Pfeifer & Reynolds LLP - Attorneys at Law

THE DUTIES OF OFFICERS AND DIRECTORS IN TROUBLED COMPANIES[1]

 

By: Michael R. Pfeifer, Esq.

 

In December, 2001, Enron Corporation declared the largest bankruptcy in U.S. history, destroying thousands of jobs and billions of dollars in investor equity, and prompting 10 congressional committees, the Securities and Exchange Commission and the Justice Department to launch investigations.[2] Investors' market losses in the Enron crash are estimated to be from $30 billion to $60 billion, compared to only $15.9 billion estimated by the FBI as the value of all property reported stolen nationwide in the year 2000.[3] According to an internal inquiry ordered by Enron's board, senior managers used off-the-books partnerships to hide losses, fool investors, and enrich themselves.[4]

 

The Enron bankruptcy capped a record year for bankruptcy filings. According to the American Bankruptcy Institute, in 2001, the number of new bankruptcy cases filed was the highest since the Bankruptcy Code was enacted in 1978 and the number of big bankruptcy cases hit a new high.[5] And this pattern has every indication of continuing. On January 22, 2002, K-Mart Corporation became the largest retailer ever to file for Chapter 11 bankruptcy protection. By March, 2002, K-Mart had announced the closing of 284 stores in 40 states, and job cuts of over 22,000 in an effort to restructure its business.[6]

 

On January 28, 2002, Global Crossing, Ltd., the operator of a fiber optic network connecting 200 cities around the world, filed for Chapter 11 bankruptcy in the fourth largest insolvency in U.S. history.[7] With nearly $12 billion in debt, the company has been accused of using improper accounting methods to artificially inflate its revenues and is facing inquiries into its practices by the Securities and Exchange Commission, the FBI, and the U.S. House Energy and Commerce Committee.[8]

 

Faced with the spreading fallout of the Enron scandal, on March 7, 2002, President Bush announced a "Ten Point Plan" to tighten financial disclosure requirements for major corporations and improve investor protection. Under the proposal, chief executive officers would be required to personally guarantee the "veracity, timeliness and fairness" of their company's financial statements. Executives would have to forfeit any bonuses if the financial results had to be restated because of misconduct. CEOs or other top company officers who are caught abusing their power would not be allowed to serve in any corporate leadership positions again.[9]

 

Against this background of record bankruptcy filings and unprecedented scrutiny of corporate executives, the need for more careful consideration of the fiduciary duties of officers and directors in the shadow of insolvency has never been greater. This article, therefore, will review the existing rules in this area, highlight emerging issues in the interpretation and application of those rules, and outline some of the ways in which officers and directors are likely to face expansion of their responsibilities---and their liabilities---in the future. Specifically, the article addresses the following questions:

 

(1) Are there any additional or special duties of officers and directors in troubled companies, and if so, what are they and to whom are they owed? (2) When, exactly, do any such additional duties arise? (3) Who is entitled to recover for breach of these duties, and what remedies are available to them? (4) What defenses are likely to be most effective and why? (5) Is there insurance and, if so, whose insurance is it? (6) In what ways are the duties of officers and directors of troubled companies likely to change in the future?

 

I. Fiduciary Duties Beyond the Corporation and Its Shareholders

 

It is fundamental that directors and officers generally owe fiduciary duties of loyalty and care to the corporation and its shareholders. These duties are defined by state law, and their breach may subject both directors and officers to personal liability to the corporation and its shareholders. Essentially, the duty of loyalty requires that directors or officers, in good faith, place the interests of the corporation ahead of their own; i.e., avoid self-dealing at the corporation’s expense. The duty of care is the obligation of directors and officers to exercise reasonable prudence by investigating and deliberating adequately, and acting with the care that an ordinarily prudent person in a like position would exercise, under similar circumstances, in making business judgments for the corporation or its shareholders. [See e.g., Rev. Model Business Corp. Act §8.30(a)] In general, the same standards of fiduciary responsibility apply to directors and officers with discretion over the affairs of the corporation. However, the liability of directors who are not also officers may not be as great as that of officers with discretionary authority.

