Strategies for Limiting Liability of Directors of a Distressed Private Company By: Bruce A. Fox
October 2021
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ince the emergence of the COVID-19 pandemic in March, 2020 and the resulting disruption to retail, hospitality and many other industries, and the more recent severe disruptions in the international supply chain, many businesses are experiencing severe challenges. And most directors of private companies know that when a privately-held corporation begins to feel the pinch of financial distress, and the prospect of insolvency looms, prudent members of the board of directors quickly take stock of their duties and responsibilities as board members. Most already know that under the applicable state corporate law they have fiduciary obligations, and are bound to act in the best interests of the corporation for the benefit of its stockholders. Those fiduciary obligations exist for directors of private corporations just as they do for directors of public corporations. But uncertainty may reign as the corporation’s financial position weakens. What actions do these obligations now require? To whom do these obligations now run?1 Whatever the financial condition of the corporation, distressed or not, the directors’ fiduciary duties to the corporation consist of both a duty of care and a duty of loyalty. So, for example, the directors can be liable to the corporation and its stockholders for damages suffered as a result of the directors’ failure to properly discharge their duty of care: did they inform themselves about the condition of the company’s finances and operations, ask appropriate questions of management, provide reasonable guidance on operational strategy and legal compliance, identify and avoid imprudent operational risk to the business, identify the corporation’s current and projected capital needs, identify alternative means of securing any needed capital, assess the advantages and disadvantages of each alternative, engage in meaningful discussion of these matters? They may also be liable to the corporation and its stockholders if they fail to discharge their duty of loyalty: were they engaged in self-dealing or did they otherwise place their own interests above those of the corporation? But do these duties of care and loyalty ever extend to the corporation’s creditors as well? When the corporation’s financial condition begins to deteriorate and the creditors are at risk of not being paid, can they challenge the performance of the directors too? Does the board ever have a duty to consider the interests of creditors as a distinct class? If so, when does that new duty arise? Note that, for purposes of this article, we will focus primarily on the corporate law of Delaware. Admittedly, the scope of any particular director’s liability is a function of the law of the state in which the corporation was formed, and thus may vary from state to state. But Delaware’s corporate law is preeminent in the U.S., both because a majority of U.S. public companies are organized under Delaware corporate law and because the sophisticated Delaware corporate law courts have developed a robust body of thoughtful and well-articulated case law on corporate law matters. Judges in other states regularly look to Delaware corporate law for persuasive guidance, albeit not binding legal precedent. So, directors of privately-held corporations, wherever they were incorporated, would do well to understand the Delaware law on this subject and also investigate the law in their particular jurisdiction. 1 While this article focuses on companies organized in the corporate form, similar fiduciary duty issues may also arise in the context of a limited liability company or a partnership, although under the laws of Delaware and certain other states these fiduciary obligations may be waived in the company’s organizational documents. Neal, Gerber & Eisenberg LLP | Two North LaSalle Street Chicago, IL 60602-3801 | 312.269.8000 | www.nge.com
The courts of Delaware, as well as certain other states, have wrestled for years with the extent to which a troubled corporation’s board of directors may owe fiduciary duties to the corporation’s creditors, either once it has become insolvent or perhaps even as it merely begins the slide toward insolvency. With respect to the earlier of these two events, occurring at some ill-defined point before a corporation is technically insolvent, a number of states followed the lead of a 1991 Delaware Chancery Court case finding that the fiduciary duties of directors may “shift” to include obligations to creditors as a corporation entered the “zone of insolvency,” even when it is not yet technically insolvent.2 Since Delaware did not then decide the nature of the creditors’ rights—could they sue directors directly, or only derivatively enforce the rights of the corporation itself?