The COVID-19 pandemic has grounded the global economy, bringing commercial activity to a screeching halt. Despite the unprecedented magnitude of the stimulus package provided by the United States government via the “Coronavirus Aid, Relief, and Economic Security Act’’ (CARES Act), companies of all creeds and sizes continue to face mounting liquidity and balance-sheet concerns. While the timeline for meaningfully remediating the global health crisis remains uncertain, it has become increasingly likely that a return to normalcy and the corresponding ramping up of economic activity will occur gradually and unevenly, potentially leaving many companies in tight financial straits.  

Should prolonged economic headwinds persist, directors and officers of companies in financial distress may soon be confronted with questions concerning how to appropriately discharge their fiduciary duties and avoid taking action (or inaction) that could potentially give rise to liability. This article discusses the impact of insolvency on directors’ fiduciary duties under Delaware law.  While some of the discussion of potential personal liability focuses on California law, many states have similar statutes, and companies should work with counsel to evaluate applicable statutes in relevant jurisdictions.

A Board of Directors’ Fiduciary Duties

The directors of a solvent corporation have the fiduciary duty to act in the best interests of the corporation and its stockholders. Under Delaware law, the guiding principle for directors meeting their fiduciary duties is the maximization of the value of the corporation within the bounds of the law. In general, directors in the United States owe two primary duties to the corporation and shareholders: the duty of care and the duty of loyalty. Directors are required to exercise these duties in good faith.  

Absent an abuse of discretion, a disabling conflict of interest, or other extenuating circumstances such as a sale of control, directors are generally given the benefit of the doubt by courts reviewing the legality of their conduct thanks to the “business judgment rule.” This rule is a presumption that in making a business decision, the directors of a corporation who have no disabling conflict of interest acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company.  

Examining the Fiduciary Duties of a Board of Directors in the Context of Insolvency

Solvency

Under Delaware law, the duties of directors of a solvent corporation run to the corporation itself and to its shareholders; no fiduciary duties are owed to creditors.

Approaching the “Zone of Insolvency”

The Delaware Supreme Court and the Delaware Chancery Court have made clear that directors’ and officers’ fiduciary duties do not change when the corporation’s insolvency becomes progressively more likely. Although practitioners had historically cautioned that as a corporation began entering insolvency, corporate officers and directors might begin to owe fiduciary duties to creditors of the corporation, recent case law has essentially eradicated that directive. In the seminal Gheewalla decision, the Delaware Supreme Court opined that the duties of directors, and the beneficiaries of such duties, do not change as a corporation enters the “zone of insolvency,” making clear 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.”[1]

Crossing the Insolvency Threshold

As a technical matter, when a corporation becomes insolvent, the scope of a board’s fiduciary duties is expanded from a limited focus on corporate shareholders to include residual beneficiaries of the corporation as well. Such an expansion occurs because when a corporation is solvent, the only stakeholders that stand to benefit directly from an increase in corporate value are the corporation’s shareholders; however, when the corporation crosses the insolvency threshold, “its creditors take the place of the shareholders as residual beneficiaries of any increase in its value.”[2] At the same time, stockholders, alongside creditors, retain the ability to bring suit and enforce the directors’ fiduciary duties.

Nevertheless, under Delaware law, the pursuit of value-maximizing strategies for the corporation remains the primary object of directors’ duties, even when the firm becomes insolvent. The Delaware Supreme Court has stressed the importance of maintaining continuity in the duties of directors before and after insolvency. In this regard, the Delaware Supreme Court has opined (affirming the Chancery Court’s opinion) that whether the corporation is solvent, insolvent, or unknowably in transition, the tasks of directors are essentially the same, stating that “[e]ven when the firm is insolvent, directors are free to pursue value maximizing strategies, while recognizing that the firm’s creditors have become its residual claimants and the advancement of their best interests has become the firm’s principal objective.”[3]

In summary, the Delaware courts’ decisions stress that in all situations, including insolvency, the duty of directors is to always direct the affairs of the corporation so as to maximize its value and that there are no fiduciary duties directly owed toward creditors.

The Determination of “Insolvency”

Because the scope of directors’ fiduciary duties expands upon a company’s degradation into insolvency, and because creditors will have standing to initiate fiduciary duty litigation on behalf of the corporation when it becomes insolvent, determining when the company crosses the threshold into insolvency is important in understanding the board’s duties and risk profile at a given time. In Delaware, there are two general tests for determining whether a corporation is insolvent: the “balance sheet” test and the “equitable insolvency” test. The balance sheet test finds that insolvency occurs when liabilities of the corporation exceed the reasonable market value of assets held. The equitable insolvency test considers a corporation to be insolvent when it is unable to pay its debts as they become due in the ordinary course of business. The equitable insolvency test may be favored, as it is simpler to apply, but both tests are largely subjective and can prove very difficult to apply in practice.

Accordingly, because the exact moment of insolvency is often difficult to ascertain, a prudent board should begin to keep in mind the interests of creditors soon after acknowledging that the company is experiencing significant financial distress. As a practical matter, in most instances, this determination should not significantly change how directors evaluate and consider strategic alternatives since, both before and after insolvency, the board’s duties run, first and foremost, to the corporation and its residual stakeholders, whether or not residual stakeholders include creditors. 

