DEEPENING INSOLVENCY A RESTRUCTURING LAWYER S PERSPECTIVE

Transcription

1 DEEPENING INSOLVENCY A RESTRUCTURING LAWYER S PERSPECTIVE PRESENTATION OUTLINE 1 Richard M. Cieri Ray C. Schrock Paul Wierbicki Kirkland & Ellis LLP 1 This presentation outline may be supplemented and modified by a comprehensive article, which the authors will distribute at the 2006 Southeastern Bankruptcy Law Institute Seminar.

2 1. Introduction and Background. (a) (b) (c) (d) (e) When a company is solvent, directors and officers are to take actions that are in the best interest of shareholders. During solvency, directors and officers do not owe creditors fiduciary duties and creditors only can expect the protection for which they bargained (e.g., covenants). However, as a company approaches insolvency (i.e., enters the zone of insolvency ) duties of directors and officers expand to include the interests of creditors. Not surprisingly, directors and officers of corporations that are either insolvent or within the zone of insolvency have faced greater legal scrutiny. In years past, however, it was very difficult to criticize directors and officers for taking steps to avoid filing for bankruptcy. In such an instance, lawsuits against directors and officers, brought by disgruntled shareholders, creditors committees or others on behalf of a corporation, have relied on various causes of action, including: (A) (B) (C) breach of fiduciary duties; fraudulent conveyance; and illegal dividend. These lawsuits expose directors and officers to personal liability in addition to any recovery that is available from directors and officers insurance policies, assuming such a policy is applicable. E.g., in WorldCom 10 former directors were found personally liable for $18 million. (f) The corporate, political and legal landscape has changed in the last several years, however, and parties are attempting to make it easier to sue directors and officers for avoiding bankruptcy. As a result, disgruntled parties, on behalf of a corporation, have resorted to another theory DEEPENING INSOLVENCY. In general, deepening insolvency is a claim that directors or officers took actions (or inaction) that prolonged the life of the corporation and that such action or inaction ultimately harmed the corporation and its stakeholders. In other words, these plaintiffs allege that had the directors or officers not falsely created the impression the company was solvent or otherwise taken

3 the action in question, the stakeholders would have dissolved the company when they could still salvage their investments (or more of their investments) or creditors could have involuntarily placed the company into bankruptcy before the assets had dissipated. (g) (h) Many courts have recognized deepening insolvency; however, courts have split on the question of whether to treat deepening insolvency allegations as an independent cause of action or as a damages theory. Today we ll explore the theory of deepening insolvency from a debtor lawyer s perspective, and in the course of this presentation, we ll discuss several interesting issues surrounding this theory du jour, including: (v) (vi) deepening insolvency as an independent cause of action; deepening insolvency as a damages theory; defenses to deepening insolvency; how those defenses have been overcome; whether deepening insolvency can be alleged for action or inaction after a bankruptcy filing; and how directors and officers can take actions to protect themselves from these lawsuits. 2. Significant Decisions Recognizing Deepening Insolvency as an Independent Cause of Action. (a) The leading case on deepening insolvency as an independent cause of action is Official Committee of Unsecured Creditors v. R.F. Lafferty & Co. (In re R.F. Lafferty & Co.), 267 F.3d 340 (3d Cir. 2001). In Lafferty, the defendants, including the directors and officers of the corporation and its underwriters, rendered opinions allegedly replete with multiple fraudulent misstatements and material omissions to carry out a Ponzi scheme. The creditors committee alleged that the defendants caused the corporation to incur debt out of all proportion of the corporation s ability to repay and ultimately forced the corporation to seek bankruptcy protection. The Third Circuit was called upon to determine if the alleged theory of deepening insolvency was cognizable as an independent cause of action. The Third Circuit ruled that: 3

