Managing the Commercial Impact of the Coronavirus: Top 5 Considerations When Operating in the Zone of Insolvency

Given the uncertainty of the effects of this pandemic on markets and industries in the U.S. and around the world, many businesses are now confronting significant and unique challenges which are causing financial distress among otherwise healthy companies. Various federal, state and local government orders restricting travel, closing schools, and closing or limiting the operations of certain businesses, and just today the announcement by many carmakers including the Detroit 3 that they are suspending operations through at least March 30th, have combined to create great uncertainty and, in some cases, a zone of insolvency, for many businesses. The overview below provides guidance to directors and officers of companies operating in the zone of insolvency.

Top 5 Considerations When Operating in the Zone of Insolvency

1.  Directors and Officers of Insolvent Corporations Owe Their Fiduciary Duties to Creditors

• When a corporation becomes insolvent, there is no value in equity. As such, creditors take the place of shareholders as the beneficiaries of the corporation’s residual value.
• As a result, the duties (e.g., care and loyalty) of officers and directors of an insolvent corporation expand to include duties owed to creditors as well as equity.

Zone of Insolvency

• What factors are considered in determining solvency or insolvency? If either of the following is demonstrated:
• Corporation’s assets, fairly valued, do not exceed the value of its liabilities (balance sheet test).
• Corporation is unable to pay its debts as they come due (equity test).  

2.  What should directors do if they are unsure of whether the corporation is insolvent?

Because the range of persons and entities who could claim to be beneficiaries of an officer or director’s fiduciary duties to the corporation changes once an entity is insolvent, the “zone” really describes a situation in which there is a risk of becoming insolvent.  As a result, the risk of having an additional constituency as the beneficiary of the fiduciary duties (that is, the creditors, ahead of the shareholders) must be taken into consideration.

3.  What are the duties owed? 

A.  Duty of care

• Duty of care governs a director’s decisions in managing the corporation.
• Focus of this duty is the process by which decisions are made, rather than the substance of the decision or its eventual outcome.
• Duty of care requires the exercise of care that an ordinarily careful and prudent person would exercise under the same or similar circumstances.
• Representing the financial interests of others imposes an affirmative duty to protect those interests and to proceed with a critical eye in assessing information.
• What process should directors undertake to demonstrate that they are fulfilling their duty of care? 
  • Consideration of facts and information
  • Create a record
• As to duty of care, it is important to document that you made decisions after obtaining information and considering the information, as well as having obtained advice and having considered the advice.

B.  Duty of loyalty

• Requires that directors act in the best interests of the corporation, subordinating other (business and personal) interests to that of the corporation.
• Requires good faith belief that actions taken are in the corporation’s best interests.
• Duty is implicated:
  • where there is conflict of interest, or 
  • by the corporate opportunity doctrine
• Examples:
  • Related company transactions
  • Directors with competitive business interests
• Directors and officers can be held personally liable for breaches of fiduciary duty.

4.  Steps to avoid personal liability:

• Retain specialists; 
• Be mindful of related-party deals; 
• Do not resign in haste;
• Act in good faith; 
• Conduct critical review of financial statements;
• Monitor and conserve cash;
• Perform credit or leverage analysis; 
• Act and engage (do not react).

5.  “Dos and Don’ts” to Avoid Personal Liability:

• DO NOT use funds withheld for payroll and other “trust fund” taxes to pay corporate expenses.
• DO NOT incur any new obligations you do not reasonably believe will be fulfilled.
• DO NOT provide inaccurate or misleading information to lenders.
• DO assure that appropriate oversight is in place to actively monitor use of cash, including review of and adherence to budgets and projections.
• DO undertake analysis and estimation of value of business, including evaluation of assets and contingent liabilities.
• DO assess status of each major creditor constituency and determine points of leverage/risk for each. 

Foley has created a multi-disciplinary and multi-jurisdictional team, which has prepared a wealth of topical client resources and is prepared to help our clients meet the legal and business challenges that the coronavirus outbreak is creating for stakeholders across a range of industries. 

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