—some states came out on either side of this latter question.3 But the Delaware courts soon came to appreciate that the “zone of insolvency” standard was largely unworkable, and fully reversed course in the Gheewalla decision in 2007.4 Shortly thereafter, a California Appellate Court similarly rejected the “zone of insolvency” standard.5 Thus, in most cases, the “zone of insolvency” is a legal concept that has outlived its usefulness and application, and a board of directors is now free to focus solely on the transition from solvency to insolvency, based on traditional understandings of insolvency. But any particular board would do well to confirm the status of the “zone of insolvency” concept in the state of its corporation’s incorporation. The Delaware Supreme Court’s 2007 decision in Gheewalla is noteworthy in two respects: In addition to its abandonment of the “zone of insolvency” standard, it also made clear that even after a Delaware corporation has crossed the threshold into insolvency, its creditors merely have standing to bring derivative actions to enforce the corporation’s rights against directors, but have no standing or right to bring actions in their own name directly against the corporation’s directors. In short, whether or not the corporation is insolvent, the board of directors of a Delaware corporation have a duty to protect the interests of the corporation and the value of its assets and business, not a duty to its creditors in their own right. Thus, the first order of business is for the directors to take all appropriate actions, some of which are discussed below, to assure and document that their fiduciary duties of care and loyalty to the corporation are appropriately discharged. Those actions alone may not be sufficient to protect the directors from personal liability arising out of their approval of certain corporate transactions. Of critical importance is the legal standard that the courts will use to assess the conduct of a corporation’s directors. In the general case, directors who have acted in good faith will not be found liable for their decisions as directors so long as they have not violated either their duty of care or their duty of loyalty. This is the so-called “business judgment” rule, which is generally applied from state to state and is deferential to the board. But a far different and stricter standard will be applied by the Delaware courts when the board approves a transaction involving a controlling stockholder or with respect to which a majority of the board is deemed to be “interested,” as is often the case with a distressed corporation. In such a case, the “entire fairness” of the transaction will become subject to review, both as to the process which was followed (“fair dealing”), and the actual economic terms as applied to minority stockholders (“fair price”). Generally, the board bears the difficult burden of proving that a transaction falling within the “entire fairness” standard is entirely fair. But under Delaware law the burden of proof may be shifted to the party challenging the transaction if either (i) the transaction was approved by a majority of votes held by the minority stockholders, or (ii) an independent committee of the board, consisting solely of disinterested directors, reviewed and approved the transaction. 2 Credit Lyonnais Bank Nederland, NV v. Pathe Communications Corp., (Del. Ch. Dec. 30, 1991) 3 See, for example, Weaver v. Kellogg, 216 B.R. 563, allowing creditors of Texas corporations to bring actions directly against directors once the corporation has entered the “zone of insolvency” (Bankr. S.D. Tex. 1997) 4 North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92, 99 (Del. 2007) 5 Berg & Berg Enterprises, LLC v. Boyle (Cal. App. 2009) Neal, Gerber & Eisenberg LLP | Two North LaSalle Street Chicago, IL 60602-3801 | 312.269.8000 | www.nge.com
Based on all of these considerations, here are a few thoughts on what a board of directors of a distressed corporation may wish to consider when presented with a potential course of action: 1. Research the Applicable State Law on the “Zone of Insolvency” and Directors’ Fiduciary Duties to Creditors. As indicated above, the rule in Delaware (where many companies are formed) is that a company’s approach into the “zone of insolvency” doesn’t afford its creditors any special rights or status to assert claims for the directors’ breach of a fiduciary duty. If the corporation has been formed in a jurisdiction other than Delaware, ask your lawyer to advise you on whether board members have any duties specifically to creditors, the nature of any such duties, and when they arise. If any such duties exist, be sure to take them into account in board deliberations. If there aren’t any, focus solely on the interests of the corporation itself, and the preservation of the value of its assets and business. 2. Make a Record of the Board’s Careful and Thorough Consideration of the Corporation’s Financial Situation and its Alternative Paths Forward. First, to discharge its fiduciary duty of care, the board should have strong evidence that it fully investigated the corporation’s financial situation and its available alternative sources of capital, and explored the implications of each option. This should include evidence that it gathered all relevant facts as to the corporation’s capital requirements, reviewed the accuracy and reliability of the facts as presented, inquired of management as to the alternatives for raising capital, and assessed the benefits and detriments of each of these alternatives. The board should consider whether the company should be required to engage an outside financial advisor to assist with the development of its strategy. The record should clearly show that the board has carefully reviewed and complied with the terms of the corporation’s existing stockholder agreements and credit agreements, and considered the impact of the proposed transaction on any existing options or other management incentives. The record should also clearly indicate the time-sensitive aspect of the corporation’s capital needs and the likely consequences of its failure to obtain such needed capital, since courts appear to be more solicitous