How can directors and officers avoid personal liability when their company nears insolvency?

Fiduciary Duties

Every state requires certain people in a company to follow “fiduciary duties” - to the business, and to the owners of the business. It is a standard defined by state law, but it generally requires them to exercise the duties of loyalty and care. Loyalty means they put the company ahead of their own interests, and avoid self-dealing; care means they make informed business decisions, and perform with a decent level of diligence. Some states let a company limit the duty, but this summary does not cover that option.

Once a company is insolvent, the fiduciary duty now goes to the creditors of the company, not to the shareholders. Why is that? Because the creditors now have a potential claim on the company assets. There are no more “company assets” for the shareholders to claim. In a practical sense, the creditors are now the “owners,” so a fiduciary has to act in their best interest. One measure of insolvency is when the company can no longer pay its debts as they come due. Another is when its debts exceed its assets. Most states accept either test.

Without any planning, the officers and directors of an insolvent company may find themselves in a pickle. They thought they were making the right decisions, to keep afloat in tough times. Maybe it looked like a profit was just around the next corner. Now, instead of basking in success, they may find themselves being sued by creditors. Ultimately, the directors and officers have to navigate the rocky road of keeping the company afloat, and trying to make it profitable, while being careful not to disadvantage any creditors. While a lot of states used to say the duties shift before the company was actually insolvent, most of them have backed away. Even so, that period before full-on insolvency is known as the ”zone of insolvency.” This is an area of some danger: on one hand, business people should not have to change their normal behavior while a business is still healthy; on the other, they need to be careful if they know the business is starting to run into trouble.

The zone has no standard definition. For most purposes, you can think of it as that middle ground where the financials of the business are problematic, but not fatal. Once you are in the zone, you may not realize that all your decisions may later be judged by someone in hindsight. For example, if you are borrowing more money, your investors may be pleased, but existing lenders may not like it. Shareholders and creditors can both challenge your decisions, based on a later investigation of what you knew and did. Who would be challenging you is sometimes just as important as what decision you make. How are you protected against all these potential challenges? The first line of defense is the ”business judgment rule.” It is a shield for an officer or director who acts in good faith and with a reasonable basis for believing his or her decision is in the best interests of the company.

Take the Following Steps to Protect the Officers and Directors

If a company is on the edge of insolvency, not all of the following steps will apply to your situation, but reviewing them will help you understand the issues that can be important. No single step guarantees protection.

First, look hard at any action that increases returns to the stockholders while leaving creditors out in the cold.

You cannot drain the company to benefit the shareholders, which leaves the company without enough assets to pay the creditors. Avoid declaring and paying a dividend, for example, or buying back stock.

Do not favor one class of shareholders over another, even in hard times.

Before you make any important decision, you should ask if you are acting in the best interests of the whole company. That means you cannot favor the stockholders. If you do not know whether the decision is truly in the best interests of the company, the first order of business is to gather all the facts that you need to make a fully informed judgment.

If you are insolvent, do not make any transfers of property for less than fair value. They can be undone as ”fraudulent conveyances.” Do not favor any one creditor, especially ones that are closely connected with you. Such payments can be ”clawed back” in bankruptcy.

It is possible for the stockholders to vote on the decisions that directors and officers make. You can try to insulate yourself by proposing a resolution that ratifies the past decisions of the directors and officers as made in good faith and with due care.

Never engage in self-dealing. If you have some personal or other connection with a party to a transaction, disclose it. Disclosure avoids the appearance of self-dealing.

If you are contemplating raising money or selling assets in a time when you are starting to feel financial pressure, keep in mind that you will be entering into transactions that might be reexamined later, in light of obligations to creditors.

Quitting the company does not automatically end your exposure for what has already occurred. A director can only resign when a state’s law or the corporation’s bylaws say he or she can. A director who quits stays liable for acts that occurred before leaving, including any wrongs that were begun while in office. Further, as a fiduciary, you cannot leave if it would cause harm to the company, or it would leave the assets unprotected.

Check the exclusions on your D&O policy. As soon as you can see trouble on the horizon, pull out your policy to read what it covers and what it excludes. When is coverage triggered? Does it cover the acts you do now, or only the acts you did before a certain date? If you resign, will you stay covered? These and other questions need to be answered so that you know how and when coverage will help protect you.

The best protection is to keep a close eye on the financials of the business. Not everyone has the talent or education, but if you are an officer or director, it is your responsibility. Those who handle the zone of insolvency well can sometimes help a company recover and thrive, and those who let things slide are inviting personal liability and business collapse.