 

Ordinarily, these fiduciary duties are owed only to the corporation and its shareholders, and not to the corporation’s creditors. However, in the context of a corporate dissolution and liquidation, the vulnerability of creditors to opportunistic actions by insiders has prompted a number of courts to find a fiduciary relationship between such insiders and corporate creditors in order to prevent self-dealing by those in control of the corporation’s assets during the final days of its life. But, even without a formal bankruptcy filing, these duties have been held to arise when the corporation is “insolvent in fact”[See Geyer v. Ingersoll, 621 A.2d. 784 (1992 Del. Ch. Lexis 132)] or, in the words of the Delaware Court of Chancery, when the corporation is in the “vicinity of insolvency.” [See Credit Lyonnais Bank Nederland N.V. v Pathe Communications Corp., Civ. A No. 12150 (1991 Del. Ch. Lexis 215)] Under these circumstances, the board of directors’ obligation is to “the community of interest that sustained the corporation, to exercise judgment in an informed, good faith effort to maximize the corporation’s long-term wealth creating capacity.” [Ibid. at p. 83]

 

II. Insolvency And The "Vicinity" of Insolvency

 

Exactly when is a corporation in the “vicinity” of insolvency? The answer is not easy to determine, particularly in light of the fact that there is not even agreement among jurisdictions over the issue of when a corporation is in fact “insolvent.” Thus, section 101(32)(A) of the Bankruptcy Code defines “insolvency” as a “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation.” This so-called “balance sheet” test, which applies in many bankruptcy and non-bankruptcy situations (See e.g. state fraudulent transfer statutes), is complicated by various valuation issues, including whether the assets of the enterprise should be valued as a “going concern” or on a “liquidation basis.”

 

Another test of “insolvency” is so-called “equitable insolvency.” Under Delaware state law for example, “insolvency” is defined to exist “when the present fair salable value of the debtor’s assets is less than the amount that will be required to pay his probable liability on his existing debts as they become absolute and matured.” (Emphasis added.) [6 Delaware Code §1302]

There is also a third test of insolvency that directors and officers may need to consider: the “unreasonably small capital” test. This is a condition “short of equitable insolvency,” but that “is likely to lead to insolvency” in the future. [See Moody v. Security Pacific Business Credit, Inc. (Third Cir. 1992) 971 F2d 1056, 1063-64.] This test is relevant in the context of alleged fraudulent transfers, where transferors must not leave themselves with unreasonably small or inadequate capital or reserves, or risk the transaction being set aside.

 

III. Fiduciary Duties In Specific Situations

 

It would probably be impossible to enumerate all of the ways in which fiduciary duties to creditors could be breached. Depending on the jurisdiction, however, there are areas of activity that are more likely than not to create problems. For example, a director or officer may breach his or her fiduciary duties to creditors by taking corporate opportunities, by participating in or approving fraudulent conveyances (transfers by an insolvent entity that receives less than reasonably equivalent value in exchange for the transfer), "preferential" payments, or merely by failing to make "adequate" provision for the satisfaction of creditor claims. Other areas of relatively greater risk include payment or nonpayment of executive compensation, indemnification, or retention bonuses for directors or officers, other labor law issues (e.g., failure to pay wages, failure to pay withholding or sales taxes, severance or assumption agreements, mishandling of employee retirement or medical benefit plans), and mergers, acquisitions, "buy-outs," and new financing.

 

The interests of various constituencies to whom fiduciary duties are owed may be in direct conflict with each other. Thus, a director's duty of loyalty to the shareholders might favor an otherwise risky transaction that could possibly increase the value of equity by averting insolvency, while the duty to creditors might suggest avoidance of the very same transaction in order to maximize the corporation's net present value. A similar dilemma arises when the ability of the corporation to qualify for new financing requires subordination by current creditors of their existing debt. Depending on the circumstances, the task of sorting out these competing interests and identifying the prudent course of action, can be enormously complicated. As observed in classic understatement by the Delaware Court of Chancery in Credit Lyonnaise: "The possibility of insolvency can do curious things to incentives, exposing creditors to risks of opportunistic behavior and creating complexities for directors."

Complications also arise from the fact that there is a split among jurisdictions over whether the fiduciary duties applicable in the vicinity of insolvency are owed only to creditors, or also to shareholders, concurrently, or only primarily to creditors and secondarily to shareholders. Thus, some courts maintain that the directors and officers of an insolvent corporation are "trustees" of corporate assets for the benefit of creditors first, and stockholders second. Others take the view that directors and officers of an insolvent corporation no longer represent the stockholders at all. In such situations, experienced advisors may need to be retained, sophisticated financial analyses conducted, and careful consideration given to the requirements of the business judgment rule.

