Serving as a director or officer on a board can be complicated, especially if the business is floundering.
Directors have certain duties to the company they are serving, but when the business is financially distressed, the beneficiaries of those duties switches to the creditors, according to Shawn Riley, the Managing Member of the Cleveland office of McDonald Hopkins LLC and co-chair of its Business Restructuring Services Department.
“In normal situations, those duties exist for the benefit of the owners,” says Riley. “However, when a business starts to experience financial distress, the obligations shift. Two questions arise: ‘When do they shift? And, how do they shift — in other words, who are beneficiaries of those duties?’”
Smart Business spoke with Riley about shifting fiduciary responsibilities and how recent court rulings are changing the rules of the game.
How are directors’ and officers’ fiduciary responsibilities defined?
The fiduciary responsibilities that directors and officers owe a business, particularly a distressed business, have been evolving. Recent court decisions suggest that the responsibilities are not as stringent as people thought they were just a few years ago.
Generally speaking, directors and officers owe their fiduciary duties to the company itself, for the benefit of the owners. To meet their fiduciary duties, directors and officers are required to fulfill two primary obligations — the duty of care and the duty of loyalty. The duty of care means they must be well informed and must reach well-reasoned decisions with respect to the company and its assets. The duty of loyalty requires that directors and officers act without conflict of interest, without benefiting themselves to the detriment of the business.
When do those duties shift?
When a company is in financial distress, case law has suggested that directors and officers have to ignore the interests of the owners and instead focus exclusively on the interests of the creditors. They must think about how to maximize the value of the business so as to pay creditors. That is a pretty significant adjustment in thinking, because directors and officers up to that point will have been running the business for the benefit of the owners.
So when, exactly, do those duties shift? Some argue that it is at the first sign of trouble. Others argue that it is only at the time of filing a bankruptcy proceeding. For others, it is the period when the business is insolvent, whether or not it is in bankruptcy. Until recently, the uncertainty over questions such as these has caused directors and officers to tread carefully.
The uncertainty in the law has diminished recently as courts over the past couple of years have introduced a dose of reason to the process. The courts have begun to suggest that the shift of duties does not occur as early as people were arguing, but rather when there is very clear evidence of insolvency, when the business simply cannot pay its debts. At that point, directors have to start thinking about the interests of creditors.
How do those duties shift?
While it seemed the rule was that directors had to completely ignore the interest of the owners, others argued that creditors’ interests and shareholders’ interest should be given equal weight.
Again, recent case law indicates that directors, even in an insolvency situation, should not ignore the interests of the owners but rather should make their primary concern the interest of creditors, at least until the point where they can demonstrate that the business is solvent again.
The continuing issue for directors and officers, however, is that this is usually judged after the fact, with the benefit of 20/20 hindsight. It is not as if, in the middle of its efforts to right itself, a business can call a timeout and ask a judge what it or its board should do. If the board is unsuccessful in turning the business around, its actions will likely be second-guessed by creditors.
Who can sue directors and officers for breach of fiduciary duties?
It is the company itself that is supposed to sue those directors and officers that it believes have breached their fiduciary duties. But it would be pretty remarkable if those directors who run the business authorize counsel to file suit against them.
Courts allow shareholders (and creditors) to assert derivative standing, in which a group of shareholders — or a creditors’ committee in a bankruptcy — sue on behalf of the company in a situation in which it would be futile to ask the company to sue. Anything that is recovered against the directors’ and officers’ insurance policies would then be distributed to the shareholders or creditors. However, the courts have started to impose tighter restrictions on the circumstances under which a creditors committee in a bankruptcy can file derivative actions. In a recent case involving a limited liability company in Delaware, the court ruled that only owners or members of the LLC could sue derivatively, meaning that creditors are not authorized to pursue directors and officers. Even if creditors could demonstrate that directors and officers clearly did something wrong that resulted in damage to creditor interests, they have no standing to pursue claims.
This may reflect a recognition that perhaps the pendulum had swung too far in one direction, authorizing aggressive lawsuits by creditors against directors and officers for marginal claims under otherwise reasonable decision points for directors. The pendulum is swinging back and the courts are limiting not only the time period claims can cover, but also the types of claims and who can file them.
This ruling may make people more willing to serve on boards, as they can join a board less worried about the potential for being sued. It should also reduce the cost of directors’ and officers’ insurance.
Shawn Riley is the Managing Member of the Cleveland office of McDonald Hopkins LLC and co-chair of its Business Restructuring Services Department. Reach him at (216) 348-5773 or firstname.lastname@example.org.