^[30] It also noted that "any benefit to be derived by the recognition of such additional direct claims appears minimal, at best, and significantly outweighed by the costs to economic efficiency."^[31] The Court of Chancery reasoned that "an otherwise solvent corporation operating in the zone of insolvency is one in most need of effective and proactive leadership — as well as the ability to negotiate in good faith with its creditors — [101] goals which would likely be significantly undermined by the prospect of individual liability arising from the pursuit of direct claims by creditors."^[32] We agree.

Delaware corporate law provides for a separation of control and ownership.^[33] The directors of Delaware corporations have "the legal responsibility to manage the business of a corporation for the benefit of its shareholders owners."^[34] Accordingly, fiduciary duties are imposed upon the directors to regulate their conduct when they perform that function. Although the fiduciary duties of the directors of a Delaware corporation are unremitting:

the exact cause of conduct that must be charted to properly discharge that responsibility will change in the specific context of the action the director is taking with regard to either the corporation or its shareholders. This Court has endeavored to provide the directors with clear signal beacons and brightly lined channel markers as they navigate with due care, good faith, a loyalty on behalf of a Delaware corporation and its shareholders. This Court has also endeavored to mark the safe harbors clearly.^[35]

In this case, the need for providing directors with definitive guidance compels us to hold that no direct claim for breach of fiduciary duties may be asserted by the creditors of a solvent corporation that is operating in the zone of insolvency. When a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners. Therefore, we hold the Court of Chancery properly concluded that Count II of the NACEPF Complaint fails to state a claim, as a matter of Delaware law, to the extent that it attempts to assert a direct claim for breach of fiduciary duty to a creditor while Clearwire was operating in the zone of insolvency.

Insolvent Corporations Direct Claims For Breach of Fiduciary Duty May Not Be Asserted by Creditors

It is well settled that directors owe fiduciary duties to the corporation.^[36] When a corporation is solvent, those duties may be enforced by its shareholders, who have standing to bring derivative actions on behalf of the corporation because they are the ultimate beneficiaries of the corporation's growth and increased value.^[37] When a corporation is insolvent, however, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.

Consequently, the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties.^[38] The corporation's [102] insolvency "makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm's value."^[39] Therefore, equitable considerations give creditors standing to pursue derivative claims against the directors of an insolvent corporation. Individual creditors of an insolvent corporation have the same incentive to pursue valid derivative claims on its behalf that shareholders have when the corporation is solvent.

In Production Resources, the Court of Chancery recognized that — in most, if not all instances — creditors of insolvent corporations could bring derivative claims against directors of an insolvent corporation for breach of fiduciary duty. In that case, in response to the creditor plaintiff's contention that derivative claims for breach of fiduciary duty were transformed into direct claims upon insolvency, the Court of Chancery stated:

The fact that the corporation has become insolvent does not turn [derivative] claims into direct creditor claims, it simply provides creditors with standing to assert those claims. At all times, claims of this kind belong to the corporation itself because even if the improper acts occur when the firm is insolvent, they operate to injure the firm in the first instance by reducing its value, injuring creditors only indirectly by diminishing the value of the firm and therefore the assets from which the creditors may satisfy their claims.^[40]

Nevertheless, in Production Resources, the Court of Chancery stated that it was "not prepared to rule out" the possibility that the creditor plaintiff had alleged conduct that "might support" a limited direct claim.^[41] Since the complaint in Production Resources sufficiently alleged a derivative claim, however, it was unnecessary to decide if creditors had a legal right to bring direct fiduciary claims against directors in the insolvency context.^[42]

In this case, NACEPF did not attempt to allege a derivative claim in Count II of its Complaint. It only asserted a direct claim against the director Defendants for alleged breaches of fiduciary duty when Clearwire was insolvent. The Court of Chancery did not decide that issue. Instead, the Court of Chancery assumed arguendo that a direct claim for a breach of fiduciary duty to a creditor is legally cognizable in the context of actual insolvency. It then held that Count II of NACEPF's Complaint failed to state such a direct creditor claim because it did not satisfy the pleading requirements described by the decisions in Production Resources^[43] and [103] Big Lots Stores, Inc. v. Bain Capital Fund VII, LLC.^[44]

