Doing Right When Things Go Wrong:
Directors’ Duties in the Zone of Insolvency

By: TODD A. TAYLOR

September 2009

Hearing about all the large companies and banks experiencing financial crises, one can become somewhat jaded to these problems. But, if you are a director of a company, publicly traded or private, you should be aware that the issues facing those companies might one day be facing your company, and you need to be prepared. When your own company faces financial struggles, directors need to be aware of a special set of duties, related to what is called the “zone of insolvency,” that can come into play and to take care to do right even when things are going wrong.

This article focuses on signs to watch for to determine if a company might be in the “zone,” how their decision processes are impacted once the company is in the zone, and what kind of legal or other independent expert advice they should seek while in the zone. It focuses on the fiduciary duties of directors and officers, how those duties change during the zone of insolvency, and how to ensure that they uphold their duties during the zone of insolvency.

Fiduciary Duty of Directors

Directors and officers owe fiduciary duties to the corporation and, in some of the private company litigation, the focus becomes shareholders (where there’s a group of controlling shareholders). Three duties that a board and officers always face are: (1) the duty of care; (2) the duty of loyalty; and (3) the duty of good faith. The duty of care requires that directors and officers act with the care an ordinarily prudent person in a like position would exercise under the circumstances. The duty of loyalty requires directors and officers to put the interests of the corporation above their own personal interests. Finally, the duty of good faith requires that directors and officers not make “ostrich-like” decisions that demonstrate a deliberate indifference to a potential risk of harm to the corporation.

When Does a Corporation Enter the Zone of Insolvency?

While courts use legal tests, in hindsight, to determine if a corporation had entered the zone of insolvency at a specific point in time, practically speaking, if a board even begins to raise questions about whether it’s in the zone of insolvency, the most prudent course of action is to begin acting like the corporation is in the zone of insolvency. A board must also recognize when it is in “debtor denial” before it is too late. In other words, boards should not continue with business as usual when indications hint that the company may be going or may actually be insolvent. A corporation breaching covenants made in its agreements, or officers raising questions regarding the company’s cash flow, are practical markers that could indicate that the corporation might be headed toward the zone of insolvency.

Additionally, three financial tests for entering the zone of insolvency are: (1) balance sheet test— whether the value of the assets or the enterprise value of the corporation exceeds the liabilities; (2) cash flow test—whether the corporation has sufficient cash flow to meet its fixed financial obligations as they become due; and (3) unreasonably small capital test—whether the company has sufficient capital to obtain or support financing for future operations.

Charging Duties

Some courts have held that when a company enters the zone of insolvency, the directors’ duties expand to include creditors of the corporation, in addition to the shareholders and the corporation itself. Other courts have compared directors to trustees administering the assets of the corporation for the benefit of creditors. In either scenario, directors of the insolvent corporation must maximize the value of the assets for payment of creditors. If a board always acted in order to maximize the enterprise value of the company, and did nothing to favor equity over creditors, the board would be satisfying its duties.

When a company is in the zone of insolvency, the absolute priority rule also comes into play. Under this rule, applicable in bankruptcy and imbedded in the expansion of duty cases, the claims of the equity holders would always be below secured and unsecured creditors of the corporation. If value is not sufficient to pay equity, the creditors essentially become the new stakeholders in the company.

Companies should discuss requirements for disclosures in financial statements or filings with the Securities and Exchange Commission (SEC) with SEC counsel, but the expansion of the board’s fiduciary duties may not, in itself, be a material event requiring filing of a Form 8‑K statement. Other things that trigger that expansion, however, such as a default in a material loan agreement, may be material events required to be disclosed.

In some instances, stating that the company was in the zone of insolvency might work against the board’s duty to maximize the corporation’s enterprise value. Therefore, legal counsel with restructuring and SEC expertise must work together to navigate these disclosure issues and the potentially competing concerns.

Retaining Independent Counsel for the Board

Retention of independent counsel to the board (as opposed to the company) is necessary when the interests of the board and the company may be in conflict, or in certain other instances. When in the “zone,” however, the interests of the corporation and of the officers and directors are the same.

Resignation of Board Members

Many experts believe that resigning when a corporation is in distress is a complete derogation of a board member’s obligations. While there is no law that prohibits a board member from resigning, it is not common practice for a board member to do so. In some cases, board members and officers may be able to obtain a release from liability through a plan of reorganization. As these releases are difficult to obtain for active board members in some jurisdictions, they are even harder to obtain for a former board member. Therefore, resigning while a company is in the zone of insolvency might be an impediment to a board member ultimately obtaining a release for actions or omissions while on the board.

Retention of Outside Experts

To meet the officers’ and directors’ duties in the zone, companies should retain outside legal counsel and financial advisors who interact with the board to ensure the board is given objective advice about how to conduct business during the zone of insolvency. Companies also can create a committee to handle these types of issues, and during the zone of insolvency, a company’s board should be taking a much more active role in seeking advice from outside experts.

The Business Judgment Rule

Under the business judgment rule, a board of directors’ business decision will be respected by the courts if the decision was made on a fully informed basis, without self-interest, in good faith, and in the honest belief that the decision was in the best interests of the corporation and its stockholders/creditors. In certain circumstances (e.g., a transaction that contemplates a change of control), a board’s duties may be heightened, to ensure that it is obtaining the best transaction reasonably available.

Interaction With Management

A common temptation for directors when the company is in distress is to intervene in management decisions. This often occurs when the board decides, often in hindsight, that management made poor decisions and cannot be trusted to solve the problem it created.

This temptation must be tempered, however, because it is never the role of the board or an individual director to manage the company. A board sets strategy and has oversight responsibility over management. If management is not performing, the board should remedy that situation either by directing management to perform to a certain level and strategy or by replacing management. No individual director, without board approval, should ever try to insert themselves into the management process. They lack the authority and likely the expertise to do so and face increased risks of liability if they do.

What the board can, and should, do is increase its oversight of management’s decisions and process. This is especially true in risk management, those decisions that can materially impact the life of the company. Working with management to create a good process for risk management review and decision making is one of the key issues facing boards now.

Deepening Insolvency

Courts recently have begun to recognize a theory of liability, termed “deepening insolvency.” Under this theory, liability may be imposed for fraudulently or even negligently prolonging the life of a corporation and increasing the corporation’s debt and exposure to creditors. As a result, directors, and officers may be targets of deepening insolvency claims.

The following are examples of scenarios in which courts recognized deepening insolvency claims:

• Directors used fraudulent financial statements to increase capital and shareholder investments, thereby deepening the company’s insolvency and causing bankruptcy;
• Parent company and directors continued to operate an insolvent company by fraudulently concealing the company’s insolvency;
• Management negligently prepared financial statements that caused the corporation to incur unmanageable debts and file for bankruptcy; and
• Management negligently prepared valuation reports that induced the corporation to continue to make corporate acquisitions and to borrow additional funds, which resulted in financial deterioration.

Thus far, not a single finding of liability solely under a theory of deepening insolvency has been entered. Rather, liability has been found only in cases where deepening insolvency is a claim in conjunction with a claim of self-dealing or fraud.

Takeaway

As a board member, even in the best of times, you bear a heavy burden of holding the aspirations of the shareholders, employees, and other stakeholders in your hands. In tough times, this burden gets heavier, but by keeping in mind your duties, you should gain comfort when the storm hits.