4 where deepening insolvency damages a corporation s property, the court would provide a remedy by recognizing a cause of action for this injury. (b) The Lafferty decision noted that fraudulent and concealed debt can damage the value of a corporation in several ways. (v) To the extent that bankruptcy is not a certainty, the incurrence of debt can force a corporation in the zone of insolvency into bankruptcy. When brought on by unwieldy debt, bankruptcy creates operational limits that hurt a corporation s ability to run its business profitably. Deepening insolvency can undermine a corporation s relationships with its customers, suppliers and employees. The threat of bankruptcy, brought about through fraudulent debt, can shake the confidence of parties dealing with the corporation, thereby damaging the corporation s assets. Finally, prolonging an insolvent corporation s life through bad debt may simply cause the dissipation of corporate assets. (c) The court s holding and rationale in Lafferty were followed in another leading case establishing deepening insolvency as an independent cause of action, Official Comm. of Unsecured Creditors v. Credit Suisse First Boston (In re Exide Techs., Inc.), 299 B.R. 732 (Bankr. D. Del. 2003). (v) In Exide, various banks established a credit facility for Exide and later loaned Exide $250 million to acquire a competitor. After Exide made the acquisition, its financial condition deteriorated rapidly. As Exide s condition deteriorated, the banks amended the loan to obtain additional collateral and guarantees. As these amendments were negotiated, Exide s financial condition continued to further deteriorate. The court in Exide reasoned that, based on Lafferty, deepening insolvency was a sound theory that was attaining growing judicial acceptance and thus was a cognizable independent cause of action where there is damage to corporate property. 2 2 More recently, a Tennessee bankruptcy court followed Lafferty and Exide, recognizing deepening insolvency as an independent cause of action. See Limon v. Buerger (In re Del-Met Corp.), 322 B.R. 781 (Bankr. M.D. Tenn. 2005). 4

5 (d) (e) Although both Lafferty and Exide determined that deepening insolvency is an independent cause of action, neither defined the elements of deepening insolvency. In interpreting the decisions in Lafferty and Exide, to the extent that deepening insolvency is an independent cause of action, the elements may include: (v) an insolvent company; fraudulent or negligent incurrence of additional liability or wrongful dissipation of assets; prolongation of a corporation s life through concealment of its deteriorating financial condition; loss of substantial value that could have been realized if the corporation s existence had not been prolonged; and harm to the corporation distinct from harm suffered by its creditors. (f) (g) However, it should be noted that neither Lafferty nor Exide addressed whether deepening insolvency is viable on its own or whether the cause of action, even if independent, requires that the defendant commit some other independently recognizable predicate act (i.e., fraud, breach of fiduciary duty) that causes deepening insolvency injuries to the corporation. Further, even if deepening insolvency constitutes an independent cause of action, one should not overlook that creditors committees and other third parties may not be able to bring such an action because they lack of standing. The trustee or debtor in possession has the exclusive right to assert the debtor s claim. Because deepening insolvency alleges an injury suffered by the corporation, and not its creditors, courts have held that only the trustee or debtor in possession has standing to bring the claim. In general, a creditors committee or individual creditor lacks standing to file a deepening insolvency claim unless they obtain approval from the bankruptcy court. 3. Significant Decisions Recognizing Deepening Insolvency as a Damages Theory. (a) Not all courts have recognized deepening insolvency as an independent cause of action. Some courts that have not recognized deepening insolvency as an independent cause of action, however, have recognized it as a damages theory. 5

