Survival in the “zone of insolvency” Featured

8:00pm EDT August 26, 2007

At the first sign of corporate financial difficulties, directors and officers should examine the effect of their decisions on a number of interest groups, according to Gary Pemberton, a litigation partner at Shulman Hodges & Bastian LLP.

“You will be scrutinized,” Pemberton says. “Examine every decision you make. If your company ends up in bankruptcy, management’s prebankruptcy decisions may mean the difference between a creditor getting a nickel on the dollar or 50 cents on the dollar.”

Smart Business spoke with Pemberton, a business and bankruptcy litigator who has tried a number of cases involving failing companies, and asked him about the “zone of insolvency” and the perils it creates for corporate officers and directors.

What is the ‘zone of insolvency’?

The courts have come up with two tests that they have used to determine if a company is in the zone of insolvency. One is the balance sheet test. Do liabilities exceed the reasonable value of a corporation’s assets? The second is a cash flow test. Is a company not able to pay its debts as they come due in the ordinary course of business, or is the company about to enter into a transaction that will result in it being unable to pay its debts as they come due?

While the courts have shown some flexibility in applying these tests, if either of these situations exist, a prudent director or officer will assume that his or her company is in what is called the ‘zone of insolvency’ and act accordingly.

What are management’s general duties, regardless of a company’s financial health?

As a matter of law, there are two general duties. One is the duty of loyalty, which means that actions must be taken in good faith and in the corporation’s best interests. The other is the duty of care. Management must take steps to be reasonably informed of all available material information. It has to act, based on that information, as any prudent person in the same position would act under similar circumstances.

If a manager abides by these two simple rules, he or she will get the benefit of what is called the Business Judgment Rule, which means the court will likely find that he or she has fulfilled management’s fiduciary duties and will not second-guess a decision simply because it turns out badly.

How does the zone of insolvency change a manager’s actions, and what are some practical actions that a top manager can perform for a company in financial difficulty?

The law has become very muddy in this area. Just a few months ago, the Delaware Supreme Court held that a creditor cannot bring a legal action against a director for breach of fiduciary duties. Whether other state courts will follow Delaware’s lead is an open question.

Regardless of what the courts decide, when faced with financial difficulty, a smart director who is not already doing so should start holding regular board meetings and scrutinize everything. Hiring experts, such as insolvency attorneys and financial advisers, is another smart move, so that if later questioned, the directors and officers can claim they made informed decisions based on prudent advice.

There are a few other practical steps management should take if their company has entered the zone of insolvency:

  • Avoid taking action that favors equity over creditors — for instance, paying a dividend or redeeming stock.

  • Avoid actions that could be deemed fraudulent transfers, like giving away a product or service for less than its fair value.

  • At the end of every board meeting, introduce and vote on a resolution that all transactions approved are in the best interests of the corporation, and have the minutes reflect why that is the case.

  • Disclose any directors’ interest in a third party that is involved in company business. Make sure it’s on the record and in the board meeting minutes.

  • Don’t hide from creditors. Directors and officers are better served by being fully transparent.

  • Ensure you have independent decision-making by creating an audit committee with independent members to make recommendations on any insider transaction (which should be avoided when a company is in the zone of insolvency).

  • Avoid preferring one creditor at the expense of another, unless there is a significant business reason to do so.

  • Avoid any self-dealing, which will negate your protection under the Business Judgment Rule.

  • When evaluating fundraising transactions or the sale of corporate assets, recognize that these will be scrutinized by shareholders and the company’s creditors.

  • Examine the corporate directors’ and officers’ insurance policy carefully for material terms and exclusions.

  • Purchase D&O insurance, or bargain for changes in the amount of coverage and terms of the current policy.

Is resignation an option?

A director’s natural instinct is to abandon a sinking ship. But by leaving, you’ve essentially removed your influence from future actions of the corporation, and your resignation may be a breach of your fiduciary duties. You will be called to account for your prior decisions anyway and leaving may create the implication that you knowingly made decisions that were not in the company’s best interests.

GARY PEMBERTON is a litigation partner at Shulman Hodges & Bastian LLP. Reach him at gpemberton@shbllp.com or (949) 340-3400.