No Liability for “Deepening Insolvency”

In the past, creditor-plaintiffs advanced a theory that officers and directors may be liable for taking prophylactic actions to enhance the corporation’s viability to operate as a going concern when such actions resulted in a worsening situation for the corporation’s creditors. This concept—the theory of “deepening insolvency”—has been roundly rejected by Delaware courts and should be of no concern to corporate officers discharging their duties with requisite due diligence and in good faith.[4]

Potential Personal Liability of Directors

Although the business judgment rule generally protects directors from personal liability in the exercise of their fiduciary duties where less than half of the board has a conflict of interest with respect to the decision and a heightened standard of review does not otherwise apply, directors of an insolvent corporation can be personally liable for a variety of specific actions. As noted below, many of the following grounds for seeking personal liability are based on California law in addition to Delaware law.  Many other states have similar statutes, and companies should work with counsel to understand the applicable laws of relevant jurisdictions.

Directors are potentially personally liable for the following, depending on the laws of a corporation’s state of domicile:  

Practical Measures for Limiting Director Liability

In making corporate decisions, a board of directors’ primary concern should be fulfilling its fiduciary duties and pursuing value-maximizing strategies for the company, even if the company is or becomes financially distressed. Such decisions should be based on a thorough and careful investigation and informed consideration of available information, taken in good faith, and be for a proper corporate purpose. 

In order to proactively limit personal and professional liability, a board of directors may wish to consider adopting those practices and diligence measures outlined below that correspond with the company’s particular circumstances in light of the current economic climate.

A. Creditor and Stockholder Liabilities

1. Fulfill fiduciary duties and, specifically:
   • Understand which constituencies it is representing (stockholders, creditors);
   • Investigate and evaluate the primary strategic alternatives to maximize value for those constituencies, and obtain, with management’s assistance, the information necessary to evaluate those alternatives properly;
   • Analyze the tradeoffs implied by each strategic alternative between creditors’ interests and stockholders’ interests;
   • Obtain the advice of counsel, including insolvency counsel;
   • Confirm that the record reflects a sufficiently deliberative process and the board’s awareness of its duties to stockholders and/or creditors;
   • Thoroughly scrutinize actions that are implemented to increase stockholders’ value but put creditors at risk;
   • Not give preference of one creditor or one class over another without appropriate justification;
   • Closely scrutinize transactions that could constitute a preferential payment;
   • Exercise care in approving transactions that leave a corporation inadequately capitalized, even if the corporation is solvent at the time;
   • Disclose and discuss any potential conflicts of interest and scrutinize all insider transactions; and
   • Prepare a wind-down budget and preserve cash that allows the company to wind down or liquidate in an orderly fashion rather than a fire sale.
2. Specifically document the scope of fundraising efforts and alternatives to financings (such as a merger, asset sale, or reduction of operations to conserve cash).
3. Assess the liabilities, both known and contingent, and the fair value of both tangible assets and intangible assets (for example, technology or supplier/customer relationships).
4. Assess the likelihood of claims for breach of fiduciary duties.
5. Confirm that indemnification agreements are in place (but note that unless adequate D&O insurance is in place, an insolvent company is unlikely to be able to satisfy its indemnity obligations).

B. Tax and Insurance Obligations

1. Confirm that all tax obligations (such as franchise taxes, sales and use taxes, and withholding obligations) are satisfied and paid in full.
2. Confirm that all insurance policy premiums are paid, including D&O insurance premiums.
3. Review all healthcare insurance policies to determine when such policies will terminate and consider COBRA ramifications.

C. Employees

1. Determine vacation benefits and similar payment obligations owed to employees as a matter of policy (review employment agreements, employee handbook, and accrued but unpaid wages).
2. Comply with the Worker Adjustment and Retraining Notification Act (WARN), if applicable (give at least 60 days’ notice of termination or pay salary and benefits in lieu of any portion of that period for which notice has not been given).
3. Consider additional severance as an incentive for employees to sign severance agreements.
4. Consider adopting a severance plan to attempt to limit employee claims to federal court.
5. Decide whether to terminate the corporation’s 401(k) plan, if any.
6. Refrain from paying bonuses or other unusual payments to executives, directors, and stockholders.
7. Make arrangements with payroll service provider to issue W-2s once the tax year ends.

Wilson Sonsini continues to monitor the global impact of COVID-19 on various industries. Wilson Sonsini's COVID-19 Client Advisory Resource is a collection of alerts, advisories, and programs—all of which are intended to help the management, boards of directors, and in-house counsel of our clients maintain key operational and business functions, despite pressing challenges related to the COVID-19 outbreak.

[1] North American Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007).

[2] Id.

[3] Trenwick Am. Litig. Tr. v. Ernst & Young, LLP, 906 A.2d 168, 175 (Del. Ch. 2006). 

[4] See, e.g., Trenwick, 906 A.2d at 205 (Del. Ch. 2006) (holding that the board’s discretion in pursuing failed efforts to maximize corporate value was protected by the business judgment rule and rejecting independent cause of action for deepening insolvency); Fehribach v. Ernst & Young LLP., 493 F.3d 905, 908-09 (7th Cir. 2007) (applying and citing Trenwick for the proposition that the deepening insolvency theory “makes no sense”).