Top Ten Considerations for the Board of a Financially Distressed Company

By Stephen M. Plotnick, Carter Ledyard & Milburn LLP, New York, New York

 

At the most basic level, a board of directors' duties can ordinarily be distilled down to a responsibility to act in the best interests of the company and its shareholders. However, the board's duties can expand when the company is experiencing financial trouble. Here are ten recommendations for companies and their board members to consider when faced with fiscal distress to help protect against incurring liability.

 

Directors owe fiduciary duties of care and loyalty. The duty of care requires that directors be reasonably informed of all relevant information when making decisions. The standard is an objective one, insofar as it imposes an obligation to be informed and to use the same amount of care that an ordinarily prudent person would use under similar circumstances. The duty of loyalty requires directors to act in good faith and for the best interests of the company and its shareholders. Directors must refrain from elevating personal interests ahead of the company's interests. With respect to financial matters in particular, this means that directors need to continually evaluate and monitor their company's financial performance and position, and must avoid involving themselves in decision-making when they are conflicted.

 

Ordinarily, a board of directors is beholden only to the company and its shareholders. Thus, when making decisions, they are required only to have the best interests of the company and its shareholders in mind. However, once a company becomes insolvent (or is approaching insolvency), the board's duties will extend to the company's creditors – because creditors are viewed as the primary beneficiaries of the board's duties and their claims are typically required to be satisfied before shareholders receive any recovery.

 

Directors' duties will shift to include the interests of creditors when the company passes the threshold from solvency to insolvency. There are two traditional tests for determining when this happens:

 

i. Cash flow test: When a company is unable to pay its debts as they come due in the ordinary course of business.

 

ii. Balance sheet test: When the company's liabilities exceed the reasonable market value of its assets.

 

Neither test is exclusive, and either or both may apply depending upon the circumstances. In some jurisdictions, directors' duties will actually shift to include creditors once the company enters the "zone of insolvency," as opposed to actual insolvency. Either way, because it is often difficult to pinpoint the precise moment when a company becomes insolvent, directors should be cognizant of the interests of the company's creditors as soon as the company becomes financially distressed.

 

Financial difficulties leading to insolvency can descend upon a company quickly. It is therefore critical that a company have in place standard procedures for the conduct of board business. A board should establish protocols for scheduling and conducting meetings. Directors will need to receive pertinent information sufficiently in advance of any meetings in order to allow for adequate time to review and prepare for any matters that will be considered. A system should be established for communicating with (and among) board members and for transmitting pertinent information to them. Members of the company's management team should attend board meetings where appropriate to present relevant information to the board. Accurate minutes for every meeting should be maintained and should reflect the parties in attendance, votes taken, and any matters tabled for future discussion. The minutes should be circulated to the board in advance of the next board meeting and then approved at that next meeting. Having clear, contemporaneous documentation of board actions, decisions, and outcomes can often prove to be key if and when those actions, decisions, and outcomes become subject to scrutiny.

 

Under normal circumstances, a director who discharges his or her fiduciary duties will be protected by the business judgment rule. This is the most deferential standard of review, and presumes that the board's decisions were made on an informed basis, in good faith, and in the best interests of the company. However, the business judgment rule may not attach, or may be overcome, by showing director conflict of interest or other evidence suggesting that a board has not faithfully discharged its fiduciary duties. For example, an enhanced level of scrutiny may be applied when the decision making process or context can be viewed as undermining the decisions of even independent and disinterested directors. The most onerous standard that may be applied to directors' decision-making is "entire fairness" review. This will be applied when a director holds some personal interest in the decision or is otherwise conflicted and, when applied, will shift the burden of persuasion to the directors to demonstrate that the transaction was fair. For this reason, it is key that directors fully disclose any actual or potential conflicts of interest.

 

Board member conflicts can and do happen from time to time. Board members must be required to disclose those conflicts before the board approves a transaction or otherwise takes corporate action. Even the appearance of a conflict can undermine board decision making, so directors should always err on the side of disclosure. In the event of a conflict, the board will need to consider recusing the interested director from the decision making process and/or appointing independent directors. Special committees may also be used to address conflicts between the interests of board members and shareholders, and it is often prudent in the event of director conflicts to grant the special committee full authority to make determinations without the vote of the entire board.

 

Even in the absence of a conflict, the needs of a board may change over time as a company's business evolves. It is important that the company understand and continually monitor the makeup, skills, and backgrounds of its board members. The company may need to adapt its board to changes in the company's business, and should periodically evaluate and consider whether the board has sufficient members with the requisite expertise to address the company's needs, or whether other skill sets would be helpful to better assist the board. Particularly in crisis situations, the board should consider forming subcommittees or engaging advisors to deal with new or unexpected issues, or issues that require expertise that current board members are lacking. Advisors can come from within the company, but outside advisors can also be used to assist the board where there is concern that the expertise or makeup of the existing board may not be sufficient to adequately consider and address a crisis.

 

A corollary to monitoring the composition of the board is to regularly review the adequacy of the company's director's and officer's liability insurance, since these policies may be triggered by challenges to decisions made by board members when crisis occurs. There are three basic types of coverage found in typical D&O policies:

 

When a fiscal crisis hits, open communication with the company's creditors can be key. Informed creditors can make for better partners and are more likely to support recovery plans. For lenders, the company can seek waivers or extensions in the event of breaches of financial covenants in loan documents. Directors are not required to favor creditors over stockholders, and will not necessarily be liable for choosing the "wrong" balance if they otherwise comply with their fiduciary duties. However, directors need to be alert to the fact that their expansion of duties means that creditors may be able to bring claims against them for breaches of those fiduciary duties. Some jurisdictions allow for creditors to bring direct claims, and most allow creditors to assert derivative claims. In practice, however, it is only creditors with the highest priority and most significant claims that will have any incentive to bring a derivative action, since any recovery belongs to the company.

 

When a financial crisis hits it is perhaps most important to continue engaging in business and not deviate from established protocols unless clearly warranted under the circumstances. Directors should engage in good faith business decisions that are in the best interests of the company and its shareholders, with input from management and with due consideration to the interests and rights of the company's creditors. Particular attention should be paid to insider transactions, which should be approached cautiously, and directors should be alert to and monitor the company's regulatory compliance. Maximizing company value will ultimately benefit the company, its shareholders, and creditors.

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With these considerations in mind, the board of a company experiencing financial distress can mitigate the many potential risks it faces. Each situation of course presents its own challenges, but the key is for the board to plan in advance and remain vigilant if and when a crisis hits.

 

Stephen Plotnick is a business litigation and trial attorney with the law firm of Carter Ledyard & Milburn LLP in New York, NY. He can be reached via email at plotnick@clm.com, and his biography is available at http://www.clm.com/attorney/plotnick_stephen.