6 (b) Deepening insolvency was energized as a theory of damages in Schacht v. Brown, 711 F.2d 1343 (7 th Cir. 1983), the first significant case to recognize deepening insolvency. In Schacht, the Illinois Director of Insurance, acting as liquidator for an insurer/corporation, alleged and sought recovery for damages from the directors and officers of the insurer/corporation for continuing in business past the point of insolvency and systematically looting the insurer/corporation of its most profitable and least risky business all actions which aggravated the insurer/corporation s insolvency. The Seventh Circuit recognized the validity of deepening insolvency as a theory of damages, declining to follow a line of cases from other jurisdictions suggesting that a corporation might not sue to recover damages resulting from the fraudulent prolongation of its life past insolvency. The Seventh Circuit noted that that the fraudulent prolongation of a corporation s life beyond solvency is not automatically to be considered a benefit to the corporation s interests. The Seventh Circuit went on to reason that: it is critical that the insolvency of a corporation be disclosed, so that shareholders may exercise their right to dissolve the corporation and cut their losses; and the acceptance of a rule that would bar a corporation from recovering damages due to the hiding of information concerning its insolvency would create perverse incentives for wrongdoing officers and directors to conceal the true financial condition of the corporation. (c) Several courts have followed Schacht and recognized deepening insolvency as a theory of damages. 3 (d) Specifically, in Allard v. Arthur Andersen & Co. (USA), 924 F. Supp. 488 (S.D.N.Y. 1996), Arthur Andersen argued that more indebtedness could not have damaged the debtor, because indebtedness provided a benefit more capital. The court acknowledged that Andersen s argument was appealing, but rejected it. 3 See e.g., Hanover Corp. of Am. v. Beckner, 211 B.R. 849 (M.D. La. 1997); Allard v. Arthur Andersen & Co. (USA), 924 F. Supp. 488 (S.D.N.Y. 1996); Latin Inv. Corp. v. L & L Constr. Assocs., Inc., 168 B.R. 1 (Bankr. D.C. 1993). 6

7 The court observed that credit may be an illusory financial cushion that lulls shareholders into postponing the decision to dissolve a corporation before management can squander the company s remaining resources. In this situation, the infusion of capital from creditors does not necessarily benefit a distressed corporation. Thus, the court ruled that deepening the insolvency of the corporation did constitute a theory of damages and such damages were recoverable. (e) (f) Both Schacht and Allard indicate that simply prolonging an insolvent corporation s life may be enough to establish a damages remedy under the theory of deepening insolvency. The best analysis of deepening insolvency, however, can be found in the decision of Kittay v. Atl. Bank of N.Y. (In re Global Serv. Group LLC), 316 B.R. 451 (Bankr. S.D.N.Y. 2004), where the court recognized the doctrine of deepening insolvency as a damages theory on much narrower grounds. (v) (vi) In Global Services, the trustee alleged that the bank who made loans and the management who requested and accepted such loans were aware that the debtor would be unable to repay its loans due to its financial condition both the bank and management disregarded the inability of the corporation/debtor to repay the loans and the loan was completed anyway. As a result of the bank s willingness to extend credit to the debtor, other creditors extended debt to the debtor, thereby simply providing the debtor with even more debt that it was unable to repay. The trustee, in bringing suit against the bank and management, alleged that the loan allowed the debtor to prolong its corporate existence and incur increased debt that would have been avoided without the loans. Furthermore, the trustee argued that by deepening the debtor s insolvency and reducing any potential recovery for the creditors, the expansion of debt was the proximate cause of the damage to the debtor and its creditors. The court, in analyzing the trustee s arguments relied in part on the business judgment rule and held that prolonging an insolvent corporation s life, without more, will not result in liability. Rather, the court stated, to recover for deepening insolvency one must show that the defendant (e.g., management, banks or others ) prolonged the corporation s life by breaching a separate duty or committing an actionable tort that contributed to the continued operation of a corporation and its increased debt. 7