 

IV. "Standing" And Available Remedies

 

Creditors' remedies for management's breach of fiduciary duties include bringing direct claims against directors and officers, seeking the appointment of a receiver or bankruptcy trustee, intervening in litigation claims of the company, and seeking termination of the period of exclusivity within which a corporation in Chapter 11 bankruptcy has to propose a reorganization plan.

 

Outside of bankruptcy, creditors of insolvent corporations have standing to bring direct action on their own behalf for breach of fiduciary duties to them by an officer or director. These lawsuits are normally filed in state court, but may be brought in federal court if the jurisdictional requirements are otherwise met. The appointment of a receiver may be sought to take over management of the company if it can be shown that existing management is diverting or wasting assets. Generally, recovery in such direct actions has been limited to repayment of the creditor's contractual obligations.

 

Within bankruptcy, the standing of a bankruptcy trustee to sue directors on behalf of creditors of the company is well established. Creditors also have independent standing to sue for breach of fiduciary duty in bankruptcy court, whether or not a trustee has been appointed, but there is a split of authority on whether creditors may sue on their own behalf, or must bring their claims on behalf of the entire creditor class. And in cases where no trustee has been appointed, bankruptcy courts have also authorized creditors' committees to bring claims against directors of the debtor for misconduct and will normally entertain motions in a Chapter 11 case for appointment of a bankruptcy trustee for "cause"---i.e., gross mismanagement, asset transfers that harm the bankruptcy estate, or even management "incompetence."

 

Creditors may also seek to influence the settlement of pending litigation or the filing of litigation to enforce contingent claims. Prompt settlement of existing litigation may often be in the interests of creditors, while shareholders' interests may favor continued pursuit of a claim to judgment, no matter how long it takes. Outside of bankruptcy, creditors' involvement may take the form of procedural "intervention" in the actual litigation itself, or it may take the form of requests for prejudgment attachments, injunctions, or the appointment of a receiver based on management "misconduct." Within bankruptcy, creditors may also emphasize the need for timely administration of the estate, the availability of assets and/or "adequate protection" for creditor claims, and the likelihood of a debtor's "effective reorganization" to influence settlements or induce the filing or abandonment of claims.

 

During the first 120 days of a Chapter 11 case, debtors have the exclusive right to propose a plan of reorganization. This period can, and often is, extended by court order and provides considerable leverage to debtors in resolving creditor claims because, during the exclusivity period, only the debtor can bring an end to the process. However, under Section 1121(d) of the Bankruptcy Code, the court can reduce the exclusivity period "for cause"---which can, of course, include managerial misconduct.

 

V. The Business Judgment Rule

 

The most fundamental defense available for directors to any legal action asserting individual management liability is the Business Judgment Rule. As described by the Delaware Supreme Court the Rule is:

 

"a presumption that in making a business decision the directors acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company...A hallmark of the business judgment rule is that a court will not substitute its judgment for that of the board if the latter's decision can be 'attributed to any rational business purpose.'"[10]

 

A director of a solvent corporation is generally entitled to the benefit of the business judgment rule unless it can be demonstrated that the director has breached one of his or her traditional fiduciary duties of loyalty (including disinterestedness) and due care (including the good faith belief that the action taken is in the best interests of the beneficiary of the duty). In discharging the duty of due care, a director is entitled to rely, in good faith, on reports prepared by officers of the corporation or outside experts.

 

If the director's actions fail to satisfy the duties of loyalty or due care, however, the protection of the business judgment rule is inapplicable, and the director's actions are then evaluated by their "intrinsic fairness." When a corporation is insolvent, or in the "vicinity" of insolvency, the expansion of a director's or officer's fiduciary duties to include creditors of the corporation thus greatly increases the risks of liability and imposes even greater requirements of due diligence and thoroughness. Consulting experienced and well-regarded experts, carefully and completely reviewing their reports and recommendations and, if a bankruptcy has actually been filed, seeking bankruptcy court approval where possible, can help to satisfy these expanded requirements. Taking the time to understand, and where possible, consult directly with the various constituents (e.g., lenders, suppliers, customers, employees and shareholders) can also be valuable.

 

What is often not helpful, however, is simply to resign when the corporation is in the "midst of the storm." An officer or director may not resign "if the immediate consequence would be to leave the interests of the company without proper care and protection."[11] In the context of an insolvency---or within the "vicinity of insolvency"--- it is certainly more difficult to find a suitable replacement; and if the corporation's condition worsens after the resignation, to explain later to skeptical shareholders and creditors why the departure was not a contributing cause of further damage.

