9 Essential Steps to Take When your Business is Approaching Insolvency

It is a well-established principle of corporate law that directors and officers have fiduciary obligations to their organizations and shareholders. These obligations are defined by state statutes and typically include a duty of loyalty and a duty of care. The duty of loyalty requires directors and officers to prioritize the interests of the company over their own personal interests and to refrain from self-dealing. The duty of care requires directors and officers to exercise diligence, make informed decisions, and act in good faith, with the best interests of the company in mind.

However, when a company becomes insolvent, the parties to whom these fiduciary duties are owed shift from equity holders to creditors. Insolvency is typically defined as a state in which a company’s liabilities exceed its assets, or when the company is unable to pay its debts as they become due. This shift in obligations is due to the fact that, in an insolvent company, there is no economic value beyond what is owed to creditors. As a result, equity holders no longer have a stake in the company.

This shift in fiduciary obligations can expose officers and directors to civil liability if they fail to navigate the delicate balance between bracing for insolvency and upholding their duties to the company and its equity holders during tough financial times. Directors and officers should be aware of the so-called “zone of insolvency,” which refers to the period when the company is facing financial difficulty and it is unclear whether it is solvent or insolvent.

During this time, directors and officers should be especially mindful of the impact their decisions will have and the parties to whom their fiduciary duties are owed. For example, a decision to take on additional debt to keep the company afloat may be viewed positively by shareholders but negatively by existing creditors. Directors and officers must understand which party can later challenge that decision.

However, decisions made in good faith are generally protected by the business judgment rule. This rule presumes that, in the absence of self-dealing or fraudulent conduct, directors and officers act on an informed basis, in good faith, and in the honest belief that their actions are in the best interest of the corporation. Thus, even during the zone of insolvency, directors and officers can take action that is in the best interest of the company without fear of liability as long as they act in good faith and with due care.

When a company is in the “zone of insolvency,” or the period leading up to insolvency, the company directors and officers should be especially vigilant to avoid actions that may expose them to personal liability. While there is no foolproof formula to insulate oneself from liability, there are several steps that directors and officers can take to minimize their risk.

1. Scrutinize actions that increase stockholder return by impairing creditors’ claims: Directors and officers should be careful about taking actions that benefit shareholders at the expense of creditors, such as authorizing a dividend or stock redemption that depletes the company’s assets.
2. Avoid preferential treatment between shareholders: Directors and officers should also be careful about showing favoritism to certain classes of shareholders over others. Any actions taken should be in the best interests of the corporation as a whole.
3. Make reasonable efforts to learn all the facts before taking action: Directors and officers should take the time to gather all the relevant information before making any decisions. This includes seeking the advice of outside experts when necessary.
4. Refrain from engaging in transfers for less than fair value: Any transfers made during the zone of insolvency should be for fair value. Payments made to certain creditors at the expense of others can be clawed back in any bankruptcy or insolvency proceeding.
5. Consider proposing a resolution affirming good faith business decisions: To help protect themselves, directors and officers may consider proposing a resolution at a stockholder meeting affirming that all prior business decisions were made in good faith after an exercise of reasonable care.
6. Avoid self-dealing and disclose any conflicts of interest: Directors and officers should avoid engaging in any self-dealing and fully disclose any personal or business relationships with parties on the other side of transactions involving the corporation to avoid the appearance of a conflict of interest.
7. Be aware of potential scrutiny of fundraising or asset sales: Directors and officers should be aware that any fundraising or asset sale transactions may be scrutinized later, especially if their fiduciary duties expand to include creditors.
8. Resignation does not provide total protection: While a director is always free to resign, resignation does not provide total protection from liability. A director will continue to have liability for pre-resignation acts and omissions, and liability may be deemed continuing even if the director resigned before an improper or illegal action was taken.
9. Familiarize oneself with D&O policy coverage: Directors and officers should familiarize themselves with the terms of any Director and Officer Liability Policy (“D&O Policy”) in place before the company enters the zone of insolvency. They should also review the policy for the effect of resignation on coverage and determine if the policy covers acts that occurred during their tenure, even if such acts were not deemed to be in violation of fiduciary duties at the time of occurrence.

Amidst the current financial instability, it is crucial for businesses and their leaders to closely monitor the company’s financial situation. Having a clear understanding of how to steer the company towards a successful future while safeguarding the directors and officers from potential legal obligations during the zone of insolvency can make a significant difference in preventing the company from failing.