When Insolvency Looms: Knowing Where You Stand
The credit crunch and resulting recession have led to unprecedented instability for many companies across all sectors. As companies have faced significant challenges, corporate counsel have had to address a range of issues which were unimaginable during the boom years. In situations of financial distress, corporate counsel have had to work under pressure to provide their boards and management with prompt, practical and prudent advice on how to approach the difficult legal issues raised by recent events. Given the weak economic environment and ongoing credit constraints, companies and their corporate counsel will likely face further tests and challenges over the next few years.
Seventeen years ago, the Delaware Chancery Court launched a thousand client alerts by opining in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., Del.Ch., C.A. No. 12150, that "in the vicinity of insolvency, a board of directors is not merely the agent of the [stockholders], but owes its duty to the corporate enterprise." The court added in a footnote that, in this "zone of insolvency," the efficient and fair course may diverge from the course that the stockholders, or any single group of stakeholders, might take. These comments were seized upon to posit that when a corporation entered this indeterminable zone, the fiduciary duties of directors shifted, from being owed to the corporation and its stockholders to the corporation and its creditors. At the time, many interpreted the Credit Lyonnais decision as empowering creditors with the right to assert direct claims against corporate directors.
The concept of direct pre-insolvency exposure to creditors was explosive and troubling news for directors. Until then, the prevailing view was that directors' duties shifted from stockholders to creditors only upon actual insolvency. However, in the years that have followed, as further cases have provided additional analysis and clarity, directors have been somewhat reassured that the practical impact of the Credit Lyonnais decision is in fact minimal.
As the liquidity crisis began to unfold in 2008, courts continued to lend an understanding ear to directors. The courts have recognized the great financial, governmental and time pressures faced by boards in negotiating and signing merger transactions in conditions exacerbated by the global financial crisis. The courts have expressed a great reluctance to second-guess informed, good-faith decisions made by boards to avert bankruptcy. As North Carolina Superior Court Judge Albert Diaz said in the case challenging the Wells Fargo/Wachovia merger, Wachovia's board faced "an unprecedented financial tsunami." (Ehrenhaus v. Baker et al., No. 08 CVS 22632).
The cases since Credit Lyonnais that have refused to recognize theories such as the action for "deepening insolvency" have left Delaware directors feeling a bit more confident of their ability to navigate treacherous financial waters free of judicial second-guessing. Counsel should however, in an abundance of caution, remind boards of the importance of considering creditors' interests as soon as the corporation becomes financially distressed, even though directors do not yet owe fiduciary duties to those creditors.
Basic Principles
While the "business judgment rule" and the fundamental protections afforded by corporate law should insulate directors from personal liability in most situations, corporate counsel must advise directors to proceed with caution. Corporate counsel should advise their directors to follow some basic principles when the specter of corporate insolvency looms.
1. Monitor Legal Developments. Regularly refresh your understanding of fiduciary and other statutory duties. Do not simply rely upon what you were told in the past. This is a fact-driven, dynamic area of the law, in which courts and legislatures regularly change the rules or attempt to give greater clarity to vague concepts. The advice that served well in one situation may not apply equally to the set of facts that you are dealing with now.
2. Take a Balanced Approach. In the "zone of insolvency," it is best to avoid unduly favoring the interests of stockholders over creditors. For example, boards must think carefully before approving dividends, share repurchases or other transactions which return capital to stockholders. Corporate counsel may require assistance from expert external counsel if the board is considering a significant transaction. It may be appropriate that the board retain its own independent advisers.
3. Review the Corporation's Solvency. Engage actively in understanding the financial statements presented to you. A clear understanding of the corporation's assets and liabilities, working capital and capacity to service debt, and performance against business plans is critical. Question the feasibility of plans and projections, as well as the assumptions that underlie them.
4. Maintain Records. Ensure that board minutes record the efforts that the directors and officers make to discharge their duties. Conflict disclosures, requests for and consideration of information material to significant decisions, such as management recommendations, and the recognition of insolvency considerations should all be duly and properly memorialized. Recording sensitive board deliberations is a job for experienced counsel - remember, the inclusion of irrelevant details could be as dangerous as the failure to provide sufficient detail.
