What To Do When Your Company May Be Insolvent

Suppose you sit on the board of directors or are a significant owner of what was a successful company. Suppose further that the company’s fortunes have taken a turn for the worse, and it is now insolvent or nearly so.

What do you do?

What Not To Do

First, do not resign out of a knee-jerk reaction, assuming it will relieve you of potential liability.

The general principles governing fiduciary duties apply whether a company is solvent or not. Essentially, a director has a duty of loyalty and a duty of care to the company. Discharging these responsibilities is not that difficult in practice. [i]

Leaving aside the moral obligation to not abandon a company when it needs you, doing so as things are becoming worse is not generally the best strategy to avoid potential liability. If mistakes happen on your watch for which you bear some responsibility, leaving will not absolve you of responsibility. Instead, leaving eliminates any chance of being part of a solution that alleviates the problem. For these reasons, one seldom sees an experienced private equity professional, for example, resigning from the board of a financially distressed portfolio company, even one filing for Chapter 11.

Corporate Director Fiduciary Duties

While neither the extent of a director’s fiduciary duties nor how a court may judge whether those duties were fulfilled change due to insolvency, something important does change: the constituencies to whom you owe fiduciary duties. You already know this on some level, at least you should if you serve on any company board, but to refresh:

1. Directors owe fiduciary duties only to a solvent company’s equity holders.
2. Directors owe fiduciary duties only to an insolvent company’s creditors.
3. Writing more precisely, in both cases above, directors owe fiduciary duties to the company. Since the company’s residual (a/k/a beneficial or equitable) owners are its equity holders when the company is solvent and its creditors when the company is insolvent, we (attorneys and courts) tend to write and speak in shorthand in terms of duties being owed directly to whoever the company’s residual owners are.
4. Since solvency is often very hard to determine, courts developed a legal fiction called the “zone of insolvency,” which is the gray area in which a company is right on the thin line between solvency.
5. Volumes of cases and commentaries exist on the subject (and how a director’s fiduciary duty expanded to include creditors when it is not clear whether a company is solvent or insolvent). However, most of those volumes are outdated because some years ago, the most influential courts decided to discard the theory altogether.

The bottom-line: courts decided this way because they wanted to protect directors from answering to two masters (i.e., equity and creditors) in the gray zone.

The general rule is now that corporate directors need to do what is best for the company (i.e., the enterprise) itself, regardless of who the residual owners of the enterprise may be.

All the above is incredibly abbreviated. Courts differ in their views. Facts matter. And the law continues to evolve.

Insolvency Is in the Eye of the Beholder

Whether a company is insolvent is sometimes evident and sometimes not.

Courts commonly determine solvency status by subjecting the company at issue to one or more of the following ‘tests’:

• The Cash Flow Test: Can the company pay its debts as they normally come due?
• The Balance Sheet Test: Are the company’s assets worth more than its liabilities?
• The Adequate or Reasonable Capital Test: Is the company likely to survive in the normal course of business, considering reasonably anticipated business fluctuations over a reasonable time? [ii]

Each test is inherently subjective, and an entire industry of experts exists, whose members battle each other in courts across the land over what each means and how they should be applied. [iii]

So, What Should You Do?

At the risk of stating the obvious:

1. Conserve cash. [iv]
2. Review all business insurance policies.
3. Review contracts for provisions that may excuse performance.
4. Don’t bury your head in the sand.
5. Don’t be too quick to throw in the towel.
6. Don’t be afraid of saying “no.”

Just Say “No”

This last point warrants elaboration. Some lenders, landlords, and other creditors may take very tough stances, making threats and demands. They may want more collateral. They may seek a personal guaranty where there was none before or the collateralization of a PG. They may ask you to stand down for a friendly foreclosure. [v] They may ask you to waive claims against them. They may even suggest you reach into your 401k (or other assets that creditors cannot seize) to pay them.

Just say no, at least until you retain an experienced corporate restructuring attorney. And remember, agreeing to nothing is not equivalent to doing nothing.

If your company is facing insolvency get smart about the general topics of corporate restructuring, insolvency, and bankruptcy. [vi] Seek out an experienced corporate restructuring attorney with whom you feel comfortable. Make sure you understand your options and understand the legal landscape enough to avoid making fundamental mistakes that could cost you dearly.

Commercial lenders are generally rational actors. They typically understand, and even commonly prefer, their defaulting borrowers to be adequately represented.[vii]

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Minority and Illiquidity Discounts
2. Dealing With Defaults
3. How to Prepare for Sale

This is an updated version of an article originally published on January 5, 2022.]

©2024. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.

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[i] Some courts and commentators refer to other fiduciary duties, but those other duties are best viewed as subsets or examples of these two main duties. My statement, “it is not that difficult in practice to discharge both duties,” could easily be interpreted as too cavalier and, to be clear, it assumes that a director is experienced, attentive, and well advised. My use of the words “not that difficult” should not be confused to suggest the contrary or that fulfilling one’s duties doesn’t take hard work. It does. What I mean is that the principles are well understood. Also, unique times may call for unique action. For example, no one should be able to fault a company’s failure to screen workers for COVID-19 back in November 2019. Not to do so today, however, may be a different story. See In Marchand v. Barnhill, 212 A.3d 805 (Del. 2019), where the Delaware Supreme Court suggested the board of directors had heightened oversight responsibilities in times of a health crisis. The court found that the board of a company dealing with a listeria outbreak that had a significant impact on the company’s operations “failed to implement any system to monitor [the company’s] food safety performance or compliance.”

[ii]  This test, which is most commonly used in the context of a specific business transaction to determine whether that specific transaction rendered the company insolvent, allows a finder of fact (i.e., court) to consider factors that the other tests do not, such as available credit and debt repayment schedules. Some courts and commentators refer to other fiduciary duties, but those other duties are best viewed as subsets or examples of these two main duties. My statement, “it is not that difficult in practice to discharge both duties,” could easily be interpreted as too cavalier and, to be clear, it assumes that a director is experienced, attentive, and well advised.  Editors’ Note: to learn more, read [cite to tield and theink link to https://www.kirkland.com/siteFiles/kirkexp/publications/2280/Document1/Shades%20of%20Gray.pdf

[iii]Read more about the various contexts in which the question of valuation arises and is fought about in the context of a financially distressed company in “Valuation: The Pillar of Corporate Restructuring.”

[iv] Read more in How a Distressed Company Can Manage Cash and Stakeholders in a Liquidity Crisis.

[v] Keep in mind that when duties are owed to creditors, they are owed to all creditors and not just to secured creditors.

[vi] Excellent starting points (forgive my immodesty but respect my acknowldgement of same) include: Dealing with Corporate Distress 01: Hello Darkness, Our Dear Friend and Opportunity Amidst Crisis.

[vii] Read 90 Second Lesson: What will your lender do if you default on a commercial loan? for more.