Directors and officers

Directors’ liability – failure to commence proceedings and trading while insolvent

If proceedings are not commenced, what liability can result for directors and officers? What are the consequences for directors and officers if a company carries on business while insolvent?

When a company is actually insolvent, the directors’ fiduciary duties to the corporation under many states’ laws expand to include the interests of creditors, as well as of shareholders. But no other consequences exist if a company carries on business while insolvent, assuming it does so in good faith and in accordance with applicable law. Courts generally view creditors in these circumstances as having sufficient protections through their contractual arrangements with the company, or fraudulent conveyance law and the implied covenant of good faith and fair dealing, such that additional layers of protection are considered unnecessary.

Directors’ liability – other sources of liability

Apart from failure to file for proceedings, are corporate officers and directors personally liable for their corporation’s obligations? Are they liable for corporate pre-insolvency or pre-reorganisation actions? Can they be subject to sanctions for other reasons?

US law imposes no obligation to file a company for bankruptcy relief when the company is insolvent. Accordingly, corporate officers and directors are not personally liable for ‘failure to file for proceedings’. If officers and directors comply with corporate law formalities, they are generally not liable for the debts and liabilities of the corporations they serve. Liability may arise on a corporate veil piercing theory. An officer or director who is a ‘control person’ may also be liable for certain state and federal payroll taxes that were not withheld and paid over to taxing authorities. Similarly, corporate directors and officers do not have personal liability for pre-bankruptcy actions unless they are found to have breached their fiduciary duties. Generally, no fiduciary obligations to creditors exist. Creditor rights are governed by contract, statute and case law concerning debtor-creditor relationships. Upon insolvency (or near insolvency), the directors’ and officers’ fiduciary obligations to the corporation may expand to take into account the interests of creditors who, upon insolvency, become the residual risk-bearers in the enterprise; however, state law is not necessarily consistent or fully developed with respect to such matters. As in all situations, directors and officers may be criminally prosecuted for fraud, securities law violations and other crimes related to the conduct of the business. Mere insolvency, or operating a company while insolvent, however, does not give rise to liability.

Directors’ liability – defences

What defences are available to directors and officers in the context of an insolvency or reorganisation?

A director or officer enjoys the same corporate law defences in the context of an insolvency or reorganisation as they do outside of this context. These include the protections of the business judgment rule as informed by the duty of care and duty of loyalty under applicable non-bankruptcy corporate law. While no insolvency or reorganisation specific protections exist, substantially all transactions outside the ordinary course of business pursued during an in-court proceeding are subject to court approval and stakeholder scrutiny. As a practical matter, officers and directors, therefore, benefit from the protections of a court order approving these transactions, which typically include findings that the transaction was entered into in good faith and is in the best interests of the debtor and its estate. Moreover, a plan may contain releases and exculpations in favour of the debtor’s officers and directors for acts and omissions made in connection with or arising from the Chapter 11 case itself.

Shift in directors’ duties

Do the duties that directors owe to the corporation shift to the creditors when an insolvency or reorganisation proceeding is likely? When?

Upon insolvency (or near insolvency), the directors’ and officers’ fiduciary obligations to the corporation may expand to take into account the interests of creditors who, upon insolvency, become the residual risk-bearers in the enterprise; however, state law is not necessarily consistent or fully developed with respect to such matters. The Supreme Court of Delaware, for example, has ruled that directors of a solvent Delaware corporation operating in the ‘zone of insolvency’ must continue to discharge their fiduciary duties to the corporation and its shareholders, not its creditors. Accordingly, in Delaware, the actual point of insolvency determines when the directors’ duties may shift to include creditor interests.

Directors’ powers after proceedings commence

What powers can directors and officers exercise after liquidation or reorganisation proceedings are commenced by, or against, their corporation?

In general, directors and officers continue to exercise their normal powers in the ordinary course after the commencement of a Chapter 11 case and a bankruptcy court will not interfere in the corporate governance of the debtor absent a showing of ‘clear abuse’. Thus, the United States Code (the Bankruptcy Code) leaves state corporate governance law largely untouched and bankruptcy courts generally do not take sides in corporate governance disputes. The primary exception is the power to order the appointment of a Chapter 11 trustee. Section 1104 of the Bankruptcy Code authorises a bankruptcy court to appoint a Chapter 11 trustee ‘for cause’ or ‘if such appointment is in the interests of the creditors, any equity security holders, and other interests of the estate’. Courts consider a number of factors when determining whether to appoint a trustee, and doing so does not necessarily require a finding of fault. These factors include, among others:

  • the trustworthiness of the debtor;
  • the debtor-in-possession’s past and present performance and prospects for the debtor’s rehabilitation;
  • the confidence – or lack thereof – of the business community and of creditors in present management; and
  • the benefits derived by the appointment of a trustee, balanced against the cost of an appointment.

 

The appointment of a Chapter 11 trustee, however, remains the exception rather than the rule.

In contrast, in a Chapter 7 case, an independent trustee is appointed who displaces management. The board typically resigns. The Chapter 7 trustee’s primary purpose is to collect, liquidate and distribute estate property as expeditiously as is compatible with the best interests of the parties. In rare instances, a Chapter 7 trustee may continue to operate the debtor’s business for the purpose of maximising its liquidation value.