8 (vii) The court also found that causation between the alleged acts and injury were lacking in this instance. (viii) According to the court, the mere extension of credit to an insolvent entity is not a tort. It may be bad banking, but it is not a tort. (ix) (x) The court went on to say that the fiduciaries of an insolvent corporation may well conclude that the corporation should continue to operate to maximize its enterprise value, and a negligent, but good-faith decision to do so will not subject them to liability for deepening insolvency. Thus, to seek to recover damages, this court required that the complaint contain specific allegations of bad faith or fraudulent intent. 4. Defenses to Deepening Insolvency. (a) (b) Two primary defenses exist to the theory of deepening insolvency: the business judgment rule; and in pari delicto (of equal fault). The Business Judgment Rule. (v) (vi) This rule provides a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interest of the company. Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914, 927 (Del. 2003). Under this rule, directors and officers are not held liable for losses due to imprudence or honest errors of judgment, so long as the challenged corporate decision can be attributed to any rational business purpose. See id. Directors may be able to defend their business decision to continue incurring debt, rather than liquidating or filing for bankruptcy relief, by relying on the business judgment rule. This rule shields directors and officers decisions from judicial scrutiny by providing an evidentiary presumption that, in making decisions, they were informed, acted in good faith and honestly believed that their decision was in the best interests of the corporation. Under this rule, courts will not review a decision by directors even if it was a poor one, instead keeping the focus on the process of making a decision, not the decision itself. In determining whether a director or officer is entitled to the protections of the business judgment rule, courts usually examine the following factors: 8

9 (A) (B) (C) whether the director or officer made an informed decision after making a reasonable effort to inform himself of the relevant facts (i.e., due care); whether the director or officer reasonably believed that the action taken was in the best interests of the corporation and its stakeholders (i.e., good faith); and the disinterestedness of the director or officer (i.e., independence). (vii) The presumptions of the business judgment rule can be rebutted by the plaintiff, who has the burden of proof. (1) The Trust Fund Doctrine. Some courts have held that the business judgment rule does not apply to decisions made by directors and officers of corporations that are insolvent or in the zone of insolvency. These courts, that have ruled that the business judgment rule does not apply, have characterized directors and officers as being trustees of an insolvent or nearly insolvent corporation. These courts have applied a higher standard to directors and officers of insolvent or nearly insolvent corporations. See e.g., Green v. Quantum Chem. Corp., No , 1995 U.S. App. LEXIS 39912, at *3 (2d Cir. Dec. 13, 1995) (noting that under New York law, directors of a corporation become trustees of the creditors when the corporation is insolvent). The rulings in these decisions are generally described as the trust fund doctrine. Under the trust fund doctrine courts will apply a heightened level of scrutiny to the actions taken by directors and officers of an insolvent or nearly-insolvent corporation, and may hold a director or officer liable under a simple negligence standard without the benefit of the business judgment rule. See Askanase v. Fatjo, 1993 WL at *5 (S.D. Tex. 1993) (applying Delaware law and stating that the business judgment rule and other rules applicable to solvent corporations are of no effect in the context of an insolvency ). Under the trust fund doctrine, the directors or officers are tasked with preserving the capital for the benefit of creditors who are deemed to have an equity-like interest in the firm s assets. (2) Recent Support for the Business Judgment Rule. A recent influential decision, however, lends support to the notion that courts will apply the business judgment rule when scrutinizing actions of directors or officers of an insolvent or nearly insolvent corporation. 9

10 Production Resources Group, L.L.C. v. NCT Group, Inc. 863 A.2d 772 (Del. Ch. 2004). (A) (B) (C) (D) (E) (F) Here, the Delaware Chancery court held that although directors and officers of corporations in the zone of insolvency owe a fiduciary to creditors, these directors and officers must only take actions that maximize the value of the corporate enterprise. This decision also appears to reject the trust fund doctrine or other theories that argue for a heightened scrutiny of directors and officers of a corporation in the zone of insolvency. In fact, this decision held that the common shield against personal liability for violating the duty of care, Del. C. 102(b)(7), is available to directors and officers of corporation in the zone of insolvency. The court noted that the kinds of claims that could be pressed against directors and officers of an insolvent firm would be at most be coextensive with, and certainly not superior to, the claims that can be brought against directors and officers of a solvent firm. Additionally, the court mentioned that as the proportion of a firm s enterprise value that is compromised of debt increases, directors must bear that in mind in determining what business decisions to make. The court went on to say that in this context, the business judgment rule remains important and provides directors of troubled firms with the ability to make a range of good faith, prudent judgments about the risks they should undertake. Therefore, this decision persuasively reasons that it would be puzzling if the zone of insolvency expands the rights of firms to recover against their directors and officers to better protect creditors, who (as opposed to shareholders) typically have the opportunity to bargain and contract for additional protections to secure their positions. Though the recent trend suggests the business judgment rule is available to directors and officers of a corporation in the zone of insolvency, it should be noted that the Production Resources decision has not been tested in the courts, and therefore, it is possible that directors and officers may be subject to the higher standard encompassed in the trust fund doctrine. (c) Overcoming the Business Judgment Rule. Although courts give great deference to directors and officers under the business judgment rule, the presumptions of this rule can be rebutted if the plaintiff can show: 10

