Governance

Fiduciary Duties in Insolvency

Regardless of its financial situation, a corporation’s board of directors owes fiduciary duties to the corporation. Boards of directors of emerging companies, like mature companies, should understand the scope of their fiduciary duties and to whom and what those duties extend as they respond to the corporation’s financial situation in the current climate. Issues surrounding satisfaction and breach of fiduciary duties can be complex and situations differ. Directors and businesses should confer with counsel regarding specific issues that arise and concerns they have.

Fiduciary Duties Generally

Generally, directors owe two fiduciary duties to a corporation:

Duty of Care. The duty of care requires directors to use the same amount of care that an ordinarily prudent person uses in similar circumstances. Directors must make informed decisions when exercising judgment.

Duty of Loyalty. The duty of loyalty requires directors to act in good faith for the benefit of the corporation. Directors must act in the corporation’s best interests and not elevate the director’s personal interests above the corporation’s interests.

For a more fulsome discussion about fiduciary duties and how board decision-making could be scrutinized, see our post about board duties here.

Duties Upon Insolvency

A corporation’s board continues to owe fiduciary duties to the corporation upon insolvency. Delaware courts have rejected the idea that fiduciary duties shift from stockholders to creditors for companies operating in the “zone of insolvency,” but things do change upon insolvency.

A corporation’s creditors are typically protected by their contracts and related laws. However, once a corporation becomes insolvent, creditors are at risk of not being paid and become the primary beneficiaries of any residual value of the corporation. Upon insolvency, creditors have the right to pursue derivative claims on behalf of the corporation.

Practical Advice

Whether or not the corporation is facing insolvency, directors have broad discretion to engage in activities that they, in good faith, believe to be in the corporation’s best interests. Still, directors should always take precautions to comply with their duties, protect the corporation and minimize their exposure to personal liability. Some of these precautions include:

Stay Informed and Maintain Records. Ensure that the board of directors has received and considers all material information related to any business decisions and maintains complete records documenting deliberations and actions.

Monitor the Corporation’s Financial Situation. Understand the corporation’s cash position, burn rate, bank facilities, other credit arrangements, and whether the corporation is at risk of breaching financial covenants or experiencing other signs of financial distress. Review financial statements, business plans, projections, and assumptions carefully. Analyze the corporation’s access to sources of cash and address creditor liabilities. Ensure appropriate actions are taken in light of the information gathered and considered.

Open Communication with Management. Keep open communication between the board and management and ensure the corporation is best prepared for risks in the industry and economy. Directors should also confer with each other.

Maximize Corporate Value/No Preferential Treatment. Maintain neutrality and maximize the corporation’s value for the benefit of all stakeholders.

Avoid Conflicts of Interest. Do not engage in self-dealing and obtain appropriate approvals for any insider transactions, such as through disinterested director or stockholder approval.

Retain Independent Counsel and Outside Experts As Needed. Consider retaining financial advisors to provide objective advice on the corporation’s financial position and prospects. Also, consider retaining counsel for the board of directors independent from the corporation in the event of a conflict.

Be Thoughtful About Resignation. When considering resignation from the board, confer with independent counsel on whether to resign and, if so, how and when.

D&O Insurance. Review the directors and officers (D&O) insurance coverage that is in place, including the applicable limits, scope and periods of coverage.

Dealing with “Dead Equity”

“Dead equity” refers to company stock owned by individuals and entities no longer contributing to the company. In general, there are two types of dead equity seen on emerging company cap tables: Departed founders/employees. A co-founder or early employee leaves a company or no longer significantly contributes […]