Publications: Board Duties in Distressed Companies

Given the current economic climate, this is a good time to review how the duties of officers and directors change when a company is undergoing financial distress and becomes insolvent and what directors can do to protect themselves from personal liability.

Corporate Governance Generally

The board of the directors and the officers of a solvent corporation owe a fiduciary duty exclusively to the corporation and its shareholders. These duties require the board and its officers to abide by the duties of loyalty, care and good faith. Briefly, the duty of loyalty is a duty to avoid conflicts of interest, including the avoidance of conduct that is in the director’s interests or the interests of a third party. The duty of good faith requires directors and officers to act in a manner that they honestly believe is in the best interests of the corporation and its shareholders at the time. The duty of care requires officers and directors to execute their duties with the care that a prudent person would exercise under the circumstances. When a board makes a decision, there is a presumption that the directors acted upon an informed basis, in good faith and in the honest belief that the action is in the best interest of the corporation. This standard is commonly known as the “business judgment rule” which protects officers and directors from personal liability even if a decision later proves to have been a mistake.

When a corporation becomes insolvent, the board can no longer solely take into account the interests of its shareholders. Board members of insolvent companies must consider the interests of its creditors, as well as any other parties that have an interest in the corporate enterprise. This is often viewed as a shift of focus from the shareholders to the creditors; however, it is more appropriately viewed as an expansion of the board’s fiduciary duties, since the board must now consider all of the interests in the corporate enterprise. As soon as the corporation becomes insolvent, the main focus of the directors should be to maximize the value of the corporation for all constituencies instead of paying particular attention to the interests of any single constituency. Even though the board must now consider more than solely the interests of shareholders of the corporation, the duties of loyalty, care and good faith continue.

When is a Corporation “Insolvent”?

The "moment of insolvency" is the first clear point when the board of directors must affirmatively take into account more than just the shareholders' interests. There are two generally accepted definitions of insolvency. One test is the balance sheet test, under which a corporation is insolvent if its debts exceed the reasonable market value of assets held. Under the balance sheet test, the term “debts” includes contingent, disputed and other obligations that may not be reflected on a balance sheet. A second is the cash flow test (also known as the "equitable insolvency" test) where the corporation is not able to pay its debts as they become due.

Actual "insolvency" can be difficult to identify. This confusion led to the development of a doctrine of law which referred to the time period before a company was clearly insolvent as the "zone of insolvency." For the last twenty years, courts have been unwilling to clearly define the zone of insolvency. Some courts have defined it as a corporation with unreasonably small capital, while other courts have held that a corporation is in the “zone of insolvency” when, even though the company is currently solvent, the directors have reason to believe at a particular point in the future the company will become insolvent.

Fortunately, Delaware courts recently provided much needed clarity by holding that creditors of a Delaware corporation that is in the "zone of insolvency" have no right to assert direct claims for breach of fiduciary duty by members of the board of directors. Creditors can still bring derivative claims on behalf of the corporation, but only when the corporation is insolvent. In a derivative action, any recovery belongs to all of the constituencies, not a particular group of creditors. In other words, the “zone of insolvency” is no longer an area of concern for boards of Delaware companies, and a board need not focus on interests of its creditors unless and until the company actually becomes insolvent.

How Directors Can Protect Themselves

When a corporation becomes insolvent, the actions of the board will be heavily scrutinized by several divergent constituencies, including shareholders, creditors, employees and community interests. In order to satisfy their fiduciary duties, directors should:

• Take the time to understand the financial issues facing the company and carefully assess all reasonably available options, including sale of all or part of the company, discontinuation of marginal product lines, workforce force reductions, etc...
• Meet more frequently than in the past. Problems can go from bad to worse quickly, so the board needs to be prepared to act and to be knowledgeable in real time. A board should also consider hiring specialized experts to provide advice on valuation, debt restructuring and other strategic options available to the company.
• Engage in extensive deliberations. Any decisions should only be made after extensive deliberation; however, a board does not need to debate for hours on end. Nor does it mean that the board must hire six experts when one or two will suffice.
• Create additional checks and balances among the board members. The board may consider creating new committees to deal with critical issues. For instance, a board may consider creating a restructuring committee to present strategic options for the full board to consider.
• Assess all compensation arrangements of board members and officers. All compensation paid to board members and officers will be under greater scrutiny. Recently, seven top executives and board members at Goldman Sachs requested that they do not receive a bonus after the stock of the company had decreased in value by more than 69% earlier this year. While this action may not have been taken in direct response to the fulfillment of their fiduciary duties, these board members clearly understand the importance of public perceptions.

Conclusion

As long as a company is solvent, the board should maximize the enterprise value for the benefit of its shareholders. If the company becomes insolvent, the directors still have the same goal: to maximize the value of the business enterprise; however, at that point, the board must also take in to account the interests of additional constituencies, including its creditors, and the board should carefully scrutinize its decision-making process to ensure that all interested constituencies, including its creditors, are accounted for.