11 gross negligence in the decision making process; that the decision was irrational or had no business purpose; that the director or officer had a conflict of interest; or that there was fraud or illegality. In particular, the business judgment rule can be overcome if directors or officers either appear on both sides of a transaction, affecting their ability to make disinterested decisions for the best interest of the corporation and not themselves or expect to derive personal benefit from a transaction at the corporation s expense. We note, however, that merely incurring more debt even though a corporation is insolvent, is not enough to overcome the business judgment rule. Borrowing more money in the hopes of increasing investments and thereby eventually returning to profitability is within the valid business judgment of directors and officers. See In re Global Services. (d) In Pari Delicto. The doctrine of in pari delicto bars a plaintiff from asserting a claim against a defendant when the plaintiff is deemed to be at fault, even if only partially, for the injury. In other words, a plaintiff s recovery may be barred by its own wrongful conduct. Although some courts have used in pari delicto to deny standing and others have used it as an affirmative defense, in essence, under in pari delicto, if the debtor engages in conduct that causes deepening insolvency, then the trustee or creditors committee standing in the debtor s shoes cannot recover damages for such injury. In pari delicto applies when the actions of management or the directors is found to be imputed to the corporation. Such actions are imputed to the corporation if they are within the scope of employment and in the interests of the corporation. Therefore, if management s misdeeds benefit the corporation by increasing its share value, revenues or profits, the misdeeds of management would possibly be imputed to the corporation. (e) Overcoming In Pari Delicto. Those standing in the shoes of the debtors have been able to overcome in pari delicto by arguing: 11

12 (A) (B) the adverse interest exception; or the innocent successor. The adverse interest exception states that a principal is not affected by the knowledge of the agent in a transaction in which the agent secretly is acting adversely to the principal and entirely for his own or another s purposes. It should be noted that courts have been loath to apply the adverse interest exception if the agent s misdeed increased the value of or benefited the corporation. See e.g., In re Bennett Funding, 336 F.3d 94 (2d Cir. 2003) (finding that in pari delicto applied to a case where managers were engaged in fraud to boost value of the corporation); Cento, Inc. v. Seidman & Seidman, 686 F.2d 449 (7 th Cir. 1982) (finding that far-reaching fraud by management designed to increase stock price and earnings could be imputed to corporation). (v) (vi) Therefore, the adverse interest exception is applied in cases where management/directors was/were engaged in a fraud solely for its/their own benefit. See e.g., In re Mediators, Inc., 105 F.3d 822 (2d Cir. 1997); FDIC v. Ernst & Young, 967 F.2d 166 (5 th Cir. 1992). Some courts have also held that the in pari delicto defense may not be asserted against trustees or creditor s committees because they are innocent successors. See e.g., Wechsler v. Squadron, Ellenoff, Plesent & Sheinfeld LLP, 212 B.R. 34 (S.D.N.Y. 1997); In re Wedtech Corp., 88 B.R. 619 (Bankr. S.D.N.Y. 1988). The reasoning behind these holdings is that a trustee s/creditors committee s ability to recover for an estate and its innocent creditors should not be denied on account of the debtors wrongful conduct. Finally, dicta in a recent case may be construed to suggest that a public corporation should be disaggregated and that the doctrine of in pari delicto should be inapplicable when inside directors are involved in fraud but the audit committee and independent outside directors are not. See In re Agribiotech, 2005 U.S. Dist. LEXIS 6466, at *39-42 (D. Nev. 2005). 12