 

Even if it does not itself constitute a breach of fiduciary duty, resignation does not absolve a director of liability for actions taken while still a member of the board or for transactions "initiated" while a director, even if they are not finalized until after the resignation.[12] In rejecting the resignation defense (sometimes called the "Geronimo theory") the court in Xerox Corp v. Genmoora Corp.,[13] stated: "Under this theory, by analogy, if a commercial airline pilot were to negligently aim his airplane full of passengers at a mountain, and then bail out before impact, he would not be liable because he was not at the controls when the crash occurred."

 

VI. Indemnification And Insurance Issues

 

For the officers and directors of a bankrupt corporation, a key issue is whether the debtor corporation can and will continue to pay attorneys fees pursuant to an indemnification agreement. In this regard, even a debtor corporation in Chapter 11 reorganization will generally not be able to advance litigation expenses on a current basis unless it demonstrates that payments are to be made under an "executory contract" that may be "assumed" under Section 365 of the Bankruptcy Code, or that these expenses constitute allowable "administrative expenses" under Section 503(b) of the Code.

 

When the indemnification payments stop, the debtor's insurance company may then be called upon to make advances under the terms of the applicable policy. A number of courts have determined, however, that a policy that insures both the directors and officers against their direct losses, and the debtor corporation itself for its losses suffered through indemnification of those officers and directors when their own coverage is exhausted, is property of the debtor's estate and subject to the automatic stay against actions by third parties.[14] Other courts have held, however, that the pertinent question is not who owns the policy, but who is entitled to the proceeds, and if the answer is the officers and directors only, the stay does not apply and litigation can proceed against the officers and directors.[15]

 

VII. A Glimpse Into The Future

 

The last major recession, in the early 1990s, not only generated new legislation, but an array of judicial decisions that significantly increased the scope of responsibility---and the risk of potential liability---for directors and officers of troubled companies. The spectacular economic collapse of giants such as Enron and Global Crossing, and the accompanying public outcry for punishment of their management and major reforms are certain to result in further increases in both responsibility and culpability for officers and directors. These changes are likely to be dramatic, as reflected President Bush's "Ten Point Initiative" referenced at the beginning of this article. Just how far the "reforms" will go, however, will likely depend on the results of investigative hearings and investor lawsuits that have now only just begun. ¨¨

Michael R Pfeifer was admitted to the practice of law in 1976, and is the managing partner of Pfeifer & Reynolds, LLP., a litigation firm based in Orange County, California. The focus of his practice is lender liability defense, financial fraud recovery, creditor rights in bankruptcy, and litigation involving the rights and duties of corporate officers, directors, and service professionals. Mr. Pfeifer can be reached by telephone at (714) 703-9300, or by e-mail at mpfeifer@pfeiferlaw.com.

--------------------------------------------------------------------------------

[1] This Article is for general information and discussion purposes only and should not be construed as, or relied on, as legal advice. For more information or to consult with the author about possible legal representation, please contact: Michael R. Pfeifer at (714) 972-9300 or mpfeifer@pfeiferlaw.com.

[2] Reuters, March 7, 2002.

[3] U.S. News and World Report, March 11, 2002, p. 36.

[4] Reuters, March 7, 2002

[5] See A. Baldo, The 2001 Story, The Deal.com (Dec. 26, 2001); American Bankruptcy Inst. Press Release, Bankruptcy Filings Surpass Record Breaking Mark (Dec. 4, 2001)

[6] Reuters, March 8, 2002

[7] Ibid.

[8] Ibid.

[9] U.S.A. Today-Business, March 7, 2002

[10] Unocal Corp. v. Mesa Petroleum Co. (Del. 1985), 493 A2d 946, 954.

[11] See 1 Morawetz on Corporations §563; Zeltner v. Henry Zeltner Brewing Co. 174 N.Y.247, 253.

[12] See Xerox Corp. derivatively as a shareholder of The Genmoora Corp v. Genmoora Corp. (1989) 888 F2d 345.

[13] Ibid.

[14] See e.g., A.H. Robins Co., Inc. v. Piccinin (4th Cir. 1986) 788 F2d 994.

[15] See e.g. Duval v. Gleason (ND Cal. 1990) Bankr L Rep (CCH) ¶ 73,721.