Anyone investing equity in an enterprise, whether creating a start-up or purchasing an established company, is a natural optimist. The hope is that the business will continue to perform well and yield its owners substantial profits year-after-year (and then maybe a hefty return upon exit). But, as those of us in restructuring know, not every company enjoys positive returns all the time. Businesses go through down cycles for different reasons – whether it be the overall economic climate (think 2008), issues specific to a particular industry (think dropping oil prices), a great idea that needs more time to blossom into a profitable company, or the classic case of being overleveraged (i.e. too much debt). As an owner of a business, it is important to recognize distress as soon as possible to create optionality, minimize the downside risk, and sometimes even take advantage of distressed opportunities to increase return.
This new series of the Weil Bankruptcy Blog will be devoted primarily to owners of businesses in distress, such as private equity sponsors. Many of the issues, however, will be interesting to management of a distressed company or anyone in the restructuring or distressed industry. We will explore initial considerations, risks to owners/sponsors, various options to create value and extend a company’s runway, strategies for negotiating with creditors, and bankruptcy techniques. We will also point out where we have previously blogged about relevant topics to give you a deeper dive into those issues.
Spotting Signs of Distress
Spotting signs of distress early increases the business owner’s options. The shorter the timeframe before a crisis, the less opportunity there is to negotiate concessions from other constituents, refinance problematic debt, or execute on other creative strategies. It is critical for owners to be realistic and conservative in assessing their distressed companies, notwithstanding the aforementioned natural tendency to be optimistic.
Two key issues for a company in distress are liquidity constrains and covenant defaults. A company that is running out of money or that is in danger of breaching covenants in its debt documents is particularly vulnerable. Later in this series, we will discuss specific strategies owners can use when faced with these issues, but for now, it is important to note that owners should keep a close eye on these two issues (and not necessarily trust that management will bring them to the owner’s attention soon enough).
Overview of Fiduciary Duties
Most owners of private companies have designees who sit on the board of directors of the company. As such, it is critical for them, as well as the company’s officers, to consider their fiduciary duties in times of distress. Fiduciary duties are generally determined by the law of the jurisdiction of formation of the company. Given that a significant percentage of large companies are Delaware corporations, we will mostly touch on Delaware corporate law here, but you should keep in mind that the law of fiduciary duties can differ depending on which state law governs and what type of entity the company is—a limited liability company (LLC), for example, versus a corporation.
To Whom Are the Duties Owed?
Most directors and officers are familiar with their fiduciary duties when their corporations are solvent. Under Delaware law, directors’ and officers’ fiduciary duties run to the corporation, and directors must always direct the affairs of the corporation so as to maximize its value for the benefit of the corporation’s stakeholders. As clarified and confirmed by the seminal case North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, when a corporation is solvent, those stakeholders are shareholders—not creditors. Thus, shareholders (but not creditors) have standing to bring derivative actions on behalf of solvent corporations because they are the ultimate beneficiaries of the corporations’ growth and increased value. Indeed, as we recently reported, courts have held that the fiduciary duties of a solvent subsidiary’s directors and officers are to operate the subsidiary for the benefit of the parent and its shareholders, even if doing so makes the subsidiary less valuable. Creditors of a solvent corporation, in contrast, are not owed any duties, and they can rely only on the contractual rights and protections that they bargained for, if any.
When a corporation is insolvent, on the other hand, creditors take the place of shareholders as the residual beneficiaries of any increase in its value. Thus, while the primary object of the directors’ and officers’ duties remains the same—the corporation, creditors have standing to bring derivative actions on behalf of insolvent corporations against directors and officers for breaches of fiduciary duty. In Gheewalla, the court declined to expand creditor standing to permit direct actions against directors and officers for fiduciary duty breaches. Instead, directors of insolvent corporations “must retain the freedom to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation.” Thus, the duty to maximize value is said to be a duty to maximize value to the entire estate, rather than to benefit a particular group of creditors.
