Lawyers Journal

Avoiding officer and director liability in insolvency

With the softening of the economy, especially in the technology and e-business sectors, a number of clients have raised questions on the issue of liability of officers and directors.

The initial question is always "Should I resign from the board?' Although there are exceptions to every rule, I normally advise against resigning. If there is already liability for past actions, resignation will not wipe the slate clean. With appropriate attention and professional advice, new liability can be avoided prior to a bankruptcy. During a bankruptcy, a court can formally approve or disapprove board decisions before they are executed. Prior to any proceeding, many responsible decisions must be made, including:
•  evaluating opportunities for sale of some or all assets;
•  responding to lawsuits and creditor claims;
•  choice of a workout expert and a bankruptcy lawyer;
•  satisfying employee and tax claims;
•  whether to file, and where.
These decisions require responsible discussions and analysis. This process will require directors to put in the time, but it is important that it be done right. If something goes awry, it will be easier to point the finger at deep-pocket officers and directors who have resigned and are not there to defend themselves. Similarly, if decisions must be made with respect to director and officer insurance policies, it is better to be part of the decision-making process than just an insured under the policy. For example, in the Baldwin United Chapter 11, the judge permitted reimbursement for ongoing litigation defense costs for those directors and officers who were still with the company, but not for those who had resigned. Staying on does not impact future SEC disclosures, which have a two-year lookback, unless the director was also an officer of the company.
There is one caveat. In a solvent company, the fiduciary duty is owed to shareholders. See In re Toy King Distributors, Inc. 256 B.R. I (Bankr.M.D. Fla., 2000). In an insolvent company, that duty is owed to the creditors as well. See Geyer v. Ingersoll Publications Co., 621 A.2d 784, 787 (Del. Ch. 1992). As the company steers towards the shoals of insolvency, that duty must also include non-shareholder constituencies such as creditors. Unfortunately, no bell tolls when a company is "near insolvency," so judgment must be applied. For example, if the company is barely solvent, but has assets to make a substantial payment to creditors, it may not be in keeping with one's fiduciary duty to risk all those funds to which creditors may be entitled in one last "Hail Mary Pass" transaction in order to bail out the company and reward the shareholders, if that transaction is very risky and has a low probability of success. (After all, the investors have decided not to make further investments in the company.) If the board took that course, it might be prudent to resign at that point and leave minutes reflecting opposition to that course. Also, in the zone of insolvency, it is very hard to find a non-insider buyer who will buy the business without first filing a bankruptcy to get the assets free of creditor claims.
The payment of wages and withholding taxes are principal corporate obligations. In Massachusetts, failure to pay employee wages (including commissions, overtime, vacation, sick days, and the like) results in criminal liability that will be prosecuted. The president of the company has liability, but not a director or other officer. Most states have similar statutes protecting workers. State and federal income and FICA taxes, which are withheld from employees become the personal liability of the "responsible officer" if they are not paid by the company. The responsible officer is the person who decides not to pay the government, but instead pays an important vendor with the withheld monies. Although this person is usually a member of management and not a director, the IRS and the DOR frequently sue all directors and officers and let them point the finger at the decision-maker. It is prudent to ensure that there is always a sufficient reserve to pay wages and withholding taxes. Severance packages are often substantially greater than the wage! severance priority of $4,650.00 (11 USC §507(a3), resulting in preference and other problems.
When it becomes obvious that the company cannot be sold, that early investors will not put in more money, that new investors cannot be found, and that potential merger partners have said no, a wind-down business plan is necessary. Seldom does the company have the managerial expertise to wind down or liquidate a company; a turnaround consultant and a bankruptcy lawyer are very helpful. There are a number of alternatives in this process. They include:
•  Wind-down by management. This requires a good plan, an analysis of contingencies, and sufficient funds to pay creditors at least a significant portion of the debt.