of board action approving a transaction when the board is viewed as having little choice but to do so. Minutes of board meetings should indicate that the board engaged in meaningful deliberations with regard to all of these matters.6 3. Have Interested Directors Recuse Themselves. In Delaware and most other jurisdictions, the fiduciary duty of loyalty generally requires a director who has a conflict of interest of whatever nature to avoid participating in decisions that benefit the director’s own interests at the expense of the company. A director in a conflict position is therefore well advised not to attend any meeting where the subject of the conflict is raised, avoid participating in any deliberations of the matter, and have the minutes reflect that the director was recused and did not vote on the matter. But recusal may not be an option in all cases, such as when most or all of the directors are interested in a transaction. 4. Form a Special Committee of the Board. In circumstances where the “entire fairness” standard is likely to be applied, consider whether it is possible for the corporation to establish a special committee, consisting of independent and disinterested directors, which can be empowered to evaluate, negotiate and approve the down-round financing and its material terms. If such a committee can be constituted in the particular situation and approves the transaction, the burden of proof will shift to any party that may seek to challenge the transaction, greatly reducing the risk of an adverse outcome by forcing the challenger to prove by a preponderance of the evidence that the transaction was not “entirely fair.” 6 Lest it seem that the board will be required to conduct fundamental financial and legal analysis which it might not be qualified to undertake, it should be understood that the board’s responsibility is to marshal the appropriate resources and analysis and evaluate the output of professionals that it retains. It is deliberation over the analyses it receives from competent professionals, rather than original work by the board, that is expected by the courts. Neal, Gerber & Eisenberg LLP | Two North LaSalle Street Chicago, IL 60602-3801 | 312.269.8000 | www.nge.com
5. Obtain Approval From a Majority of the Disinterested Stockholders. If the “entire fairness” standard is likely to be applied and it’s not possible to establish a special committee that consists solely of independent and disinterested directors, perhaps the board can arrange for the transaction to be reviewed and approved by a majority of the corporation’s disinterested stockholders—which is the other way to shift the burden of proof to any party that might challenge the transaction. 6. Grant Existing Stockholders the Right to Participate in an Equity Financing. If an infusion of additional equity is being contemplated by a controlling stockholder and all existing stockholders are given the right to participate in the equity financing, whether or not they have preemptive rights, and they all receive full and proper disclosure of all material information regarding the financing and its context provided to them, the board and its controlling stockholder will have a powerful argument to add to their defense against any challenge of the “entire fairness” of the transaction—although this is no guarantee that the transaction is entirely fair. In many cases minority stockholders will not have the ability to participate in a proposed equity financing, even if they desire to do so, but at a minimum the offer for the minority stockholders to participate and preserve their percentage holdings will eliminate one strong argument that could otherwise have been made by those who might challenge the dilutive impact of the equity financing. 7. Make Reasonable Efforts to Secure Outside Investors. If a controlling stockholder is considering an equity infusion that will dilute minority interests, the solicitation of an equity investment by an independent third party can help establish the terms and conditions available to the corporation in the marketplace, which can then either be accepted by the corporation in place of an interested party transaction with a current stockholder, or used to demonstrate the fairness of the terms of the transaction actually entered into with a controlling stockholder. An inability to obtain an offer for an alternative financing within the required time frame, despite good faith efforts to do so, will also be an important fact supporting the defense of any challenge to the transaction. 8. Get a Fairness Opinion. If time allows and the corporation’s budget can support it, the board or special committee should consider engaging an independent financial advisor to review the proposed transaction and to deliver a formal opinion on the fairness of the price and terms to the minority stockholders. If a fairness opinion has been prepared by a respected financial advisor afforded a reasonable amount of time to conduct its due diligence and deliver its opinion, it can greatly enhance the defense of any challenge to the transaction. Serving on the board of directors of a privately-held corporation is certainly an honor, but it comes with duties and the attendant risk. To manage that risk, directors should take those duties seriously, in a privately-held corporation no less than in a publicly-traded one, and zealously discharge them for the benefit of the corporation to maximize the value available for all of its stakeholders.
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