While the light of economic recovery may be appearing on the horizon, many sectors of the economy continue to suffer slow growth and persistent or periodic struggles with liquidity as a result of low demand for goods and services. Until consumers determinatively shake off the historically low levels of confidence and reverse the current trends of debt reduction and increased savings rates, some businesses will fall on hard times.
A struggling business and its leaders (e.g., directors and officers of corporations, or managers of limited liability companies) seeking to avoid the entity’s failure as it experiences liquidity challenges or insolvency need to heed some legal rules that may not be readily apparent.
Smart Business spoke to Steve Dettmann and Douglas Landrum of Jackson DeMarco Tidus Peckenpaugh about a few common legal matters for those businesses, and their principals (and guarantors), to consider when the business experiences difficult times.
Management may be liable to creditors
Normally, the duties of the directors of a corporation and the managers of a limited liability company are owed to the equity holders of the business. However, if a business has insufficient equity or is insolvent, management personnel may become personally liable for approving distributions to shareholders or other equity owners. For a Delaware business entity, the Delaware Supreme Court has held that when a corporation is actually insolvent, fiduciary duties arise for the benefit of creditors in the place of shareholders — under the theory that the creditors of an insolvent corporation become the beneficiaries of any increase in value and suffer the detriment of further decreases in value of the corporation’s remaining assets. Thus directors and managers should ascertain an accurate financial understanding of proposed actions of struggling businesses.
Not all guaranties are the same
Another area where principals become exposed to personal liability for obligations of the business is by executing guaranties. In many lending circumstances involving small and medium-sized business entities, lenders will require guaranties of varying types from principal equity owners. These guaranties come in many forms — some absolute, some limited and some contingent. Some guaranties are unconditional and others may limit the lender’s recourse to a specific set of assets or circumstances. Most guaranties contain a set of waivers pursuant to which the guarantor waives statutory suretyship defenses — some ironclad and others suffering notable deficiencies. Understanding the difference is key.
In commercial real estate lending, the borrower’s principals are frequently induced to give the lender a “springing” guaranty (sometimes referred to as a “recourse carve-out” guaranty) under which the lender’s right to seek recovery beyond the borrower or the specific secured collateral arises only upon the occurrence of specified events. These events typically include “bad boy” acts of the borrower (notwithstanding that only certain of the acts are inherently “bad”) including, among others, fraud, misrepresentation, commission of waste, prohibited transfers, failure to pay real estate taxes or failure to properly apply security deposits, reserves or insurance proceeds. The spring on some guaranties is sprung (i.e., the recourse obligation arises) when the borrower, during times of financial difficulties, seeks legal protection from its creditors through the filing of a petition in bankruptcy — even though the bankruptcy petition may be later dismissed (i.e., like bells that cannot be unrung, certain springs cannot be unsprung). Therefore, if a commercial real estate enterprise is failing, guarantors having influence over the actions of the borrower should consult with counsel to ascertain the potential consequences of a borrowing entity’s proposed actions before those actions are taken, and to carefully navigate through potential foreclosure of real property security so as to avoid, where possible, the triggering of liability under a guaranty.
Completion guaranties are commonly used as credit enhancements for construction financing, but the remedies available to a lender are uncertain. Generally, recovery under a completion guaranty is limited to the increase in value of the collateral that completion would offer; and where a lender on an underwater project cannot demonstrate that the value upon completion would exceed the as-is value, then the completion guaranty may be worthless.
Knowing which type of guaranty binds the principal, and whether there may exist a partial or complete defense to recovery, is essential to determining what actions should be taken or decisions should be made on behalf of the business.
Filing bankruptcy may not be a good idea
While a debtor-in-possession (DIP) usually acts as the trustee upon the filing of a bankruptcy petition under Chapter 11 of the United States Bankruptcy Code, if the business cannot present or implement a viable plan to reorganize in a Chapter 11 bankruptcy, under certain circumstances, the bankruptcy case can be converted to a Chapter 7 liquidation upon request of the creditors. Independent U.S. Trustees appointed by the court in Chapter 7 bankruptcy liquidations are compensated based upon what they are able to collect on behalf of the estate for payment to the creditors of the bankrupt entity. With this motivation, the trustees frequently look into the pre-petition acts of management and equity holders to determine whether the bankruptcy estate may have causes of action that could bring a recovery. A Trustee may therefore act in a manner opposed to management and equity holders, as they look for evidence of insider transactions, misuse of corporate assets for personal benefit, distributions to equity holders at or near the time of insolvency or breaches of duties that could provide access to policies of directors and officers liability insurance.
Accordingly, if a struggling business is unlikely to be able to reorganize in bankruptcy, then it may be a better course for management to wind-up the business and distribute assets to creditors (similar to a bankruptcy liquidation) without filing a case with the United States Bankruptcy Court. Negotiating with creditors for a liquidation of the company’s assets without a bankruptcy case may avoid the appointment of a trustee who turns out to be the worst enemy of former management or owners.
Remember tax obligations
One of the knee-jerk reactions of management in a difficult business setting is to use funds withheld from employee wages (income tax, social security tax or Medicare withholdings) for liquidity purposes instead of paying over the funds to the IRS and other tax authorities. This is one of the worst methods that management could employ to prop up the business as it begins to fail, as any “responsible person” of the business (meaning the individual or group of individuals within an organization who, individually or collectively, has sufficient authority to pay over withholding taxes) may be held personally liable by the IRS for a Trust Fund Recovery Penalty — a 100 percent tax penalty — for failing to pay over taxes withheld from the employee.
If a business is struggling, management and equity holders must be mindful of the many traps that exist from which could arise personal liability, and a small investment in consultation with legal counsel before actions are taken may be essential to avoiding unnecessary loss.
Steve Dettmann is Senior Counsel, Real Estate Practice Group and Douglas Landrum is a Shareholder and a Member of the Corporate Practice Group at Jackson DeMarco Tidus Peckenpaugh. Reach them at SDettmann@jdtplaw.com and DLandrum@jdtplaw.com, respectively.