Director and Officer Liability
© 2010 Cohn Whitesell & Goldberg
How does financial distress change the fiduciary duties of directors and officers? Is Chapter 11 the only way to avoid fiduciary liability? What are the consequences of resigning as director of a troubled company? How much protection does D&O insurance really offer? What are the do's and don't's for directors and officers of a company on the verge of Chapter 11 or an out-of-court debt restructuring?
Directors and officers have fiduciary duties to the corporation they serve.
The duty of care requires the use of reasonable care in conducting the affairs of the corporation. In order to protect directors, courts have developed the "business judgment rule" whereby a director or officer who exercises business judgment will have no liability even for decisions that turn out badly. It is possible for a Delaware corporation to include in its corporate charter a provision virtually eliminating liability for breach of the duty of care.
The duty of loyalty requires directors and officers to act solely in the interests of the corporation; a director or officer who has a personal interest in a proposed transaction with the corporation must disclose the interest, and a director generally may not vote on a transaction in which he or she has a personal interest.
Directors also have a duty of good faith. While the scope of this duty is still being shaped by the courts - and will likely be a topic of intense litigation in light of recent corporate scandals - the duty of good faith appears to require at minimum that directors try to properly perform their duties, for example, by keeping informed about important corporate matters.
To whom are these fiduciary duties owed? In the absence of financial distress, these duties are owed solely to the stockholders of the corporation. When a corporation approaches the "zone of insolvency," courts have determined under the corporate law of Delaware and some other states that directors and officers owe a fiduciary duty to creditors, too. This legal principle results in two difficult questions for the directors and officers of a financially distressed corporation: (1) how do you know whether the company has entered the "zone of insolvency"? (2) when a duty is owed both to creditors and stockholders, how can you discharge that duty without having personal liability?
Uncertainty in this area of the law means that in some situations, placing the corporation into Chapter 11 is the only way for directors to avoid an unacceptable level of personal exposure. Chapter 11 can reduce personal exposure for directors by providing for prior court approval of actions requiring a board vote outside of Chapter 11. However, CWG rejects the view that financial distress automatically requires a Chapter 11 filing. The firm's senior partner, Daniel C. Cohn, has counseled boards of directors of many troubled companies concerning their fiduciary duties, and has addressed this topic as part of continuing education programs for insolvency professionals, most recently for the American Bankruptcy Institute. Even when a corporation is in financial distress, directors and officers have the benefit of provisions of corporate law permitting them to rely on the advice of competent and independent professionals. To assure that directors and officers receive proper protection from reliance on professional advisors, those advisors must be experienced in insolvency matters and free from conflicts of interest. These standards may require that new counsel be engaged when insolvency looms.
To Resign or Not to Resign
Many directors consider resigning when their corporation enters a period of financial distress. Sometimes this is the best approach. Once the financial crisis is at hand, however, resignation will not eliminate whatever danger of liability has already arisen, and may damage the director's reputation. In some circumstances, resignation may even increase a director's personal exposure; for example, there may be liability for leaving the corporation without sufficient directors to enable the corporation to act at a critical time. Directors who continue to serve a corporation during a Chapter 11 case are often in a position to receive indemnification and/or releases as part of a consensual Chapter 11 plan. The decision to resign or to remain should be taken only after careful analysis of all potential consequences.
D&O Insurance
Situations of financial distress give rise to unique issues under insurance policies covering director and officer liability. If the corporation enters bankruptcy, will the policy still protect the directors and officers? While coverage will generally continue despite bankruptcy, some policy provisions may result in the bankruptcy court to treating proceeds of the policy as an asset of the bankruptcy estate - potentially harming the directors and officers. If the corporation is unable to meet its obligations, how will the deductible under the insurance policy be paid? Some policies provide for a waiver of deductible when the corporation is in bankruptcy, and in other situations it may be possible to establish an escrow account to fund deductibles. Whenever financial distress is on the horizon, or even when it is not, D&O coverage should be reviewed by counsel familiar with insolvency issues.
Other Liabilities
Aside from lawsuits alleging breach of fiduciary duty, directors and officers of a financially distressed corporation may be subject to other liabilities as well. In many states, managers are personally liable for unpaid wages to the corporation's employees. Especially when potential personal liability extends to vacation pay and employee benefits, it is wise for management to put into place a means to assure that these obligations will be paid by the corporation so that personal exposure can be avoided. Withholding taxes, sales taxes and any other taxes that the corporation is required to collect and remit to taxing authorities may, if not paid, be personal liabilities of directors and officers. (By contrast, the corporation's own tax liability - for example, income taxes, the employer's portion of social security, and so on - will seldom give rise to personal exposure.) Finally, directors and officers should be aware that press releases, letters, e-mails and even telephone discussions with creditors may generate personal liability for directors and officers of a troubled company. Even the act of accepting goods and services provided on credit may generate personal liability to a manager who has reason to believe the corporation will not pay for them.
In sum, when insolvency looms, it is vital for the corporation to address all potential forms of liability of its directors and officers, so that they will be able to devote themselves to the best interests of the corporation without being distracted by fears of personal exposure. Back to resource center
This article provides general
information concerning its topic. It is not intended to provide
legal advice or to create an attorney-client relationship.