When Chapter 11 Hits, D&O Claims Can Take the Unsecured Director Down

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Corporate Compliance Insights - November 9 2021

Actions Against Directors, Officers Common After Chapter 11 Bulk-Asset Sales Leave Nothing to Recover

In the event of Chapter 11 Bankruptcy, creditors often look to recover funds by individually targeting directors or officers (via D&O claims). Those who have a history of bad judgment, lack of dependence or failure to see looming issues could find themselves on the hook.

Measured by the recoveries of unsecured creditors, the success rate in Chapter 11 bankruptcy cases is relatively low. Driven by secured lenders’ declining patience for and willingness to fund time-consuming reorganizations, corporate bankruptcy cases increasingly result in expedited bulk-asset sales that leave no meaningful assets after payment of secured debt.

As a result, unsecured creditors’ committees frequently look to other sources of recovery, such as litigation claims against directors and officers (commonly referred to as D&O claims). For these individuals, unless defense costs are paid by insurance carriers or the company, the burden of litigation can be prohibitively expensive and extremely painful even if such lawsuit is without merit.

Let’s explore some of the things that unsecured creditors’ committees look for in evaluating whether viable D&O claims exist and protective measures directors and executives can take in furtherance of their fiduciary duties.

The Board’s Role in Chapter 11 and D&O Claims

The business judgment rule is the underpinning of corporate governance and is the primary legal protection available to directors under Delaware law. When evaluating potential claims against a board member, one looks at whether the board and its members functioned properly and exercised reasonable business judgment. There may be liability for making decisions without being fully informed, especially when approaching insolvency.

Written presentations to the board, board minutes and interviews of board members will reveal whether the board made reasonably informed decisions on a timely basis. If a director or officer objects to a particular decision or course of action, they should voice their dissent and have that objection recorded in the minutes. Any conflict of interest or potential personal gain for a director or officer related to a course of action under consideration by the board should also be disclosed and recorded in the minutes and such person should abstain from voting on such matters. Of course, confirm that the record reflects a sufficiently deliberative process.

Of critical importance is whether the board provided the guidance and leadership required of them. Directors should seek out and rely on information provided by those who run the key aspects of the day-to-day business. And when certain business decisions are inevitably beyond a director’s area of expertise, do not refrain from consulting with legal counsel, financial advisors or experts for reports or opinions that are necessary to be adequately informed.

A board is supposed to provide a lens to management that better enables it to enhance shareholder value. To do that, the board must be composed of persons who have the requisite knowledge and expertise. Consequently, a creditors’ committee looks at each member’s qualifications and experience.

A Properly Functioning Board

As the body responsible for providing oversight and guidance to senior management, the board should be free from undue influence by management. Directors who are family members or friends of the CEO or founder of the company, and thus who are unlikely to stand up to the CEO or founder, are likely targets for an unsecured creditors’ committee. This concern is especially heightened with respect to members of board committees charged with investigating actions by management.

The committee will ascertain which of the board members are independent. In doing so, the committee will inquire who nominated the board member, whether the board member is a creditor or shareholder, whether the company had related party transactions with the board member and whether the board member is likely to be so loyal to the person who nominated them that it overpowers their fiduciary duties to the company.

A director’s independence is most often scrutinized when they are indebted to a person or entity with a discernable interest in an action under the board’s consideration. A director may be considered indebted or beholden if there is evidence to suggest a director cannot act in the best interests of the corporation and its shareholders because of personal, professional or financial relationships or dependence to another person or entity.

An effective board should not be dominated by one person or by a group of members of the board. For example, a board that is dominated by the company’s founder or CEO is an invitation to exorbitant compensation for the CEO and to the approval of actions without proper board vetting. A board that is chaired by the CEO or composed of a majority of insiders raises conflict issues since the board is supposed to oversee management, especially in times of distress.

Dysfunction may prevent the board from providing management with the requisite oversight or direction. Board members who dominated the board, who did not actively participate on the board, who sat on too many boards to make the requisite time commitment to the company or who were not independent may be indicative of dysfunction.

A board member should be knowledgeable of their fellow board members so as to not risk getting painted with the same brush if fellow members are derelict in their duties. Board members are obliged to help assure that the board as a whole properly functions. They should not only be concerned about their individual behavior.

When Distress Occurs

The failure to see timely the need for change have resulted in many Chapter 11s. Companies often commence bankruptcy cases because management failed to react on a timely basis to changed market conditions or obsolescence of the company’s products. Sometimes senior executives stubbornly deal unrealistically with litigation. And, sometimes the failure of an attempted debt restructuring is because of competing interests. The question is whether the board was aware or should have been aware of the forgoing and whether the board responded in an informed, timely manner free from personal conflicts or influence.

Thus, the board should be knowledgeable of competitive intelligence and make certain that management is reacting to it. The board of directors should make sure that a CEO is looking at the future environment rather than only at the current one.

The fiduciary duties of directors and officers do not change as a corporation approaches insolvency. However, when a corporation becomes insolvent, the scope of a board’s fiduciary duties broadens from a limited focus on shareholders to include creditors as well. It is not business as usual when in the zone of insolvency. Fortunately, directors cannot be held liable for an insolvent debtor’s continued operations in the good faith belief that they may achieve profitability or obtain a better result for stakeholders, even if their decisions ultimately lead to greater losses or expectations that do not come to fruition.

Board members should be alert for signs of financial distress, and they should make sure that the distress is addressed early enough to be fixed. Board members should be involved in fixing a distressed situation before it is too far gone. This requires the director to regularly monitor actions and negotiations intended to resolve the financial distress.

Board members also should be realistic about the situation and have an understanding of enterprise value and of which stakeholders are out of the money. Further, when insolvency threatens, directors should consider the interests of other stakeholders besides shareholders, such as creditors, and then balance the interests. In Delaware, upon insolvency board responsibility shifts to creditors.

There is no liability for pre-bankruptcy actions absent a breach of fiduciary duty. The business judgment rule presumes that the board member acted in an informed manner, and the burden is on the person challenging a board decision to establish facts that rebut the presumption.

The debtor need not win the battle to avoid Chapter 11. However, the board should be able to demonstrate that the management’s actions in attempting to avoid bankruptcy were vetted with the benefit of untainted board input. Reports, analyses or opinions received by directors must be more than window dressing.

Finally, resigning from the board rather than engaging in order to find a solution to a debtor’s financial distress may be viewed as derogation of duty. In terms of minimizing or eliminating potential liability, it may be better to stick around and try to fix things. Resigning will not change the past and a board member still may be investigated.

Reprinted with permission from the November 9, 2021, issue of Corporate Compliance Insights. © 2021 Corporate Compliance Insights. All Rights Reserved.

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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