6/4/2020 (re-published in TerraLex Connections - 8/7/2020)
Running a successful business is a tough job. In the age of pandemic, it’s even tougher. Deciding how best to manage your business over the next several months and years is akin to answering the Mad Hatter’s riddle; there is no right answer. As you chart the course, it might be helpful to have in mind the standards by which your decisions will be judged if it ever comes to that.
A. Officers and directors have a fiduciary duty to the company’s shareholders and, sometimes, to its creditors.
Corporate officers and directors owe a fiduciary duty to the company and its shareholders (or members in the case of a limited liability company) to make decisions that reasonably protect and conserve the company’s interests.
So, what defines a fiduciary duty? Fiduciary duty is actually comprised of two separate duties: the duty of care and the duty of loyalty. The duty of care refers to the officer’s or director’s responsibility to exercise the level of care that a reasonably prudent person would use under similar circumstances. The duty of loyalty means the officer or director will be guided in their decisions by the company’s best interests, not their own self-interest.
If an officer or director fails to abide their fiduciary duty, they can be held personally liable for the consequences. Of course, officers and directors have different spheres of influence and each can be held individually liable only to the extent of their discretionary authority over, and power to influence, the company’s relevant actions. Just to underscore the risk, if a director fails in their fiduciary duty to the company resulting in an unwarranted $1 million or greater loss, the director or officer could risk being held liable for that loss out of their own personal assets.
An officer’s or director’s fiduciary duty gets more complicated when the business hits the economic skids. Once a company enters the “zone of insolvency,” or is actually insolvent, an officer or director has to include creditors’ interests in their decision making. This shift is required as the company’s financial troubles deepen because in a liquidation, distress sale or bankruptcy proceeding, its assets are more likely to be utilized to satisfy creditor claims than shareholder interests.
The shift in the scope of an officer’s or director’s fiduciary duty to include creditors expands and complicates an officer’s or director’s potential liability. In the ordinary course, where the company is generating a profit (or at least reliably breaking even), officers and directors can ignore the interests of creditors who are obliged to protect themselves. When creditor claims fall within the scope of officers and directory fiduciary duty, however, those creditors can also pursue claims for any alleged breach of that duty and seek their claimed losses.
How a director or officer meets their fiduciary duty is not always obvious. Let’s say, for example, that the business has slowed and payment of accounts receivable has been delayed. As a result, it looks like the company will need to draw on its line of credit to survive the financial rough patch. There is, however, no certainty that business will pick up in the next six months, or even the next two years. If it doesn’t, the company will have to consider taking on further debt, otherwise restructuring or closing its doors. If the company were liquidated in the near term, however, the proceeds would comfortably cover the company’s outstanding debt obligations, but nothing more.
Does the director, confronted with this scenario, already have to consider creditor interests and if so, over and above shareholder interests? Is the company in the "zone of insolvency?" Is it important to consider that if the company closes then its employees, including the executive staff, will be out of a job in a tight (maybe nonexistent) jobs market? Is it appropriate to make a bet on the company’s long term chance of survival or instead should a director look to protect and conserve corporate assets so that existing creditors can be paid what they’re owed?
B. The saving grace of the business judgment rule.
While considering scenarios of this type, a director should draw some comfort from the so-called business judgment rule that provides a safe-harbor against the prospect of liability for the breach of his or her fiduciary duty.
Under the business judgment rule, courts presume that a director or officer make their decisions in good faith, with the company’s best interests in mind, after having reasonably assembled and considered adequate information. The rule is predicated on the belief that directors and officers, not litigants and the courts, are best suited to make good business decisions. The rule is designed to protect against directors and officers making overly conservative decisions or qualified individuals from assuming leadership positions out of fear of expansive liability. As a practical matter, the rule sets a high bar for a party seeking to pursue a fiduciary duty breach.
The presumption afforded by the rule can, however, be destroyed where an interested party can rebut the presumptions implicit in the rule. For instance, the director or officer would lose the benefit of the business judgment rule if a shareholder or creditor (again, depending on the solvency of the business) established that the director or officer had merely “rubber stamped” a decision, or otherwise proves the officer or director failed to exercise reasonable care in securing and considering pertinent information. Likewise, the business judgment rule evaporates where the director or officer engages in self-dealing or where the questioned decision-making is grossly negligent.
The best way for directors and officers to avoid liability is for them to meet the terms of their duty to their companies. Preliminarily, this means having systems and procedures in place that allow the officers and directors to exercise reasonable oversight. The company should, for instance, have regular board meetings, with regular financial reporting and means of assuring that the reports are accurate. It also means having the tools available to analyze issues as they come up. This may require that the director or officer insist that the company retain experts (e.g., lawyers, investment advisors, doctors and property appraisers) who can advise on issues outside the board’s or C-suite’s expertise.
In addition to having sufficient background information, the director or officer needs to evaluate it fully. Failing to examine the issue before exercising one’s independent judgment is little better than exercising no judgment at all.
The requirement that a director or officer exercise independent judgment applies even where it is plain that they will be on the losing side of any dispute over the right thing to do. Notwithstanding that they will be outvoted or outmaneuvered, the officer or director still has to articulate their concerns to the other decision makers. While the potential accrual of a director’s or officer’s liability ends once they have resigned from the board, resignation in the midst of a dispute, standing alone, will not likely absolve the director or officer of liability that in fact accrued during their tenure in office. Therefore, to the extent possible, the director should attempt to fix problems before leaving or at least attempt to do so and document those attempts.
Two further means of protecting against officer and director liability are: 1) the inclusion of an exculpatory clause in the company’s corporate charter or operating agreement; and 2) the purchase of appropriate officers’ and directors’ insurance.
An exculpatory clause that frees the officer and director from liability for negligent decision making further insulates the officer or director from personal liability. Such a clause cannot eliminate or limit the liability of a director: (i) for any breach of the director's duty of loyalty to the corporation or its stockholders; (ii) for acts or omissions not in good faith; (iii) for acts involving intentional misconduct or knowing violation of the law; or (iv) for any transaction from which the director derived an improper personal benefit. Simply put, an exculpatory claim largely eliminates claims based on the duty of care.
Finally, officers and directors should work with an insurance broker so that the company or they secure adequate coverage for any claimed errors and omissions they may make or be accused of making. In establishing coverage, be sensitive to who controls and is entitled to the policies benefits. It can be problematic if the policy is written in favor of the company and the company files for bankruptcy protection. Because Director and Officer policies can be complicated, determining the one that fits the circumstances will benefit from expert guidance.
 Without getting too far into the weeds, there are several ways to establish “insolvency” including: balance sheet insolvency; valuing assets at fair market value or fair value; ascertaining whether the company is able to meet its debts as they become due; and, assessing whether the company will be able to cover its anticipated debts with its anticipated income.