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Best Practices for Directors of Privately Held, Financially Distressed Companies

Private equity firms routinely appoint directors to boards of their privately held portfolio companies and other investment vehicles, some of which will eventually face financial distress. Often, a person appointed to a board by a private equity firm has a relationship with the firm (e.g., they work there or are a trusted friend) but limited experience when it comes to what to do under troubled circumstances. Such individuals may worry about their personal liability in such a situation. What should such an individual do?

The first thing is to make sure that the board is functioning properly, meaning that it holds regularly scheduled meetings, keeps minutes for them, and observes other business formalities. In addition, it is critical that the director actively participates in those meetings and be prepared to both understand the situation and vote or take other actions based on an educated understanding of the circumstances. All of that should be standard operating procedure. 

From there, however, the director (and correspondingly, the board) will want to fill in any gaps in knowledge or experience that may result from the difficult circumstances. A nonexhaustive list of examples includes:

  1. Are things happening quickly, suggesting a need for more frequent or emergency board meetings? If so, schedule them and attend.

  2. Do adequate channels of communication exist with management? If not, establish and maintain them.

  3. Does the company have the right management team in place? If not, consider a change or additional assistance, such as appointing a CRO.

  4. Does the management team need help from a turnaround specialist or firm? If so, hire an individual or firm to assist either the CRO or the existing management team.

  5. Is the company working with experienced restructuring professionals with good ideas? Most lawyers and, for that matter, financial advisors will say they have the relevant experience—test that. Even if it has the proper experience, sometimes replacing the existing team can inject fresh perspectives or a different chemistry into the process.

  6. Does the board need its own counsel or advisors to guide it? If so, or when concerned about conflicts, hire them.

  7. Does the company’s budget need to be adjusted or restricted to control cash? If so, implement reforms. Creditors will expect 13-week rolling cash flows and more generally that the company is on top of its financial problems—make sure that the necessary information is at hand.

  8. Does the company have adequate liquidity for the near future? This is critical. Hoping that things will change in a few weeks is not sufficient. If the director is not reasonably comfortable that the company can pay its upcoming bills, the board should immediately explore ways to obtain additional cash.

  9. Would it be beneficial to involve key creditors or other stakeholders in strategy discussions? If so, involve them. No one likes surprises. And while alarming creditors or investors is something to be avoided, it is better to ease people into a difficult situation than to drop them into a crisis. Otherwise, they will lose confidence in the company.

This all may seem rather obvious, and the individual probably feels like it is what a prudent director should do under the circumstances. If so, the director is thinking about the situation in the right way and is exercising his or her fiduciary duties properly, which, in all circumstances, is twofold: (1) the duty of loyalty, and (2) the duty of care. 

Effectively, all of these questions go to the duty of care. A director must exercise reasonable effort, concern, and judgment, given the difficult circumstances. The duty of loyalty, which largely subsumes the sometimes separate duty of good faith, requires that there be no conflict between the company’s interests and those of the director. Directors must act in good faith and discharge their duties in the best interests of the company, avoid self-dealing, observe confidentiality obligations, and not abuse corporate opportunities for personal gain. As long as directors comply with these fiduciary duties, they are entitled to the protections of the “business judgment rule” and are generally not subject to liability for their decisions and actions.

Directors must act in good faith and discharge their duties in the best interests of the company, avoid self-dealing, observe confidentiality obligations, and not abuse corporate opportunities for personal gain.

Fear of the ‘Zone’

Still, in the back of the director’s mind, he or she might be concerned about the “zone of insolvency” and even “deepening insolvency” and worry about liability that he or she might incur to creditors if the board does not do something differently now that the company is in trouble. A company is considered to be in the zone of insolvency when it is near the point where (1) the sum of its debts is greater than its assets, and it has no reasonable prospect of continuing successfully or (2) the company is unable to pay its debts as they come due in the ordinary course of business.

