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Advice for directors and officers of distressed corporations: Fiduciary duties.

Byline: Marc J. Carmel, G. Alexander Bongartz, Mark Poerio

When corporations encounter financial distress, their directors and officers generally find themselves in unfamiliar situations. While most are well prepared for overseeing business in the ordinary course of operations, they often are unaware of the duties and personal liability and other risks that accompany their corporation's financial distress. As with any new situation, sometimes they do not even know what advice to seek.

This is the first in a series of four pieces that provide a basic understanding of the issues directors and officers are likely to confront. It focuses on fiduciary duties. The remaining pieces will focus on corporate governance, compensation and benefits issues, and protections in the event of potential liability. These articles focus on Delaware law because many companies are organized in Delaware and many other states follow Delaware law.


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How to apply the lessons of Trados to your M&A Fiduciary duties for financially distressed or insolvent Delaware corporations ________________________________________________________________________________________________________________

Fiduciary Duties

As a result of managing a corporation, directors and officers owe special obligations to the company. These obligations, or fiduciary duties, that a director or officer must fulfill are based on the form of legal entity (corporation, LLC, Trust, etc.) and the state in which the entity is incorporated or organized (for many corporations, Delaware state law). These factors affect any fiduciary duty analysis and can significantly alter the duties of directors and officers.

State law generally imposes the duty of care and the duty of loyalty on directors and officers. The duty of care is an obligation of directors and officers to act on an informed basis after considering all relevant information and deliberating among themselves and with advisors. The duty of loyalty is an obligation of directors and officers to act in the best interests of the corporation without engaging in self-dealing or stealing corporate opportunities.

Impact of Insolvency

The most recent decisions (by judges in Delaware and several other relevant jurisdictions) hold that fiduciary duties are owed to the corporation that the director and officer is serving and do not change whether the corporation is solvent, approaching insolvency (described as the "zone of insolvency"), or insolvent. Based on these decisions, directors and officers should continue to exercise their duty of care and duty of loyalty to act in a manner that is best for the corporation.

While duties may not change whether their corporation is solvent or insolvent, exercising those duties becomes significantly more important when the corporation is confronting distress. With distress, directors and officers will be facing many more issues operationally and financially. Additionally, if the corporation is insolvent, creditors will not be repaid in full. When that happens, creditors often look for other ways to recover what they are owed and lawsuits for breaches of fiduciary duties is one avenue they may pursue.

Enforcing Breaches

There are differences in who can enforce a breach of fiduciary duties when the corporation is solvent as opposed to insolvent. In all situations, a corporation is able to sue directors and officers. But the law also recognizes that corporations may not always sue their own directors and officers even if warranted because the corporation, by its very nature, acts through its directors and officers. Therefore, they may decide not to pursue litigation against themselves or their colleagues.

To address this, under certain circumstances, parties are given "derivative" standing to sue directors and officers on behalf of the corporation. When the corporation is solvent, equity holders may have some ability to invoke derivative standing and sue directors or officers on behalf of and for the benefit of the corporation, and creditors are unable to invoke derivative standing. If the corporation is insolvent, creditors may have some ability to invoke derivative standing and sue directors and officers. Courts mostly have abandoned the concept of determining whether corporations can be in some "zone of insolvency" (between solvency and insolvency) and, instead, treat those situations as the corporation being solvent or not solvent. After coming to this conclusion, these courts don't have to decide whether equity holders or creditors can invoke derivative standing in the "zone of insolvency" because they have decided that no such zone exists.

Solvent vs. Insolvent

To determine whether a corporation is solvent, courts primarily use two different tests: the "balance sheet" test and the "cash flow" test. Generally, a corporation is only solvent if it satisfies both tests for solvency under Delaware law.

Under the balance sheet test, courts analyze whether the aggregate fair market value of a corporations' assets (after accounting for the cost to liquidate the assets) exceeds the amount of money it would take for the corporation to satisfy all of its liabilities (whether on-balance sheet or off-balance sheet and whether matured, contingent or unliquidated). Under the cash flow test, courts analyze whether a corporation is able to pay its debts as they come due based on proceeds generated from operations and the sale of assets, as well as potential capital raises.

Personal Liability

Directors and officers are able to: (1) prospectively limit the ability of parties to bring claims for breaches of fiduciary duties through exculpation provisions in corporate formation documents; (2) act in a manner to reduce or eliminate the likelihood that breaches of fiduciary duties occur; (3) contract with other parties to satisfy claims for breaches of fiduciary duties through indemnification agreements and director and officer liability insurance; and (4) negotiate for agreements to release them from liability. Each of these topics will be addressed in a future installment in this series.

Get Advice

It is difficult to navigate the issues that directors and officers confront with a distressed business. Receiving advice from experienced advisors is key. Directors and officers need to understand their duties and how to effectively manage their enterprise. That's the first step, and it's an important one because creditors and equity holders (and possibly courts) are likely to question actions (and inactions) of directors and officers--often with the benefit of twenty-twenty hindsight.
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Publication:Inside Counsel Breaking News
Geographic Code:1U5DE
Date:Jun 26, 2015
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