The current disruption to normal business operations across the country means that many businesses will soon be under significant financial pressure, if they are not there already. As their companies edge toward insolvency, directors are going to have to make significant decisions about the companies and their operations. Boards may be concerned, as they make critical and difficult decisions, that creditors or others may later attempt to claim that they violated their legal duties. This concern in turn leads to the question about exactly what duties directors face as their companies approach insolvency.
In general, directors of solvent companies do not owe creditors fiduciary duties. A solvent company’s duties to its creditors are instead defined in other ways – for example, by the law of contract, bankruptcy laws, general commercial law, and creditors’ rights.
Whether companies take on fiduciary duties to creditors when they approach the “zone of insolvency” is very much a matter of state law. Under the law of Delaware, the state under whose laws many companies are organized, “duties of directors are fundamentally the same whether a corporation is solvent, insolvent, or trending towards insolvency,” according to March 26, 2020 memo from the Stinson law firm entitled “The Director’s Dilemma: An Overview of Director Fiduciary Duties when Insolvency Looms” (here), “ with the goal of pursuing ‘value maximizing strategies for the benefit of the corporation and its ‘residual stakeholders.’”
Delaware law is “emphatic” that directors’ fiduciary duties do not shift from the shareholders to the creditors when a corporation is operating in the “vicinity” or the “zone” of insolvency, according to a March 20, 2020 memo from the Fried Frank law firm entitled “Director Fiduciary Duties in an Insolvency Context”(here). According to the Delaware Supreme Court’s 2007 decision in the Gheewalla case (here), when a solvent company is navigating in the zone of insolvency, “focus for Delaware directors does not change: Directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.”
However, once a company becomes insolvent, directors’ obligations are altered; the creditors “join the shareholders in the group of residual owners” to whom the directors owe duties, according to the Stinson law firm memo. As the Delaware Chancery Court recognized in the 2015 decision in the Quadrant Structured Products case (discussed at length here), Delaware law recognizes a creditor’s right to make a derivative claim on behalf of an insolvent corporation for breaches of fiduciary duty. However, this right is derivative only; creditors of insolvent corporations are not owed direct fiduciary duties, but are only owed duties in their capacities as the eventual recipients of the firm’s residual value.
Under Delaware law, the question of whether or not a company is insolvent is determined in one of two ways – under the “cash flow test” (if the company is unable to pay its debts as they fall due in the normal course of business), or under the “balance sheet test” (if the company’s liabilities are in excess of a reasonable market value of assets held). As specified in the Quadrant decision noted above, “to bring a derivative action, a creditor-plaintiff must plead and later prove that the corporation was insolvent at the time the suit was filed.”
Because creditors become residual claimants of the corporation once the corporation becomes insolvent, directors must at the point of insolvency “take into account the creditors’ interests along with the interests of other residual claimants (including the shareholder),” as the Fried Frank memo notes. The memo further notes that “directors of a company that is or is likely to become financially troubled, should monitor carefully when the company may become insolvent – and when making decisions, should consider whether the corporation could, in hindsight, be viewed as having been insolvent at that time (in which case, the directors should have taken into account the creditors’ interests as well as the shareholders’ interests).”
In the current health emergency, many companies are going to have to wrestle with these issues and the difficult problem of assessing when the company is insolvent. These problems will be particularly acute for companies whose cash flow has been cutoff because of government mandates and social distancing requirements.
We are clearly in uncharted waters, and the comprehensive uncertainty about the current situation, including in particular its duration, represents an important context within which directors decisions later surely will be evaluated. In the meantime, as the Stimson law firm memo notes, “directors of insolvent or distressed corporations should recommit to faithfully discharging their duties of care and loyalty, including good faith, oversight and disclosure.”
Among other things, directors need to be “properly and continuously informed of material and relevant information affecting the corporation.” In addition, directors should “seek appropriate legal and financial advice” to insure they are properly informed.
One matter that may of particular concern as to do with the payment of dividends. Directors potentially could face “significant liability” if the company pays a dividend that, it is later argued, pushed the company into insolvency. In the current circumstances, companies facing significant disruption because of the coronavirus outbreak “will want to receive a significant amount of valuation and financial analysis before declaring a dividend.”
Finally, and as the Stinson law firm’s memo notes, perhaps now more than ever, boards should “ensure that management maintains an appropriate D&O liability insurance program.”
This final point bears emphasis. The fact is that the D&O insurance marketplace was already disrupted even before the coronavirus outbreak dislocated the business environment. The insurers are now stressed and struggling to respond to the current health crisis. Companies whose D&O insurance renewal is approaching will need to be in close contact with their insurance advisors as the D&O insurance marketplace is changing on a daily business. In many cases, insurers are seeking significant additional underwriting information. Certain classes of business have suddenly become hard to place. Terms and conditions (including in some cases the inclusion of a cororavirus-related exclusion) are also changing quickly.
For many companies, their upcoming D&O insurance renewal could prove to be significantly more difficult and demanding than has been the case in the past – particularly for those wrestling with solvency concerns.