To date, the Court of Chancery has never recognized that a creditor has the right to assert a direct claim for breach of fiduciary duty against the directors of an insolvent corporation. However, prior to this opinion, that possibility remained an open question because of the "arguendo assumption" in this case and the dicta in Production Resources and Big Lots Stores. In this opinion, we recognize "the pragmatic conduct-regulating legal realms . . . calls for more precise conceptual line drawing."^[45]

Recognizing that directors of an insolvent corporation owe direct fiduciary duties to creditors, would create uncertainty for directors who have a fiduciary duty to exercise their business judgment in the best interest of the insolvent corporation. To recognize a new right for creditors to bring direct fiduciary claims against those directors would create a conflict between those directors' duty to maximize the value of the insolvent corporation for the benefit of all those having an interest in it, and the newly recognized direct fiduciary duty to individual creditors. Directors of insolvent corporations must retain the freedom to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation.^[46] Accordingly, we hold that individual creditors of an insolvent corporation have no right to assert direct claims for breach of fiduciary duty against corporate directors. Creditors may nonetheless protect their interest by bringing derivative claims on behalf of the insolvent corporation or any other direct nonfiduciary claim, as discussed earlier in this opinion, that may be available for individual creditors.

Conclusion

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 its directors. Therefore, Count II of NACEPF's Complaint failed to state a claim upon which relief could be granted. Consequently, the final judgment of the Court of Chancery is affirmed.

[1] Sitting by designation pursuant to Del. Const. art. IV, § 12 and Supr. Ct. R. 2 and 4.

[2] North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2006 WL 2588971 (Del.Ch. Sept. 1, 2006) ("Opinion").

[3] This action was initially filed in the Superior Court; it was dismissed without prejudice for lack of subject matter jurisdiction. Transfer to the Court of Chancery was permitted under 10 Del. C. § 1902.

[4] The relevant facts are primarily selected excerpts from the opening brief filed by NACEPF in this appeal.

[5] Complaint at ¶ 36 ("Except for money advanced to it as a stopgap measure by Goldman Sachs in late 2001, Clearwire was never able to raise any significant money.").

[6] Id. at ¶ 40.

[7] Id. at ¶ 45.

[8] Id. at ¶ 50.

[9] See Branson v. Exide Elecs. Corp., 625 A.2d 267 (Del.1993).

[10] The basis for personal jurisdiction relied upon by NACEPF, provides:

Every nonresident of this State who after September 1, 1977, accepts election or appointment as a director, trustee or member of the governing body of a corporation organized under the laws of this State or who after June 30, 1978, serves in such capacity, and every resident of this State who so accepts election or appointment or serves in such capacity and thereafter removes residence from this State shall, by such acceptance or by such service, be deemed thereby to have consented to the appointment of the registered agent of such corporation (or, if there is none, the Secretary of State) as an agent upon whom service of process may be made in all civil actions or proceedings brought in this State, by or on behalf of, or against such corporation, in which such director, trustee or member is a necessary or proper party, or in any action or proceeding against such director, trustee or member for violation of a duty in such capacity, whether or not the person continues to serve as such director, trustee or member at the time suit is commenced. Such acceptance or service as such director, trustee or member shall be a signification of the consent of such director, trustee or member that any process when so served shall be of the same legal force and validity as if served upon such director, trustee or member within this State and such appointment of the registered agent (or, if there is none, the Secretary of State) shall be irrevocable.

10 Del. C. § 3114(a) (emphasis added).

[11] Donald J. Wolfe, Jr. & Michael A. Pittenger, Corporate and Commercial Practice in the Delaware Court of Chancery § 3-5[a] (2005).

[12] In re General Motors (Hughes) S'holder Litig., 897 A.2d 162, 168 (Del.2006) (quoting Savor, Inc. v. FMR Corp., 812 A.2d 894, 896-97 (Del.2002)).

[13] Complaint at ¶ 30.

[14] Id. at ¶ 7(a).

[15] Id. at ¶ 7(b) (emphasis added). NACEPF also asserts that "Clearwire was unable to borrow money or obtain any other significant financing after March 2001, except from Goldman Sachs." Id. at ¶ 7(c).

[16] Id. at ¶ 30.

[17] Id. at ¶ 36.

