09 Nov Zoned Out
The fiduciary duty of directors and officers to the shareholders of their corporation is a fundamental axiom of corporate law. Almost as familiar is the notion that when a corporation enters the “zone of insolvency”, those fiduciary duties expand to include creditors as well.
What may be far less familiar is determining precisely when the corporation has entered the zone of insolvency – and what to do when it does.
Where is the “zone of insolvency”?
It has been said that the zone of insolvency is a bit like obscenity: It’s practically impossible to define . . . but you sure know it when you see it. It may not be as well known that many businesses transit the zone of insolvency with surprising frequency at various points during their corporate lifecycles.
A recent law review article notes that “between 2000 and 2004, approximately 4% of 6,178 large publicly held companies engaged in merger and acquisition activity that placed over 75% of their assets at risk. Likewise, approximately 467 smaller businesses risked half their assets, and at least 603 smaller businesses risked one-fifth of their assets. Thus directors’ and officers’ fiduciary duties may oscillate between shareholders and creditors numerous times per year depending on the risk-taking strategies in which they engage.” Jonathan T. Edwards and Andrew D. Appleby, The Twilight Zone of Insolvency: New Developments in Fiduciary Duty Jurisprudence That May Affect Directors and Officers While in the Zone of Insolvency, 18 J. Bankr. L. & Prac. 3 Art. 2 (2009) (citing Anna M. Dionne, Living on the Edge: Fiduciary Duties, Business Judgment, and Expensive Uncertainty in the Zone of Insolvency, 13 Stan. J.L. Bus. & Fin. 188, 191 (2007)).
Add to this the changing nature of financial investments in many companies (which now feature “hybrid” instruments with both equity and debt characteristics) and the dramatic adjustment of multiples and valuations that have occured in the capital markets over the last 12 months, and it is easy to see that the “zone of insolvency” is hardly a bright line. Instead, it is more akin to a solar flare – it can depend as much upon the corporation’s financial structure and upon market conditions as upon the decisions made by the corporation’s officers and directors.
What to do once you’re there?
When a financially at-risk corporation faces either operational or balance sheet insolvency, its directors and officers may face a variety of unique pressures and challenges. Among them:
– Time pressure: A corporation with little or no operating liquidity is like a swimmer deprived of oxygen – precious little time remains before everything goes completely black.
– Credit constraint: The corporation may face an uphill battle for additional, needed credit. Frequently, the only readily available source of cash are parties with close ties to the corporation – i.e., insiders. And such parties are apt to require advantageous terms in exchange for their incremental risk.
– Anxious stakeholders: Creditors and shareholders anxious to protect their respective stakes in the corporation are likely to increase their scrutiny of every new transaction, and to “second-guess” anything that might further jeopardize their positions.
Top management’s response to these pressures is well-summarized by the adage that “process rules.” Because each corporation’s situation calls for a unique set of decisions, and because corporate officers and directors have general duties of care and loyalty to the corporation (and to creditors when the corporation is operating in the “zone of insolvency”), they best protect themselves who ensure that any decision:
– Is advised by (but not delegated to) outside advisors.
– Involves directors who are independent and disinterested.
– Considers shareolders and creditors.
– Documents full, open, neutral and reasonable exploration of available options.
Two very recent articles offer similar advice and summarize some practical tips on insulating directors and officers – or on identifying behavior that may fall short of the fiduciary duties expected of such individuals when a corporation faces troubled times or elevated risk.
Gerard S. Catalanello and Jeffrey R. Manning offer their insights in a recent Turnaround Management Journal piece entitled “A Fresh Look into the Zone of Insolvency,” while Frank Aquila and Peter Naismith provide similar guidance in “Directing Within the ‘Zone’,” available in Banking Director magazine’s 4th Quarter’s issue. Each is worth perusal.
When do “zone of insolvency” considerations kick in? And how frequent are such concerns likely to be in this market? Catalanello and Manning put it this way:
[G]iven the realities of today’s economy and the capital markets, a company that has debt maturing in the next 18 months is likely to be at least approaching the zone [of insolvency]. If its corporate debt is trading at a material discount (i.e., more than 20 percent discount to par), a company probably is well over that stark demarcation.
Officers, directors . . . and creditors – take note.