Critical Board Issues for Financially Distressed Companies

When a company begins experiencing financial distress that threatens its continued existence, its directors and officers must be vigilant about exercising their fiduciary duties. The company's equity holders as well as outsiders will view decisions made during this time with particular scrutiny. Additionally, there are areas of law that attach personal liability to directors and officers; and, while risk of personal liability always exists, even in healthy firms, the potential for liability is heightened when a company is in financial distress.

Compounding the risks of personal liability, a financially distressed company may lack the resources necessary to indemnify its directors and officers, notwithstanding the indemnification agreements it may have with such individuals, and may even allow its director and officer insurance policies to lapse, because it is simply unable to pay the premiums.

I. Zone of insolvency

Financial distress that threatens the continued existence of a company is generally referred to as the “zone of insolvency.” There are three general tests to determine if a company has reached the zone of insolvency: (a) the value of the company's assets is less than its debts, (b) the company lacks sufficient capital to carry on its business, or (c) the company cannot pay its debts when due. Regardless of the technical application of these tests, if directors and officers believe their company is in the zone of insolvency, they should assume that it is and act accordingly.

Whether a company is insolvent or even in the zone of insolvency can have material implications on the duties and liabilities of its directors. Under normal circumstances, directors owe the company's shareholders the fiduciary duties of loyalty, care and good faith. Once a company is insolvent, however, the directors' duties shift to benefit the company's creditors.

Less clear is the alignment of directors' fiduciary duties when a company is in the zone of insolvency. The law in this area is still evolving. Until recently, the common view was that the directors' duties begin to shift, but are not completely shifted, to the company's creditors in the zone of insolvency, and that liability could be imposed for fraudulently or negligently prolonging the life of a company and increasing its debt load.

This theory of liability has been called “deepening insolvency.” A recent Delaware case, Trenwick America Litig. Trust v. Ernst & Young LLP, 906 A.2d 168 (Del. Ch. 2006), however, changed the legal landscape by holding that deepening insolvency is not an independent cause of action or theory of liability. But an even more recent Delaware case, In re The Brown Schools, 2008 WL 1849790 (Bankr. D. Del. April 24, 2008), allowed deepening insolvency as a theory of damages where a director had breached the duty of loyalty, further complicating the law of directors' obligations and liabilities in the zone of insolvency.

II. Personal liability for directors and officers

Directors and officers of companies approaching or in the zone of insolvency must avoid the following actions and omissions to which personal liability may attach:

1. Failure to pay wages

The individuals responsible for making payroll decisions within a company may be personally liable directly to an employee as well as face criminal liability for “willful” failure to pay wages under both state and federal wage and hour laws. In addition, under Washington state's “anti-rebate” statute, personal liability can arise for the willful failure to pay compensation due under a contract. Courts have held that, absent a bona fide dispute as to the payment obligation, any knowing failure to pay wages meets the willful standard.

While company officers are generally responsible for payroll decisions, during times of crisis, the company's board of directors often steps in to make day-to-day financial decisions, including payroll decisions. Thus, personal liability can arise when officers or directors are forced to evaluate whether to use limited cash resources to pay creditors or taxes rather than employees, to pay only certain employees, or to terminate employees who have severance agreements that the company may be unable to honor.

It should be noted that a company's insolvency or bankruptcy is not a defense against a wage claim. In fact, an aggrieved employee may determine that a company's director is the only potential defendant with resources worth pursuing. Liability of willful failure to pay wages can include double damages, interest and attorneys' fees.

2. Failure to pay taxes and priority of federal claims

Under federal and many state laws, the “responsible person” in a company can be held personally liable for failure to pay or withhold federal and state payroll taxes including income tax, and both the employer and employee portions of FICA. Under federal law, the penalty for failure to pay is equal to the entire amount of the tax that should have been paid, plus interest from the date of the penalty. And under certain states' laws, a similar liability exists for failure to pay sales tax or other taxes that are collected by a company and held for the benefit of the state or local governments.

Officers and directors must pay careful attention to cash flow and accounts payable in times of financial distress to ensure that collected taxes are not being used to pay other creditors or make payroll. Personal liability may attach in situations where a director or officer knew the tax liability was due, but approved payments of other obligations instead.

