Distressed companies: Mitigating potential personal liability of directors

Directors of corporations always owe fiduciary duties to the company’s stockholders. However, during market downturns or when a company becomes distressed, those duties may expand or take on enhanced importance and the risk of director personal liability may increase.^[1]  This article focuses on the circumstances that could trigger director personal liability and as well as some measures the board can take to mitigate the risk and liability. Please note, the information in this article is not exhaustive, is limited in jurisdiction and scope as noted herein and should not replace advice of legal counsel.

Typically, directors owe the duties of care and loyalty^[2]  to a corporation’s stockholders, but in the context of insolvent companies, directors may owe fiduciary duties to a corporation for the benefit of all of its residual claimants, which includes both creditors and stockholders. Depending on the jurisdiction, courts use the cash flow^[3]  and balance sheet tests^[4]  (or a combination of the two) to determine insolvency of a company.

Personal Liability. If a company is approaching insolvency, in addition to personal liability for breaches of fiduciary duties, directors and officers may become personally liable for certain of the corporation’s outstanding obligations. In most states, a corporation’s failure to take one or more of the following actions will result in strict personal liability to the directors and officers of the corporation:

• Pay wages and compensation owed to employees;
• Withhold and pay federal employment taxes;
• Contribute or withhold for unemployment, workers’ compensation and disability taxes;
• Maintain workers’ compensation insurance; and
• Pay sales and use taxes.

The list of actions above is certainly not exhaustive and the personal liability triggers vary widely by jurisdiction and industry, but generally includes the most common scenarios that an insolvent company is likely to face.

Mitigation. In addition to carefully monitoring their fiduciary duties and corresponding actions, directors may consider taking the following specific precautions to mitigate their personal liability:

1. Directors’ & Officers’ Liability Insurance: Before serving on a board, most institutional directors will require the corporation to obtain directors’ and officers’ liability insurance and enter into an indemnification agreement with the director. The indemnification agreement memorializes the corporation’s obligation to indemnify a director for appropriate actions taken by such director within the scope of his or her duties. The directors’ and officers’ liability insurance acts as an additional layer of protection to ensure the company can meet its obligations under the indemnification agreement and may cover the director under certain scenarios outside of the scope of the indemnification agreement. Further, as a corporation nears termination (whether that be by bankruptcy, receivership or some other dissolution), it might be prudent for the corporation to obtain a tail policy on its existing directors’ and officers’ insurance policy. This will ensure coverage for a period of time (typically 6 years) after the underlying policy expires, which will protect the directors and officers from potential causes of action arising after termination of the corporation.
2. High Engagement: While directors should endeavor to attend all board meetings and engage and contribute at each meeting, this becomes paramount as the corporation nears insolvency or becomes insolvent. As a company nears insolvency, the board should call meetings more frequently and engage with management to actively monitor the financial state of the company. For example, management should provide detailed updates on cash and burn rate on a regular basis, so the board can determine what further action is required. At meetings, the board should explore and consider all options (eg, capital raise, company sale, bankruptcy, winddown, etc.) that are in the best interests of the stakeholders of the corporation and should ensure that winddown decisions are made prior to the Company becoming fully insolvent. For example, in a winddown (ie, a dissolution process managed by the corporation informally), the corporation will need to properly account for its runway and accordingly, lay off employees before it is unable to meet payroll obligations while maintaining enough staff to assist with the winddown.
3. Proper Process: As the directors begin to consider the potential options, it is important that they diligently consider all potential alternatives and operate with their fiduciary duties at the top of mind. As evidence of this process, a secretary should maintain detailed meeting minutes, directors may engage personal legal counsel to advise on their fiduciary duties and corresponding conduct, and the corporation may hire professionals (eg, bankers, accountants, special counsel, etc.) to assist with the analysis of potential options on an arms’-length and informed basis.
4. Priority: Once the board determines it is in the best interests of the stakeholders to terminate the corporation, the process must be conducted in a manner that addresses the applicable priority of all stakeholders. The stakeholder order of priority is typically (a) employees (ie, payroll, taxes, workers’ compensation); (b) service providers assisting with the winddown; (c) secured creditors; (d) unsecured creditors; (e) preferred stockholders; and (f) common stockholders.

Should you have any additional questions or wish to consult with a legal professional on the matters referenced herein, please feel free to reach out to the authors of this article or any other DLA Piper attorney.

_{[1] It is important to acknowledge that there are limited circumstances in which stockholders (if deemed controlling stockholders) may be held to standards similar to those of directors and could be subject to personal liability for breach of their fiduciary duties; however, this topic is outside of the scope of this article.
[2] The duty of care requires directors to: (a) be fully informed of all reasonably available information before making a corporate decision; (b) act in good faith and in the best interests of the corporation and its stockholders; and (c) act with a degree of care that a reasonably careful and prudent businessperson would exercise under similar circumstances. The duty of loyalty requires directors to act and make decisions in the best interests of the corporation and its stockholders (and not in their own personal interest or the interests possessed by any other director, any officer, or any controlling stockholder with interests not shared by the stockholders generally)
[3] The cash flow test (also known as the equitable insolvency test) states that a company is insolvent if it cannot pay its debts as they become due in the ordinary course of business.
[4] The balance sheet test (also known as the legal insolvency test) states that a company is insolvent if its liabilities exceed the reasonable market value of its assets.}