The last few years of economic uncertainty have pushed a lot of companies to take a hard look at their own financial health. Most will weather the storm, but the companies that survive may not be able to operate the same as they once did. Old structures and ways of operating may need to be abandoned for new ones. Some will go bankrupt. The hard question is which ones. It all depends on how leaders respond when business gets tough and resources run short. That is where the chain of command comes in. Directors and officers retain their fiduciary duties to the company even if the company’s financial health is strained; the question is who is the company supposed to be looking out for?
In a corporation, the big decisions are made by the board of directors. The officers make the routine decisions, but the board oversees them and makes the major calls. In a closely held company, things can get muddier. In a small company, the shareholders and the officers might be the same people. The shareholders who control the company might also be the ones making the daily decisions. This can blur the lines between who is responsible for what, especially when the company starts to struggle. A fiduciary is someone entrusted to act in someone else’s interests. You have to think about the person whose interests you’re supposed to be looking out for whenever you take any action. And when the business is under financial distress, anyone who’s suffering a lost investment will look for someone to blame.
A Duty of Care and a Duty of Loyalty
In the normal course of business, directors and officers owe their duties to the company itself: a duty of care and a duty of loyalty, with a duty of good faith inside them. The duty of care asks for the care an ordinarily careful and prudent person would use in similar circumstances, and for consideration of all material information reasonably available. That’s basically a fancy way of saying directors have to keep their fingers on the company’s pulse, so to speak. The duty of loyalty involves things like self-dealing, while the duty of care concerns how directors manage the corporation and its affairs. Decisions should rest on the merits, not on anyone’s personal interests. The duty of good faith means you act honestly in what you believe to be the corporation’s best interest. These three duties are incredibly vague. They are, however, fundamental to a director’s relationship with a company, and a director’s failure to fulfill these duties can result in serious consequences.
The good news is the business judgment rule. A director or officer must make a decision in good faith, with a rational business purpose, in the best interest of the company, and with due care. If he or she does so, then the business judgment rule will protect him or her from second-guessing by a court or liability, even if the decision later turns out badly, unless some exception applies. Just think about it: If courts were out second guessing your decisions every time things didn’t go your way, you would never make any decisions to begin with! Being a good steward of an organization doesn’t require that a director never makes a mistake. It is not necessary to choose the ‘correct’ option when a choice has to be made. It is not necessary to find the ‘best’ solution. However, there are exceptions to the business judgment rule, such as when the decision maker commits fraud, engages in a conflict of interest or is grossly negligent.
The rule also assumes you did the work. Directors and officers should review all reasonably available information on the subject of a decision, and the board should actively and critically discuss it. In practice, that can mean reviewing the books of the company and digging into the important questions facing the business. It means chairing a board meeting with an actual agenda, including a discussion of critical issues such as the ongoing financial health of the company. Courts presume directors acted within the rule, so the standard of review usually appropriate for judicial scrutiny of corporate decisionmaking is the business judgment rule, unless and until a plaintiff successfully rebuts the presumption. Then the burden shifts, and you have to prove the “entire fairness” of the transaction, not just show that it was objectively “rational.”
There are other layers of protection, depending on your state. Put simply, if a corporation has a provision in its certificate of incorporation for exculpation, this means that individual corporate directors are protected from being held personally liable if they breach their duty of care. These provisions typically cannot cover the duty of loyalty. So it is possible for a corporate director to face liability for violating the duty of loyalty. Some states also protect directors who rely in good faith on the corporation’s records and on information, opinions and statements from employees and professional advisors. A director should seek corporate advice from qualified professionals, at least when the situation is complex.
When the Company Begins to Struggle
So what does this have to do with a struggling company? Do the fiduciary duties of a company’s directors and officers change based on its financial health? The short answer is “yes”. But not as early as many people think. The traditional view is that directors owe their fiduciary duties to the corporation that they serve. However, a more complicated picture emerges when the company begins to struggle. Over the years, courts have changed their view on this topic. A 1991 Delaware case, Credit Lyonnais, led some courts and commentators to conclude that once a company nears the “zone of insolvency,” the duties of its directors and officers shift to include creditors. That approach has been reined in. Credit Lyonnais didn’t mean what people thought it meant, and later Delaware decisions made clear that the zone of insolvency has no existence for purposes of fiduciary duty claims; the transition occurs at the point of insolvency itself. Being “in the zone of insolvency” does not, standing alone, trigger the shifting of the fiduciary duty of directors and officers of a corporation to include creditors of the corporation.
What happens at that point? Once the corporation is insolvent, in Delaware at least, creditors have legal standing to bring action against the directors of the corporation to enforce the fiduciary duty of directors owed to the corporation. However, creditors do not have the right to sue to enforce fiduciary duties owed directly to them. The reason is simple: an insolvent company has no equity left, so it is the creditors, not the shareholders, that have become the ultimate beneficiaries of its residual value. The directors’ fiduciary duties continue to be owed, as always, to the company, not to the creditors. But they now owe them not for the benefit of the shareholders but for the benefit of the creditors, as the potential recipients of any residual value left in the company. The “benefit of the creditors” takes over from “benefit of the shareholders.”
Symptoms of Insolvency
So when is a company insolvent? There are two tests. The first is balance sheet insolvency, when your liabilities outstrip your assets. (Courts look at the fair market value of the assets.) The second is cash flow insolvency, where a company is unable to pay its debts when they become due and payable. It sounds simple, but it can be pretty tricky to prove that a company is unable to pay its debts. The exact moment a company crosses the line may not be easy to identify, which is exactly why the people in charge need to be fully informed. The tendency to downplay the seriousness of the situation is understandable. But the owner of a struggling business needs to recognize the symptoms of insolvency and take appropriate action.
In practical terms, does this mean every owner needs to be a lawyer, accountant or doctor? Not at all. It simply means being aware of the areas of possible concern and asking the right questions. It means involving your attorneys, accountants and other advisors appropriately. If you are starting to experience liquidity issues, it means planning for a moment when your company may no longer be able to pay its bills when due. Directors do not need to be perfect or wise or lucky. But at the first sign of trouble, a director should be asking questions and gathering information. That is why the chain of command matters for a business under financial stress in 2026: you need to know who is making the decisions, whether they are informed and acting in good faith, and to whom their duties run as your company’s finances change.