In addition, Section 3713 of Title 31 of the U.S. Code requires that an insolvent debtor pay the federal government first before paying its other unsecured creditors. Outside of a bankruptcy proceeding, this means that unsecured claims of the U.S. government must be paid prior to claims of other unsecured creditors. Officers and directors who fail to exercise their authority to prevent such payments before the federal government has been paid in full may be held personally liable for the amounts they have “diverted” from the federal government.

3. Distributions to shareholders

Under Washington state law and the law of other states that have adopted the Model Business Corporation Act, a corporation cannot make any distributions to its shareholders if, after giving effect to the distribution, the corporation cannot pay its liabilities when due in the usual course of business or if the company's total assets would be less than its total liabilities, plus (unless the corporation's articles specifically state otherwise) the amount that would be needed to satisfy any preferred shareholder's preferential rights upon dissolution if those rights are superior to the rights of the shareholder receiving the distribution.

Similarly, under Delaware law, a corporation cannot make any distributions to its shareholders unless the distributions are made from the company's surplus (defined as the amount by which the company's net assets exceed its stated capital) or the company's net profits from the current or preceding fiscal year; provided, that a dividend may not be declared out of net profits if the company's capital has been diminished to an amount less than the aggregate capital represented by the issued and outstanding stock having a preference on the distributions.

A director who votes for or consents to a distribution made in violation of the foregoing rules or the corporation's articles of incorporation is personally liable to the corporation for the amount of the distribution that exceeds the amount that could have been legally distributed. In addition, under Washington state law, if a shareholder accepts such distributions with the knowledge that the distribution violated the foregoing rules or the articles of incorporation, then the shareholder is personally liable as well.

III. Issues in transactions with financially distressed companies

1. Fraudulent transfers

Payments made for less than fair consideration while insolvent, and transfers made with intent to hinder, delay and defraud creditors, are “fraudulent transfers.” Problem areas for directors and officers include:

Insider transactions. A failing company's officers and/or directors are often the best suited by knowledge, inclination and experience to purchase all or part of its assets. Where bills will remain unpaid or shareholder expectancies trashed, the exposure to the purchasers is an important consideration. In this situation, a bankruptcy proceeding, including the sale of assets through an auction process, with full and complete disclosure, may help obtain clean title. The process will not, however, produce a release of real or imagined liability for an officer or director of the seller.

Transfer of technology or assets. If it appears that a company will be unable to survive, management may be tempted to transfer the company's core technology or assets to a new or debt-free entity to preserve the potential of the intellectual property and the business concepts of the enterprise. Unless fairly and carefully scripted, this kind of transfer can create liability for the company's professionals, directors and officers on both sides of the transaction.

Severance packages. A company's survival may necessitate replacing management, and outgoing officers may require a significant severance payment as part of the process. In some cases, severance will involve the compromise of a pre-existing employment agreement and will actually save the company money by reducing its obligations with respect to the minimum term of employment, deferred compensation or other benefits owed to the officer.

Trading stock options for a cash payment, however, is similar to a redemption and will not be seen as a prudent exercise of discretion in these negotiations. Viewed later, amid the ashes of the failed company, severance payments and other consideration paid to outgoing officers or directors will be carefully scrutinized.

Asset sales. Often an important option for a failing company is the sale of its assets in an arm's length transaction. Because the sale might be attacked by the company's creditors, the buyer of its assets may demand that the company be sold through a bankruptcy. Such sales can generally be effective in insulating the buyer from imagined liabilities. However, the costs are often far greater than justified by the risks, and using bankruptcy for the sale of an insolvent company should not be a knee-jerk reaction.

2. Patent licenses in bankruptcy

The many implications of a Chapter 11 bankruptcy for a company desiring to reorganize, sell or liquidate are subjects for other advisories. However, one factor must be noted here: Filing a bankruptcy can cause a company to lose the benefit of any patent license to which it was the licensee. If a company's technology or its value is tied to a patent license, the company should consult counsel regarding bankruptcy and its effects on licensed rights.