As directors approach the 'zone of insolvency'.

• Author: CIERI, RICHARD M.

Long before Chapter 11, a director must exercise extreme caution when a corporation even begins to exhibit signs of financial distress. There are numerous steps that directors can take to substantially reduce their risk of liability.

IT IS NOT UNCOMMON for directors to find themselves on the board of a corporation experiencing serious financial challenges. Directors of such a financially troubled corporation are vulnerable to lawsuits from stockholders, creditors, and the corporation itself because, with the company's financial future potentially at stake, every significant decision may be examined in the future using "20-20 hindsight." If a financially troubled company ultimately commences a reorganization in bankruptcy, ongoing decision making by directors becomes less relevant because most significant decisions in bankruptcy are subject to review by stakeholders and approval by the bankruptcy court.

Outside of bankruptcy, however, decisions facing directors of a financially distressed entity can be perplexing and are made without the safety net of court approval. Thus, to maximize their chances of avoiding potential liability, it is essential that directors of a financially troubled company understand how to protect themselves.

Unfortunately, too many directors lack a sufficient understanding of their role and responsibilities -- especially when the corporation suffers a financial crisis -- until it is too late to avoid potential adverse consequences. With appropriate advance planning, however, there are numerous steps that directors can take to substantially reduce their risk of liability in the event of financial distress. With this goal in mind, this article briefly discusses (a) the fiduciary duties of directors under state laws in the United States, (b) potential sources of director liability, and (c) related strategies for protecting directors of financially troubled companies.

Potential sources of liability

The accompanying sidebar provides an overview of the fiduciary duties of directors and describes the "zone of insolvency." With that as a backdrop, here are some of the significant potential sources of liability for directors:

Breach of Fiduciary Duties. A director of a solvent corporation generally is entitled to the protection of the "business judgment rule" (discussed below) -- and thus is shielded from liability -- unless the director is found to have breached one of his or her traditional fiduciary duties (i.e., the duty of care and the duty of loyalty, as discussed in the accompanying sidebar). When a breach of duty occurs, a director may be subject to liability.

In general, courts analyze the following elements to determine whether such a breach of duty has occurred:

Due Care -- Did the director make an informed decision following a reasonable effort to familiarize himself or herself with the relevant facts? It is important to note that, in exercising due care, directors generally are entitled to rely -- in good faith -- on reports prepared by officers of the corporation or outside experts.

* Good Faith -- Did the director reasonably believe that the action taken was in the best interests of the corporation and its stockholders (or, where applicable, its creditors)?

* Disinterestedness -- Did the director engage in self-dealing?

Where a director has not acted with due care, in good faith, and in a disinterested manner, the director may be found to have violated the applicable fiduciary duties and may be subject to liability.

Statutory Liabilities. In addition, the directors of a corporation may face potential liability under state and federal statutes for, among other things, (a) certain actions approved by the director while the corporation was in the zone of insolvency that harm or potentially harm creditors and (b) obligations not satisfied by the corporation for which the directors have secondary liability (i.e., the directors are liable if the corporation does not pay the amounts owed):

* Illegal Dividends -- Directors may be held personally liable to the corporation, or to the corporation's creditors in the event of dissolution or insolvency, for any willful or merely negligent payment of an unlawful dividend. A dividend generally is unlawful if it is made at a time when the corporation is insolvent, or if there are reasonable grounds to believe that the corporation would be rendered insolvent by the dividend. Each state has its own dividend rules, which must be carefully examined before a dividend is declared. In most jurisdictions in the United States, liability for the declaration of an "illegal dividend" is subject to a safe harbor if the directors rely in good faith on reports prepared by officers of the corporation or outside advisers indicating that the dividend is appropriate.

*...