13 5. A Troubling Decision Recognizing Postpetition Deepening Insolvency. (a) (b) Deepening insolvency claims have focused on the conduct of directors, officers and other professionals prior to the bankruptcy filing. Recently, however, one court has recognized a claim for postpetition deepening insolvency. See In re LTV Steel Co., Inc., 333 B.R. 397 (Bankr. N.D. Ohio 2005). In LTV, the administrative claimants committee sought to bring a derivative action on behalf of the debtor against its directors and officers. The administrative claimants committee alleged that the debtor s directors and officers were aware that several months after the petition date the debtor could soon be unable to pay its postpetition debts; nevertheless, the debtor continued to incur additional trade debt, which it could not pay in full. The court granted the administrative claimants committee s motion for standing to sue derivatively. In doing so, the court noted that a growing number of jurisdictions have recognized the theory of deepening insolvency and a committee may be granted standing to pursue prepetition as well as postpetition actions. (c) (d) It remains to be seen whether other courts will agree with the LTV court that a committee may have a colorable claim for postpetition deepening insolvency, and if so, what the effects will be on a debtors directors and officers. Given that a debtor s actions for any decision made outside of the ordinary course of business are approved by a bankruptcy court, however, we believe a postpetition deepening insolvency transaction will be very difficult to prosecute even if it is recognized. Further, if this theory continues to be prosecuted, it will make it even more difficult to get qualified directors and officers to come into an insolvency situation, thus harming all stakeholders. 6. Summary of the Debate over Deepening Insolvency. (a) Some courts, particularly in the Third Circuit, have recognized that deepening insolvency can be an independent cause of action. However, these courts have failed to define the elements of deepening insolvency. Moreover, it is not clear that creditors can easily obtain proper standing to bring deepening insolvency claims since the claims belongs exclusively to the debtor and trustee. 13

14 (b) Other courts, though not recognizing deepening insolvency as an independent cause of action, have recognized it as a theory of damages. It appears that certain courts have held that simply prolonging an insolvent corporation s life through the incurrence of increased debt may be enough to recover damages. See e.g., Schacht and Allard. However, a recent court decision has questioned this assertion and held that prolonging an insolvent corporation s life without more is not enough to recover deepening insolvency damages. See Global Serv. According to Global Serv., the directors and officers or other defendants must have sought and incurred loans on behalf of the corporation/debtor, which not only prolonged its life, but also were sought and incurred in bad faith. The Global Serv. decision makes it difficult to determine how deepening insolvency damages differ from damages that could be recovered for breach of fiduciary duty or fraud on the part of directors and officers. (c) Deepening Insolvency Should Be Considered a Damages Theory. (v) (vi) We agree with courts and commentators that have found deepening insolvency is, at best, a theory of damages and that breaching a separate duty must be found to pursue the theory of deepening insolvency. First, a complete panoply of actions already exists to hold directors and officers to comply with their duties. Second, deepening insolvency lacks the definition of elements essential to give it life as an independent cause of action. See Rebecca Lamberth, Deepening Insolvency and Lawyer Liability, (2005). Third, as Global Services recognized, there is no absolute duty to liquidate a company. Instead, managers, in their business judgment, may decide that incurring debt is in the best interests of the company s stakeholders. Accordingly, one primary underpinning for finding an independent cause of action fails to exist. Fourth, without requiring breach of a separate duty, banks could be held liable for extending credit to insolvent companies. This could lead to an absurd result because, if this were the case, most insolvent companies would be forced to liquidate. Finally, however, the distinction between an independent cause of action and a damages theory is, in most circumstances, a needless argument. This is because this alleged tort, without more definition, adds nothing to the panoply of well-established torts. 14

