We are currently at the beginning of an economic downturn driven by a global pandemic that has resulted in unprecedented economic disruption that has been, and will continue to be, severe. Many companies are now confronting immediate difficulties, including an inability to conduct normal operations, dramatic declines in revenue, inability to service debt, disruption to M&A activity, and delayed or canceled financing rounds. This environment requires companies to make difficult decisions regarding operations, capital, employees, and a host of other matters in order to survive. As companies wrestle with these challenges, directors must be acutely aware of and adhere to their fiduciary duties or risk exposure to personal liability.
While the challenges posed by the COVID-19 virus may be novel, the standards by which directors’ decisions are measured remain the same. Regardless of whether a corporation is solvent, nearing insolvency, or insolvent, directors always owe a duty to the company itself. If a corporation is insolvent, however, directors also owe duties to the company’s creditors.
Directors generally owe two main fiduciary duties to the company and its stakeholders: (1) the duty of care; and (2) the duty of loyalty. Care requires a director to be reasonably informed of all relevant information and alternatives, to act in good faith and in a prudent and deliberate manner when making business decisions. The duty of care cannot be delegated to other decision-makers. A director’s personal liability to the corporation or its stockholders for breach of its duty of care may be eliminated or limited in a corporation’s articles or certificate of incorporation. Loyalty requires that a director act in, and make decisions based on, the best interests of the corporation and not to act out of self-interest.
In making decisions, directors are protected by the business judgment rule provided that they comply with the fiduciary duties of care and loyalty. The business judgment rule presumes that the board acted on an informed, good faith basis and in the honest belief that the decision was made in the best interests of the corporation and relevant stakeholders. In times of crisis and financial distress, it is especially important to act diligently and give increased attention to proper corporate governance. Understanding that a director risks personal liability for breaches of fiduciary duties and that the stakeholders to whom those duties are owed may shift based on the financial health of the business, a director should:
- take care to keep informed (even more than normal) of all material information reasonably available and devote adequate time to reviewing and considering alternatives before making a decision;
- understand the company’s financial statements, cash flows, liquidity, business plan projections, credit arrangements, leases, and covenants and assess its ability to access sources of funding, including government funding, under current market conditions;
- participate in and hold frequent board meetings for which minutes of every meeting are carefully prepared to document deliberations with respect to material issues and board approvals and, in this environment, establish a process for remote communications that is consistent with state law and the company’s charter documents;
- provide active oversight that challenges management and not become simply a rubber stamp;
- adopt, implement, and monitor an oversight system at the board level that results in an effective and increased flow of information, particularly with respect to overseeing COVID-19 issues and its impact on the company;
- assess all aspects of the company’s business, including business risks and workplace health and safety issues posed by COVID-19, the competitive landscape, as well as the various rights of lenders and creditors;
- focus on value preservation and enhancement, without taking unjustifiable risks, in order to maximize recovery for creditors and other stakeholders;
- retain and rely upon qualified and experienced professionals to help discharge the duty of care for areas in which the director has no particular expertise, including with respect to legal, valuation, medical, accounting, and financial matters;
- give heightened attention to capital raising transactions and asset sales that may later be criticized in light of the board’s expanding duties to creditors and carefully consider how such transactions may impact creditors and stockholders;
- avoid incurring additional unsecured credit that the company does not have the ability to repay;
- examine the value of the company’s assets using realistic market values and the ability of the company to engage in one or more value maximizing transactions—which in difficult situations may mean continuing operations to preserve going concern value or selling or winding down the company;
- increase transparency and open communications with the company’s lenders, employees, and other key stakeholders, particularly those whose assistance or forbearance may be critical to preserving value;
- review restructuring and shut down alternatives, which may include whether a key employee retention plan should be developed;
- confirm that all tax and payroll obligations are satisfied and assess the applicability of the WARN Act for employee terminations, ERISA for benefit plan obligations and other requirements particular to the business that may need to be addressed;
- evaluate whether the company has sufficient D&O insurance coverage in place and whether there are exclusions that would vitiate coverage in the event that the company ceases operations or files for bankruptcy protection;
- abstain, when appropriate, from voting on and participating in the deliberations relating to matters that could give rise to a conflict of interest;
- consider the benefit of establishing an independent committee of directors where warranted or adding independent directors to the board of directors to increase the disinterestedness of the board;
- avoid conflicts and even the appearance of being on both sides of a transaction;
- ensure that there is no preferential treatment for insiders, particularly those who are stockholders, executives, guarantors, or lenders of the company;
- give increased attention to transactions with insiders to ensure fairness and create adequate records to support approval;
- understand that private equity firms holding a controlling position in a company through their contractual rights, roles in the governance and debt and equity holdings will receive heightened scrutiny and be subject to increased risks when an enterprise is troubled; and
- use caution when considering whether to resign due to the financial distress of a company in order to ensure that no harm will follow and that such resignation will not later be viewed as an abdication of the director’s duties.
The uncertainty and disruption to the economy created by the COVID-19 pandemic is without comparison in recent history. Exercising increased oversight and monitoring the company’s business viability, legal compliance, and financial performance and reviewing available alternatives is imperative for a board to ensure that it is fulfilling its fiduciary duties. All decisions should be based on a thorough and informed review of material information and may require a proactive approach with respect to fundamental business decisions.
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This alert is a periodic publication of Ballard Spahr LLP and is intended to notify recipients of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.