Pleading insolvency in Delaware requires a showing that (i) a company’s liabilities exceed its assets and there is no reasonable prospect that the business can be successfully continued (balance sheet test), or (ii) the company is unable to satisfy its obligations as they become due in the ordinary course of business (equitable insolvency test). Courts have widely acknowledged that such tests lack a bright line quality and are highly factual. Importantly, Gheewalla erased the fuzzy area of law relating to the fiduciary duties owed to corporations in the hard to define “zone of insolvency”—either the corporation is solvent or it is insolvent. Nevertheless, as the precise moment of a corporation’s insolvency is uncertain, directors should begin to consider all stakeholders’ interests when nearing insolvency.
What Are the Duties?
The duties that Delaware directors and officers owe to a corporation are the duty of care and the duty of loyalty. To satisfy the duty of care, directors and officers must exercise a degree of care and prudence in making decisions and carrying out their responsibilities that an ordinarily careful and prudent person would exercise under the same or similar circumstances. The duty of loyalty obligates directors to act in good faith and in the best interests of the corporation and its stakeholders, and to refrain from engaging in activities that permit them to receive an improper personal benefit from their relationship with the corporation. The duty of loyalty prohibits self-dealing and usurpation of corporate opportunities by directors and officers.
The Business Judgment Rule
Under the well-known business judgment rule, there is a presumption that, in making a business decision, the director or officer of a corporation, whether solvent or insolvent, acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Absent an abuse of discretion, the director’s or officer’s business judgment will be respected and will not be second guessed by the courts. A plaintiff can overcome the presumption of the business judgment rule by showing that the director failed to satisfy the duty of care or the duty of loyalty or lacked good faith in carrying out these duties. In such a circumstance, a court will typically scrutinize the challenged transaction substantively under the “entire fairness test,” and the burden will shift to the director or officer to prove the transaction was fair to the corporation.
Additional Board Considerations
Notwithstanding the foregoing, directors and officers of companies in financial distress must be mindful that their actions are more likely to be challenged in the future because of the increased likelihood that the company will end up insolvent and stakeholders will decide to sue any deep pocket to try to bring in more value. Moreover, as a company’s financial distress deepens, directors and officers may be faced with fewer options to “save” the company and may agree to transactions that appear to “give away too much” and even so may not succeed in keeping the company out of bankruptcy. As we recently reported, directors and officers should take some comfort that transactions in such situations are not judged in hindsight, and the business judgment rule can still offer protection when a business fails despite last-minute efforts.
It is also worth noting that court analyses of these issues tend to be fact-intensive, and interesting fact patterns can lead to counter-intuitive results. For example, as we reported last year, a Delaware court recently acknowledged that a parent corporation may have a cause of action against a subsidiary (not just the subsidiary’s directors and officers) in a circumstance where the subsidiary controls the parent. Yes, you read that correctly—click on the link to understand the bizarre fact pattern that led to this conclusion. But the point again is that the facts matter.
When a company is in distress, an owner should consider whether it makes sense to resign from the board of directors or to bring in independent directors. The latter may be especially prudent if the owner is considering an interested party transaction as a method for extending the company’s runway. As we previously reported, courts have granted insider directors the benefit of the business judgment rule and dismissed breaches of fiduciary duty claims against them when the majority of independent directors also voted in favor of the challenged transaction.
The importance of D&O insurance cannot be overemphasized. As we previously discussed, given the extra scrutiny and risks the board and management face when a company is in distress, it is important to ensure that the company has appropriate D&O insurance in place (both coverage and amount).
Controlling Stockholder Duties
Under Delaware law, a controlling stockholder (one who owns a majority interest or owns less but exercises control over the business affairs of the corporation) can owe similar fiduciary duties to a corporation, even when the corporation is solvent. The intricacies of the duties of controlling stockholders are beyond the scope of this overview, but controlling stockholders should be particularly mindful of the impact of these duties (especially the duty of loyalty) in the context of transactions between the corporation and the controlling stockholder, which are vulnerable to challenges of self-dealing.
Owners of companies in or nearing distress are advised to keep their antennas up for further signs of distress. It is also a particularly useful time to ask counsel for a refresher of the old fiduciary duties lecture, with a particular emphasis on issues most relevant to companies in distress so that the owner can be armed with the tools necessary to navigate through (hopefully) unchartered territory.
More entries in this new Sponsor/Owner Series are coming soon. Future entries will delve into other issues an owner of a troubled company should consider, as well as various options a sponsor/owner can pursue to minimize risk and maximize the value of its investment.