15 (d) Certain defenses (i.e., in pari delicto and the business judgment rule) against deepening insolvency exist that have proven difficult for trustees and creditors committees to overcome. 7. Potential Effect of Deepening Insolvency Actions. (a) (b) (c) (d) Regardless of whether deepening insolvency is an independent cause of action or a theory of damages, it is a growing litigation risk for directors and officers and lenders. This trend toward litigation carries with it an unfortunate corollary lenders may be reluctant to support a distressed company other than as a post-bankruptcy lender if doing so could be an invitation to litigation. Moreover, directors and officers may be reluctant to make good-faith efforts to explore alternatives that avoid the significant costs, uncertainty and disruption of a bankruptcy if they may be affected by the shadow of potential future claims if a bankruptcy should become unavoidable. Ironically, a tactic intended to enhance creditor recoveries may have the opposite effect by forcing earlier (and perhaps premature) bankruptcy filings and creating an environment that results in fewer out-of-court restructurings. 8. Actions Leading to Successful Deepening Insolvency Claims. (a) Courts have found a variety of actions by directors and officers that support deepening insolvency liability. Directors and officers should avoid these actions. Specifically courts have found validity to deepening insolvency claims where: management failed to accurately disclose financial information and directly injured the corporation (i.e., by self-dealing, looting or dissipating assets of the corporation); management solely failed to disclose the true financial condition of the corporation; there is bad faith or fraudulent intent on the part of the directors and/or officers; or an audit was inadequate by failing to uncover material transactions and lack of internal controls. 9. How Directors and Officers Can Best Protect Themselves. (a) Comply with Fiduciary Duties. When a corporation comes close to entering the zone of insolvency, directors and officers must monitor their corporation s financial position 15

16 very closely to determine whether it is operating within the zone of insolvency. Directors and officers should assess the fair value of the corporation s assets and liabilities conservatively and assume the corporation is insolvent. Upon proceeding on the assumption that the corporation is in the zone of insolvency, directors and officers should approach every corporate decision with the objective of enhancing the wealth generating ability of the corporation. Moreover, directors and officers should assume they will not be able to take advantage of the business judgment rule and that they will have to defend the intrinsic or entire fairness of their decisions. (b) Avoid Conflicts of Interest. When the corporation enters the zone of insolvency, directors and officers must put the interests of the corporation, its shareholders and creditors, above personal interests possessed by a director or officer or controlling shareholder. For example, a transaction in which a director appears on both sides of a transaction or in which a director receives a personal benefit that is not received by shareholders generally is considered to involve a conflict of interest and should be avoided. (c) Avoid Preferential Treatment to Insiders. Directors and officers must act in the best interests of the corporation and its shareholders and creditors, when within the zone of insolvency. Accordingly, directors and officers should avoid preferential treatment of other insiders, favored shareholders or any other discrete creditor or corporate constituency. In addition, and most notably, directors should not accept personal benefits for supporting a particular transaction. Tread carefully as this is a ripe area for the courts to find deepening insolvency issues. (d) Fully Disclose the Material Aspects of a Transaction. Directors and officers should endeavor to fully disclose all material aspects of a transaction to independent directors. 16

