10 Key Steps To Follow When Your Business is Approaching Insolvency

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It is well known that directors and officers of corporations (and managers of limited liability companies) owe fiduciary duties to their organizations and their shareholders (or members). These fiduciary obligations are defined by state statutes and, though there are variations from state to state, they typically include a duty of loyalty and a duty of care. The duty of loyalty requires directors and officers to put the interests of the company before their own personal interests and generally prohibits self-dealing. The duty of care requires directors and officers to exercise diligence, to make informed decisions, and to act in good faith so that their actions are in the best interest of the company. Though beyond the scope of this discussion, some states allow these duties to be limited either by so noting in the organizational documents or complying with other requirements.

However, when a company becomes insolvent, the party to whom these duties are owed shifts from the equity holders to the company’s creditors. Most states define insolvency in two ways—(1) when a company’s liabilities become greater than the sum of its assets or (2) when the company becomes unable to pay its debts as they become due—and embrace both definitions. The shift in duties occurs because when a company is insolvent, there is no value in the company beyond that owed to the company’s creditors so that the equity holders no longer have an economic stake in the company. 

Without proper planning and awareness, this shift in fiduciary obligations brought on by insolvency can expose a company’s officers and directors to civil liability. It therefore is essential that officers and directors walk the delicate balance between bracing for insolvency and upholding their duties to the company and its equity holders during tough financial times. Further, although states have backed away from finding that a director’s or officer’s fiduciary duties shift before the company is actually insolvent, directors and officers should take care to know when they are in the so-called “zone of insolvency.” 

There is no standard definition of the zone of insolvency, but it generally means the time period when the company is facing financial difficulty and it is difficult to know whether the company is actually solvent or insolvent. When a company is in the zone of insolvency, directors and officers should be especially aware of the effect their decisions will have and that the party to whom their fiduciary duties are owed may have shifted. For example, a decision to increase debt to keep the company going may be viewed positively by a shareholder, but negatively by an existing creditor. Knowing which party can later challenge that decision is important. However, in both circumstances a director’s or officer’s good faith decisions will generally be protected by the business judgment rule, which presumes that, in the absence of self-dealing or fraudulent conduct, directors and officers act on an informed basis, in good faith, and in the honest belief that their actions are in the corporation's best interest.

While there is no single formula to insulate oneself from liability in the time leading up to insolvency, company directors and officers should assess the need to take any or all of the following steps when they are in the zone of insolvency: 

  1. Scrutinize actions that increase stockholder return by impairing creditors’ claims.
  2. Be careful about giving shareholders preferential treatment at the expense of creditors (e.g., authorizing and funding a dividend or a stock redemption).
  3. Be careful about preferential treatment between classes of shareholders. 
  4. Make reasonable efforts to learn all the facts before taking a specific course of action; directors should genuinely believe that any decisions made are in the best interests of the corporation in its entirety (i.e., decisions will be reviewed in hindsight in light of the effect of such actions on the corporation).
  5. Refrain from engaging in transfers for less than fair value, which could be unwound as fraudulent conveyances, or in preferential payments to creditors. In any bankruptcy or insolvency proceeding, payments made to certain creditors at the expense of other creditors can be clawed back, especially if there is some connection between the company and the creditor. 
  6. Consider proposing at an annual stockholder meeting (or any other meeting of stockholders) a resolution affirming that all prior business decisions and actions taken by the directors and officers of the corporation were taken in good faith after an exercise of reasonable care.
  7. Do not engage in any self-dealing. Fully disclose any personal or business relationships with parties on the other side of transactions involving the corporation to avoid the appearance of a conflict of interest.  
  8. In evaluating potential fund raising transactions or a sale of assets of the troubled corporation, be aware that these transactions may be scrutinized later in light of any subsequent expansion of directors’ fiduciary duties to include creditors. 
  9. While a director is always free to resign under state law and under the corporation’s charter and by-laws, resignation does not provide total protection. A director will continue to have liability for pre-resignation acts and omissions. Also, a director has a duty not to resign if resignation will cause immediate harm, allow harm to occur, or leave corporate assets unprotected. Liability may be deemed continuing even where the director resigned before the improper or illegal action was taken if the improper or illegal action had its inception prior to the director’s resignation. 
  10. Directors should familiarize themselves with the terms of coverage and exclusions of coverage of any Director and Officer Liability Policy (“D&O Policy”) in place before the corporation enters the zone of insolvency. In addition, a director contemplating resignation should review the D&O Policy for the effect of resignation on such coverage. The director should also determine if the D&O Policy covers acts that occurred during his tenure, even though such acts were not determined to be in violation of fiduciary duties at the time of occurrence.

In these uncertain financial times, it is important for companies, and those leading them, to maintain a weather eye on the company’s finances. Knowing not only how best to navigate the company’s future but how to protect its directors and officers from potential liability while in the zone of insolvency may mean the difference between a company on sound footing and one that is  susceptible to collapse.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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