Implications of Insolvency — Legal and Otherwise — for Directors
By Ross Waetzman and Frank Monaco

Directors will be vulnerable to countless allegations of misconduct.

 

Reflecting on United States military operations in Iraq, General Norman Schwarzkopf said, “… had we done something different, we probably wouldn't be facing what we are facing today.” No quote may better reflect the thoughts of directors and officers defending against breaches of fiduciary duty years after the onset of corporate insolvency.

Despite the noblest of intentions, as corporate distress increases, so does litigation risk for directors, officer, or other party with fiduciary duties (collectively, “directors”). This is the chemistry of insolvency, driven by corporate law and human (litigious) nature.

It is incumbent that a board is capable of monitoring for insolvency and has an action plan on how to proceed when detected. Taking action when insolvency is discovered or thought inevitable is good for both a company and its directors. Indifference towards insolvency risks being forced to face tomorrow what few directors wish to face today.

Insolvency Defined

Directors must be aware of insolvency, which triggers legal implications for boards. Unfortunately, insolvency is determined differently not only by state law, but also by bankruptcy law. Bankruptcy tests of insolvency, however, are a good yardstick as they are governed by federal law, allowing uniform perspective for multijurisdictional issues. In addition, these tests mirror those used by many states.

Bankruptcy law provides three insolvency tests. The most common is the “Balance Sheet Test,” which finds a company insolvent when the sum of its debts is greater than the fair value of its assets. The fair value of assets relates to a valuation of the assets, typically using common appraisal techniques (i.e., the Income, Market, and Cost Approaches). Debt includes all liabilities of the company at face value, even if publically traded at a discount. In practice, a determination of insolvency using the Balance Sheet Test is complex; directors may seek to consult a valuation expert for assistance.

A second test is the “Cash Flow Test,” which establishes insolvency when a company cannot pay its obligations as they come due. The Cash Flow Test is easier to perform than the Balance Sheet Test, but leaves much more room for interpretation. For example, if a company pays its obligations by borrowing further debt, does this reflect solvency? Several metrics should be considered to rule out missing red flag indications. Careful application is required with respect to the company’s industry, seasonal factors and other considerations.

A third test provided by bankruptcy law is the “Capital Adequacy Test.” More nebulous than the previous tests, this test establishes insolvency when a transaction leaves a company with unreasonably small capital. A company found solvent under other tests may still lack sufficient capital to weather financial turbulence.

The Chemistry of Insolvency

Directors should understand the implications of insolvency, both legal and otherwise. As bankruptcy professionals can attest, by the time a company files for bankruptcy, directors will be vulnerable to countless allegations of misconduct. These allegations — sometimes pled in public court filings — can arise from numerous sources, including employees, shareholders, regulatory bodies, and even creditors (secured or otherwise).

While directors may not consider that they owe duties to creditors, this is the case in many jurisdictions upon the onset of insolvency. In states like Delaware, once a corporation is insolvent, creditors replace shareholders as the residual beneficiary. Further, creditors gain standing to bring derivative actions for breaches of fiduciary duty, expanding litigation risk for breaches of fiduciary duty. See North American Catholic Educational Programming Foundation Inc. v. Gheewalla (930 A.2d 92 (Del. Ch. 2007)) and Quadrant Structured Products Co. v. Vertin (102 A.3d 155 (Del. Ch. 2014)).

Financial distress, however, often elevates human emotions, particularly since insolvency can be associated with a failed business strategy. Even when triggered by uncontrollable events, creditors are increasingly at risk of substantial loss. Creditors are increasingly likely to second-guess the actions of fiduciaries, allege misconduct, and assert damages to offset loss. Scapegoats are targeted; witches are hunted; the mob expands as other constituents join the fray.

The prospect for litigation against directors increases once a company enters bankruptcy. Under bankruptcy, creditor committees are often granted rights to pursue litigation on behalf of creditors or the debtor. In addition, a company that files for protection under bankruptcy law may also be required to fund litigation costs against its directors.

As a final point, the lookback period for pursuing misconduct can be as long as six years. With litigation risk looming six-years post action and prospects for a wide cast of angry stakeholders, it behooves directors to adopt a heightened standard of conduct upon detection of insolvency.

Taking Action

A distressed company is analogous to a sick patient. Attentive care may prevent a future trip to the emergency room whereas inattention may have dire consequences. Similar to good preventive health measures, directors must be attuned to symptoms of financial distress. Directors should adopt procedures to periodically monitor financial performance (at least quarterly if not monthly), including presentations by management.

If not already in place, directors should adopt action plans if their company is insolvent. Far too often, directors are passive in the face of distress, possibly hopeful that matters may correct themselves. However, inaction itself can be a legal cause of action. (In Rosebud Corp. v. Boggio, 561 P.2d 367 (1977), a Colorado court found a director liable for his inaction while a self-dealing sale transaction took place.)

Key tenants of good action plans should include that directors adopt an enhanced standard of conduct. This starts with documenting the details of decision making, including but not limited to:

            • problems requiring director resolution;

            • options considered for resolution;

            • why certain options were not pursued; and

            • the manner in which certain decisions were adopted and implemented.

Independent turnaround advisors can provide additional support for directors exercising their duty of care. No procedures define how duty of care is provided by directors; however, courts consider two criteria related to breeches of these duties — time spent on evaluating company issues, and reliance upon experts.

Consulting such professionals reinforces that directors acknowledge the seriousness of insolvency and are augmenting their expertise accordingly. Turnaround professionals provide numerous services, including identifying the root causes of insolvency, providing possible solutions, and even engendering support from creditors and other key stakeholders.

Bankruptcy counsel should also be consulted. This is not to prepare for bankruptcy, but rather to avoid such a development altogether. Seasoned counsel will understand legal options, negotiating positions, and other considerations to aid a company as it navigates unconventional waters. Again, consulting such professionals supports directors properly exercising their duty of care.

Understand and Anticipate the Risks

The subject of insolvency is important for directors, who must be in a position to identify the advent of insolvency and take deliberate action. Regardless of how fiduciary duties are upheld, litigation risk increases as a company approaches insolvency. Litigation risk extends years beyond when directives are made. Directors who understand and anticipate these risks, carefully weigh and document decisions, and proactively take action best serve their companies and themselves. They mitigate litigation risk far into the future and — for peace of mind when that future arrives — minimize second-guessing of their past decisions.

 


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