17 For example, a director should disclose: (A) (B) (C) all of his or her relationships with any principals in the transaction; all of the director s contacts with interested third parties; and all analyses or studies that suggest that the transaction will result in a benefit to the director or officer. (e) Base All Corporate Decisions on Sufficient Information and Deliberation. Management must act in an informed and considered manner. Accordingly, prior to making a business decision, the directors should inform themselves of all material information reasonably available to them. This may include reports, studies or other informational materials prepared by outside professionals or employees of the corporation. (f) Maintain Corporate Records Documenting Compliance with Fiduciary Duties and Corporate Formalities. Deliberation, analysis and information are vital to satisfying directors and officers fiduciary duties. The lack of any of these elements may result in personal liability for the directors and officers. Importantly, because courts are willing to view transactions, including the incurrence of debt, with perfect hindsight, directors and officers must: Always keep the possibility of judicial review in the back of their minds when making decisions. Accordingly, directors should maintain detailed and accurate corporate records documenting compliance with their fiduciary duties and adherence to corporate formalities. (A) (B) (C) In the past, it was common for minutes of the corporate board meetings to be short and not detailed. Minutes of a meeting would merely note that a specific action was approved, without describing the directors deliberations. Because of heightened scrutiny, including the possibility of deepening insolvency, that directors are facing with regard to their 17

18 corporate stewardship, failing to keep reasonably detailed records of events in the boardroom is unwise. (D) Minutes of board and committee meetings should contain a description of each significant item discussed by the directors, including: (1) a summary of the topics discussed; (2) the material issues presented on each topic discussed; and (3) the major factors taken into account or relied upon in reaching a decision on each topic discussed. (E) In sum, the minutes should provide sufficient detail to clearly reflect what transpired in the meeting. (g) Hire an Expert to Draft Minutes of the Board Meetings. The reason this may be advisable is that the minutes may eventually be closely examined by plaintiffs or judges who are questioning the propriety of actions taken. The board could also require committee chairpersons to sign the minutes of each committee meeting, because it would make them think twice about approving and signing off on any action that is not in the best interests of the corporation s stakeholders. (h) Take Advantage of Safe Harbor Provisions. Some state laws provide directors and officers with a safe harbor that insulates them from liability with regard to a particular type of decision or action. For example and notably, in Delaware, directors are protected from liability for certain actions if they in good-faith rely on: (A) (B) (C) records of the corporation; information, opinions, reports or statements presented to the corporation by its officers or employees or committees of the board of directors; or information, opinions, reports or statements presented to the corporation by any other person as to matters the directors reasonably believe are within such person s professional or expert competence. 18

19 Directors and officers should also ensure that any decisions are made only after appropriate deliberation and consideration of all material information reasonably available to them. Beware of Fraudulent Transfers and Preference Liability. Most states have adopted the Uniform Fraudulent Conveyance Act or the Uniform Fraudulent Transfer Act. Under these statutes, creditors can assert fraudulent transfer claims against a corporation and its directors and officers. Avoid transactions which delay, hinder or defraud creditors. Hire professional experts to determine if the proposed transaction will subject the corporation to liability for fraudulent transfer under either the Uniform Fraudulent Conveyance Act or the Uniform Fraudulent Transfer Act. (j) Continue to Comply with Applicable Statutes and Regulations. As a corporation encounters financial problems, directors and officers may consider improving its short-term liquidity position by temporarily ceasing to comply with certain laws or government regulations. For instance, a corporation may delay paying trade creditors, taxes or taking steps necessary to comply with labor, employment or other regulations. Courts, however, may view such actions as disregarding the best interests of the stakeholders of the corporation and additional evidence that the directors and officers of an insolvent corporation prolonged its life to benefit them. (k) Make Certain that Directors and Officers have D&O Insurance to Cover the Costs and Settlement of Any Potential Litigation. Carefully review the corporation s D&O insurance policies to ensure that directors and officers are covered if the corporation files for bankruptcy. Consult experts if necessary. If necessary, consider drop-down insurance or alternative D&O insurance to ensure coverage in case directors and officers are denied coverage for any reason under the primary D&O insurance plan. 19

20 10. Conclusion. (a) Although the courts have not conclusively determined whether deepening insolvency is an independent cause of action or a theory of damages, what is clear is that creditors have and will continue to use deepening insolvency as one of many litigation tactics against directors and officers of distressed companies. 20