•  Composition. This is similar to a Chapter 11, only it is quicker, cheaper, and without court oversight. A committee of creditors is formed; a proposal is submitted to the committee to pay a certain percentage on the debt; and a substantial portion of creditors assent to the paydown. In this scenario, the company may continue with a reduced debt burden. Sometimes, payment over time is possible through the use of a so-called "trust mortgage" held by a representative of all the creditors and secured by a security interest in all the company's assets. Compositions are not often successful, however, and many are followed by a Chapter 11, a Chapter 7 or an assignment.
•  Assignment for the Benefit of Creditors. This is an inexpensive and speedy (30 to 60 days) substitute for a liquidating bankruptcy. The assets of the company are transferred to a professional who will liquidate those assets and divide the proceeds among the creditors in the same priority as they would be distributed under the Bankruptcy Code. This is a common-law remedy and is not a bankruptcy. It has the benefit of being relatively quick and inexpensive with the result of a larger distribution being made to creditors more quickly than in a bankruptcy. Key to its success is the professional reputation of the person chosen as the assignee.
•  State Court Receivership. Roughly similar to a bankruptcy in the state court, but without the bankruptcy protections. In Massachusetts it is designed for a single creditor to make a recovery against a debtor after a judgment has been entered. It is cumbersome and not often used for a large body of creditors. In Rhode Island, however, it is very frequently used as a substitute for bankruptcy.
If none of these measures is appropriate, a bankruptcy can be filed. Bankruptcy is a federal proceeding which is easy and relatively cheap to initiate. In Chapter 7, a trustee is appointed who gathers all assets, liquidates them, and distributes the proceeds in accordance with a federal priority schedule. If the company can be reorganized, then a Chapter 11 is filed. It is expensive, and retainers for lawyers often exceed $250,000. A Chapter 11 permits the debtor to restructure its debt as long as it can get consent from the holders of 67 percent of the creditors in amount and 50 percent of the creditors in number. A Chapter 11 can also be filed to sell substantially all of the assets of the company. A so-called Section 363 sale allows the purchaser to buy some or all of the assets free and clear of all liens, claims, and encumbrances. It tends to be more expensive than a straight sale of assets, but is often necessary if the purchaser is concerned about contingent or unknown liabilities which may follow those assets. Bankruptcies take time. It often takes 12 to 24 months before any assets are distributed to creditors or a reorganization is approved. Directors have virtually no role in a Chapter 7. Their role in a Chapter 11 varies. Only major decisions go to the board, such as the reorganization plan, a sale of assets, or a liquidation.
There are less expensive and quicker sales outside of bankruptcy that may be helpful in a wind-down. If there is a secured party, such as a bank, with a lien on all assets, then the bank can foreclose and sell the assets at an auction to a third party. As long as the auction sale is conducted in a commercially reasonable manner, is at arm's length, in good faith and without collusion, the purchaser gets the same title as the bank would have as a foreclosing party. Although this procedure is more frequent in real estate transactions, it can take place in personal property transactions as well. It is also possible to use an assignment for the benefit of creditors as an alternative to a foreclosure provided the lender consents. An assignment is often used if there will be a surplus after payment to the secured creditors as it suggests a fair price for the sale and permits a quick distribution of the surplus to unsecured creditors after the bank is paid. If the debtor has valuable leasehold interests, anti-assignment clauses may preclude getting the value for those assets in a foreclosure sale or assignment for the benefit of creditors. Section 365 of the Bankruptcy Code permits the sale of those real estate assets notwithstanding an anti-assignment clauses. Insiders can buy at auction and Section 363 sales. There must be full disclosure of their insider status and these sales are closely scrutinized by courts and others to insure that they are commercially reasonable, in good faith, at arm's length and not collusive. The wind-down of a retailer to the public needs special attention to insure that consumer statutes and priorities are maintained, such as customer lists, deposits, privacy, and the like.
The foregoing is an overview of the issues which may be raised in the winddown of a business. Each business is different and generates it own set of issues, but this outline should provide a headstart in locating and resolving them.
Paul Daley is an attorney with the firm of Hale and Dorr in Boston. This information is adapted from materials from a December 2001 MBA CLE seminar, "Recent Developments in Bankruptcy Law" (BLD02).

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