In her classic 1969 book, On Death and Dying, Dr. Elisabeth Kübler-Ross described five stages through which an individual transitions when confronted with a prognosis of terminal illness. The first of the stages she identified was “denial”—the earnestly held belief that “this can’t be happening to me; the doctors must be wrong.” If asked, any experienced restructuring professional can quickly catalog at least a dozen cases in which he or she has been involved where corporate managements have failed to acknowledge a growing financial problem. The performance excuses are legion and generally run along the lines of “we will have improved results next quarter” or “despite our disappointing results, we are very excited about our prospects for the future.”
- Waiting too long to address the issues, hoping things will get better.
- Waiting too long to address the issues, rationalizing that openly acknowledging distressed conditions will “sink the company.”
- Over-stretching waning liquidity options to make payments and avoid defaults (“borrowing from Peter to pay Paul”).
- Effecting short-sighted deals or taking short-sighted actions as band aids.
Unfortunately, as the meltdowns at Bear Stearns and Lehman Brothers have painfully illustrated, a company’s failure to timely recognize that it is operating with impaired liquidity and to appreciate the severity of the “distress” can prove calamitous. In the more congenial banking environment of years gone by, a company’s failure to meet a maintenance or other covenant would have precipitated a negotiation with the company’s lenders with a view towards waiver of the default and/or amendment of the underlying loan documentation. In today’s credit-constrained world, such a technical default may begin a potentially irreversible slide into bankruptcy.
In such situations, directors of financially troubled companies are likely to find themselves caught in the middle of a zero-sum game between “out-of-the-money” stockholders who are willing to have the company “bet the ranch” to salvage their investment and creditors who are loath to see their potential recoveries jeopardized through quixotic endeavors to “maximize” stockholder value. Needless to say, faced with the prospect of financial loss, both stockholders and creditors will be quick to litigate if a course of action chosen by the board of directors threatens to impair their respective interests. As a consequence, directors of all but the healthiest of companies need to understand the contour of their fiduciary duties in the context of financial distress.
Fiduciary Duties: Solvent Companies
A bedrock principle of Delaware law is the notion that directors of solvent companies owe fiduciary duties of loyalty and care to the corporation and its stockholders.
In contrast, it is equally well established that fiduciary duties are not owed to creditors of a solvent company. Such creditors are presumed to be able to protect themselves contractually or through creditors’ rights laws. Similarly, the directors of a solvent company do not owe fiduciary duties to holders of the shares of a Delaware corporation’s preferred stock. Again, such holders are deemed able to protect themselves through the negotiated provisions of the certificate of designation and/or the stock purchase agreement by which they became holders.
Beyond these seemingly simple principles, the analysis becomes more complicated and revolves around whether the company is, in fact, solvent or not. Ironically, while a company’s solvency can change (literally) from one day to the next (as the implosions at Bear Stearns and Lehman Brothers vividly demonstrate), the need to prove or disprove solvency “after the fact” can result in lengthy and expensive litigation. Indeed, the issue of insolvency in the Iridium bankruptcy case took 50 days of trial and testimony, 52 witnesses, seven experts and 866 exhibits. For a troubled company, professional financial advice in the form of a solvency opinion may be needed to assess solvency at any given point in time.
Fiduciary Duties: Insolvent Companies
A corporation is deemed insolvent under Delaware law when (i) there is a deficiency of assets below liabilities with no reasonable prospect that the business can be successfully continued in the face thereof or (ii) it is unable to pay its debts as they come due. The test is forward-looking: it is not enough for a corporation to meet its current obligations; it must be able to meet its future obligations as well. The fiduciary analysis focuses on the board’s belief at the time and whether that belief was reasonable.
The state of insolvency, in and of itself, does not change the focus of directors’ duties, which is the corporation itself. In Nelson v. Emerson, the Delaware Chancery Court stated that: “It is settled Delaware law that an insolvent company is not required to turn off the lights and liquidate when that company’s directors believe that continuing operations will maximize the value of the company.”
