The Law Office of J.R. Smith presents the January 2024 topic series, “Fiduciary Duties.” Each week the firm will explore the duties imposed upon various leadership roles in various business entities.
To thy shareholders, be true…unless the company is going broke!
Continuing the January topic series following the fiduciary duties of board members (or managers in the LLC context), we look this week at the uncomfortable discussion of duties to shareholders and creditors when an organization becomes insolvent or is on the brink of insolvency. No one ever wants to discuss the organization they are entrusted to run is being run aground, but it can and does happen. This topic focuses on how the shift in fiduciary duties from shareholders to creditors occurs, specifically how and when, and what can be done to avoid this situation.
Normally, a court will not second guess a board’s decision-making process due to the business judgment rule, under the assumption that the decision in question was made by a board of directors that was informed, made in good faith, and is in the best interests of the company. This is true when the company is solvent, but when is not, some courts have held that the board members fiduciary duties are diverted to its creditors.
These courts have found company creditors whose interests are affected by the corporate decisions have standing to assert claims against directors and officers for breach of fiduciary duty that a company becomes insolvent, or on the brink of insolvency. (see RSL Comm’ns PLC v. Bildrici, 649 F. Supp.2d 184, 205 (S.D.N.Y. 2009).
Fiduciary Duties: Directors of Solvent Companies
Our previous topics covered that the Directors owe certain duties to the shareholders, specifically, a duty of loyalty, a duty of care, and a duty of good faith when making decisions that affect the company and its shareholders. When keeping to their duties, Directors are often protected by the business judgment rule (primarily) and several other provisions that are fact specific.
When does the shift in duties occur? Is there a bright-line rule of Insolvency?
The typical attorney answer applies here: it depends.
Insolvency occurs when there is either a balance sheet insolvency, as in the company’s liabilities exceeds its assets, or when there is a cash flow insolvency, meaning that there is an inability to pay the debts as they mature in the ordinary course of business.
Several jurisdictions have found that the duties of the directors shift when a company enters the zone of insolvency. This means that when it becomes apparent or should be apparent that the company is going to be in financial trouble, the directors must be aware that the creditors basis for standing increases and should factor this in any decisions put forward before the board.
Other jurisdictions have held that it takes the act of insolvency to trigger the shift in fiduciary duties. Erring on the side of caution, directors/managers should likely consider the zone of insolvency the trigger point in which they document the potential for liability to both shareholders and creditors in their decision-making process.
Potential for Direct and Derivative Claims by Creditors
There are some jurisdictions that allow creditors of insolvent corporations to bring direct claims against directors for breaches of fiduciary duty and other jurisdictions which allow creditors to bring only derivative claims against directors on behalf of the company for a breach of fiduciary duties. The difference between these is that derivative claims benefit all stakeholders of a company, where direct claims merely benefit the individual claimants.
Preventing these Claims
Some signs of insolvency can be seen before it occurs, allowing the Board/Managers to implement policies and procedures to try to avoid it. Unfortunately, a financial crisis can strike a company without notice leaving the Board little time before responding. Relying on the swift action of the Board/Managers to manage financial stress usually requires advance planning. The recommended steps to prepare for a crisis are:
Establish standard protocols,
Keep records detailed enough to “CYA”,
Maintain the proper insurance on directors and officers,
Verify and document that Board’s needs are reviewed and maintained, and if not implement a policy or procedure to remedy any deficiency,
Disclose conflicts and continue to review periodically for previously undisclosed or potential conflicts,
Communicate, communicate, communicate.
(For more information, contact the Law Office of J.R. Smith for a checklist of preparation procedures.)
Crisis Mode: Next Steps
When it is apparent (or close to realization) that the company is in crisis, the first thing to be done is to retain independent counsel, form a special committee, and maintain existing protocols.
Counsel for the company represents the company and Directors should not rely on their advice, nor that of outside counsel. Directors need advice retained for the sole purpose of representing their interests concerning their fiduciary duties, potential liability, and what should be done to mitigate and minimize risk in their role.
The special committee’s purpose is to address conflicts of interest between the board members, shareholders, and creditors, conduct any internal investigations, and review the change of control events. Some firms have authorized the special committee to have the full authority over the board and to make determinations on behalf of the board without requiring a vote of the entire board. If this step is taken, and a special committee is given this power, verify the meeting minutes reflect this decision.
Just because the red lights are flashing, and the alarms are going off DOES NOT mean it’s okay to deviate from established practices and protocols unless it is clear that doing so is warranted under the circumstances. It is strongly recommended that deviation from established practices and protocols only be done upon the advice of outside counsel of the company and concurred with by the director’s personal counsel.
Protect Yourself at All Times
There is no shortage of examples of public scrutiny when financial trouble is on the horizon, much less when crisis is front and center and colors every aspect of the Directors/Managers thoughts and actions.
Risk Management by the Board/Managers includes, at a minimum, doing the following:
Keep engaging in the business. It is instinctive to hit the brakes and stop engaging in business decisions, but you must keep acting in good faith, doing what is in the best interest of the corporation, its shareholders and creditors to keep the duties of loyalty and care.
Maximize Value. The Director/Managers duty in a crisis is to maximize the company value for the benefit of both shareholders and creditors. Even with financial restraints, directors should work with management to drive development and production to increase the value of the enterprise.
Look for Insider Transactions. Potential insider transactions should be looked for with scrutiny and cautiously approached. Document any insider transaction at an arms’ length to avoid any inference of impropriety.
Evaluate Regulatory Compliance. Directors should reevaluate and continue to monitor the company for compliance with tax, environmental, and workplace regulations.
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