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Reader Profile

David Jaffe
Partner and Corporate Governance Attorney
Fox Rothschild LLP, Pittsburgh

Editor's note: Each month, we ask a Directors & Boards reader to comment on critical issues facing directors today. If you'd like to participate in this section in the future, please email Scott Chase.

For board directors of insolvent corporations seeking restructuring alternatives, what are the top risks to avoid?

In this recession, with the absence of fully functioning credit markets, companies face an array of sub-optimal choices in the struggle to survive. The pressure will continue unabated for the foreseeable future. In this new “normal” environment, investors, creditors and other corporate stakeholders who have suffered financial losses are likely to attempt to hold directors accountable for ignoring warning signals, taking undue risks and engaging in reckless behavior. If any form of director self-dealing or conflict of interest is implicated, the risk to corporate decision-makers increases. Directors, officers and their advisors need to be proactive in minimizing such risk.

In short, stakeholders who were once colleagues in the enterprise now are rivals. The cracks in the façade lay bare a multitude of conflicting interests among creditors, shareholders, employees, management and directors. As boards deliberate over restructuring, they begin to realize that there are no “win/win” options and that their decisions are likely to be challenged in court.

What is the basic legal standard of review of director conduct?

Directors have a legal obligation to manage a corporation’s business and affairs in good faith and in a manner they reasonably believe to be in its best interests. In fulfilling this function, directors are viewed as company fiduciaries and must fulfill two essential duties – loyalty and care. In discharging those duties, directors generally are insulated from judicial second-guessing by a legal doctrine known as the “business judgment” rule (BJR). The BJR protects disinterested corporate directors from liability for corporate acts or omissions through a presumption that they have exercised due care and loyalty and acted in the company’s best interests.

There are exceptions to the BJR where courts examine a board’s conduct more closely and actively. Generally speaking, this can occur where the board is negligent or has failed to properly inform itself, where certain kinds of transactions are implicated (such as friendly or hostile change of control) or where conflicts of interest emerge. Outside of a merger or change of control context, most transactions will fall within the BJR absent any board negligence or conflicts of interest. If the company files a voluntary petition to reorganize under federal bankruptcy law, the board will enjoy the BJR presumption unless negligence or self-dealing implicate the higher “enhanced scrutiny” standard of review.

In a conflict scenario, when a director has interests in a transaction on both sides of the table, the BJR will not apply because any form of director self-dealing will be perceived to compromise director independence. In those circumstances it is well settled legally that the board has the burden to establish the entire fairness of the transaction, sufficient to pass the test of careful court scrutiny. An especially vexing dilemma arises in insolvency where a director is also a creditor.

Are decisions made in solvent times viewed differently through the lens of insolvency?

Directors need to know to whom the duties are owed. The corporate entity is the primary beneficiary of fiduciary duties owed by the board. In a solvent company, shareholders as residual risk-bearers have the right to seek enforcement of these duties, but do so on behalf of the company as a whole rather than as direct beneficiaries. When a corporation is nearing insolvency, parties who may derivatively enforce directors’ duties expand to include creditors. This exposes directors to an inherent quandary, because they are now answerable to two constituencies that often have directly conflicting objectives. Once the corporation is insolvent, creditors replace the shareholders as the indirect corporate beneficiaries. At that point, the creditors have standing to sue directors for fiduciary breaches on behalf of the company.

How do boards know when a company has crossed the line into insolvency?

Boards must determine when the corporation has reached the point of insolvency because insolvency is the point at which directors’ duties shift to creditors. Transactions that may have been prudently calculated risks aimed at increasing shareholder value during solvent times may be deemed to be imprudent acts that erode asset values in creditors’ eyes when the corporation is insolvent. Moreover, while insolvency in fact is not a prerequisite for relief under federal bankruptcy laws, it does trigger certain legal rights in the debtor relating to preferential and/or fraudulent transfers to creditors.

Under the law there are three basic tests for determining insolvency – the “balance sheet” test measuring the company’s fair value; the “cash flow” test to determine whether the company can pay its debts when due; and the “capital adequacy” test of whether the company has sufficient capital to cover current and anticipated operating expenses, capital expenditures and long-term debt.

If a major creditor is on the board, how does that change the legal standards and obligations that directors need to uphold?

In public and private companies, creditors often are represented on the board. This arises frequently where hedge funds, private equity investors and other non-traditional lenders make investments in the issuer’s convertible debentures or other debt obligations. When this occurs, the director designee is burdened with two conflicting obligations – to act in the company’s fiduciary interests and to act in the creditor’s interests. Faced with this dilemma, the conflicted director serves neither of his corporate masters effectively. On one hand, his fiduciary duty will preclude him from taking actions that may maximize a recovery for his creditor-principal. On the other hand, his interests as a representative of a creditor cast a cloud over his impartiality.

For the board to preserve its autonomy and decision-making discretion under the BJR in this context, it must identify and call out all potential conflicts of interest among the directors and in the management ranks. It must undertake prophylactic measures to insulate corporate decision-makers from any actual or potential undue influence by interested parties. After a dispute has arisen (and therefore with the benefit of hindsight) courts will examine carefully the board’s deliberative processes in order to ascertain whether or not it implemented procedural safeguards to ensure fair and informed decision-making.

How can a board’s special committee proactively identify potential conflicts of interest?

The proper use of a special committee of independent directors is often afforded great deference by courts in establishing prima facie evidence of procedural fairness. However, the devil is in the details. If facts suggest that the committee is a sham or merely window dressing, courts will disregard the BJR and apply the higher standard of enhanced scrutiny.

Recent Delaware Chancery Court cases suggest some clear guidelines for establishing a special committee. Each committee member must truly be independent and free from undue influence by controlling stockholders, influential creditors and other directors or executives. The committee’s mandate must be clear and unambiguous, the committee must be vested with a level of sufficient authority and real bargaining power (including the authority to reject a transaction) and not act merely in an advisory capacity. Third, the committee must have the authority to hire its own legal and financial advisors to be separate from, and independent of, the corporation’s legal and financial advisors. Where committees rely upon the company’s advisors, courts have found advisors’ advice tainted because of the financial inducements inherent in the advisor’s relationship with the corporation and its control parties.

David A. Jaffe (djaffe@foxrothschild.com) is an attorney and partner with Fox Rothschild LLP in Pittsburgh, focusing on corporate governance, corporate finance and mergers and acquisitions. In addition to his governance practice, he represents control parties, investors and management groups in leveraged acquisitions and sales.

David has advised public and privately held companies in complex transactions and as a general business advisor. Recent transactions include a leveraged buyout of an industrial services company; $55 million acquisition refinancing and modifications of subordinated debt obligations; special counsel to the board of a public company regarding formation of a committee of independent directors to consider various strategic alternatives including change in control transactions; and a corporate split up transaction including the formation of a holding company under the Delaware merger statute and the transfer of intellectual property assets into a newly-formed intellectual property licensing company.

David has represented clients in various forms of corporate finance transactions, including underwritten offerings of debt, equity, and innovative "hybrid" instruments, as well as in more traditional credit transactions such as syndicated bank loans.