[18] For that proposition, the Court of Chancery relied upon Production Res. Group v. NCT Group, Inc., 863 A.2d 772, 782 (Del.Ch. 2004) (quoting Siple v. S & K Plumbing & Heating, Inc., 1982 WL 8789, at *2 (Del.Ch. Apr. 13, 1982)); Geyer v. Ingersoll Publ'ns Co., 621 A.2d 784, 789 (Del.Ch.1992) (explaining that corporation is insolvent if "it has liabilities in excess of a reasonable market value of assets held"); and McDonald v. Williams, 174 U.S. 397, 403, 19 S.Ct. 743, 43 L.Ed. 1022 (1899) (defining insolvent corporation as an entity with assets valued at less than its debts).

[19] For that proposition, the Court of Chancery also relied upon Production Res. Group v. NCT Group, Inc., 863 A.2d at 782 (quoting Siple v. S & K Plumbing & Heating, Inc., 1982 WL 8789, at *2).

[20] In light of its ultimate ruling, the Court of Chancery did not attempt to set forth a precise definition of what constitutes the "zone of insolvency." See Credit Lyonnais Bank Nederland N.V. v. Pathe Commc'ns Corp., 1991 WL 277613, at *34; see also Production Res. Group v. NCT Group, Inc., 863 A.2d at 789 n. 56 (describing the difficulties presented in identifying "zone of insolvency"). Our holding in this opinion also makes it unnecessary to precisely define a "zone of insolvency."

[21] See Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031, 1039 (Del.2004) ("In this case it cannot be concluded that the complaint alleges a derivative claim. . . . But, it does not necessarily follow that the complaint states a direct, individual claim. While the complaint purports to set forth a direct claim, in reality, it states no claim at all.")

[22] See Guth v. Loft, 5 A.2d 503, 510 (Del. 1939) (while not technically trustees, directors stand in a fiduciary relationship to the corporation and its shareholders); Malone v. Brincat, 722 A.2d 5, 10 (Del.1998).

[23] See Production Res. Group v. NCT Group, Inc., 863 A.2d at 790.

[24] See, e.g., Wal-Mart Stores, Inc. v. AIG Life Ins. Co., 872 A.2d 611, 625 (Del.Ch.2005), aff'd in part and rev'd in part on other grounds, 901 A.2d 106 (Del.2006).

[25] See, e.g., Simons v. Cogan, 549 A.2d 300, 304 (Del.1988); Katz v. Oak Indus., Inc., 508 A.2d 873, 879 (Del.Ch.1986); Geyer v. Ingersoll Publ'ns Co., 621 A.2d 784, 787 (Del.Ch. 1992); Production Res. Group v. NCT Group, Inc., 863 A.2d 772, 787 (Del.Ch.2004).

[26] E. Norman Veasey & Christine T. Di Guglelmo, What Happened in Delaware Corporate Law and Governance From 1992-2004? A Retrospective on Some Key Developments, 153 U. Pa. L.Rev. 1399, 1432 (May 2005).

[27] Credit Lyonnais Bank Nederland N.V. v. Pathe Commc'ns Corp., 1991 WL 277613 (Del. Ch.); Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772 (Del.Ch.2004); Trenwick America Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del.Ch.2006); Big Lots Stores, Inc. v. Bain Capital Fund VI, LLC, 922 A.2d 1169 (Del.Ch.2006).

