'Deepening insolvency' adds to board challenges: a growing risk area for directors of troubled companies is the developing theory of deepening insolvency.

• Author: Raymond, Doug
• Position: LEGAL BRIEF

AS READERS OF THIS journal know, directors are obligated to serve in good faith and with due care and loyalty. In doing so, in most instances they are protected by the business judgment rule, which provides a strong presumption that the directors have acted on an informed basis, in good faith, and in the honest belief that they have acted in the best interest of the company.

However, directors' duties are less clear when the business is struggling and their protection from liability is less certain. The zone of insolvency doctrine has expanded directors' fiduciary duties to include the corporation's creditors when a corporation is close to being insolvent. That is, when a corporation is nearing insolvency, the directors, in determining what is in the company's best interests, must take into account--and perhaps give priority to--the effect of their actions on the corporation's creditors. If they fail to do so, they may have liability for breaching their fiduciary duties. However, under this doctrine, directors are still protected by the business judgment rule (subject to the usual exceptions).

It can be difficult for directors of a company that is facing serious financial difficulties to tell when the line has been crossed into the zone of insolvency and directors' fiduciary duties have shifted. However, as the value of the company's equity decreases, this doctrine requires the board to focus on preserving the value remaining for the creditors.

For example, if the value of the equity has completely disappeared, the stockholders may be willing to take significant risks in an effort to restore that value because they have nothing to lose and everything to gain. On the other hand, the creditors would probably prefer to preserve the remaining value so that they can be repaid. The directors must weigh both of these competing interests. At the least, the zone of insolvency cases significantly expand the directors' fiduciary duties well before the actual filing of a bankruptcy petition.

In addition, directors face challenges under the developing (and not well-defined) theory of deepening insolvency. The core of the deepening-insolvency theory is the principle that directors of an insolvent company should not continue the business if it results in a continued worsening of the business to the detriment of creditors.

Initially, the deepening insolvency doctrine imposed liability on directors only if they continued the business for fraudulent or...