5. Insist Upon Full D&O Protection. To the extent possible, insist upon charter and bylaw provisions that represent best practice with respect to exculpation, indemnification and expense advancement (be aware that there are limitations to the utility of these provisions, particularly in bankruptcy). Confirm that your corporation maintains adequate D&O insurance, understand its terms and/or consider purchasing an additional personal layer of coverage. When appropriate, consider requesting an indemnification agreement to supplement both the charter/bylaws provisions and the D&O insurance coverage. Confirm where insurance proceeds will be received in the event of a bankruptcy. Yes, all of this can be expensive and time consuming, but these are important lines of defense in case of litigation and potential personal liability.
6. Avoid Self-Dealing. When it comes to any transaction that could possibly be characterized as self-dealing of any kind, it is always essential to be beyond reproach. When insolvency is a possibility, it is essential that boards diligently comply with their obligation to disclose personal interests and avoid participating in decision-making if a conflict might be perceived. Receipt of fairness opinions for certain transactions may be appropriate. When in doubt, obtain professional advice.
7. Do Not Resign in Haste. Often a director will seek to resign when a crisis is looming - not because the director is shirking his duty, but rather because his "day job" requires his full attention and the director believes he may not be able to do justice to both roles. Before a director resigns his or her position, it is essential to give due consideration to how that resignation will be perceived. As a general matter, the law obliges directors to remain in office if their resignations might cause or permit immediate harm to the corporation or its business.
Gaining Full Understanding
While these seven principles are good "rules of the road" in almost any situation, in the context of the current financial crisis they are essential. Beyond these principles, corporate counsel should encourage directors to have a full understanding of all aspects of the corporation's financial picture. While a director's primary objective should always be to do the best possible job for the corporation and its various constituencies, in times of crisis a better understanding of the financial state of affairs will allow directors to more fully assist management in their efforts to steer the company clear of financial disasters. Corporate counsel may also want to recommend a few basic steps to help directors better understand the depth of potential problems:
• Maintain a Regular Dialogue. Engage in a dialogue with management with respect to the areas of the business that have been most affected. Seek to understand how these will impact budgeted initiatives, future plans and projections. Assess the impact of declining asset values, "mark to market" requirements and adverse ratings actions. Evaluate the performance of the management team in handling the challenges faced. Review the adequacy of the corporation's reporting structures—have you been caught unawares?
• Understand the Credit Facilities. Gain a working familiarity with the corporation's credit facilities, covenants and compliance history. Keep an eye on any assignment of loans, and caution management to exercise consent rights carefully. Be aware that one lender's failure to enforce a covenant does not imply the same treatment by the same lender or its assignees in the future.
• Take a 360° View. Monitor the financial health of key suppliers, customers and competitors. Question management as to the impact of supplier and customer insolvencies. Consider whether key contracts might be renegotiated in the light of current circumstances. Stay on top of industry trends, as well as the performance and problems of competitors. Remember, competitors approaching insolvency often take seemingly irrational actions which could further erode your company's revenues and profits.
Although the recession may have ended, the outlook for the balance of 2009 and beyond continues to be somewhat sobering. As the after-shocks continue to be felt, many corporations may well be operating in the "zone," whether or not they are aware of it.
It is fortunate that most courts recognize the real difficulties that directors face on a daily basis and the importance of having talented individuals willing to serve as corporate directors. While the risk of litigation and the possibility of personal liability may always exist, acting prudently and following a few sensible practices will not only lead to the best available outcome for the corporation, but it should all but eliminate the risk of personal liability. So if insolvency looms, directors are wise to follow the advice from their corporate counsel.
Frank Aquila is a partner and Peter Naismith is an associate in Sullivan & Cromwell's mergers and acquisitions group. They can be reached at aquilaf@sullcrom.com and naismithp@sullcrom.com, respectively. The firm advised the board of Wachovia in the transactions referenced in this article.