At the first sign of corporate financial
difficulties, directors and officers
should examine the effect of their decisions on a number of interest groups,
according to Gary Pemberton, a litigation
partner at Shulman Hodges & Bastian LLP.
“You will be scrutinized,” Pemberton
says. “Examine every decision you make. If
your company ends up in bankruptcy, management’s prebankruptcy decisions may
mean the difference between a creditor
getting a nickel on the dollar or 50 cents on
the dollar.”
Smart Business spoke with Pemberton,
a business and bankruptcy litigator who
has tried a number of cases involving failing companies, and asked him about the
“zone of insolvency” and the perils it creates for corporate officers and directors.
What is the ‘zone of insolvency’?
The courts have come up with two tests
that they have used to determine if a company is in the zone of insolvency. One is the
balance sheet test. Do liabilities exceed the
reasonable value of a corporation’s assets?
The second is a cash flow test. Is a company not able to pay its debts as they come
due in the ordinary course of business, or
is the company about to enter into a transaction that will result in it being unable to
pay its debts as they come due?
While the courts have shown some flexibility in applying these tests, if either of
these situations exist, a prudent director or
officer will assume that his or her company
is in what is called the ‘zone of insolvency’
and act accordingly.
What are management’s general duties,
regardless of a company’s financial health?
As a matter of law, there are two general
duties. One is the duty of loyalty, which
means that actions must be taken in good
faith and in the corporation’s best interests.
The other is the duty of care. Management
must take steps to be reasonably informed
of all available material information. It has
to act, based on that information, as any
prudent person in the same position would
act under similar circumstances.
If a manager abides by these two simple
rules, he or she will get the benefit of what
is called the Business Judgment Rule,
which means the court will likely find that he or she has fulfilled management’s fiduciary duties and will not second-guess a
decision simply because it turns out badly.
How does the zone of insolvency change a
manager’s actions, and what are some practical actions that a top manager can perform
for a company in financial difficulty?
The law has become very muddy in this
area. Just a few months ago, the Delaware
Supreme Court held that a creditor cannot
bring a legal action against a director for
breach of fiduciary duties. Whether other
state courts will follow Delaware’s lead is
an open question.
Regardless of what the courts decide,
when faced with financial difficulty, a
smart director who is not already doing so
should start holding regular board meetings and scrutinize everything. Hiring
experts, such as insolvency attorneys and
financial advisers, is another smart move,
so that if later questioned, the directors and
officers can claim they made informed
decisions based on prudent advice.
There are a few other practical steps
management should take if their company
has entered the zone of insolvency:
- Avoid taking action that favors equity
over creditors — for instance, paying a dividend or redeeming stock. - Avoid actions that could be deemed
fraudulent transfers, like giving away a
product or service for less than its fair
value. - At the end of every board meeting,
introduce and vote on a resolution that all
transactions approved are in the best interests of the corporation, and have the minutes reflect why that is the case. - Disclose any directors’ interest in a
third party that is involved in company
business. Make sure it’s on the record and
in the board meeting minutes. - Don’t hide from creditors. Directors
and officers are better served by being fully
transparent. - Ensure you have independent decision-making by creating an audit committee with independent members to make
recommendations on any insider transaction (which should be avoided when a
company is in the zone of insolvency). - Avoid preferring one creditor at the
expense of another, unless there is a significant business reason to do so. - Avoid any self-dealing, which will
negate your protection under the Business
Judgment Rule. - When evaluating fundraising transactions or the sale of corporate assets, recognize that these will be scrutinized by shareholders and the company’s creditors.
- Examine the corporate directors’ and
officers’ insurance policy carefully for
material terms and exclusions. - Purchase D&O insurance, or bargain
for changes in the amount of coverage and
terms of the current policy.
Is resignation an option?
A director’s natural instinct is to abandon
a sinking ship. But by leaving, you’ve essentially removed your influence from future
actions of the corporation, and your resignation may be a breach of your fiduciary
duties. You will be called to account for
your prior decisions anyway and leaving
may create the implication that you knowingly made decisions that were not in the
company’s best interests.
GARY PEMBERTON is a litigation partner at Shulman Hodges
& Bastian LLP. Reach him at [email protected] or (949)
340-3400.