[28] Rutheford B. Campbell, Jr. & Christopher W. Frost, Managers' Fiduciary Duties in Financially Distressed Corporations: Chaos in Delaware (and Elsewhere), 32 J. Corp. L. 491 (2007); Richard M. Cieri & Michael J. Riela, Protecting Directors and Officers of Corporations That Are Insolvent or In the Zone or Vicinity of Insolvency: Important Considerations, Practical Solutions, 2 DePaul Bus. & Com. L.J. 295, 301-02 (2004); Patrick M. Jones & Katherine Heid Harris, Chicken Little Was Wrong (Again): Perceived Trends in the Delaware Corporate Law of Fiduciary Duties and Standing in the Zone of Insolvency, 16 J. Bankr. L. & Prac. 2 (2007); Laura Lin, Shift of Fiduciary Duty Upon Corporate Insolvency: Proper Scope of Directors' Duty to Creditors, 46 Vand. L.Rev. 1485, 1487 (1993); Jonathan C. Lipson, Directors' Duties to Creditors: Powe-Imbalance and the Financially Distressed Corporation, 50 UCLA L.Rev. 1189 (2003); Ramesh K.S. Rao, et al., Fiduciary Duty A La Lyonnais: An Economic Perspective on Corporate Governance in a Financially-Distressed Firm, 22 J. Corp. L. 53 (1996); Myron M. Sheinfeld & Harris Pippitt, Fiduciary Duties of Directors of a Corporation in the vicinity of Insolvency and After Initiation of a Bankruptcy Case, 60 Bus. Law. 79 (2004); Robert K. Sahyan, Note, The Myth of the Zone of Insolvency: Production Resources Group v. NCG Group, 3 Hastings Bus. L.J. 181 (2006). Vladimir Jelisavcic, Corporate Law — A Safe Harbor Proposal to Define the Limits of Directors' Fiduciary Duty to Creditors in the "Vicinity of Insolvency:" Credit Lyonnais Bank Nederland N.V. v. Pathe Commc'ns Corp., 18 J. Corp. L. 145 (Fall 1993). See also Selected Papers from the University of Maryland's "Twilight in the Zone of Insolvency" Conference: Stephen M. Bainbridge, Much Ado About Little? Insolvency, 1 J.Bus.&Tech.L.; 335 (2007); J. Directors' Fiduciary Duties in the Vicinity of William Callison, Why a Fiduciary Duty Shift to Creditors of Insolvent Business Entities Is Incorrect as a Matter of Theory and Practice, 1 J.Bus.&Tech.L.; 431 (2007); Larry E. Ribstein & Kelli A. Alces, Directors' Duties in Failing Firms, 1 J.Bus.&Tech.L.; 529 (2007); Frederick Tung, Gap Filling in the Zone of Insolvency, 1 J.Bus.&Tech.L.; 607 (2007).

[29] Production Resources Group L.L. v. NCT Group, Inc., 863 A.2d at 790 (emphasis, added).

[30] See, e.g., Big Lots Stores, Inc. v. Bain Capital Fund VII, LLC, 922 A.2d at 1181 (citing Stephen M. Bainbridge, Much Ado About Little? Directors' Fiduciary Duties in the Vicinity of Insolvency, 1 J.Bus.&Tech.L.; 335 (2007).

[31] Opinion at *13.

[32] Id.

[33] Malone v. Brincat, 722 A.2d 5 (1998).

[34] Id. at 9.

[35] Id. at 10.

[36] See, e.g., Guth v. Loft, Inc., 5 A.2d 503, 510 (Del.1939).

[37] See, e.g., Aronson v. Lewis, 473 A.2d 805, 811 (Del.1984) partially overruled on other grounds by Brehm v. Eisner, 746 A.2d 244 (Del.2000).

[38] Agostino v. Hicks, 845 A.2d 1110, 1117 (Del.Ch.2004); see also Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d at 1036 ("The derivative suit has been generally described as `one of the most interesting and ingenious of accountability mechanisms for large formal organizations.'") (quoting Kramer v. W. Pac. Indus., Inc., 546 A.2d 348, 351 (Del.1988)); Guttman v. Huang, 823 A.2d 492, 500 (Del.Ch.2003) (noting the "deterrence effects of meritorious derivative suits on faithless conduct.").

[39] Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d at 794 n. 67.

[40] Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d at 776; see also Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 195 n. 75 (Del.Ch.2006).

[41] Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d at 800. The court reserved "the opportunity . . . to revisit some of these questions with better input from the parties." Id. at 801.

[42] Id.

[43] In Production Resources, the Court of Chancery expressed in dicta a "conservative assumption that there might, possibly exist circumstances in which the directors [of an actually insolvent corporation] display such a marked degree of animus towards a particular creditor with a proven entitlement to payment that they expose themselves to a direct fiduciary duty claim by that creditor." Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d at 798. We think not. While there may well be a basis for a direct claim arising out of contract or tort, our holding today precludes a direct claim arising out of a purported breach of a fiduciary duty owed to that creditor by the directors of an insolvent corporation.

[44] Big Lots Stores, Inc. v. Bain Capital Fund VII, LLC, 922 A.2d 1169 (Del.Ch.2006). In Big Lots, the Court of Chancery reiterated, also in dicta, that any potentially cognizable direct claims asserted by creditors in actual insolvency should be confined to the limited circumstances in Production Resources, namely, instances in which invidious conduct toward a particular "creditor" with a "proven entitlement to payment" has been alleged. Id. The suggestion in that dicta is also inconsistent with and precluded by our holding in this opinion.

[45] In Re Walt Disney Co. Derivative Litigation, 906 A.2d 27, 65 (Del.2006).

[46] Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d at 797.