At the same time, however, the Delaware Supreme Court also made it clear in NACEPF v. Gheewalla that when a corporation is insolvent, creditors have standing to assert derivative (but not direct) claims against directors for breach of their fiduciary duties. The logical underpinning of this conclusion is that, upon insolvency, creditors take the place of stockholders as the principal constituency injured by any fiduciary breaches that diminish the value of the corporation.
Fortunately, in balancing conflicting stockholder and creditor interests, directors remain entitled to the “business judgment rule” presumption that they are acting independently, in good faith and with due care. Insolvency notwithstanding, the rule continues to protect directors so long as they act on an informed basis, in good faith and in the best interests of the corporation.
However, because creditors of an insolvent company can bring derivative actions for breach of fiduciary duty, directors’ actions, even though protected by the business judgment rule, can be subject to litigation. Accordingly, directors need to take special care in distressed situations to ensure that they have built a record of staying informed and taking actions that best serve the entire enterprise rather than any single group of stakeholders. Such care is especially warranted when a controlling stockholder is a principal party to a transaction such as an exchange offer or a down-round financing. In such situations, the more exacting “entire fairness” standard of review may be applicable, and a board may be well advised to secure both a fairness opinion and a solvency opinion from an independent financial advisor to buttress it’s decision-making process.
Duties in the Zone of Insolvency
Between the relative bright lines of solvency and insolvency lies the oft-referenced “zone of insolvency,” where the company is on the brink of becoming insolvent. The concept was first introduced into Delaware jurisprudence in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., a case in which the Delaware Chancery Court articulated the possible conflicts that might arise in the context of impending insolvency: “[I]n the vicinity of insolvency, circumstances may arise when the right (both the efficient and the fair) course to follow for the corporation may diverge from the choice that the stockholders (or the creditors, or the employees, or any single group interested in the corporation) would make if given the opportunity to act.”
Until relatively recently, Credit Lyonnais was cited for the proposition that directors of a corporation in the zone of insolvency owe fiduciary duties to both stockholders and creditors. In more recent cases, however, the Delaware courts have called this view into question. In Production Resources Group, LLC v. NCT Group, Inc., the Chancery Court observed that Credit Lyonnais was intended to operate as a “shield” against stockholder suits (alleging that directors had acted to protect creditors) rather than as a “sword” for creditors to force directors to favor creditor interests.
Similarly, in Gheewalla, the Delaware Supreme Court affirmed that fiduciary duties do not shift to creditors: “[W]hen a solvent corporation is navigating in the zone of insolvency, the focus for…directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its [stockholders] by exercising their business judgment in the best interests of the corporation for the benefit of its [stockholder] owners.”
It is generally difficult to ascertain when a company enters the zone of insolvency. While the tests for insolvency are easy to state, their application can be difficult – especially where there are unknown or contingent liabilities.
Although the Delaware courts have not defined the boundaries of the “zone of insolvency,” at least one case, Adlerstein v. Wertheimer, set forth several factors to be considered:
- Was the company facing a liquidity crisis?
- Was there a dearth of trade credit?
- Was there insufficient cash to meet payrolls?
- Did the company’s auditors refuse to issue a going concern opinion?
Other “signposts” demarcating the zone of insolvency might include the fact that a company
- has been financing losses through asset sales or short-term borrowings;
- is in an industry or sector that is experiencing a downturn;
- is emphasizing short-term profits over generating positive cash flow;
- is extending its accounts payable over lengthening periods of time
- is taking aggressive accounting positions.
When a company is operating within the zone of insolvency, many otherwise ordinary decisions by the board of directors will be subject to increased scrutiny by stakeholder constituencies and, potentially, by the courts:
- failing to reduce costs;
- collateralizing unencumbered assets to raise cash;
- continued declaration of dividends;
- sales of assets for arguably less than “reasonably equivalent value”
- failure to consider a sale of the company; or
- pursuing financing alternatives without making contingency plans for a bankruptcy filing.
Often, companies struggling in the zone of insolvency are forced to turn to controlling stockholders for liquidity through Private Investments in Public Equity Securities, (PIPEs) and down-round financings. These types of transactions are frequent targets of litigation and should be carefully reviewed by a committee of independent directors with the assistance of highly qualified advisors.