Director of a troubled company? Stay alert! As a director of a troubled company, decisions you make can trigger huge potential liabilities--unless you take steps to limit or avoid your exposure. (Corporate Governance).

If you are a member of a corporate board of directors, you already know that you owe fiduciary duties to the company and its shareholders. These fiduciary duties arise under state corporate statutes and case law. What you may not know is that should the corporation approach insolvency, these responsibilities may flip -- or gradually shift -- to the company's creditors under certain circumstances. If this happens, the decisions you make will most likely change completely. Today's challenging economic conditions make this an excellent time to review this topic.

The board-level issues related to a company approaching insolvency are highly complex, and raise many questions. For example, for a cash-burning company with only enough cash in the bank to pay off company creditors: Is it the appropriate time to pay off those creditors and wind down the company? This would guarantee no return to the equity holders, but at least the creditors would be made whole. What if the assets can be sold and turned into cash as part of winding down the company? Does this give the company a longer lifeline? Do you know for sure that the company's assets can be sold? What price will they bring? What about the responsibility the company and its management have to the company's employees?

Added to the questions are management's optimistic statements that a big customer order is on the horizon and that the order will be made if only the company can hang on. Should the company spend additional funds chasing the order? These and similar issues and questions must be carefully addressed to avoid legal exposure.

Under ordinary circumstances, the rights of company creditors are specified by contracts entered into with those creditors (loan agreements, leases, etc.). However, in many states, including California and Delaware, directors may become subject to claims by creditors for breach of fiduciary duty if they take or fail to take certain actions when a corporation is in the vicinity of insolvency.

For example, in a leading Delaware case (Geyer v. Ingersoll Publications Co., 621 A.2d784 (Del. 1992)), a creditor of a corporation sued the corporation's chairman/controlling stockholder when the corporation defaulted on the creditor's promissory note.

The creditor alleged that the company chairman engaged in transactions that resulted in an improper shift of assets to the stockholder, thereby rendering the corporation unable to repay the creditor. The court ruled that because the corporation was allegedly insolvent at the time, the creditor validly alleged a claim for breach of fiduciary duty owed by the director directly to the creditor.

Similarly, a California court, stating that a corporate controller-dominator is treated the same as a director of an insolvent corporation -- and, therefore, has a fiduciary relationship to its creditors -- determined that when the defendant paid himself instead of making funds available for creditors, he violated his fiduciary duty to creditors (Commons v. Schine, 35Cal.App.3d 141 (1973)).

Given the facts in the two preceding cases, the courts were willing to supplement a creditor's contractual protections with fiduciary duty protections. This greatly increases a director's potential liability, deeming it necessary for directors to be alert to when fiduciary duties to creditors arise. It is not an easy task -- given the fact-specific nature of situations involving troubled companies.

For one thing, it is not easy to determine when a corporation is "in the vicinity" of insolvency. From the existing case law, courts seem to apply two different tests for insolvency itself. Some courts and commentators have used a balance sheet approach, determining that a corporation is insolvent when its liabilities exceed its assets.

This test is difficult to apply when you have no idea if the company's underlying assets are worth anything on their own. Other courts prefer a cash flow test, which defines insolvency as an inability to meet debts as they become due. It is very difficult to determine which methodology a court would use or how far back potential liability to creditors goes. For this reason, directors should seek legal guidance at the earliest signs of trouble.

Another problem is the inconsistent nature of applying the business judgment rule to near insolvency situations. Although directors' actions are generally protected by the business judgment rule -- under which courts will not second-guess directors' business decisions as long as the directors were disinterested, acting in good faith and reasonably diligent in informing themselves of the facts -- the business judgment rule provides no clear-cut protection in the context of insolvency.

Given the complexity of this area, directors of potentially insolvent companies should take steps now to reduce their exposure to creditors' claims by considering the following guiding principles:

* Make sure the company's directors and officers (D&O) insurance is paid up. Review the policy, paying special attention to provisions that claim to terminate coverage if the corporation becomes insolvent.

* Include indemnification provisions as well as provisions limiting the personal liability of directors for breach of the duty of care in the corporation's corporate charter and indemnification agreements.

* At the first sign of cash shortage or an inability to pay debts as they become due, seek the advice of legal counsel. Under both California and Delaware law, a director can substantially reduce exposure if he or she relied upon the advice of qualified counsel.

* Avoid engaging in any insider deals when a corporation gets into financial trouble unless these deals are made in good faith and thoroughly scrutinized with the help of qualified legal counsel.

* Thoroughly evaluate liquidation and reorganization plans (including bankruptcy proceedings) and other business plans, understanding that once a bankruptcy petition is filed, the pre-petition conduct of directors will be scrutinized by independent parties, which may increase the likelihood of litigation against directors.

Directors must be alert to any deterioration in the corporation's financial condition that may trigger duties to creditors. Following the recommendations outlined above and engaging legal counsel at an early stage should enable directors to limit or avoid liability for claims by creditors.

Greg T. Williams ([e-mail]) and Michael S. Greger ([e-mail]) are partners in the Orange County, Calif., office of business and real estate law firm Allen, Matkins, Leck, Gamble & Mallory LLP (www.allenmakins.com).