Jessica Boelter, a partner in the Corporate Reorganization and Bankruptcy Group of Sidley Austin LLP, and Wayne Elggren, a managing director in the Disputes and Investigations Practice of Navigant, provide their perspectives based on years of experience in bankruptcy matters.
What are the fiduciary duties of directors and officers of a corporation that is insolvent or in the zone of insolvency?
Boelter: A director of a solvent corporation owes fiduciary duties, including the duties of care and loyalty, to the corporation and its shareholders. Good corporate governance practices entitle disinterested directors to be shielded from judicial secondguessing under the business judgment rule. When a corporation is insolvent, directors’ fiduciary duties expand to include the corporation’s creditors in recognition of the fact that creditors are the beneficiaries of an insolvent corporation’s value. The Delaware Supreme Court has held that creditors do not have a direct claim for breach of fiduciary duty against a solvent corporation’s directors when the corporation is operating in the zone of insolvency. This issue, however, remains open in other jurisdictions.
Elggren: In a bankruptcy of significant size someone will investigate prepetition transactions to see if an insolvent debtor received reasonably equivalent value. If not, claims can be brought against the beneficiaries of the transactions, and possibly those who authorized them.
What are the warning signs that indicate insolvency?
Boelter: Courts recognize two types of insolvency: balance sheet (sum of debts exceeds fair value of assets), and equitable (unable to pay debts when due). A multitude of factual and legal issues surround these tests, and thus it is uncertain whether a future court will determine that a troubled company is insolvent. The courts have not provided a clear definition for the “zone of insolvency.”
Elggren: Indicators of insolvency include not paying undisputed trade debts as they come due, projecting an inability to timely pay debts, projecting cash flows with little cushion to meet downside events, violation or projected violation of loan covenants resulting in debt acceleration, financial statements indicating negative equity, a going concern opinion issued by auditors, debt trading at deep discounts, low credit ratings, a leveraged buyout transaction or an inability to raise additional equity in the marketplace.
How do directors discharge their fiduciary duties when the corporation is insolvent or nearly insolvent?
Boelter: Directors should discharge their duties in good faith and in a manner they reasonably believe to be in the best interests of the corporation through informed judgment based upon all relevant material information.The corporation should retain competent legal and financial advisors to advise the board, and refrain from engaging in overly risky strategies that may only serve to benefit potentially out-of-the-money equity holders. Interested directors should recuse themselves from decisions on which they lack independence.
Elggren: Close attention to potential indicators of insolvency is essential. Management should provide directors with realistic cash flow projections; monthly GAAP financial statements; analysis of the impact of pending transactions on projections, financial statements, credit ratings, bond and stock prices, including contingencies; and a report of any creditor payments not made according to terms. An independent third party should opine through annual financial statement audits, solvency opinions, evaluation of the company’s projections, and due diligence on pending transactions; and considering credit ratings and discounts to trading prices for bonds or other debt.
How do directors protect themselves when their corporation is in the zone of insolvency?
Boelter: Adhere to good corporate governance practices, examine the exculpation provision contained in the corporation’s certificate of incorporation, and confirm that the corporation’s director and officer liability insurance policies include “Side A” coverage that protects the directors where the corporation is insolvent.
Elggren: Director and officer liability insurance should be large enough to pay for a robust defense, protect the assets of the directors and officers, and provide a meaningful settlement to extricate the directors and officers from litigation. A director can seek indemnities from major shareholders or other stakeholders.
Contact authors Jessica Boelter at jboelter@sidley.com and Wayne Elggren at wayne.elggren@navigant. To read an unabbreviated version of this article, please visit Navigant.com/gccorner.