Considerations for Existing and Potential Directors and Officers of Financially Distressed Companies

Date: March 7, 2012

The historic downturn in the economy has negatively impacted many companies. A director or officer of such a company (D&O), or anyone considering a new position as a D&O, would, of course, focus on improving the financial performance of the business. However, it is important for both existing D&Os, and even more so for new D&Os, to be aware of his or her fiduciary duties, including the “special duties” that arise when a company becomes “insolvent.” The potential for individual personal liability for D&Os increases when the company’s financial performance declines, including for breach of fiduciary duty, mismanagement, fraud, corporate waste, and under some state wage laws, for unpaid employee wages and taxes. Understanding the duties that are owed and how to perform your responsibility as a D&O will help avoid personal liability. Also, taking steps that the law states are acceptable action to minimize liability is essential to protect against suit and liability.

The Duties Owed

When a company is solvent, the D&Os owe fiduciary duties of care, loyalty and good faith to the company and its shareholders. Accordingly, a D&O should avoid acting for personal gain or for the interest of another, and act reasonably in decision-making for the company. Importantly, a D&O must also be active in the role, be well-informed, and avoid making decisions that demonstrate a deliberate indifference or disregard of potential harm to the company. In the end, the objective of a director or officer of a solvent company is to create wealth for the company’s shareholders. However, when a company becomes insolvent, the focus of duties shifts to include the interests of creditors of the company in addition to the shareholders, since the creditors are then the primary beneficiaries of the assets of an insolvent company, not the shareholders.

When does the Focus Change to Include Creditors?

The D&O duties do not shift to the creditors until the company is, in fact, insolvent. Some courts have held, however, that the duties of D&Os expand to include creditors when the company is in the “zone of insolvency,” which is essentially when a company may not be insolvent but nonetheless is in severe financial distress. Regardless of the distinction, D&Os must be aware that when management, the board, or financial advisors begin raising questions about the solvency of a company, such as insufficient cash to meet financial obligations as they become due and payable, and/or insufficient capital to obtain or support financing for future operations, this is when the duty to creditors comes into play.

How to Minimize Personal Liability Exposure

To navigate financially turbulent times and minimize personal liability, D&Os should consider the following:

  • Retain independent counsel for the board (as opposed to company counsel) to advise the directors on their duties and the proper discharge of such duties;
  • Retain outside counsel for the company as well as financial advisors to advise the board and company on transactions, strategic alternatives, financing and corporate governance, and conduct an internal investigation, if necessary; 
  • Establish a special committee to develop, plan, implement and oversee such strategic alternatives as an out-of-court restructuring, bankruptcy filing, merger or acquisition, sale, recapitalization, or liquidation; 
  • Resist the temptation to resign, as some experts view this as abandonment in derogation of fiduciary obligations, and an absent director or officer may forego certain benefits such as releases that may be later obtained; 
  • Hold and attend regular meetings at which management and advisors provide full and complete information on which to base a decision. More frequent meetings should be held as the company’s financial distress becomes increasingly dire. Diligence is the hallmark of care; 
  • Document the board meetings thoroughly in minutes and circulate minutes for review promptly after the meetings. All decisions, information, advice and the basis for decisions should be included in the minutes to support an informed decision; 
  • Engage in regular consultation, if appropriate, with creditor constituencies; 
  • Avoid dividends, payment on closely related party loans and other distributions to shareholders unless they are fully disclosed and designed to maximize the company’s value; 
  • Assess the adequacy of D&O insurance coverage, including any coverage exclusions that may be applicable under the circumstances; 
  • For new D&Os who are serving as an agent of an investor, obtain D&O insurance from the investor, as well as indemnity from any liability in their role with the company; and 
  • Analyze and amend, if appropriate, corporate documents to provide for indemnification and exculpation to the fullest extent allowable by law.

Exercise Business Judgment

Consistent with the above considerations and the proper discharge of fiduciary duties, directors and officers should take action that enables their business decisions to be made on a fully informed basis, without self-interest, in good faith, and with the honest belief that the decisions are in the best interest of the company and its shareholders and creditors, as applicable. If these elements are established, decisions made by D&Os will in all likelihood be respected by the courts if later challenged.

This article was originally published in Corporate Board Member magazine, March 2012.