The director, however, can take comfort in the fact that, for the most part, the law strongly favors the director so long as he or she continues to satisfy the duties of care and loyalty. Courts in most jurisdictions, including Delaware and New York, have specifically rejected the zone of insolvency theory, which argues that, because the shares of a potentially insolvent company are essentially worthless, directors should instead look out for creditors who may soon own the company. See North American Catholic Educational Programming Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007); RSL Communications PLC v. Bildirici, 649 F. Supp. 2d 184 (S.D.N.Y. 2009).

In addition, the theory of deepening insolvency, under which a troubled company would face liability for taking steps that worsen its condition, has also been rejected by most courts. See, e.g., Trenwick America Litigation Trust v. Ernst & Young, L.L.P, 906 A.2d 168, 205-06 (Del. Ch. 2006). The court in Trenwick stated: “The fact that the residual claimants of the firm at that time are creditors does not mean that the directors cannot choose to continue the firm’s operations in the hope that they can expand the inadequate pie such that the firm’s creditors get a greater recovery. By doing so, the directors do not become a guarantor of success.” Id. at 174.

By rejecting these theories, courts have reaffirmed that the directors of solvent companies, including those in the zone of insolvency, owe their duties to the company and its shareholders alone. For example, in Gheewalla, the Delaware Supreme Court found: “When a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.” 930 A.2d at 101. Only when a company has actually become insolvent do directors owe a fiduciary duty to creditors. See Bildirici, 649 F. Supp. 2d at 202.

Taken to the extreme, do these rulings mean that directors could take a troubled company’s cash to Las Vegas and gamble it to try to turn around the company’s fortunes? No. Betting all of a company’s money speculatively, where the odds are stacked against success, would violate the duty of care, and the directors would not be protected by the business judgment rule. But, it does mean that directors can go far in taking business risks and exploring perhaps very difficult scenarios before getting themselves into trouble. In fact, courts have held that “even when a firm is insolvent, its directors may, in the appropriate exercise of their business judgment, take action that might, if it does not pan out, result in the firm being painted in a deeper hue of red.” See Trenwick, 906 A.2d at 174.

Don’t Abandon Ship

Despite these protections, when a company faces financial distress or a possible restructuring, a director’s impulsive reaction might be to resign from the board instead of taking steps to guide the company through its troubles. However, this may not be the best move for several reasons, so a director who is considering abandoning ship should carefully consider the potential downsides of such a move.

First, resigning may result in the director not getting a release in any future bankruptcy or workout. Second, resigning does not insulate a director from any potential liability incurred prior to his or her resignation, which could be mitigated in time through action taken by the board. Third, it is possible that the director could be held liable for breach of the director’s fiduciary duties to the company, particularly if the resignation left the company in the hands of wrongdoers, crippled the board’s ability to further navigate its troubled circumstances, or otherwise made matters worse for the company.

Courts in key jurisdictions have sent a strong and clear message to directors of solvent and potentially troubled companies, and to potential litigants, that directors’ duties do not change, either in terms of what they are or to whom they are owed, when a company is the zone of insolvency. But, directors must always be mindful to do their job in accordance with their fiduciary duties. That sometimes includes not jumping from a listing or sinking ship. 

Chris Donoho

Christopher R. Donoho III

Hogan Lovells US LLP

Christopher R. Donoho III is a partner and head of Hogan Lovells US LLP’s Business Restructuring and Insolvency practice for the United States. He represents private equity clients or their portfolio companies in financially troubled situations, advising on refinancings, divestitures, or Chapter 11 bankruptcy reorganizations. 


Chris Bryant

Christopher R. Bryant

Hogan Lovells US LLP

Christopher R. Bryant is a counsel in Hogan Lovells US LLP’s Business Restructuring and Insolvency practice in New York. He acts for financial institutions and other clients in connection with distressed acquisitions and divestitures, Chapter 11 cases, and out-of-court restructurings and workouts. 


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